Important Note: This article is not an investment recommendation and should not to be relied upon when making investment decisions - investors should conduct their own comprehensive research. Please read the disclaimer at the end of this article.
As oil and natural gas prices took another nosedive in the past several weeks, E&P companies rushed one after another to raise significant amounts of equity to shore up their balance sheets and address what is clearly managements' and investors' number one current concern: is the company able to survive this downturn without ending in distress or restructuring?
The list of companies in the sector raising equity since the beginning of this year includes Devon Energy (NYSE:DVN), EQT Corp. (NYSE:EQT), Pioneer Natural Resources (NYSE:PXD), Hess Corp. (NYSE:HES), Energen Corp. (NYSE:EGN), Oasis Petroleum (NYSE:OAS) and several others.
Cabot Oil & Gas (NYSE:COG) is the latest among large-capitalization E&P operators to bring a large equity offering to the market.
Cabot just announced a ~$0.9 million share offering (based on 43.7 million shares, assuming the green shoe is exercised in full, and assuming a 6% discount to today's close of $21.53 per share). The offering will increase Cabot's share count by up to 10.6%.
Cabot stands out for its exceptional natural gas assets in the Marcellus and a conservative balance sheet. The company is also differentiated by an enviably low sustaining capital requirement - the company anticipates to sustain or grow its production in the Marcellus in 2016 by spending slightly over $200 million.
Cabot's strengths are recognized by the market. At today's share price, the company's equity market capitalization stands at a strong $8.9 billion. This compares to the company's total debt of $2.0 billion.
(Source: Cabot Oil & Gas, February 2016)
So why is an asset-rich company with what appears to have a solid balance sheet and low interest burden issuing a large amount of equity?
The answer relates to the strong negative cash flow momentum which may leave even a financially strong and conservative company like Cabot vulnerable to the risk of debt covenant violation.
The review of Cabot's covenants provided below makes it clear that an equity offering is a prudent and necessary move, as the risk of the company's leverage ratio coming uncomfortably close to the covenant limit was high.
The equity raise of the proposed size should fully address the covenant risk. In the absence of the offering, credit considerations would have been an increasingly strong headwind for the stock.
Covenants - Senior Notes
As of December 31, 2015, Cabot had $1.6 billion of senior unsecured notes outstanding in multiple issues and tranches.
Under the recently amended senior notes agreements, Cabot is subject to a minimum asset coverage ratio of 1.25x (present value of proved reserves to debt, as defined in the agreements, calculated on a before-tax basis) through December 31, 2017, which increases back to the pre-amended ratio of 1.75x beginning on January 1, 2018 and thereafter.
The amendments also introduced a leverage ratio covenant, defined as the ratio of debt to consolidated EBITDAX. The leverage ratio may not exceed a maximum ratio of:
- 4.75x through and including December 31, 2016;
- 4.25x through and including December 31, 2017; and
- 3.50x beginning on March 31, 2018 and remains in effect until the company maintains a leverage ratio below 3.0x for two consecutive fiscal quarters ending on or after December 31, 2017, or receives an investment grade rating by Standard & Poor's Ratings Services (S&P) or Moody's Investors Service, Inc. (Moody's).
In addition, the amendments provide for potential increases to the original coupon rates ranging from 0 to 125 basis points depending on the asset coverage and leverage ratios at the end of the respective quarterly period (as of December 31, 2015, based on the company's asset coverage and leverage ratios, there were no interest rate adjustments required).
In addition, the note agreements include a minimum annual coverage ratio of consolidated cash flow to interest expense for the trailing four quarters of 2.8x.
There are also various other covenants and events of default customary for private placement style debt instruments.
Covenant Concerns - Credit Agreement
In conjunction with the amendments to the senior notes, Cabot also amended its revolving credit facility.
The minimum asset coverage ratio covenant and maximum leverage covenant under the credit agreement, as amended, are essentially similar to those in the senior notes.
The revolving credit facility also contains various other customary covenants, which include:
- Maintenance of a minimum annual coverage ratio of consolidated cash flow to interest expense for the trailing four quarters of 2.8x.
- Maintenance of a minimum current ratio of 1.0x.
Cabot's unsecured credit facility is subject to annual April 1 borrowing base redeterminations (banks may also request an interim redetermination twice a year or in conjunction with certain acquisitions or sales of oil and gas properties).
The revolving credit facility currently provides for a borrowing base of $3.4 billion and commitments of $1.8 billion.
Using the current strip pricing, Cabot was at real risk of coming uncomfortably close to the 4.75x leverage ratio limit under its debt covenants.
The vulnerability is caused by the dramatic contraction in cash flows that Cabot has experienced, similar to many other E&P operators.
The equity offering addresses the concern. After paying the outstanding balance under its credit facility, Cabot will have a significant liquidity cushion and will be able to fund the shortfall in its capital program should the delivery timeline for Constitution Pipeline surprise on the early side.
Investors may wish to include a review of their 2016 financial models for E&P companies against debt covenants to anticipate potential equity offerings and other steps that companies may be forced to take in order to address imminent credit risks.
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Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment, tax, legal or any other advisory capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. The author explicitly disclaims any liability that may arise from the use of this material.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.