A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.
If that old saying – often attributed to Mark Twain – holds true, there’s a risk that companies in the oil and gas industry are going to get wet.
It is four weeks since that fateful Monday – March 9 – when the Brent crude price nosedived by more than 30% at the start of trading – its sharpest drop since the Gulf War in 1991.
The rout – breathtaking in its speed – was triggered by the collapse of a production capping agreement between Russia and Saudi Arabia and the Covid-19 outbreak’s chokehold on demand.
Since then, a host of oil majors have reined in their spending plans, in many cases by more than 25%, in a bid to weather this “perfect storm”.
Some of the likely consequences include the deferral of projects, acquisitions and IPOs and the early termination of rig contracts.
Decommissioning will also come into focus if EnQuest’s decision to call time on the Thistle and Heather fields are signs of things to come.
Respected research consultancies have made hair-raising predictions about the supply chain, including the demise of 200 oilfield service companies in the UK and Norway and a million job losses worldwide.
Words like “brutal” and “bloodbath” have been used, though one highly-regarded analyst did offer hope when saying “all is not lost” for the North Sea, “yet”. That’s about as good as it gets.
Amid this ordeal came an announcement from Delek Group, the Israeli-headquartered owner of Ithaca Energy, to say it had been granted a temporary injunction against a lender – identified as Citibank by Israeli media – who demanded the immediate repayment of a £46 million loan.
How bad an omen is Delek’s predicament for the wider oil industry?
Andy Hartree, senior adviser at consultancy Gneiss Energy, warned some companies will fail in the current climate.
“There will be those who default on their debt,” Hartree said. “The banks will say ‘there’s no less rainy day to wait for’ and companies will go bust.”
Borrowers face two key problems, said Hartree, a market risk management expert who built up RBS’s commodity derivatives business.
The first is a shutting off of the taps to any additional lending.
Hartree said: “The first thing that tends to happen when the oil price crashes through the floor is that the financing communities, led by the banks, say ‘stop’.
“They won’t sanction any new loans or facilities and any deals that were being worked on will be put on hold.
“That’s not unreasonable when there’s been a shift like this one. None of the previous episodes like Sars had anything like the calamitous impact we’re seeing with Covid-19.
“And could you have guessed that Saudi Arabia and Russia would fall out at some stage? It was bound to happen at some point, but the fact it happened at that time and so dramatically was less foreseeable.”
The second big problem lies in hedging, intended to protect a firm’s debt capacity – its ability to repay a loan within a specified period.
Hartree, whose grounding in risk management started in his days at Shell, said hedging often “doesn’t do its job properly” because of the way it is applied.
Borrowers do not want to hedge 100% of their production, because they are in the business for the upside, he said.
Lenders, meanwhile, don’t offer or impose hedging for periods as long as five-plus years, because they’re often not sure the production is still going to be there, but more crucially, don’t understand the importance of long-term value support in protecting debt capacity.
A bank may impose hedging on 75% of production in the first year, 50% in the second and 25% in the third, for example.
Once the first year has ended, the 75% hedge is “history”. The borrower is down to two more years, with only 50% and 25% of output protected.
At that point, they may want an extension, but if the price has fallen sharply since the initial arrangement, they can only do so at the “dreadful” new price.
It means the banking industry does not protect itself and its clients very well, lamented Hartree, former head of commodity market solutions at Lloyds Bank. Industry sets itself up for a fall.
So, at a glance, how well hedged are certain companies?
Ithaca, whose debt facilities consist of a £1.33 billion ($1.65bn) reserve-based lending facility plus £400m senior unsecured notes, has almost 80% of 2020 oil production hedged at $64 per barrel. Combined oil and gas hedging covers more than 70% of forecast production in 2020 and in excess of 50% in 2021.
Fitch Ratings said Ithaca was “well positioned to survive the oil price shock, if it turns out to be short lived, given its flexible capex and well-hedged position for 2020-21”.
But that didn’t stop Fitch downgrading Ithaca and placing the company on “rating watch negative”, reflecting the “potential pressure” it may face due to “liquidity issues” experienced by Delek.
Returning to Delek, Hartree said Citibank’s calling-in of its loans was “somewhat draconian” and that “we’re probably not seeing the whole story”.
EnQuest, which had debt of £1.1 bn ($1.36bn) at the end of February, has hedged 20% of 2020 production at $65 per barrel.
The company said last month it retained “significant liquidity” with cash and available facilities of £215m ($268m) and had no additional repayments of its senior credit facility due in 2020, with the facility maturing in October 2021.
But RBC Europe downgraded EnQuest to underperform and warned that the firm’s financial obligations “exceeded the value of its tangible assets” at current crude prices.
More promisingly, RBC believes there are deals to be struck between the company and its lenders, but said it sees “little appeal” in EnQuest for equity investors.
Premier Oil – which is trying to buy £660m of North Sea assets from BP and Dana Petroleum, despite having debts of £1.59bn ($1.99bn) – has 40% of its first-half production hedged at $64 per barrel this year and 14% of second half output at $63.
The company has been hounded by its largest creditor, ARCM, which is trying to derail the deals with BP and Dana.
ARCM said last month that Premier would soon run out of money, with prices below $40 per barrel.
Premier responded by saying it had “significant liquidity” in the shape of £107m in unrestricted cash and £263.5m in undrawn loans. The London-listed firm also believes it can cut £80m from its 2020 investment budget.
Hartree said: “I know Premier Oil’s share price is under severe pressure because the company is saddled with debt.
“But you cannot say that however difficult life has been made, Premier Oil’s banks haven’t expended an enormous amount of effort to keep them alive.”
Hartree said it is in the interest of the banks not to call in their loans.
“If they actually say ‘you defaulted on your loan, we’re calling it in, you haven’t got any money and your company isn’t worth anything so we’re not going to get any money back’, then they are only volunteering to crystallise a loss,” he said.
“They may ultimately face one anyway, but most lenders will be thinking ‘how can we get this through to a less rainy day?’”
Hartree did warn that the current environment would drive some banks out of the upstream industry: “They might not necessarily be replaced by newcomers, because with the oil price we have now, there is not a lot of hay to be made.”
Beware borrowing base reviews
John Kennedy, partner in Burness Paull’s banking team, thinks it is unlikely that lenders will look to call in loans more quickly in most cases, at least in the short term.
Kennedy said the reserve-based lending (RBL) market, for example, had been very liquid in recent years and that many producers had been building up cash reserves and cutting their debts.
But he said the crude price slump had created “perfect storm” conditions that were likely to put short term pressure on an “otherwise healthy situation”.
He said borrowers might be concerned that lenders will look at their loan documentation to consider if current headwinds may leave them in default.
But many will still be hoping current crude prices will not persist too long and hedging should protect enough cashflow for debts to be serviced, for a time at least.
It’s true that almost every RBL has a clause which would let the lender call a default if there is a material adverse change (MAC) in the borrower’s position.
But it is extremely rare for a lender to rely on an MAC clause alone to accelerate debt.
MACs are always heavily negotiated and if a lender imposes one incorrectly, it will be in breach of contract.
Kennedy did sound a couple of notes of caution.
Every six months, lenders reassess and reset the “borrowing base” amount – the projected value of oil and gas revenues from projects – which determines how much a client can borrow.
If they think the borrowing base amount has gone down significantly, they might try to bring forward a reduction in the amount
The situation could be exacerbated if the latest downturn decimates the supply chain and production takes a hit as a result.