After a relatively quiet 2018 for oil and gas defaults, the sector appears to be back in the spotlight this year with 10 rated oil and gas issuers downgraded to 'D' or 'SD' so far in 2019. Many of the more speculative names in the sector are exhibiting signs of distress and appear increasingly vulnerable to Chapter 11 bankruptcy, selective defaults or out-of-court restructurings. While hydrocarbon price volatility throughout the first half of this year is partially to blame, the lower echelon of rated issuers is also struggling to meet market demands of operating within internally generated cash flow and is experiencing investor fatigue due to disappointing returns. Moreover, with a tighter spigot for new financing, many companies are also facing liquidity constraints, refinancing concerns, and exploring various strategic alternatives often driven by disillusioned stakeholders.

It is not surprising that many of the sector's weaker links are survivors of the downturn that began in 2014. However, the underperformance of numerous reorganized issuers has been startling. After all, these companies emerged from bankruptcy with clean balance sheets and were remodeled to thrive in a "new normal",range-bound commodity price environment. This has hardly been the reality, as a significant number of recently reorganized companies continue to shed market value and face the possibility of a round-trip to the bankruptcy court.

Back From The Brink

The lower-rated companies able to circumvent the torrent of bankruptcies that hit the industry in 2015 through 2017 were typically those that benefited from a lack of immediate debt maturities, were able to significantly cut costs or sell non-core assets, successfully arranged alternative funding, and engaged in liability management exercises (typically in the form of distressed debt exchanges). While these actions helped prolong their runway, several holdouts have recently decided to throw in the towel (see Bristow Group Inc., PHI Inc., Weatherford International plc, and Jones Energy Inc.).

In the section below, we highlight some credits we dub the 'survivors'. Most of these fall within the 'CCC' rating category, and their debt trades at distressed levels.

Table 1

California Resources Corp.

The highly-leveraged former spin-off of Occidental Petroleum Corp. will be dependent on oil prices and capital markets to address a heavy debt maturity schedule beginning in 2021. Given current market conditions and yields, this could be quite challenging, as high operating expenses and interest costs weigh down the company's ability to generate cash for debt repayment. California Resources' second-lien notes due 2022 currently trade at less than 75 cents on the dollar.

Denbury Resources Inc.

This carbon-dioxide enhanced oil recovery (CO2 EOR) operator's production stream consists almost entirely of oil, providing atypical leverage and sensitivity to oil pricing. During a period of higher pricing, this emboldened an ill-fated merger with Eagle Ford driller Penn Virginia Corp. in 2018. With that deal terminated, Denbury has turned its eye back to pushing out its subordinated debt maturities (via additional debt exchanges) and preserving liquidity on its undrawn revolving credit facility that is set to expire in 2021. The company's subordinated notes due 2023 trade at less than 55 cents on the dollar and its senior convertible notes due 2024 trade around 65 cents on the dollar.

EP Energy LLC

The Apollo-led leveraged buyout of EP Energy in 2012 has run its course and restructuring risk has greatly increased. Recent efforts to reduce debt through exchanges, open market purchases, and asset sales do not appear to have adequately fixed an overburdened capital structure as the company nears a significant bond maturity in May 2020. EP Energy's longer-dated unsecured notes due 2023 trade below five cents on the dollar.

Hornbeck Offshore Services Inc.

This Gulf of Mexico-focused offshore supply vessel (OSV) operator was able to stave off restructuring after arranging a $300 million term loan back in mid-2017 that has served as its primary source of liquidity. Since then, the company has taken on additional loans and methodically targeted its 2019-2021 maturity wall with a series of debt exchanges. But the OSV operating environment remains weak, and more than $650 million of notes is coming due in the next two years. Hornbeck's unsecured notes due 2020 and 2021 trade at 50 to 65 cents on the dollar.

Jonah Energy LLC

This Wyoming-focused natural gas producer has benefited from a strong hedge book, but financial metrics and liquidity are expected to weaken as favorable hedges roll off soon. Production growth will also likely be muted by a lower capital spending budget, while unsecured debt trading at less than 50 cents on the dollar heightens exchange risk.

Pioneer Energy Services Corp.

