The mining sector was forced to be creative when commodities declined a few years ago. Now it is the oil companies’ turn
If oil prices remain low into 2016, some of Canada’s oil and gas companies may start looking to their brethren in the mining industry for guidance. It’s a notion that would make any self-respecting oilman grind his teeth, but Canada’s miners know a thing or two about how to ride out a tough time for a long time.
While they have been scrambling to keep the wolf from the door for years, the sharp tumble in oil prices that started in late 2014 has been spreading that particular brand of pain to a wider swathe of companies in the resource sector.
But from gold to gas, cash is king. Trying to generate it and trying to hang on to it have become a major preoccupation.
Some companies have been trying to offload non-core assets to shore up their balance sheet, only they are not seeing eye-to-eye with potential buyers over valuation, making such sales unexpectedly problematic.
It has resulted in what John Cuthbertson, an energy practitioner at Burnet, Duckworth & Palmer LLP in Calgary, calls “deal paralysis. It’s due to an expectation gap. One side thinks that with time the pricing will be even better while the other side, the distressed company, feels that this is the bottom and they don’t want to transact at such a huge discount. They think they’ll be getting skinned.”
US private-equity firms like Kohlberg Kravis Roberts & Co. (KKR) and Apollo Global Management have built up large war chests and are said to be among those prowling Canada’s battered resource sector for deals. But the volume of transactions being completed is more of a thin trickle than a gush.
“There’s been a lot of interest from US private equity but it seems to be very difficult to get deals done,” says John Turner, leader of the global mining group at Fasken Martineau DuMoulin LLP in Toronto. “That’s a big part of the distressed deal story.”
Boards facing dwindling reserves of cash have been getting more aggressive in their approach, he says, resulting in increasingly creative attempts to raise capital.
“I’ve seen some term sheets that are a little bit new and strange, to me, in terms of the way people are trying to package assets. We’re seeing variations on streaming and other royalty arrangements. People are looking at new products that may have an artificial component – it could be a security of a particular issuer but it becomes a call on the underlying commodity price – people are trying to be innovative that way.
“I haven’t seen many of these kinds of deals done, and there is a certain amount of skepticism that they’re in the company’s interest. They’re probably not a preferred route but it’s a situation where some companies are a little bit desperate given how long the downturn has gone on.”
The problems being experienced across most of the resource sector are potentially fatal for thousands of Canada’s junior miners, many of which are single-product, single-mine plays, says Gordon Chambers, a partner at Cassels Brock & Blackwell LLP in Vancouver.
“A lot of them are just putting the company on ice and hoping they can survive and pay their listing fees until things pick up. You spend no money on the project and lay everybody off. At the junior end of the market, that’s just endemic, most of them are just running on fumes.
“The juniors never had any cash flow so why would anyone lend them money? They’ve got no money to service their debt. That’s why they’re restricted to equity because their business model doesn’t involve the generation of cash — it’s finding something and selling it off to someone who will actually build something. That’s what’s so interesting about Canada, we have more junior mining companies than anyone else in the world and they’re all entirely equity financed.”
If commodities prices don’t start to bounce up again in 2015, an increasing number will be forced into distress sales, Chambers predicts. “I think there’s a lot more of that kind of M&A activity to come, picking up a company that’s been hanging on and hanging on. That is one response to distress, finally someone comes in and takes me out of my misery.”
Yet maybe not.
Putting the company up for sale, even for a producer willing to give a bit on the valuation, is not always a viable exit strategy. Cline Mining Corp., a metallurgical coal producer, is one of those that found that out the hard way.
Coal prices were down so long that Cline suspended production at its key mine in Colorado to conserve cash while it pursued strategic alternatives, says Jay Swartz, a partner at Davies Ward Phillips & Vineberg LLP in Toronto.
“The bondholders tried to sell it, couldn’t sell it, and were continuing to incur costs just to maintain the thing in a mothball state,” says Swartz, whose firm acted for them.
“They finally did a plan of arrangement where they paid a bit to the unsecured creditors and some others, and took over 100 per cent ownership of the mine. They recapitalized it and they’re just going to sit on it until the world changes. I think that’s typical of a lot of things that are happening in this climate.”
When it comes to restructuring, oil and gas is the sector to watch, says Chambers. Companies tend to have much larger capital expenses than miners and debt is a common part of the capital structure.
“In Canada, people have been saying the sky is falling in the mining sector for the last five years, whereas it’s been more like five months in the oil and gas space. They’re earlier in the cycle, but it’s going to happen. So I think the oil and gas space is the one to watch, that’s where the interesting games will be played.”
Companies in Canada’s oil patch are fundamentally different from their US counterparts in one very important way: They are famously debt averse.
People still talk about the lessons learned from Dome Petroleum, which grew by acquisition to become the country’s largest independent. A bloated Dome sank on debt when world oil prices plunged in 1986, and one of Canada’s former crown jewels ended up being sold off to Amoco Corp.
