An overriding theme for U.S. high yield energy companies in the current oil price environment is having sufficient financial liquidity (cash, bank credit, etc.) to cover their obligations as earnings come under pressure due to low oil prices. Maintaining liquidity until oil prices recover will be paramount for energy companies to survive, even for those names that aren’t especially levered. It is likely that most energy-related companies will see a marked increase in financial leverage (and subsequently financial risk) over the coming months due to the depressed oil price environment.
A key source of liquidity for these companies is via their asset-backed bank credit facilities (or more specifically, reserved based lines or RBLs, which are tied to an individual company’s proved reserves, mostly oil and natural gas). These RBLs are often covenanted and most are revalued every six months by the bank group providing the RBL. Obviously lower oil prices means the value of most companies’ reserves have declined and RBLs will be adjusted accordingly, affecting credit availability.
The revaluation of RBLs will be kicking off soon, plus many Exploration & Production (E&P) companies are expected to test their covenant levels even if there is a modest recovery in oil prices. It is our belief that most bank groups will be supportive during the spring review season. Furthermore, we believe most companies will have success obtaining covenant relief as banks are keen to give their clients ample runway to navigate the current commodity price environment.
Last week, U.S. E&P company EXCO Resources, announced that it was granted covenant relief from its bank group in exchange for a c.20% reduction in its RBL. EXCO’s bank group lowered the company’s borrowing base to $725 million from $900 million. The revised agreement also removed the existing total leverage ratio covenant (essentially a cap on total financial leverage imposed by the bank group) until Q4 2016 when it will be re-instated at 6.0x debt-to-EBITDA (a measure of a company’s indebtedness compared to its earnings) with this level gradually decreasing to 4.5x by Q1 2018.
The banks were not entirely altruistic as the revised facility added a senior secured leverage covenant of 2.5x (limiting the amount of leverage allowed where the banks are positioned in the capital structure) and an interest coverage ratio of 2.0x to still ensure the banks have an avenue to re-negotiate the RBL should circumstances deteriorate materially worse-than-expected.
This is encouraging news as it supports our thesis that banks will be supportive of their E&P clients, especially since EXCO was not a distressed or massively over-levered company (relatively speaking) – EXCO’s net leverage as at Q3 2014 was c.3.5x debt-to-EBITDA, but it was widely anticipated that this leverage measure would go much higher in 2015 at current oil prices. The 20% reduction in the RBL is also consistent with our expectations that most companies will see moderate but manageable RBL reductions. It does not mean the company is in the clear as the operating environment is still extremely challenging, but the relaxing of the covenant gives the company some breathing room to navigate with less worry about breaching covenants or running out of liquidity in the near-term. The market has reacted positively to the news as EXCO’s 2018 USD bond is trading up 7 points (it was trading at 68 prior to the announcement).
While not necessarily a precedent (other more-distressed companies have successfully renegotiated their covenants), the EXCO news is encouraging as it demonstrates bank group support for the sector as we expect similar circumstances with numerous U.S. high yield E&P companies over the coming weeks and months. With a number of high yield energy bonds trading between 60 and 90, there is value to be had and opportunities to invest in the sector as long as one can understand and identify those companies with sufficient liquidity and/or those likely to be supported by their bank groups.