Upstream Oil & Gas Perspectives on the High-Yield Explosion

While natural gas prices remain mired at historically low levels thanks in large part to domestic onshore oversupply and crude oil prices continuing to reflect strong global demand, we are seeing recent changes in investor demand within the sector.  One notable trend is growing investor confidence in the E&P industry and as a result, there’s been an explosion in high-yield bond issuance.  During the first quarter of 2012, North American E&P companies have executed 17 new high-yield debt offerings raising $12.8 billion in gross proceeds, which eclipses every yearly total from 1993-2009, and is already the most E&P high-yield debt raised in any quarter in history.  KeyBanc Capital Markets (KBCM) has acted as Lead or Co-manager on four E&P high-yield transactions, year-to-date. 

From a macro perspective, it’s important to note that interest rates remain at historically low levels, driving down the cost of new debt and providing ample refinancing opportunities.  Since the 10-year U.S. Treasury Note hit a low of 1.72% on Sept. 22, 2011, yields have climbed slightly, but remain below 2.5%. At the current level of 2.3%, rates are lower than they have been 95% of the time since 2000. In Exhibit 1 below, we see a clear correlation between falling interest rates and E&P high-yield issuance as more companies seek to lock in lower financing rates.

As an asset class, high-yield debt is also generating increased attention based on low projected and historical default rates coupled with an attractive risk/return profile relative to current market conditions. This trend has manifested itself through a general increase in fund inflows (nearly $14 billion YTD), resulting in an excess supply of cash to be invested. At KBCM, we’ve seen more of this capital being allocated to the E&P sector, as high-yield investors are often diverging from the somewhat cautious perspectives held by rating agencies. 

Simply put, we see the upstream oil & gas sector being viewed as a defensive play by investors due to its historically low default rates. In fact, we see investors “looking through” Moody’s and S&P ratings, focusing on business fundamentals, quantifiable asset characteristics and hedged underlying commodity price exposure. 

Revitalized investor appetite for high-yield E&P debt has also presented the opportunity for a number of first-time issuers to come to market in recent months, including Oasis Petroleum and Kodiak Oil & Gas. KBCM acted as the joint-lead bookrunner for Kodiak’s $650 million private placement note offering in November 2011, which was used by the company to finance a major acquisition and pay down existing debt. Other similarly positioned mid-sized E&P companies may be well advised to seize the opportunity to issue high-yield debt given favorable market conditions, before investor attention begins to wane. For example, investor appetite may soften later this year as interest rates rise and awareness increases relative to producers’ financial exposure to un-hedged natural gas prices in 2013 and beyond. 

Adding to the fervor in the high-yield market — a large number of major corporate M&A deals have closed in the last 18 months, making investors more aware of the potential for short-term bond gains. For example, the quality and nature of Oasis Petroleum’s assets are recognized to be potentially attractive to acquirers. Accordingly, a specific clause was included in the terms of Oasis’ high-yield offering to reward investors in a change of control situation, thereby favorably impacting current interest rate charges to the company.

Although the last 12 months have been the most all-time active for the E&P high-yield space, we have observed a corresponding downturn in alternative financings.  In some situations, an alternative source of capital for upstream oil & gas companies, beyond senior secured debt, is a second lien term loan to fund drilling or acquisition capital expenditures. Our observation is that second lien activity is counter-cyclical to high-yield activity in the upstream sector.

A senior secured revolver sized by the present value of the company’s proved reserves typically is the most common source of debt financing for an E&P company. However, the available borrowings under such facilities are restricted by the level of a company’s producing reserves, with limited credit given for undeveloped or unproved assets — which often constrains the ability of smaller E&P companies to finance drilling or acquisitions to fuel growth. Enter high-yield and second lien credit facilities, which have been employed in the E&P sector since the mid-1990s to fund the development of nonproducing reserves, drilling of exploratory wells, and acquisitions of undeveloped acreage and/or other companies.

Although most E&P second lien facilities are multi-year term loans, they usually are intended only as temporary financing until high-yield or equity issuance is available, or a borrower’s proved reserves support a more permanent financing option.  The most common circumstances of second lien financings include situations such as limited existing production relative to non-producing reserves and/or undeveloped land, limited or no access to public capital markets, or if the capital requirement is too large for an over-advanced facility but too small to support the issuance of public debt. 

The following table in Exhibit 2 describes several second lien facilities funded since 2010 in the upstream oil & gas space. It is not surprising that several of these facilities have already been replaced with alternative sources of capital.  A noteworthy example of a recent second lien issue is the $50 million second lien term loan arranged by KeyBank for Rex Energy in November 2011. Rex was not yet of sufficient size to access the public debt markets in a cost-effective manner, so in order to finance the acquisition of additional leases in the Utica Shale play, Key arranged a competitively priced second lien facility for Rex, providing additional liquidity.

The E&P industry has proven to be well deserving of investor confidence, whether with the current flurry of high-yield issuance or alternatively through senior debt and second lien facilities. We are fortunate to have a well-established and robust domestic upstream sector with a track record of being responsible in addressing debt obligations and providing attractive returns to investors.

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