AUSTIN, Texas—The current downturn in oil and gas is far worse than most imagine, worse even than 1986. However, recovery is in sight for well capitalized companies in the very best basins—and for the investors who back them.

In fact, the simplest takeaway from the “Capital Markets Speak” panel at the recent Energy Capital Conference presented by Oil and Gas Investor is that oil and gas has morphed into a Dickensian world characterized by a handful of well capitalized companies who see the best of times in opportunity—and a larger bucket of public companies with wounded balance sheets who are facing the worst of times.

“Our view is 50%, roughly, of public companies by number will not make it through the cycle without significant debt restructuring,” said Doug Reynolds (left), managing director and head of U.S. business for Scotiabank. Reynolds told conference attendees that energy companies caught on the wrong side of ballooning debt-to-capitalization metrics are finding they can’t do new transactions, sell, raise equity, or exhibit market capitalizations that are just too small to provide optionality.

“Many of them, frankly, will just not make it,” Reynolds said.

And yet, opportunity exists. Reynolds and fellow panelist William Lambert, vice president for investment banking at Goldman Sachs (NYSE: GS), anticipate the rising logjam in delayed transactions is about to break open. Meanwhile, Wall Street is looking to reenter the energy markets by mid-year.

“The first half of 2015 was a very challenging environment where bid-ask spreads were incredibly wide,” Lambert said. “We see that narrowing. We see the potential for transactions to come and continue to get done throughout 2016.”

Before examining the roots of optimism for the panel’s two speakers, it is necessary to assess the carnage in today’s oil and gas markets. That carnage was created by a 70% drop in commodity prices vs. 2014.

“That’s the quickest, deepest drop ever, at least as far as we go back, which is to 1980s prices,” Reynolds said. “It’s worse than 1986, which I think some of us old guys in the room remember was pretty shocking.” Reynolds said.

Lambert pointed to recent progress in commodity prices, but noted the industry still faces an uphill struggle.

“We're certainly at a point in time where the market feels a little bit better. We've had a rally off the recent lows,” Lambert (right) said. “But I think the important thing to remember is while the spot price is up, call it $12, $13, we've seen the back half of the curve not move very much. And frankly, part of that is the investor universe recognizing that the ability of producers to deliver volumes is real.”

Consequences of the steep commodity price drop include credit agencies re-rating price decks lower while yields on energy-related bonds have ballooned to high levels. Hedges are running out in 2016, particularly for oil-weighted E&Ps, adding further discomfort to investors on the credit side of the business.

“The new price decks that have been put out have created tremendous pressure on the [oil and gas] industry and are going to continue to play through as new deals come to market,” Lambert said. Echoing a theme common to most conference presenters, Lambert pointed out that oil and gas companies will need more equity to complete future deals rather than relying on easy access to debt markets.

Both speakers identified several positives in the market. These include the amount of investment dollars circling the industry. Energy-related private-equity funds raised $39 billion in 2015, most of which has not yet been invested, Reynolds noted.

“There’s been a little bit of fundraising in 2016, but there’s significant private-equity money that’s ready to go to work to complement the public equity market we have,” Reynolds said.

The Scotia Bank executive noted there are three ways to make big money in oil and gas. The first is to find a new area like the Eagle Ford or Bakken. The second is to manage a company well and grow efficiently.

“The third is to catch the commodity price cycle right,” Reynolds said. “We think as a result of the significant drop [in commodity prices] this represents a cyclical low that will be a great opportunity for investment in our space.”

Lambert reviewed changes in investor mindset in regards to oil and gas companies. Investors have transitioned away from financing production volume growth and now look at balance sheet strength as a major filter for investment. Stock prices for well capitalized companies have held up better than commodity prices. Indeed, the market will need $60 oil to justify the net asset value which investors are ascribing to the very best companies.

Citing survey responses from a Goldman Sachs conference in early 2016, Lambert noted investors are seeking companies with strong capital structures who are exposed to low breakeven prices and stack pay potential, which offer multiple ways to win. In particular, investor interest remains high in the Permian, Stack and Scoop plays.

“One of the things that we've looked at is the Permian Basin, which you’ve heard us say a few times now,” Lambert said. “It is the stellar play that people are most interested in. You can see that the valuations on an adjusted and unadjusted basis have held very well. What this really tells us is there is an opportunity for a producer to buy an asset where they can meaningfully step in early in the life cycle and capture an opportunity to still add value.”

Lambert analyzed how oil and gas companies allocated proceeds from the recent spate of $10.5 billion in equity raises for energy companies. Two-thirds of proceeds were allocated to some form of deleveraging, Lambert said. In fact, the actual percentage was as high as 90% when adding corporate general purposes, including the repayment of revolvers, to the allocation formula.

Investors subsequently rewarded oil and gas companies issuing equity since the stock prices of those firms have performed better than non-equity issuing peers. Investors viewed equity issuances as balance sheet protection.

Reynolds said the mergers and acquisitions market was set to improve after setting a record low in transaction volume in 2015 and starting slow in 2016. To date, the industry is only seeing a 10% sell-through rate on marketed transactions, primarily because of lingering issues with bid-ask spread and asset quality.

“Lots of what is being marketed today has very little undrilled or PUD [proved undeveloped] value at the current strip,” Reynolds said. “Its hard to make those deals go when you’re paying PDP [proved developed producing] for production and the seller has debt to pay.”

Reynolds said the bid-ask spread is narrowing, while improved commodity pricing vs. the February lows is beginning to thaw the transactions market since few sellers want to let go of properties at the cyclical bottom.

“Coming soon is greater activity in M&A land and core basins,” Reynolds said. “Transaction values continue to confirm significant undrilled value in those core areas.”

Indeed Reynolds said activity could increase as early as the second quarter as transactions that have been on the market for some time cross the finish line after buyers and sellers find ways to make them happen.

“I do see a renewed sense of optimism,” he said. “We are firmly of the view that there’s significant value beyond current production in core basins. The technology advance in the United States is staggering in its extensive pace, and it is actually accelerating. Equity is certainly available and we think things will pick up dramatically this year.”


Richard Mason can be reached at rmason@hartenergy.com