Energy has joined mining in its need for creative dealmaking in a challenging environment
Executives in Canada’s oil patch, who have long looked to the lessons learned from Dome Petroleum in the 1980s, are considering a different source for guidance these days: Charles Darwin.
Thousands of the country’s junior miners have been locked in a life-or-death struggle for survival for years. But the sharp drop in oil prices just before Christmas has expanded the fight for survival to the smaller explorers and producers in the oil and gas sector as well as the companies that service them. Many have been left unexpectedly vulnerable with US$100/barrel oil stripped away.
“In Canada people have been saying the sky is falling in the mining sector for the last five years,” says Gordon Chambers of Cassels Brock & Blackwell LLP in Vancouver, but “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. I think the oil and gas space is the one to watch.”
You might think the speed of the collapse in oil prices would spark a quick flurry of distress-driven deals, but it didn’t. Low prices, it turns out, put buyers and sellers sharply at odds over valuation and just how much a company and its reserves were actually worth.
John Cuthbertson, an energy practitioner at Burnet, Duckworth & Palmer LLP in Calgary, calls it “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.”
In the meantime, junior and mid-sized oil and gas companies can look to the country’s junior miners, who have significant experience at scaling back burn rates to a faint flicker in hard times.
Chambers warns many of them are not out of the woods yet, especially the single-product, single-mine plays.
“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.”
Debt markets have little interest in junior resource companies in general, he says, making cash on hand about the only number that counts.
“The juniors never had any cash flow so why would anyone lend them money? They’ve got no money to service their debt. 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.”
With commodity prices sinking below the level of the Great Depression, an increasing number of companies may be forced to sell their prized assets even though they don’t like the valuations.
“Some people have frankly missed the boat on this. They watched prices drop and they didn’t take offers they thought were too low. Then the offers were off the table and companies running out of cash have been left not knowing what to do.”
Swartz points to Cline Mining Corp., a metallurgical coal producer, as an example of a company that found it had no interested buyer.
Coal prices were down for such a long period that Cline suspended production at its key mine in Colorado to conserve cash in 2012 while it pursued strategic alternatives. No buyer emerged and the bondholders were left paying to maintain the mine in a mothballed state.
“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,” says Swartz, whose firm acted for them. “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.”
In the meantime, he says a number of large American private-equity funds have set up distressed funds to focus on resources.
“They’ve raised billions of dollars. I’m sure they’re going to go out there and say: This is a down market, we can cherry pick assets. I’m sure they’re searching all over the place and if they’re one of the few sources of capital, they’ll have a lot of leverage to negotiate deals.”
Chip Johnston, a partner at Stikeman Elliott LLP in Calgary, says if the tough times continue, the weaker players that have been hanging on will inevitably fall away. “I think you have to fundamentally go through this Darwinian process.”
It’s not just juniors and mid-sized companies getting squeezed by languishing commodity prices. Even the majors and super-majors are feeling the pinch.
Cenovus Energy Inc. announced in February it was doing a $1.5-billion bought-deal share offering just to fund its 2015 capital expenditure program. By that point, the company had already cut 800 jobs, scaled back its cap-ex 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.
But only the largest producers like Cenovus Energy have the luxury of being able to issue shares.
Producers of all sizes have another option to keep the cash coming in: royalty streams, or an agreement to forward sell a percentage of their production. The streams provide a steady cash flow, but not everyone is a fan.
“It’s not necessarily an inexpensive way of financing and it ties up a lot of your upside,” says John Turner in Toronto, who leads the global mining group at Fasken Martineau DuMoulin LLP. “Typically, with these royalty deals, to the extent that you discover additional resources then the royalty applies to that resource, so you’re taking away potential future revenue.
“On the other hand, it’s a way to raise capital that’s not as dilutive as others. So it’s one of those things where I’ve seen a lot of term sheets recently but I haven’t seen a lot of the deals being done right now. It’s one alternative, and not necessarily the most favoured one.”
Another option open to integrated producers is selling off mid-stream assets to raise cash. Encana Corp. became one of the first to do a mid-stream sale, selling 500 kilometres of pipeline and compression facilities in BC for $412 million.
The buyer, Veresen Midstream – a new partnership between Veresen Inc. in Calgary and Kohlberg Kravis Roberts & Co. – agreed to invest up to $5 billion to support mid-stream development in the Montney basin under a 30-year fee-for-service agreed arrangement.
Alicia Quesnel, an M&A and energy practitioner at Burnet, Duckworth & Palmer in Calgary, believes it’s an emerging trend.
In structuring such sales with a taker-pay obligation, Quesnel says, “the company gets the benefit of cash from the sale but they still have access to the facility they previously owned.”
Looking out at the deal landscape over the second half of this year, Donald Greenfield, who leads the energy practice group of Bennett Jones LLP, sees an increase in the number of insolvencies, especially in companies that have debt obligations and fixed capital spending commitments.
“There have been a bunch of CCAA [Companies’ Creditors Arrangement Act] filings already and if you asked around our office, I think you’d probably find out we’re involved in talking to creditors or companies about others,” he says. “It’s the typical story when commodity prices drop. Companies struggling to service lots of debt, with little or no light at the end of the tunnel, will become distressed.”
Most people are also expecting a definite uptick in M&A activity, says Greenfield, who heads the firm’s energy practice group. Some see the US$8.3-billion sale of Talisman Energy Inc. to Spain’s Repsol SA as the beginning of a trend.
“Talisman faced the same issue everybody faces: low commodity prices. In addition to that, I think they had a relatively high debt load for their size and they also had spending commitments that were fixed, like in the North Sea.
“Talisman said in its filings it had been selling assets and was facing a more difficult environment to continue to sell assets, and its ability to raise equity was also going to be challenging. There will be other companies facing those same problems.”
Chambers also sees an increase in distressed-deal activity.
“I was just talking to someone in Calgary the other day and it was his view that 2015 was going to be a great year for law firms in the oil patch because of all these restructurings that are going to have to happen. It’s 2016 he’s scared about because when the music’s stopped, and you’ve picked up the chairs that have fallen over, then what?
“The interesting thing to me is we’re now going to test the limits. Commodity prices are down, some of those companies that took on streaming obligations are going to go under, now we’re going to test all that boilerplate on the back of the agreements that the lawyers argue over, and see how it all works.”