By: Chris Mathews – Houston Business Journal – For at least the past decade, oil and gas companies in Houston and Texas at large have made billions of dollars from the shale boom and fracking advances. But even amid historic U.S. onshore production growth, banks and investors are pulling away from the oil and gas industry because they haven’t generated strong returns on their investments.
The Shale Boom and Shifting Investor Expectations
With technological breakthroughs in hydraulic fracturing, or fracking, producers were better able to extract resources from the tight rock formations in the Eagle Ford Shale and the Permian Basin.
Texas is largely driving U.S. oil and gas production growth. According to a U.S. crude supply forecast from Houston-based energy investment banking firm Tudor, Pickering, Holt & Co., Texas operations in the Eagle Ford Shale and Permian Basin will drive production growth in the U.S. for years to come.
To attain that production growth, producers had worked to grow their operations almost at any cost. That meant investing back into the company — purchasing acreage and wells, investing in technology to more efficiently extract resources from the earth, building the company workforce. Between 2010 and 2015, the Houston metro area added an average of 145,000 people each year, according to a Kinder Institute analysis of U.S. Census Bureau data.
That also meant taking on oodles of debt from traditional investors, like banks and shareholders. But with oil prices skyrocketing upwards and Texas oil and gas companies seeing serious production growth, these investments seemed sound.
Then in 2014, oil prices began to drop rapidly. Oil prices fell by 75 percent, the rig count dropped by 80 percent and exploration budgets were cut by 62 percent, according to the Greater Houston Partnership. One in every four energy jobs in the Bayou City was lost during the oil downturn of 2014 and 2015.
Since the oil downturn, the energy industry has seen numerous bankruptcies, mergers and acquisitions as firms attempt to reorganize their capital structures. In what has been a relatively recent shift, energy investors have started to push back against producers spending at any cost. Lance Loeffler, CFO of Houston-based oil field services giant Halliburton Co. (NYSE: HAL), said that for Halliburton, the investor mindset shift came about halfway through 2018.
“Producers were going back to the same pace in terms of the fervor to spend, in terms of capital allocation, and the investor community effectively said, ‘Slow down,’” Loeffler told the HBJ. “I think what they said was, ‘We don’t like it when we see you outspending your capital budget.’”
Instead of growth at any cost, energy investors are now placing an emphasis on free cash flow and generating returns on their investments.
“From an oil and gas perspective up and down the oil chain, that is a very different mentality than what they have been accustomed to in many, many cycles — going back as far as I can remember,” Loeffler said.
Bottom of the Cycle
Bobby Tudor, chairman of Tudor, Pickering, Holt & Co., said that the low price of oil is largely contributing to souring outlooks from energy investors. With West Texas Intermediate (WTI) prices hovering around the mid $50s and natural gas prices hovering around $2.50, very few companies can actually generate free cash flow, Tudor said.
“Fundamentally, investors have ceased to believe in a rising commodity price,” Tudor said. “If investors feel like they’re not going to get any help from a rising commodity price, and the companies are not able to generate free cash flow, then they just don’t see a compelling investment case.”
Looking at the data, it’s plain to see why energy firms have drawn the ire of their investors. If you had invested $100 in the S&P 500 on Jan. 1, 2010, its current value would be $267, according to a Tudor, Pickering, Holt & Co. analysis of FactSet data. If you had invested $100 in an energy sector index on Jan. 1, 2010, its current value would be $102.
“[The investors] have lost money in the space for a long time now, and they’re kind of sending the message that they’re not willing to lose more,” Tudor said.
The closing of doors by the bank debt market and the high yield market has opened a door for another financing group — private equity. While banks tend to shy away from risky loan investments, private equity is all about high risk, high reward.
“Whether it’s a public investor or private investor, they’re looking for a higher return — so they’re willing to take and underwrite more risk to get that return,” said Colt Luedde, managing director of Houston-based investment banking firm GulfStar Group. “You would expect that [private equity] would do things that a bank wouldn’t do.”
Due to their risk appetite, there is still private equity interest in the energy sector, but it’s not as robust as it was previously, Tudor said. He said that private equity funds raising money to put into energy equities are having a hard time nabbing investments.
“I think the hole that private equity is filling now is primarily on the credit side — less on the equity side,” Tudor said. “That’s where specialty lenders and hedge funds and others have stepped in.”
Outside of receiving investments through banks, investors and private equity groups, energy companies are consolidating in order to better their capital structures. Houston-based Occidental Petroleum Corp. (NYSE: OXY) acquired The Woodlands-based Anadarko Petroleum Corp. in a megadeal valued at $55 billion, including the assumption of debt.
The consolidations have trickled down the oil chain — Houston-based oil field services firm Baker Hughes merged with General Electric Co.’s oil and gas business in July 2017, creating a $32 billion enterprise. However the marriage between the two firms fell apart — GE announced plans to separate from Baker Hughes in June 2018 after less than a year together.
If a company struggling with its capital structure can’t receive an investment to pay off its debt and can’t find a buyer, filing for Chapter 11 bankruptcy protection is an option — but one that obviously comes with its own detrimental costs to a business. There have been 50 bankruptcies across the oil and gas upstream, services and midstream spaces in the first three quarters of the year, according to data from Haynes and Boone LLP’s bankruptcy report. That’s up from 35 during the same period of 2018.
Of the 2019 bankruptcies, 19 filed in the Southern District of Texas, whose bankruptcy court is based in Houston. That’s up from the 16 filed in the district in 2018. The shift from 2018 to 2019 in the city is more marked when the size of the bankruptcies is taken into account — companies brought $17.98 billion in debt to the Houston court in 2019, up from $9.4 billion in 2018, according to the Haynes and Boone data.
Brian Matlock, leader of accounting and advisory firm BKD’s national energy and natural resources practice, has consulted energy companies of all sizes on their capital structures. Apart from filing for Chapter 11, merging, cutting costs or selling, avenues are limited for companies looking to correct course.
“It’s a tough situation,” Matlock said. “The reality is there’s not a lot of options out there.”
Pushing for Stability
Amid the current financing landscape in oil and gas and shifting investor expectations from Wall Street, Tudor expects to see further bankruptcy filings and consolidation in the sector.
“The practical effect of that is that there are a lot of private companies that are going to get smushed together,” Tudor said on a Houston Business Journal panel. “There will be bankruptcies, and some companies will just be dissolved and will go away.”
Loeffler said that driving returns and free cash flow continues to be the mission for Halliburton. But with the low price of oil right now, he notes that it will be hard to please everyone.
“Ultimately with the WTI price we’re at today, it may mean there’s not enough dollars in that barrel to be split to keep both operators shareholders happy and oil field service shareholders happy,” Loeffler said.
While companies can work to better their own internal capital structures, the entire industry is waiting on the commodity prices to climb up again. Oil and gas is a cyclical business — and Houston has seen these highs and lows before. But it will take pricing stability and an emphasis on generating returns for investors for traditional investors to get back into the fray.
“The business is not in free fall — it’s not fundamentally sick. Nor is it healthy and growing,” Tudor said. “So really for the business to grow and be healthy and generate cash flow and have employment growth, we need an oil price that’s higher than what we have — and I would pick $10 or so higher.”