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In general, a company has three options to choose from to finance itself: common stock, preferred equity and debt. Because most oil and gas companies use a combination of common stock and debt, those are the two sources of capital that I will focus on. Common stock is more expensive for a company to issue than debt, and while that may seem counterintuitive because interest must be paid on debt, it actually makes plenty of sense. A company pays out its earnings to three main parties: the government, debt-holders and shareholders. If the company goes bankrupt, it's required by law to first pay any taxes it owes to the government, then any interest or other obligations on its debt, with the remaining or residual cash or liquidity value of the company going to its shareholders. Because shareholders are last on the list, they require a higher return which is paid to them in the form of dividends and stock price appreciation.

Because common stock is more expensive to issue than debt, does this mean oil and gas companies should use all debt financing? Not quite. Because debt must be paid back to debt-holders on a structured basis (usually semi-annually), it raises the threat of insolvency or bankruptcy. Essentially this: If a company can't make its debt payments, it goes out of business; if a company doesn't return enough value to its stockholders, its stock price declines. I'm not belittling a stock price decline. A low stock price due to poor performance could force a company to issue more equity (stock), which can be dilutive to shareholders and put a lot of pressure on the company to perform. If a company fails to perform or put share capital to work, it's going to be out of business just the same. So what should an oil and gas company's capital structure look like? Let's take a look at a couple other industries for some perspective.

The industry or segment a company finds itself in often determines, to some extent, the type of capital structure the company chooses. For instance, most technology companies, such as Apple (NASDAQ:AAPL), use all or nearly all equity financing because of the high business risk in technology. That particular industry tends to be cyclical in the sense that technologies quickly become outdated and businesses must be fast to adapt in order to survive. Owing $1 billion in debt to debt-holders, on top of the innate business risk, would make owning/investing in a tech company that much more risky. Utilities, such as Duke Energy (NYSE:DUK), provide customers with a service they need in electricity. Thus, utilities have less business risk than tech companies, giving them the option to issue debt to finance themselves.

Judging from the analysis in the paragraph above, what type of capital structure would you expect average oil and gas companies to have? On one hand, exploring for hydrocarbons is a risky process (like investing in technology) and if the exploration campaign fails, the company could lose millions drilling dusters. On the other hand, if your campaign is successful and you have a field of gushers, that's a lot of recurring revenue your company will have over an extended period of time (similar to utilities). While people on planet earth need energy more than they need iPads, commodity prices have been cyclical historically which increases business risk. From what I just described, maybe the answer is a little bit of both. Let's take a look at how existing oil and gas companies are financing themselves.

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As you can see from the companies listed above, capital structures run the gambit, from a company like Sanchez Energy (NYSE:SN) which has a debt-to-market cap of 0% to an ATP Oil & Gas (ATPG) whose debt-to-market cap is 1,388%. The average debt-to-cap in this analysis is 191%, but if we take the top two and bottom two companies on each side out, we get an average of 52%. I think we could reasonably draw the conclusion that, at least judging from the index I created, oil and gas companies use about half as much debt as equity. If a company is above the third quartile in a debt index, its debt levels are high among the peer group and you should question its long-term solvency.

If you look at the market caps of the companies listed above, you'll notice that there might be some correlation (exclude GMX Resources (GMXR) and ATP) between small or early stage companies and low debt levels. This should make sense, because small and early stage oil and gas companies probably have fewer recurring revenues from established production, which makes raising debt a risky endeavor. Breitburn Energy Partners (NASDAQ:BBEP) is a smaller company who has debt levels above the 50th percentile (Quartile 2), but they're an MLP which purchases assets in established fields (you won't find BBEP drilling off the coast of Africa anytime soon). So, depending upon the stage and corporate structure of a company, capital structure can vary.

Why might smaller companies like GMXR or ATPG have chosen to structure themselves with high debt levels? The answer is that issuing debt at moderate levels not only lowers a company's cost of capital, but also increases its return on equity. Think about it like this: Pretend a company has $1 million in debt outstanding and a $1 million market cap (shares outstanding * price per share). Its capital structure at this point is 50% debt, 50% equity. Now, pretend that company needs to raise another $1 million to finance its capital budget. The company has two options, to sell $1 million worth of shares or $1 million worth of debt. Assume the company can issue $1 million in face value of 5-year bonds at 5%, while shareholders demand a 12% return on investment. The choice should be simple right? Issue debt. That's what GMXR did in the mid-2000s to finance drilling costs in the Haynesville Shale. What happened next? Natural gas prices tanked, the Haynesville became uneconomic and now the company is scrambling to find oil and liquids rich production.

Why has Chesapeake (NYSE:CHK) struggled so much recently? It has $13 billion in debt outstanding and its production is over 80% natural gas. The company levered up (issued debt) to build big acreage positions in shale plays all over the U.S., and since gas prices tanked it has been searching for ways to raise capital to finance its budget and pay down its debt. Debt is a great way to grow a company when times are good, but it should be used with caution. If you have an oil-weighted company in your portfolio with high debt levels, its stature as a going concern should be questioned if oil prices start to dive.

Can a company have too little debt? Look at Approach Resources (NASDAQ:AREX), an established E&P company with a balanced portfolio of oil and gas and only a 10% debt-to-market cap. If the company needs financing over the next several years, it's well positioned to issue bonds or draw on its revolver instead of diluting its current shareholders. In effect, its shareholders would take on more risk from a financial perspective, but have more upside if the company is successful in deploying the capital it raised in debt markets. (Ask yourself this: Would you rather be one of a few shareholders, or one of many? It's the age-old risk/reward question). If a company has issued very little debt and has solid production, it might be playing it too safe and hurting its shareholders' returns.

Is there a perfect capital structure for every oil and gas company? Probably not. Some companies are weighted towards gas, some towards oil, and depending upon a company's future expectations of commodity prices, it may vary its capital structure. Additionally, most companies hedge their production these days to protect against commodity price fluctuations, which makes it easier for them to run higher debt levels (BBEP and Linn Energy (NASDAQ:LINE) are both MLPs that hedge a large share of their production). What we should be doing as investors is tracking debt levels of companies and questioning the solvency of outliers, particularly if they have high debt levels and high exposure to a single commodity.

Source: Debt In The Oil And Gas Industry: How Much Is Too Much?