The events of the last year have seen an increase in financial restructuring in the oil and gas sector, and it would be a fair assumption that this trend will continue. Stuart Preston looks at some of the valuation issues that may arise during periods of restructuring.
The events of the last 12 months have seen numerous financial restructurings, with Chapter 11 bankruptcy increasingly prevalent in the US oil and gas sector. In this environment, the traditional Scheme of Arrangement (SoA) and the new Restructuring Plan (RP) regimes present financial restructuring options within the UK market.
A critical component of any financial restructuring is the valuation of the restructured entity, and the allocation of value across its various classes of creditors. In determining, and challenging, the valuation of any company, subjective judgement in respect of key assumptions will always form the focal point of that valuation exercise.
Different stakeholders will have different perspectives as to the reasonableness of such subjectivity. The potential upside for some will be so significant that courts are expected to be faced with disputes falling out of the RP regime.
While such disputes will be anticipated across all sectors, the nature of exploration and production (E&P) and oilfield services (OFS) companies (and their assets) could typically result in competing valuations that are materially far apart in their conclusions.
Let's look at the key factors that companies and stakeholders will want to consider when contemplating value and financial return in oil and gas restructurings.
Recent and future challenges within the oil and gas market
In April 2020 the oil price was languishing somewhere between $20 and $30 per barrel. In the USA, it dropped into negative territory, all a consequence of the fallout between Organisation of the Petroleum Exporting Countries (OPEC) and Russia over proposed oil production cuts during the COVID-19 situation.
The cumulative impact of the OPEC fallout and coronavirus resulted in:
significant fall in demand and, in respect of the 'Big Oil' supermajors, heavy losses, significant cuts in capital expenditure (capex) and reduced dividend returns
numerous oil and gas businesses entering Chapter 11 proceedings in the USA
a lower rate of insolvency in the UK, albeit some larger corporates, both E&P and OFS, have restructured their debt position
an expectation of consolidation across the sector, particularly within OFS, where there is significant excess capacity in certain sub-sectors and financial challenges are forcing shareholders and directors to consider their options
This is coming at a time when the energy sector increases its focus on energy transition. The UK government is targeting net-zero emissions by 2050 while, in Scotland, the target has been set at a more ambitious 2045.
This has brought about a change of strategic priorities across the sector:
The Big Oil supermajors have made carbon neutral pledges and are beginning to seek out opportunities in the renewables sector
Many businesses have gone as far as to link executive pay to environmental strategies
Investors are refocusing on greener sources of energy. Many will no longer support the oil and gas sector without some sort of commitment to a move towards energy transition.
Significant investment by UK and devolved government in renewables, hydrogen and carbon storage. The recent North Sea Transition Deal being an example of such investment.
Despite these structural market drivers, in recent months we've witnessed oil prices push back towards $70 per barrel with some (not all) commentators making bullish predictions of $100 per barrel in the short to medium term.
However, let's not be fooled into thinking that the challenges faced by the oil and gas sector have disappeared forever. Despite the recent pick-up in trade, it remains a volatile sector with a relatively fickle oil price.
There remains an element of caution throughout the market. In some areas, this caution translates into doubt as to:
1 long term sustainability of the oil price rebound
2 short- to medium-term levels of demand
Consequences of a troubled oil and gas market
Reduction (or volatility) in oil price, coupled with falling demand, has brought consequences across the entire spectrum of the oil and gas supply chain, with erosion in EBITDA in many instances.
This presents questions as to:
1 current and future viability
2 relevance of capital structures
3 ability to service secured and unsecured debt
4 sustainability of enterprise value in the long term
A number of larger corporates across the sector have recognised the challenges of being over-leveraged in a troubled market and have sought to implement financial and operational restructuring strategies.
In the US, Chapter 11 proceedings have been increasingly common across the oil and gas sector:
Chesapeake Energy emerged from bankruptcy in February 2021 with the removal of $7.8 billion of debt from its balance sheet and $1 billion of cost from its income statement
In March 2021, Valaris had its Chapter 11 plan confirmed by the Court, with $7.1 billion trimmed from its net debt and $550 million of cash in the bank
In the UK, SoA and the newly implemented RP regime have been used to implement restructurings across the sector:
KCA Deutag had its SoA confirmed in December 2020, converting $1.4 billion of its $1.9 billion debt into equity, reducing debt leverage from 6.3x to 1.4x and knocking $106 million off its debt service costs
Having been unable to implement a SoA some 12 months before, Premier Oil’s RP was unopposed by its creditors, allowing it to restructure its debt and, ultimately, merge with Chrysaor
Valuation considerations in a restructuring scenario
A critical input in the consideration of financial restructurings will be valuation assessments of the debtor company. In some cases, such valuations, and their underlying assumptions, can be hotly disputed.
