E&P players pump DrillCo deals as lower-risk bet on sector recovery

13 February 2018
More E&P borrowers are expected to raise DrillCo funding this year as management teams aim to boost development while also curbing leverage, according to multiple industry and financing sources.
 
Thus far, growth capital piling into the nascent energy sector recovery has been largely cut off from the public equity markets, where hype last year surrounding an IPO window was short-lived. The bond and loan markets remain open, but are mainly utilized by borrowers in need of large-scale liability management, the sources continued. Filling the void, DrillCo deals have become a popular mechanism that allows companies to raise development capital for hot shale plays while still safeguarding cash flow.
 
In practice, DrillCo deals entail a financial backer committing successive cash tranches to cover development of an operator’s assets in a specific area. In exchange, the investor gets a share of the wellbore interests. Once a targeted internal rate of return is reached, the investor side hands majority field interest back to the operator. Deal structures also come with protections against conditions turning unfavorable, as performance-based terms typically allow for capital providers to pull commitments before next in line tranches are accessed.
 
“Companies take a dilution on asset value [up front] but arguably end up creating more value on those assets,” Alex Montano, a managing director at ROTH Capital Partners, told Debtwire.
 
As such, the long-term strategy can be useful for overlevered, public E&P companies that are focused on managing cash flow and credit metrics, the sources noted. Likewise, value investors have an opportunity to bet on the sector’s comeback potential. “DrillCo is probably the most innocuous way to solve their problems or achieve growth – not adding debt nor bringing in an industry partner to have a chunk of the acreage,” said Lynn Bass, a managing director of Silverstone Energy Partners. “It’s a very effective way for them to boost enterprise value.”
 
DrillCo deals for public E&P companies struck over the past year include Chaparral Energy with capital provider Bayou CityCalifornia Resources Corp. with Benefit Street Partners, Earthstone Energy with IOG Capital, and SandRidge Energy with an undisclosed investor.
 
Private equity-backed operators have also joined the fray as sponsors continue looking for ways to engineer growth ahead of eventual sales, the timetable for which has become elusive as the sector still grapples with recovery. “Many PE sponsors are expecting to hold their [energy] portfolio companies for a longer period as the A&D market has gone quieter in the past few quarters,” said Charlie Shufeldt, managing director of IOG Capital.
 
Debt funds already active in the energy space have begun to adapt strategies accordingly, with several new DrillCo compatible vehicles launching. For instance, Ares -backed Development Capital Resources was formed last year, as was Apollo-owned Wolfcamp Drillco Operating LP

Shoot to drill

The climate is ripe for DrillCo deals to proliferate in the near term as activity in the Permian, Eagle Ford, and the SCOOP/STACK plays provides growth momentum, the sources noted. “DrillCos are not employed in the discovery or early stages of new plays, but are meant for plays that reach the capital-intensive development stage and are predictable statistically,” said Silverstone’s Bass.

Among the high-yield companies bulking up in regions where activity has pushed US rig count higher are Sanchez EnergyLonestar Resources, and Legacy Reserves. Regional upticks in activity, however, present risk that output may outstrip demand, and undermine OPEC-led production cuts, the sources continued. Oil prices dipped to USD 52.29 per barrel yesterday (February 13), after Baker Hughes reported that total US rig count climbed for the third straight week.

To de-risk, DrillCo agreements generally allow parties to suspend drilling when oil prices slump to a certain level, or block operator’s future access to funding for a project area if performance lags. Still scarred from the wreckage of the recent oil crisis, investors in talks over newer DrillCo agreements have been flirting with the prospect of increased protections in the way of liens and/or securitization of properties, the sources said. Should a DrillCo operator file for bankruptcy, the liens would give investors a secured position; and outside of bankruptcy, the liens would give investors the opportunity to foreclose on the properties if the company does not perform, noted Mike Darden, chair of the oil & gas practice group at Gibson, Dunn & Crutcher.
 
But while liens would benefit DrillCo investors, the co-opting of lending characteristics may risk setting off regulatory red flags while also complicating a borrower’s credit standing. To that point, modeling certain DrillCo deals to work more like debt instruments than JV structures could compel public operators to account the capital as debt, several buyside sources said. “What I see is accounting firms and the SEC are worried about some fancy off-balance sheet trick to the debt rules,” one of the buyside sources said.
 
Provisions on recourse and precautionary mortgage are also potential triggers for the SEC’s attention, the sources continued. “If the financial partner in the deal has some sort of recourse to help them hit their rate of return target, that might involve forcing the operator to sell assets and use the proceeds to make up for shortfall of returns,” said IOG’s Shufeldt.
 
Another trigger that could raise financial regulator eyebrows is when the operator grants the DrillCo partner a precautionary mortgage across some of their assets as collateral for a deal, Shufeldt added.
SandRidge Energy's USD 200m agreement with an undisclosed investment fund announced in 2Q17 serves as an initial battlefront on some of these issues, the sources noted. The deal targets SandRidge’s wells in the NW STACK, and is pending preclearance of “certain accounting matters” from the SEC, according to the company’s 2Q17 announcement. 

The SEC and SandRidge declined to comment.