From waves of reanimated corpses feeding on unfortunate strangers trapped in a western Pennsylvania farmhouse in Night of the Living Dead to the hordes stalking the beleaguered survivors in the current smash TV hit The Walking Dead, zombies have captivated audiences. But real life zombie companies aren’t as entertaining. The dramatic and sustained plunge in hydrocarbon prices since mid-2014 has ravaged the finances of oil and gas producers to the extent that some observers have labeled the weakest of these “zombie” companies. These cannot sustain themselves on current pretax cash flow and look to be shuffling slowly toward their ultimate demise. Today we take a walk through the living dead to uncover the zombies.
Before we go further, please note that we are not an investment advisor and this analysis is not intended as investment advice. RBN looks at company level numbers to see what they mean for the industry as a whole, not implications for any particular company’s stock.
Previously on Independent Exploration and Production (E&P) Companies
We’ve been keeping tabs on the progress of independent oil and gas producers as they navigate the stormy waters of falling oil and gas prices since the end of 2014. In May 2015 we posted a blog series dividing up the E&Ps into various categories based on oil or gas focus and market capitalization. We detailed how Q1 2015 results showed that although E&P companies were slashing their capital spending they still expected to maintain production output overall in both the oil and natural gas sectors with some areas like the Marcellus and Utica seeing stronger results from improved productivity (see Free Fallin). We updated that analysis for Q2 in August 2015 (see More Changes) and for Q3 in November 2015 (see Slip Slidin’ Away) noting that capital spending plans were falling as companies tightened their belts against longer term low price expectations. In October 2015 we described how fall bank borrowing redetermination reviews treated E&P companies fairly leniently even as low prices ate into cash flow (see Time Of The Season). This time we take another look at the E&P indie herd - in search of the weak and the frail.
To identify the walking dead, we first screened the income statements and balance sheets of over 50 U.S. independent E&P companies. Within that universe we looked for companies with an Interest Coverage ratio (defined as earnings before interest, taxes, depreciation, amortization, and exploration expense or EBITDA divided by Interest) below 3 times, and a Debt to Capital ratio above 75% based on 3Q/15 financial results. Having these metrics makes it difficult or impossible for companies to access traditional capital markets to remedy their financial issues. In other words, they’ve maxed out all their credit cards.
Next we took a look at the ability of companies that matched our criteria to sustain current cash flow. Just as retail stores eventually go out of business if they can’t restock their shelves, oil and gas companies slowly die from falling production if they can’t replace what they’ve sold. In the E&P world that’s called production replacement, which is the ability to add oil and gas reserves equal to what is being produced. If reserves aren’t fully replaced, production starts its natural decline. To determine each company’s ability to replace production, we estimated normalized 2016 cash flow (excluding non-recurring items) based on 3Q/15 results and compared it with “maintenance capital”, the level of investment needed to replace 2015 production. We estimated maintenance capital by multiplying estimated 2016 finding and development costs per barrel of oil equivalent (boe) by 2015 production volumes. We estimated 2016 finding and development costs by taking average 2014 finding and development costs of about $19/boe and reduced that number by 25% for 2015 and another 25% for 2016 based on the level of cost reductions we have seen in the industry, and rounded the result to $11/boe. The twelve companies that met our interest coverage and debt metrics and are unable to replace production from estimated 2016 cash flow made our list of zombies (see Table 1).