While there was no dispute as to valuation for Premier Oil, as an example, there was much debate around the valuation of Chesapeake Energy. In that case, the debtor valued the company at between $3.5 billion and $4.7 billion.
The unsecured creditors suggested that it carried a value of $7.1 billion (based on, inter alia, a rebounding oil price) and the judge concluded that it was worth $5.1 billion. One material point of disagreement being the most appropriate oil price to apply in the valuation model.
The introduction of the RP to the suite of UK restructuring options throws up the concepts of genuine economic interest and cross-class cram down. These weren't a component of the SoA provisions and their introduction by the Corporate Insolvency and Governance Act 2020 (CIGA) will ensure that valuation considerations fall at the centre of negotiations between different, and competing, classes of creditors in many future RPs.
For those considered to have no genuine economic interest or any class that rejects the plan for reasons of impairment, valuation could become a key battle ground in what lawyers anticipate will be a growing area of dispute.
In proposing a RP, there are numerous considerations for company and creditors alike, but, in most cases, only one will typically really matter: what is the value of the restructured entity and where does that value break?
This is an important assessment in the context of the RP, but also in the context of the relevant alternative, should the prospect of cross-class cram down become a realistic possibility (considered further below).
In considering the options available, a company needs to form a robust position on:
1 the composition and ranking of the capital stack
2 the valuation of the company
The former was an area of dispute in the original SoA for Premier Oil. Nevertheless, the latter has the potential to be even more contentious. Placing a value on a company requires an element of subjective judgement and will, even in the most straight forward valuation, garner differing opinions on the key assumptions applied.
The complexity of oil and gas valuations
The valuation of an oil and gas company is, at the best of times, complex and, in determining the appropriate valuation methodology, typically driven by that company’s place in the supply chain: E&P or OFS; upstream, midstream or downstream? Throw in the volatility of the current market (oil price, demand and energy transition considerations), and it becomes even more challenging, and therefore, even more ripe for dispute.
Stakeholders across the capital stack in any restructuring need to understand the key drivers of the company’s value and the likely impact on their return of small variances in those key drivers.
There are three valuation approaches:
1 The earnings (or market) approach constitutes applying an appropriate multiple to company’s future maintainable earnings (FME), typically by identifying a range of comparable quoted companies (CQCs) and/or comparable transactions (CTs)
2 The income (or DCF) approach constitutes taking predicted cash flows and applying an appropriate discount rate to determine the net present value of those future cash flows
3 The asset approach essentially values a business on a net asset or balance sheet basis
It's often the case that a combination of two or more of these valuation methodologies is appropriate, and it is no different in the oil and gas sector.
As a rule of thumb an upstream (E&P) company will combine the income approach with the asset approach. The first step being to place a value on its oil and gas reserves (typically using an income approach) and then adding the value of these reserves to the net value of other assets and liabilities.
For midstream, downstream and OFS companies, either the earnings approach or the income approach will be used, perhaps a combination of both, although the chosen approach may typically be driven by availability of reliable information.
Potential areas of dispute in an oil and gas valuation
Given the different bases of valuation, the interaction between them, and the differing perspectives of stakeholders, there are various potential points of disagreement.
Typical points of challenge when placing a value on a company’s reserves (using the income approach):
Which oil price should be used in assessing future value?
What volumes does the company anticipate, and are these reasonable given the current status of the asset under valuation?
What assumptions are applied to unproved reserves? Or to end of life assets?
Are there considerations in respect of ease of extraction from reserves and/or location of reserves?
What are the decommissioning liabilities?
Which discount rates have been applied in assessing net present value of future cash flows from specific reserves?
Of course, an E&P company will typically have numerous interests in oil and gas reserves, all at differing stages of respective life cycles. This can result in numerous (and material) areas of disagreement.
Differences of opinion are also commonplace when valuing a business using the earnings approach:
What is an appropriate assessment of FME, particularly given the sector and pandemic challenges of the last 12 months?
