The first signs of financial distress often surface when CFO's start to play games with their balance sheet. First, comes the ballooning of current liabilities as payable balances are stretched out to the max to preserve cash. Next, the most astute vendors catch on fairly quickly to the gamesmanship and move to COD terms for new purchases. Once that happens, the gaming CFO typically faces a 'run on the bank' which prompts a full revolver draw and generally, soon thereafter, a bankruptcy filing.
As Bloomberg points out, this exact scenario played out last year in the oil industry when crude prices tanked and E&P companies were forced to max out their credit lines.
For example, consider last fall, when more than 20 energy companies had borrowed more than two-thirds of their limit on their credit lines, according to Spencer Cutter, a senior credit analyst with Bloomberg Intelligence. More than four of those have since filed for bankruptcy. The degree of distress last year wasn't surprising given the sharp plunge in oil prices that started in 2014. A mounting number of energy companies were forced to sell assets, restructure or file for bankruptcy.
But now that oil prices have rebounded and borrowing costs for riskier junk-rated oil companies have dropped, it makes sense to think that the worst companies have either filed for bankruptcy or recovered, right? Well, not so much actually.
This is not the case. For evidence, just look at the relatively high number of companies relying on revolving loans for their financing needs. At least 11 oil and gas producers are using 70 percent or more of their borrowing-base credit lines, according to Cutter. That includes smaller companies such as Trinity River Energy, Yuma Energy and Mid-Con Energy, and some larger ones such as Sanchez Production Partners and California Resources.
Of course, while maxing out credit lines can provide the short-term liquidity required to avoid bankruptcy in the short-term, eventually banks will have the opportunity to reset spreads and reduce exposures and then the game generally comes to an abrupt end.
Similarly, banks could cut lines of energy companies for failing to have a more sustainable capital structure, forcing them to scramble for financing when investors are still somewhat skeptical about their future. About 24 percent of exploration and production companies will likely have the base size of their revolving credit lines cut in the upcoming round of redeterminations, according to a Haynes and Boone survey.
To be clear, this is a better outlook than six or seven months ago, when oil prices were lower and OPEC members hadn't yet agreed to curb production. But in an odd twist, banks may be more willing to allow smaller, less-important energy companies to fail now than they were a year ago. That's because the largest banks have already cut their exposure to the asset class and are less at risk of losses should these borrowers go belly up. Wall Street's biggest banks just lived through a significant scare after helping oil and gas companies lever up, only to watch them suffer amid plunging crude values. It's logical these lenders would continue to cut their potential losses now, during a relatively sanguine period, by limiting their loans to the weakest companies.
Over the next few weeks, companies will start announcing their new revolving credit agreements. Investors shouldn't be surprised at some bad news for smaller energy companies that still haven't fortified their balance sheets. Just because oil prices have stabilized and even marginally increased doesn't mean that there won't be additional rounds of energy-related bankruptcies and restructurings in the near future.
That said, high yield investors don't seem to be all that worried so we're sure everything is just fine.