Debt and liquidity management is the main theme in the oil and gas industry as the businesses in this industry try to get through the down cycle in oil prices. Whiting Petroleum (NYSE:WLL) is also making these moves to enhance its debt profile and reduce some interest expense. The options become limited for the oil companies when the oil prices go down as the value of assets also takes hit, and unless the business is sitting on some extremely lucrative assets, sources of funds become limited. Selling rich, lucrative assets is a difficult decision to make as the eventual recovery in oil prices will mean that these assets can contribute significantly to the business.
At the moment, however, converting debt into equity is becoming a preferred way of managing debt. This causes dilution for the current shareholders but helps the business in its bid to survive. As a result, current shareholders do not look too bothered about the prospect of dilution as long as the debt is being taken off the balance sheet. The underlying assumption here is that if the business is able to survive this down cycle then the stock might give a healthy return once the oil prices recover. This is apparent from the reaction given by the Whiting Petroleum shareholders as the stock lost about 6.5% when the expected dilution will be considerably larger.
The company is exchanging $1.06 billion worth of convertible notes for "mandatory" convertible notes of the same value. While the previous notes also had the option of conversion, these new ones have this feature mandatory in them. The interest rate, principal amount and the maturity is the same, so you can say that only a single term of the notes has been changed. However, this term is particularly important and changes the whole mechanism of the notes. The image below shows the notes being exchanged.
Source: Press Release linked above
This is a substantial move for the company as Whiting's total debt was above $5 billion at the end of the last quarter. So the exchange will result in total reduction of about 20% in its long-term debt. Remember that $1 billion of this long term debt is from the credit agreement and another debt worth $1.25 billion is issued on just 1.25%. That means that more than half of the remaining long-term debt is relatively low-cost. The credit agreement has a complex interest rate structure which allows the banks to charge a different rate based on the ratio of outstanding borrowing to the borrowing base - more details of the credit agreement can be read with the interest rate schedule on page ten of the 10-Q linked above. In total, Whiting will save over $31 million in annual interest payments - interest expense for the last year was over $334 million. This accounts for more than 9% decrease in the annual interest expense.
On the other hand, dilution will also be substantial. If the lowest price ($8.75) for conversion is applied then the company will have to issue 114.8 million shares, which means that the dilution will be 56%, and if the conversion price was $12.10 then the company will have to issue 83 million new shares, resulting in dilution of about 40%. However, we are likely to see dilution figures of somewhere in between these two extremes. In isolation these dilution figures are scary as any investor will be spooked at the prospect of such high dilution levels. However, as this move is allowing the company to reduce its debt by about 20% and interest expense by more than 9%, the net affect should be positive in the long term.
Whiting's leverage ratio was just above 1.1 before this transaction. It will come down further and allow the company to negotiate future debt on better terms if there is a need for further borrowing. In addition to this, the decreased leverage ratio will be beneficial for the company in meeting its debt covenants. Cash position will also get better due to the savings from interest. Operating cash flows for the last year were just above $1 billion and cash balance at the end of the first quarter was just $1 million, down from $16 million from the same quarter last year. Cash position further highlights how important it was for the company to execute this transaction and get some breathing space by reducing interest expense and leverage ratio. Reduced leverage ratio can also make it easier for the company to increase its borrowing from the credit facility without violating the covenants. This will result in better liquidity. Overall, this move is a net positive for the company and should help it strengthen its financial position as the oil prices recover over the next few months.
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