Aside from its inherent dependence on upstream activity levels, almost all of Pioneer's domestic drilling rigs will be up for re-contracting this year. Liquidity is limited, as the company approaches a potential springing maturity on its term loan in about two years and is unlikely to sell assets into a reluctant market. The oilfield services and contract drilling provider's unsecured notes are trading below 50 cents on the dollar.

Sanchez Energy Corp.

The Eagle Ford-centric E&P company has continued to struggle with operational issues and lower-than-expected production rates in the wake of its complex acquisition of the Comanche assets from Anadarko Petroleum Corp. in 2017. Management turnover and the addition of board members with turnaround experience points to elevated risk of a restructuring transaction. Sanchez's unsecured notes are trading at less than five cents on the dollar.

Recently Reorganized And Under Pressure

In theory, distressed companies who elude Chapter 11 put themselves at an economic disadvantage relative to reorganized entities due to their higher debt and interest burden. While this holds true, it is fascinating that many recently reorganized oil and gas companies have evidently not fared much better since emergence than the embattled 'survivors'. Based on market indicators such as equity capitalization and indicative debt trading levels, there appears to be a possibility that many of these companies could soon end up back in court for Chapter 22 proceedings—a euphemism for a second Chapter 11 bankruptcy filing. The table below displays a handful of names who have lost, on average, 65% of their market value since their post-reorganization shares began trading or after transformative events such as initial public offerings, spin-offs, or combinations, for instance.

Table 2

In particular, smaller producers across Oklahoma's SCOOP/STACK and Merge plays have been disproportionately eschewed by investors despite operating in a region that was billed as the second coming of the prolific Permian Basin not too long ago. The underlying reasons for this have been attributed to unanticipated rock complexity, higher weighting of natural gas production, and flawed spacing plans that led to interference among parent and child wells. These factors, along with others, have inhibited the post-bankruptcy experience for local E&Ps including Alta Mesa Resources Inc., Roan Resources Inc., and Chaparral Energy Inc. Tapstone Energy LLC, which is a private operator in the region, has also come under pressure with its bonds trading at approximately 65 cents on the dollar.

The selloff among these reorganized companies hasn't spared operators outside of the Mid-Continent, though. Halcon Resources Inc., which sold off its Bakken shale assets in order to reposition itself as a Permian pure-play, has again hired restructuring advisors as it contends with declining liquidity, covenant issues, and debt trading around 30 cents on the dollar. Ultra Petroleum Corp. is another interesting case where the company was arguably hamstrung by an aggressive valuation during its bankruptcy process, which left the Wyoming natural gas producer over-leveraged heading into an oversupplied gas market. Furthermore, the company's horizontal well tests bared limited success, and Management has reverted to an all-vertical drilling program. As a result, Ultra has cut guidance several times and has been actively pursuing debt exchanges in an effort to reduce leverage and push out bond maturities. Its unsecured and second lien notes are trading at roughly 10 and 45 cents on the dollar, respectively.

A Bet On Consolidation

Despite the challenges facing companies across the sector vertical, vertical, not all of its troubled participants are standing pat. In the first half of 2019 we've seen several noteworthy mergers or acquisitions among speculative-grade oil and gas companies that seem to be targeting cost synergies, operating efficiencies, and to some extent, supply correction. These include the Ensco Rowan plc (B-/negative) merger of offshore drilling rig operators; Comstock Resources Inc.'s (B/Stable) announced acquisition of fellow Haynesville gas producer Covey Park Energy LLC (B/Stable), and Keane Group Inc's (B+/Stable) proposed combination with previously reorganized oilfield services provider C&J Energy Services Ltd. The market has mostly reacted indifferently to the latter deal, while the Ensco/Rowan and Comstock/Covey transactions have received a lukewarm response, with debt at both entities continuing to carry double-digit percent yields.

To summarize, it appears none of the companies we've considered here are out of the woods yet, and market indicators are pointing to a high likelihood of bankruptcy for many of the downturn's survivors as well as a host of reorganized entities. Meanwhile, the jury is still out on whether contemporary consolidation initiatives will enhance viability for some of the industry's speculative-grade issuers.What we have repeatedly learned is that in most cases, where there is smoke there is fire. Barring a sharp reversal in commodity pricing, the sector could shortly be facing another reckoning.