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Oil and gas producers will increasingly talk M&A and asset sales if oil prices remain near USD 50 per barrel, but are first exploring other structures to manage through the period, energy industry sources say.

Likely buyers and sellers have not found commond ground on pricing, and upstream companies under financial pressure are not yet in capitulation mode. That has buyers starting to think more creatively about how to structure new investments.

Few fire sales

Falling commodity prices have put many upstream companies in a precarious position. They see not only a drop in earnings but also the prospects of smaller borrowing base and reduced access to high yield debt and equity issuance markets. Many companies have announced deep cuts to capex and face an eventual drop in production.

In contrast, a growing group of well-funded corporate and financial buyers are preparing to make deals, yet few are expecting to clean up on fire sales.

One reason is that banks will not force most companies to act immediately. It will be at least a month or two before companies know where they stand with lenders as the banks begin their semi-annual borrowing base re-assessments, said Keith Behrens, managing director, energy group head, Stephens, Inc., speaking on the sidelines of IPAA Private Capital Conference in Houston last month.

Most upstream operators are well-hedged, and have used high-yield bonds or other instruments to extend debt maturities well into the future - so they can withstand negative cash flow for some period of time, said Scott Joyce, managing director and head of upstream oil & gas for BNP Paribas, also speaking on the sidelines of the IPAA Private Capital Conference. It could be early 2016 before distressed situations really begin to arise in earnest, and only if the current low price environment continues through the year, he said.

Companies over their covenants by 5% to 15% will likely be able to work out arrangements with lenders, who can “kick the can down the road,” Behrens said. Lenders will not be able to ignore overages by 25%, he said. Such companies are evaluating multiple options to pay down or refinance that bank debt, Behrens said, and selling assets or the company is last on the list.

Options include replacing bank debt with second lien term loans or mezzanine financing project equity arrangements, volumetric production payments (VPP); or farm-ins.

So-called project equity structures like the type of financing Linn Energy (NASDAQ:LINE) just arranged with GSO Capital could become common, said Behrens during prepared remarks at IPAA Private Capital. Lenders in that space include GSO Capital, IOG Capital, Old Ironsides, Stellus, and Encino Energy, Behrens said during his presentation. Linn announced last month that GSO, a unit of Blackstone, had agreed to commit USD 500m to finance its drilling program in return for owning a percentage of the wells.

The Linn/GSO deal could be copied by other operators. For example, Magnum Hunter Resources (NYSE:MHR), which has a data room open now for Ohio Utica/Marcellus assets, could think about a similar transaction structure, according to a recent report by Mergermarket.

VPPs offer another avenue for recapitalizing bank debt, Behrens said. VPPs are structured investments where an upstream operator sells production from a field or property that expires after delivering a specified total aggregate volume or a particular length of time.

Farm-in in favor

Upstream companies do not see this as a good time to sell proved, developed and producing (PDP) assets for cash, said Josh Batchelor, managing partner and co-founder of private equity firm Sage Road Capital, also on the sidelines of the IPAA Private Capital Conference. Buyers who can get creative in using non-cash structures, such as farm-ins or other options, are seeing more success, said Batchelor and a third industry banker.

Farm-ins essentially involve trading a working interest in return for some or all drilling costs, and can help companies plug an oil-price-induced spending plan deficit. The structure allows the buyer to get a foot in the door on high quality assets that they may not have the cash to buy outright. And of course, both parties share in the upside.

On a recent quarterly earnings call, when Apache Corp. (NYSE:APA) CEO John Christmann was asked to comment on the M&A landscape, he noted that farm-ins were an attractive option, saying "If things stay where they are there's a lot of folks that are significantly outspending. There [are] a lot of clocks on acreage. We're seeing things pop up right now and for drilling a well we can earn pretty big acreage blocks."

Offshore Gulf of Mexico producers Stone Energy (NYSE:SGY) and Energy XXI (NASDAQ:EXXI) both identified farm-outs as attractive ways to preserve capital in the current environment, according to recent reports by Mergermarket.

A&D angles

Companies that must consider sales are not wont to dispose of their crown jewels at current prices, said a fourth banker. As a result, current assets on the market fail to excite buyers.

Deals are “hard to get done” right now because the assets being offered are not of high enough quality, said Mike McMahon, managing director of private equity firm Pine Brook Road Partners. Sellers may need to have a higher component of PDP properties to enable transactions to occur, said Jason Lindmark, vice president of business development, Merit Energy, also speaking on the sidelines of the IPAA conference.

Rather than part with production, upstream companies could first look to sell midstream assets, said Vance Scott, partner and leader of A.T. Kearney’s Americas Energy Practice. Such deals will be attractive as midstream assets will command a premium, he said.

Midstream asset divestitures are expected to be the “primary avenue of acquisition growth” for MLPs in 2015, said Brian Kessens, managing director portfolio director, Tortoise Capital. Kinder Morgan’s announced acquisition of Hiland Partners, owned by Harold Hamm, the CEO of Continental Resources (NYSE:CLR), is an example of such a trend, Kessens pointed out.

If low oil prices persist, a larger number of companies will become more interested in a combination, the fourth banker said. Using equity as currency would allow both sides to participate in the upside, without having to time it exactly, the banker speculated.

Buyers and sellers seem to agree that equity is attractive, because it is expected to go up in value when prices return, said Mike Bock, co-founder, Petrie Partners during a Q&A panel during the IPAA event. But companies selling in a low price environment need cash, and not equity, to de-lever, disagreed a sixth industry banker, who said he hasn’t seen seller interest in equity.

Several companies seeking buys also noted that assuming a seller's debt in a deal would be more attractive than issuing new debt, as the high yield market is expected to tighten for oil and gas names.

All the same, buyers will be wary of triggering change of control provisions that require bonds to be redeemed at par value, said Geoff Davis, managing director, Morgan Stanley, speaking on the sidelines of the NAPE Business Conference in Houston on 11 Feb. Deals structured as asset sales don’t require buyers to take on the seller's debt, and that could be a more attractive option, he said.