In military terms, D-day is the date when a combat operation is started. In a sense, this April is going to be D-month for many of the country’s shale operators.
You see, April and October are the months that banks traditionally recalculate the value of properties energy companies use as loan collateral. The process is officially known as the “redetermination of the borrowing base.”
Last October, banks were using an $80-a-barrel level for oil in valuing companies’ assets. But with prices almost half that, the value of these properties has shrunk substantially.
If things don’t change fast, come this April… many companies’ reserve financing and their ability to borrow further from banks will be damaged.
Tightening the Screws
Bloomberg reports that more than 20 U.S. oil companies have already used in excess of 60% of their existing credit line – a credit line that’s sure to be lowered by banks in the spring.
That’s not good news for the companies or their investors that are holding junk bonds in these firms.
You see, since 2000, energy companies have issued more than $140 billion in high-yield bonds. These types of bonds now account for 14% of the $1.3-trillion U.S. junk bond market.
And the price of these bonds have swooned as investors fretted over their finances. Average yields in June were only 5.7% on these bonds – currently yields are about 9.7%.
Thomas Watters, the Managing Director of oil and gas research for Standard & Poor’s, told Bloomberg, “This could start a downward spiral for some of these companies because liquidity will dry up. I call it a liquidity spiral. They’ll start burning right through cash.”
That leaves stressed energy companies with two potential avenues. One is to cut expenditures… drastically. The second is to seek other financing, such as second-lien loans against their assets.
These loans usually come with high interest rates and an equity kicker, meaning the lender becomes a part owner of the company.
This isn’t good news for the existing shareholders, nor the junk bond holders. You see, the claims of existing unsecured creditors, such as the holders of junk bonds, get pushed further down the payment ladder in the event of a negative credit event, such as a default.
And defaults will happen…
A Bleak Future
Barclays forecasts that if oil stays below $60, up to 20% of energy junk bonds could default by 2016.
Even more pessimistic is Leonard Tannenbaum, CEO of Fifth Street Management. He told the Financial Times, “I don’t think people understand how much this move in oil is going to effect the high-yield market. Half the energy companies in the high-yield market will default.”
The reason for Tannenbaum’s pessimism is that companies will have no choice but to turn to financing – like second-lien loans – to stay afloat.
Yes, the future isn’t looking pretty for energy junk bond holders.
The average yields in December were up to 10.4%, although prices rallied in the new year.
But, don’t expect that rally to last for long – especially as the oil and gas companies’ D-day approaches.
And the chase continues,