That conservatism means the normal leverage for oil and gas companies is two times debt to cash flow, unlike in the United States where the leverage can run at six or seven times. And Canadian explorers and producers tend to get their financing from banks or banking syndicates, which don’t typically sell debt to third parties for their own balance-sheet purposes. They’re more likely to restructure the company or extend and pretend on the loan.
Bank cooperation comes at a price, says John Sabine, counsel in the Toronto office of Bennett Jones LLP. And the price can be steep. “In exchange for an extension of your debt or waiver of a covenant breach they’re charging more fees and piling it on to the debt. So you can end up with a huge pile of debt with your banker sitting there.”
Sabine uses the example of a company with a $100-million debt obligation with a number of tests and a stipulation that the company is in default if it misses a deadline.
“Once you go into default, the banks are sitting there and saying: ‘Okay, for an additional $10 million that you need to extend your operations, we’ll charge you a fee of $5 million.’ So now your loan goes from $100 million to $115 million,” he says. “To stay in business, you pretty much have to do it.
“And if you don’t make the next 60-day requirement and you have to extend again, the bank will give you another $10 million to keep your operation but there are fees and charges. And all of a sudden instead of being $100 million, the debt is $130 million. So the equity gets squeezed out.”
To avoid going offside on debt repayments, an increasing number of companies are turning to joint-venture partners, says Sabine, adding that strategy, too, can sometimes be a bit like doing a deal with the devil.
“If you’re sitting there and you’ve got a really good prospective piece of ground, you can negotiate a joint venture where you step back and for them incurring the ongoing obligations up to the amount you already spent, they earn in.
“The problem is that most people have to pick financially strong and viable partners. The partners have full access to all the resources, all the background, all the data. If the company has to raise additional money and can’t do it, then the partner becomes the acquirer.
“Amongst our client base that’s something people get concerned about now. If prices in the commodity continue to fall they could find themselves not the partner in the project, but being swallowed.”
It’s not just juniors and mid-sized companies feeling the pinch of slumping commodities prices. Even the majors and super-majors are feeling some heat.
Cenovus Energy Inc., one of Canada’s largest integrated oil companies, announced in February it was doing a C$1.5-billion bought-deal share offering to fund its 2015 capital expenditure program. By that point Cenovus had already cut 800 jobs, scaled back its CAPEX program, shelved some expansion plans, and had been trying to sell or spin off some of its royalty-free properties to shore up its balance sheet.
The financing was considered telling about the kinds of pressure even the large resource companies have been facing — it is estimated many of Canada’s landlocked producers need oil at $70 a barrel or more and need north of $90 a barrel to be guaranteed a profit.
Some large upstream and integrated producers are reportedly looking at selling off mid-stream assets to raise cash.
“In Canada, our oil and gas industry has a lot more of the upstream players owning mid-stream assets,” says Craig Hoskins, a partner at Norton Rose Fulbright Canada LLP in Calgary. “It’s much more common than in the United States, where they are really two distinct industries.
“You have to wonder whether, to come up with creative financing means at a time oil prices are low and capital markets are closed off, we’ll see more of the Canadian upstream players deciding to go this route.”
Giant Encana Corp. became one of the first to sell some midstream assets to generate cash, selling 500 kilometers of pipeline and compression facilities in British Columbia to Veresen Midstream, a new partnership between midstream Calgary-based provider Veresen Inc. and KKR.
The new partnership agreed to invest up to $5 billion Canadian to support mid-stream development in the Montney basin – one of North America’s hottest energy plays – under the 30-year fee-for-service arrangement.
Alicia Quesnel, an M&A and energy practitioner at Burnet, Duckworth & Palmer LLP in Calgary, believes the sale is on the cusp of an emerging trend. In structuring it with a taker-pay obligation over a long term, she says, “the company gets the benefit of cash from the sale but they still have access to the facility they previously owned.
“Typically mid-stream businesses are not growth businesses. It’s a little more like a utility where you know you’re going to get a steady distribution over the life of the facility.”
Chip Johnston, a partner at Stikeman Elliott LLP in Calgary, is not so sure there will be a rush of sales. “People love midstream because it’s a play on energy without commodities. Capital is very keen on the kind of yield it offers but part of the dynamic in the Canadian industry is owners are not keen to give up control of their destiny. Those are big issues for a company in terms of what they can sell and at what price. So those assets will get looked at and folks have started to do very interesting things around that.
“The challenge in Canadian business is transportation has always been tough, and I think it breeds a certain conservatism to giving up those assets. The Americans have a somewhat more wide open transportation system, fundamentally they can sell into lots of markets we can’t, and I think they’re probably ahead of us in terms of thinking about how to monetize and manage those assets.”
There’s nothing like a battered balance sheet to light a fire.
Sandra Rubin is a freelance legal affairs writer.