A Battle in the Making in the Oil and Gas Sector: Second Lien vs. High Yield Debt

In the oil and gas industry, there is a storm brewing between holders of second lien debt and unsecured high yield bonds.  These creditor groups are finding themselves pitted against one another as oil and gas companies become increasingly leveraged in an effort to alleviate liquidity constraints.

As widely publicized, oil prices precipitously decreased in 2014 and depressed prices have continued into 2015, with prices falling from $103 per barrel a year ago to around $60 per barrel today.  With this prolonged decline and period of weak oil prices, oil and gas companies are having difficulty breaking even.  Therefore, it is not surprising that many industry players, particularly the upstream division (comprised of exploration and production activities), have experienced tightened liquidity.  Larger and well-diversified companies are best equipped to weather the storm because they are able to rationalize liquidity by suspending new projects and future exploration, selling non-core/non-producing assets and demanding price reductions from service providers.  While these measures have helped ease some financial stress, they are often not enough and companies have turned to the debt capital markets as a source of liquidity.  These new financings provide companies with much needed time to either wait out this period of depressed oil prices or formulate a restructuring plan.

Second lien financings have become a popular method for oil and gas companies to raise capital.  This has been an attractive investment option for lenders, particularly hedge and credit funds, because it has the benefit of a collateral package as well as attractive pricing.  Many recent deals have been priced in excess of Libor + 10% and have been heavily oversubscribed.  In a typical scenario, such financings are layered in above high yield unsecured bonds and below first lien secured debt, usually a reserve-based lending facility (“RBL”).  Companies are often able to obtain second lien financing while complying with the terms of the high yield bond indentures, which usually have generous baskets for incurring or priming second lien debt.  Additionally, while RBL credit agreements typically contain more restrictive covenants regarding the incurrence of new debt, many RBL lenders are willing to waive such covenants on the condition that the proceeds of the second lien financing will pay down a portion of the existing RBL debt.

Although second lien financings are helpful in the short term, they are only stopgap measures that eventually compound the problem of oil and gas companies being overleveraged.  Much of the new second lien debt is tied to how much debt can be incurred under the unsecured bond indenture, rather than the value of the collateral or the borrower’s ability to service the debt.  The end result is that many companies are simply stacking their capital structure with additional layers of debt and unless oil prices rise precipitously (which seems unlikely in the immediate future) or service providers agree to further acquiesce on prices (which also seems unlikely insofar as they have already agreed to major price cuts), the inevitable debt restructuring will be further complicated by the addition of new debt and a new seat at the negotiating table.  While debt maturities vary, several major oil and gas companies will see a large portion of their debt mature within the next three years.

Multi-layered capital structures are not new or unique, and many of the larger bankruptcies and restructurings have involved numerous tranches of secured and unsecured debt with intricate intercreditor issues.  In many typical corporate financing structures where the secured debt encumbers “all or substantially all assets” of the borrower, if the secured debt exceeds the value of the collateral, there is typically little value left for unsecured debt, including unsecured high yield bonds.  However, this is not usually the case in exploration and production cases.  In a typical RBL structure, the collateral pool usually consists of only those assets that form the borrowing base under the credit facility—and would typically exclude unproven reserves such as undrilled acreage or formations or royalty streams owed to oil and gas lessees.  Second lien lenders have a junior lien in the RBL collateral, meaning their security interest will not extend beyond the RBL borrowing base.  As a result, these companies typically have a significant amount of unencumbered assets.  Those unencumbered assets would be available to satisfy, on a pari passu basis, all unsecured claims, which would include unsecured high yield bonds and any deficiency claims to the extent the second lien debt is undersecured.  Given the reduced reserve estimates caused by falling oil prices, second lienholders may be looking to a company’s unencumbered assets as a primary source of repayment, which will put them at odds with the interests of high yield bondholders.

Given the current liquidity constraints in the market, borrowers understandably need to consider all financing options.  While adding a layer of debt will complicate a restructuring, there may not be many feasible alternatives.  Parties such as holders of second lien debt and high yield bonds will be front and center in negotiating the company’s restructuring plan—a process that will likely be contentious as they attempt to allocate unencumbered assets between them.  In a bankruptcy setting, we would expect to see these issues play out at plan confirmation, with the bankruptcy court needing to adjudicate the rights of second lien holders and high yield bondholders following a fact-intensive inquiry tied, in large part, to the value of the assets (encumbered as well as unencumbered) and the language of the underlying debt documents.