On June 20th, 2014 the price for a barrel of crude oil on the NYMEX reached $107.26. Analysts’ beginning of the year predictions, which priced oil at over $100 for the year, appeared accurate. Few if any expected oil prices to fall, and then keep falling to a dip below $30. Even with hedges in place, this unexpected, sustained price drop has crippled oil E&P revenues. Natural gas E&Ps are suffering from low prices as well. Producers have been operating in a low price environment for five years, but the last time that we saw prices this low was in 2012 during the onset of horizontal drilling. Unlike in 2012, new production and discoveries, particularly in the Marcellus and Utica, mean the oversupply is here to stay. Henry Hub prices are not expected to exceed $4 per MCF for at least 5 years. Many investments in both oil and gas that once projected to generate strong positive cash flows and profits no longer can generate enough cash to support the debts used to fund the project. Thus, as prices remain low, more and more companies are running out of cash to support once manageable debts. 42 oil and gas E&P companies went bankrupt in 2015, and 39 have declared bankruptcy from the beginning of the year to May of 2016. Oilfield services, whose business depends on these E&P companies, have experienced a similar spike in bankruptcies.
For these E&P and services companies, the decision to file for bankruptcy does not have to signal the demise of the business. Despite the sense of doom often associated with the word “bankruptcy,” if executed properly Chapter 11 reorganization in fact affords these financially distressed or insolvent companies an opportunity to restructure their liabilities and emerge as sustainable going concerns. Once a petition for Chapter 11 is filed with the bankruptcy court, the company usually undertakes a strategic review of its operations, including opportunities to shed assets or even lines of businesses. During the reorganization proceeding, stakeholders, including creditors and equity holders, negotiate and litigate to establish economic interests in the emerging entity. The Chapter 11 reorganization process concludes when the bankruptcy court confirms a reorganization plan that specifies a reorganization value and that reflects the agreed upon strategic direction and capital structure of the emerging entity.
In addition to fulfilling technical requirements of the bankruptcy code and providing adequate disclosure, two characteristics of a reorganization plan are germane from a valuation perspective:1
- The plan should demonstrate that the economic outcomes for the consenting stakeholders are superior under the Chapter 11 proceeding compared to a Chapter 7 proceeding, which provides for a liquidation of the business.
- Upon confirmation by the bankruptcy court, the plan will not likely result in liquidation or further reorganization.
- Establish the value of the business under a Chapter 7 liquidation premise.
- Measure the reorganization value of a business, which outlines both the haircuts required of pre-bankruptcy stakeholders and the capital structure of the emerging entity. A reorganization plan confirmed by a bankruptcy court establishes a reorganization value that exceeds the value of the company under a liquidation premise.
- Demonstrate the viability of the emerging entity’s proposed capital structure, including debt amounts and terms given the stream of cash-flows that can be reasonably expected from the business.
