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It is no secret that the players in the oil and gas market are looking for ways to maintain, survive, and continue to innovate. The downturn has lasted for nearly two years and it has taken the industry nearly as long to respond to the drop in price. Output has fallen to nearly 8.8 million barrels per day and the decline seems to continue at what seems like a historic pace. Oil prices have dropped 65% from a high of $107 since mid-2014, which has cost thousands of jobs and has already caused many bankruptcies.

More bankruptcies on the horizon

Analysts believe there are more bankruptcies on the horizon because of the oil price outlook for the rest of the year. It has been estimated that approximately 300 upstream companies will file for bankruptcy in 2016. This has not stopped companies from investing in the industry though. In fact, the downturn has given many companies the opportunity to grab market share. This is where the private equity firms enter. They have positioned themselves to be the providers of new capital. They are doing their due diligence in acquiring non-core assets and distressed companies.

Companies are more likely to accept more demanding terms that they would have not accepted before the downturn. More deals between PE firms and oil and gas companies should be expected as loans are beginning to be renegotiated, and PE firms with large pools of cash are likely to jump in and lead the recovery. However, if the deals do not pick up soon it could be because companies simply cannot do them. Many companies won’t or cannot sell their best assets, so therefore the only assets for sale have low margins. Lower service costs have made those low-margin assets more attractive, but not enough that PE firms are clamoring to take them on.

The puts the oil and gas companies in a difficult situation. Billions of dollars’ worth of loans are expected to be restructured. Capex budgets have been cut, opex is being pulled in where possible, and whatever is left is typically distributed to shareholders rather than reinvested. Not only is this an issue, but another skills shortage is looming as highly skilled employees leave the workforce.

Confidence from PE firms is rising

PE firms have not been very active in the past year and a half because they’ve focused on their own portfolio companies, but with what many believe to be the bottoming out of prices, confidence from the PE firms is rising. The relationship between the oil and gas market and PE firms is symbiotic to the cycles that oil and gas markets go through. As oil prices gradually rise and settle, PE firms begin to seek out mid- to small-sized E&P companies. Additionally, companies looking to stay afloat for much longer are having to turn to PE firms instead of borrowing from their bank.

Price volatility and unstable financing markets constrain PE firms from investing capital, but it has not stopped them. The lack of financing and the amount of debt maturing in the next half of the year will likely increase the number of distressed companies, giving way to more opportunities for PE firms.

The movement of the PE firms does not mark the beginning of a turnaround though. The true litmus test of the market will be when the asset market opens and becomes active again. The first three months of 2016 saw 39 deals between oil and gas companies and PE firms announced. Often the first quarter is the quarter with the lowest number of buyers because sellers typically push transactions at the end of the previous year. Many believe that the second half of 2016 will be the time when this happens, especially for E&P companies.

Because of the low risk, PE firms are continuing to take bets on oil and gas. Nearly $1 billion has been raised or spent by PE firms for oil and gas related companies. Producers are now seeking relationships with strong partners that have expertise in specific areas. Often, PE firms believe they can operate more efficiently, even if they are not oil and gas niched. Companies are looking for niche PE firms though, so they can be confident the PE firm understands the cycle.

Not only are oil and gas companies looking towards PE firms, but banks are too. Banks have increased the amount of money they have set aside to cover losses in the oil and gas market. Some of those banks are trying to sell distressed loans to PE firms in order to remove them from their balance sheet.

Prior to the dip in oil prices, banks planned to extend loans to oil and gas companies based on the value of their reserves. These loans would have allowed oil and gas companies to spend cash when they needed to, similar to a credit card. These loans known as, revolver loans, were often the cheapest form of financing for producers and were generally considered risk-free by banks. However, once the price of oil dropped to its lowest points, banks, influenced by regulators, began to cut revolver loans to oil and gas companies and have begun to sell them to PE firms at deep discounts.

PE firms have a significant advantage right now. They have the opportunity to seek the perfect oil and gas asset at the price that is suitable for them. Because of this advantage, the oil and gas market should learn to embrace the PE cycle until it is capable of funding itself once more.

Originally published in Oil and Gas Financial Journal.

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