React now or Fail!
On April 10, 1912 the Titanic set sail from Southampton on its maiden voyage bound for New York. The disastrous events that unfolded during that voyage were so significant that children that were not even born at the time have vivid memories of the events and lives that were lost. Unfortunately the sad truth is that the disaster could have been avoided by better training, more lifeboats, extra attention etc.
It has been well publicized that the E&P industry has been struggling with oversupply and low commodity prices (as well as other commodities). This is nothing particularly new in the industry as many insiders have appreciated the cyclical nature of the market place for years. The magnitude of the industries’ challenges is so significant that avoiding the equivalent of Titanic like scenarios and navigating through extremely difficult waters is the question may be keeping most of the executives awake in the midnight. We cannot provide life jackets or lifeboats but sound advice acted upon early can change outcomes. Not only could E&P companies be facing insolvency or major downsizing the problems have a knock on effect on suppliers to the industry, their employees, government agencies and communities as a whole. Historically E&Ps (especially the larger organizations) have had the luxury of being able to fund new projects and increase production and profitability.
However, with current commodity prices as they currently stand, how will these companies respond to the changing market conditions? How can we avoid the equivalent of the Titanic in the oil and gas industry, as it navigates through some extremely treacherous waters.
We have been in a multiple conferences and forums where people much smarter than us examined in detail the underlying causes of this crisis. The main takeaways from those events could be summarized as:
- China’s Economy – China is the second largest consumer of oil in the world and its growth rate is not stable and, accordingly, demand for oil fluctuates.
- American Shale – The US experienced a growth of around 80% in its shale gas production in 2014 with production totaling more than 9 million barrels per day, with the inevitable decrease in oil prices.
- Elasticity of Demand – Ironically, low oil prices have increased demand and this may in turn stimulate further growth, increasing the demand for oil.
- OPEC – To date, OPEC has not reduced its output quotas, leaving oil prices low with an oversupply in the market. It remains to be seen if this stance will continue or if we will see a reduction in production quotas.
- Geophysical Flash-points – There have been historical spikes in oil prices but given the overall state of supply in the market these geophysical flash-points have been absorbed with little consequence.
Our couple of cents here would be to give some practical advice for the executives, their bankers and other stakeholders of the challenged businesses. Also provide them with practical and expedient advice to assist them through this difficult period.
Clearly these factors and the market place overall are not going to stabilize overnight and it will likely take some time before we see an improvement.
Early Warning Signs
By acting early companies afford themselves more options and input in to their ongoing future, or sometimes demise. Too often early warning signs are ignored, the financial and operation position of the company worsens and the company’s indebtedness to both its secured and unsecured lenders increases. Certain fairly major deteriorating health indicators are as follows:
- Company cannot pay the creditors within normal terms and they put the payables on hold until the next cash inflow;
- On a regular basis company’s financial results indicate that its losing money and that the liquidity position is being eroded;
- Company may have requested an extension of the overdraft facilities and/or cheques may not have been honored by the Bank;
- New suppliers will only do business on cash terms;
- Unable to purchase goods and services to efficiently carry on the business;
- Layoffs and unpaid wages;
- Creditors have taken or threatened legal action.
- Breach or near breaches of financial covenants
Act Early – Business Reviews (look-see, viability reviews)
If initiated early enough business reviews can assess available roadmaps to navigate through cash crunch situations without going through expensive insolvency proceedings. Such reviews could be executed by special internal team or external consultants with specialized knowledge of insolvency matters. Neither company nor the lenders want to use insolvency proceeding as this avenue often leaves the creditors unpaid or with a small dividend. A business review can be instigated by a stakeholder with a direct interest in the financial position of the company. The purpose of the review is to work with management to:
- assess the severity of the current financial position;
- what can be done to alleviate the pressures on the company;
- identify additional resourcing if required;
- prepare a list of recommendations and conclusions; and
- monitor the implementation of the recommendations.
During the course of a business review the consultant will visit the company’s operations, obtain an understanding of the business and review the current financial position and forecasts prepared by the company. These forecasts will be analyzed and question based on business understanding and realistic expectations of future outcomes. Thereafter a report or presentation will be provided to the stakeholders and monitoring procedures can be agreed to ensure that the conclusions and recommendations are acted upon by the management. Overall, the depth and the cost of the business review by the consultants depend on a number of factors including:
- complexity of the business;
- the openness of management;
- the accuracy of the current financial position; and
- quality of cash flow and profit forecasts analysis and assumptions.
To be effective and efficient consultants should not only have sound financial backgrounds but even more importantly they should have a broad total understanding, in many industries, allowing then to hold meaningful discussions within the various stakeholders to facilitate root cause analysis.
If these items are already managed at high standard by the company, development of an early road-map is the most cost effective solution while offering the largest range of options open to the company and stakeholders in the future.
Business reviews can help to avoid potential icebergs.
Formal Insolvencies – avoid unnecessary costs before hitting the fan
If early warning signs are not addressed by companies or stakeholders (including banks) there is the danger that they will become subject to formal insolvency proceedings under one of the following pieces of legislation:
- The Bankruptcy and Insolvency Act (“BIA”), a detailed statute which includes Canada’s bankruptcy regime and a proposal regime, pursuant to which insolvent debtors can achieve compromises with their creditors;
- The Companies’ Creditors Arrangement Act (“CCAA”) which permits the reorganization of insolvent companies with debts, including debtors’ affiliates, over $5,000,000 and compromise of creditors’ claims through a plan of arrangement; and
- The Winding-up and Restructuring Act which governs the liquidation and restructuring of certain types of companies, including banks, insurance companies and trust companies.
It is worth mentioning that Directors can become personally liable in certain circumstances for company’s liabilities and this should be avoided wherever possible at early stage.
From all the scenarios that we have come across in the current market it is the PROACTIVENESS of the management and stakeholders, which allows a reduction in insolvency costs and keeps the company trading as a going concern wherever possible.
Difference between smart vs. wise man
One of the features of a well-managed company is its recognition of risks by its decisions and its preparation/adoption of mitigating strategies. This is tremendously important in a company’s overall strategic plan but it is also extremely important in a) project management and b) execution (especially larger/complex projects). It is often the case that companies will have a project execution plan (often based on a stage gate methodology) but the plan is not always followed rigorously enough (including risk assessments) and this adversely impacts project costs and outcomes. In difficult financial times this is even more important and will be the subject of our next discussion.