How have CQCs and CTs been identified? Are they truly comparable?
What adjustment is to be made to market multiples to reflect the characteristics of the business being valued?
In assessing comparability of CQCs and CTs, there are numerous factors to consider, whether that be scale, the nature of the business, geographical presence or its position in the supply chain.
If the earnings approach is used for an E&P company, then the mix of product, nature and location of reserves, equity stake in assets and relative risk profile (including existence of end-of-life assets) are all key considerations.
For an OFS company, oil price volatility (and likely future trends) will be a key consideration, being the part of the supply chain that is most likely to be impacted by a low oil price.
Energy transition, as noted above, has become an increasingly important focal point for many oil and gas companies. This, on its own, can have a significant impact on valuation.
Anecdotal evidence suggests that the UK investment market currently places greater weight on energy transition than might be the case in the US. Some listed companies that have a pure oil and gas focus are experiencing reducing equity value, with some contemplating floating on the New York, rather than the London, stock exchange.
In the future, we would expect such considerations to generate further areas of disagreement, whether or not in a restructuring situation, as companies de-merge clean energy divisions from oil and gas divisions, reducing the value of the oil and gas business while enhancing the likely future value of, and return from, the clean energy business.
Relevant alternatives for oil and gas restructuring
There's no guarantee that a restructuring will be universally accepted. Specific classes of creditor could object. The new RP regime provides the potential for a debtor to exercise cross-class cram down provisions.
In determining whether these provisions are available, the debtor needs to satisfy two new tests:
1 None of the members of the dissenting class would be any worse off than they would be in the event of the “relevant alternative”
2 The RP has been approved by at least one class of creditor or member, who would have a genuine economic interest in the company in the relevant alternative
These cram down conditions (as defined in CIGA) mean that the company and its advisers need to determine the most appropriate relevant alternative and quantify likely return to creditors in that relevant alternative.
The relevant alternatives available will be driven by the extent of the current financial and economic challenges facing the company. The reality, however, is that the relevant alternative will be a form of insolvency, with the financial return being driven by what the company and its advisers consider to be the most appropriate insolvency strategy in the circumstances.
The complexity of this assessment will again be driven by the size of the business and the nature and value of its assets, bringing yet more subjectivity into the equation, and more grounds for potential dispute. Key stakeholders will want to understand the relevant alternative, challenge the underlying assumptions and may also have a view on the appropriateness of the alternative.
Determining likely return
Having assessed valuation of the company and its assets for both the RP and the relevant alternative, the next step for a company and its advisers is to assess the likely return to each category of stakeholder across the capital stack.
This return to stakeholders is driven by an entity priority model (EPM): having assessed current and future value, the company will input relevant asset values into an EPM, along with sums owed to each class of creditor, such that likely financial return to those classes of creditor is determined.
The company is expected to present an EPM that clearly demonstrates the relative merits of the proposed RP when compared to the relevant alternative. Other stakeholders may take a different view, presenting their own assessment of financial return or an alternative proposal that will secure them a better return from any restructuring process.
EPM’s are, in the context of large financial restructurings, complex models, typically designed to unwind complex positions and structures. They aren't immune to error and the slightest inaccuracy can have a significant impact.
Stakeholders will want to be certain that the EPM is reflective of the agreed capital structure and that it incorporates a complete and accurate assessment of asset value.
What's next for oil and gas restructuring?
All in all, in valuing oil and gas companies, numerous subjective assessments are required, all of which can be interpreted in different ways, depending upon the nature of a stakeholder’s financial interest.
Minor variances in key assumptions can have a significant impact on value:
it could be the difference between being considered to have a genuine economic interest and not
it could also result in specific classes of creditor rejecting RP proposals which may, in turn, bring cross-class cram down (and the relevant alternative) into play
Accordingly, it would be prudent to assume that stakeholders will want to scrutinise and challenge valuations, perhaps with an underlying threat of litigation, to strengthen their bargaining positions during restructuring negotiations.
Stakeholders should be prepared for lengthy, and potentially costly, battles as RPs become more prominent across the oil and gas sector during times of financial challenge.
Early and, importantly, independent valuation advice from a credible expert (sector and restructuring), as well as robust modelling input in respect of EPMs, will be critical for key stakeholders to ensure an appropriate strategy that will deliver best possible return on their exposure.
For support with oil and gas evaluations, get in touch with Stuart Preston.