Tim Richards is an audit partner for KPMG in Canada based in Calgary. Tim has over 15 years of experience in serving the energy industry and provides audit services to a wide variety of public and private oil and gas exploration and production companies and energy service companies operating in Canada, the U.S. and internationally, including several foreign national oil companies with Canadian assets. While Tim focuses on auditing and accounting issues, he has involvement in transaction related services and provides advice on a considerable number of acquisitions, financing, reverse take-overs and other expansion acquisition activities.
The Daily Oil Bulletin/JWN Energy engaged Tim to provide insight in how oil and gas operators successfully managed balance sheets through the last tumultuous five years and what trends could impact future financial sustainability.
The oil and gas sector has seen extreme price volatility the last five year that resulted in numerous bankruptcies or asset sales of companies with exposed balance sheets. What can operators learn from companies that successfully managed their balance sheets throughout the last five years and positioned themselves for the current recovery? What can they learn from those that failed?
In the past operators chased production growth and tried to keep the ratio of debt to cashflow in the range of 2-3 times. If the debt to cash flow ratio increased the companies managed through equity raises. As the equity markets dried up the ability for companies to alter their capital structure became very limited. This coupled with most companies being tied to reserve base lending arrangements left companies seeking asset sales or alternative financing arrangements to manage debt levels.
The successful operators did not chase production growth but rather managed capital allocation and focused on their cost structure to keep debt to cash flows significantly lower than 2 to 3 times, more at the level of 0.5 to 1 times. Some operators termed out significant portion of the reserve base lending arrangement to eliminate the risk of commodity prices on a portion of the debt. But most who succeeded the last three to four years adopted a cash flow spend model. These actions allowed these companies to avoid layering on hedges that were either mandated as part of lending arrangements or by management for survival purposes. This allowed the companies to take advantage of increases in prices quicker and further strengthen the balance sheet and increase shareholder returns.
How important was financial hedging in protecting the balance sheet during the last five years? From your experience, what are the key considerations in a financial hedging strategy throughout a price cycle and what should operators be looking at in the current point in the cycle?
I see hedging as an insurance contract and companies need to clearly define what they are trying to insure against. In the past most companies used hedges to protect capital allocation decisions, acquisition metrics, debt to cash flow ratios, or just as a market diversification tool.
Given the run on commodity prices and the significant increase in cash flows companies are currently realizing their debt levels are shrinking or being eliminated altogether and the growth models is not top priority, and therefore there are less things to insure against. We do see the hedging continuing to protect acquisition metrics and as a diversification tool but the percent hedged will likely drop.
We also continue to see hedges put in place on the market diversification front but the type of hedge contract has changed from swaps and collars to puts and basis/differential contracts.
Therefore I believe you will see a number of companies let current hedges fall off and wait for the long-term price curves to show substantial increases prior to entering into future hedges. With that said I don’t see the fundamentals for oil or gas prices changing in the near future … but we all know how quickly COVID changed everything.
As commodity prices and at least the mid-term outlook look positive it appears attitudes towards debt are changing. What are some of the considerations that need to be accounted for in managing debt throughout the cycle? Where did you see companies get in trouble during the previous cycle?
The industry was heavily reliant on reserve based lending which creates near term pressure to manage proved producing reserves, sometimes at the expense of longer-term investment and drilling decisions.
With debt levels in the upstream sector considerably reduced there will likely be a new focus on the appropriate amount of leverage knowing that in periods of high downward volatility lender support can retract sharply.
What is the absolute amount of debt that is supportable? Operators need to be careful that with a sharp uptick in commodity pricing, annualized debt to cash flow can look positive but the total amount of debt in relation to the size and growth objectives of the entity could tell a different story.
Throughout the downturn we have seen companies use alternative finance mechanisms like selling royalties or infrastructure assets. With improved pricing and cash flows will we see this type of financing diminish or does it still make financial sense?
The alternative financing arrangements are primarily used to unlock value or where more traditional alternatives were not available given the risk profiles of the investment decision. Given the increased pricing environment and the strong cash flows there likely will be less of the alternative financing arrangements used to fund operations of companies.
But with that being said, there still remains a lot of unlocked value in the oil and gas industry where traditional financing/cash flow models can’t fund the projects. The oil and gas industry is very opportunistic therefore these arrangements are not gone but new evolutions will be developed to unlock value in assets that don’t meet the risk profile for traditional debt/equity financing.
Asset retirement obligations (ARO) are a significant public relations issue for operators. The AER is changing regulations to ensure operators have the financial capability to manage ARO and to ensure they are spending at appropriate levels to limit future liabilities. Is ARO becoming a substantial balance sheet factor?
Since the Redwater court decision, ARO has been a focus area of the various regulators, banks and in the M&A market. Therefore, I don’t believe ARO is a new focus area on companies’ balance sheets. We do however see operators focus on reducing the ARO liability and taking advantage of the various government programs to clean up liabilities.
I believe that operators will continue to allocate capital to reduce ARO as companies continue to see strong cash flows which makes the capital allocation decisions a little easier to spend on clean up vs. in the past 5-7 years where the majority of cash flow was utilized to moderately grow, pay down debt or to ensure survival of the company. Operators understand the need to continue to focus on being responsible operators and ARO reduction is just one way we will continue to see operators strengthen the ESG scorecard and address the changing regulatory environment.
The last five years have been a hard ride for Canadian oil and gas producers.
Wild price volatility, a pandemic-induced price crash, ongoing market access issues, oil production curtailment, the rise of the ESG movement, and finally a geopolitical crisis are just some of the challenges industry faced.
The end result of this period of instability is a reinvigorated industry – forged in fire so to speak – and ready to take on the world as the commodity cycle turns once again.
The 2022 Top Operators Report examines the 2017-2021 timeframe, identifying key trends that shaped the present energy landscape and what lies ahead for the 62 Canadian headquartered public operators tracked this year.
To sort through these challenges we are once again leveraging the experience of professional services firm KPMG in Canada to provide insight into the last five years of change and what strategies operators could pursue to thrive in the inevitable turbulence ahead.
Data analysts from Evaluate Energy are providing context to the stream of information coming from corporate financial reporting and other relevant documents. Analysts from geoLOGIC systems ltd. offer context into trends in activity and technology to manage costs.
We’re also tapping into a broad swath of the insights and opinions from industry leaders gleaned from Daily Oil Bulletin coverage.
To download the 2022 Top Operators Report, click here.