Analyzing the Effect of Debt on the Equity Valuation of Oil and Gas Producers in the Current Commodity Price Cycle
Authors: Devashish Manoj K. 
Published: April 2016

While a severe drop in commodity prices was expected to have an adverse valuation impact on oil & gas producers, the variability of this impact across the Exploration and Production ("E&P") company universe has surprised industry participants. What factors caused the impact to be magnified for certain companies and muted for others? In this paper, we have investigated the role of debt in the current financial crisis afflicting the E&P industry, and proposed a new approach for a financially leveraged E&P company to measure, manage, and reduce the impact of commodity cycles on its equity value. We analyzed the last three years of publicly available financial information for seventy-one publicly traded E&P companies operating in the United States. By performing statistical analyses using this information, we observed a modest correlation between a company's financial leverage and its equity value loss. It is noteworthy that the debt load by itself did not explain a majority of the performance variability, and there were obvious signs of other factors influencing the equity performance which we also investigated. Those influences (other than debt) include the geologic basin where an E&P company's reserves are located and the extent of commodity price hedging by the company. In summary, we have three key observations: (1) the degree of a company's equity value loss has a modest correlation with the amount of its financial leverage; (2) the relationship between financial leverage and equity value loss changes from basin to basin which indicates that the value loss is a function of reserve economics; and (3) a subset of relatively leveraged E&P companies, aided by their prudent management of commodity price hedges, significantly outperformed their similarly leveraged peers which highlights an important linkage between the management of debt and hedges. This paper presents an in-depth analysis of observation #3 and concludes with a discussion of hedging practices and recommendations aimed at enhancing a producer's ability to add reserves, achieve cost reductions, and preserve debt service capacity through a commodity down cycle.

Since data analysis showed the valuation impact to be basin-specific (i.e., varied by basin, all else being equal), we segregated our E&P company roster into smaller subsets based on which basin holds the majority of a producer's reserves. The Appalachian Subset, which includes any SEC reporting company that has the majority of its reserves located in the Appalachian basin, constituted the largest subset of thirteen companies and was, therefore, chosen for comprehensive research (see Appendix 3). While we noticed the presence of a relationship between corporate leverage and equity value loss, there were certain exceptions within the Appalachian Subset of E&P companies, namely Company 3, Company 32, and Company 55, for whom a relatively high leverage did not cause a correspondingly high value loss. Our study of their SEC reports revealed that these outperforming companies maintained a sizeable commodity price hedge book which, we believe, immunized their equity valuations against the potential for value diminution from a relatively higher leverage profile.

Among the thirteen Appalachian companies, six distinguished themselves from the rest of the group on the basis of their superior equity performance. The stocks of these six companies, referenced as the Leaders in this paper, performed largely in line with the performance of the underlying commodities (i.e., the price performance of oil and gas). However, the other seven Appalachian producers experienced an equity value loss significantly in excess of the loss experienced by the underlying commodities. Based on the use of the Devashish Method of Equity Value Immunization discussed herein, we have tried to explain the outperformance by the Leaders using detailed financial data from SEC reports, primarily 10-Q and 10-K. Through this exercise, we identified a common trend – continuous hedging to align the total hedged volume with the total financial leverage – emerging out of the disparate hedging practices employed by these Leaders. As prescribed by the Devashish Method, we have used a graphical tool to analyze whether a company's debt load could contribute to its equity value diminution following a precipitous fall in commodity prices. Under the Devashish Method, this graphical analyzer tool is called the DEVA Plot – an acronym for the Debt effect on Equity Valuation Analyzer. The DEVA Plot of one or more comparable companies is a Cartesian plot of certain debt and hedge metrics of the companies discussed herein. The Devashish Method states that, through price hedging, it should be possible for an E&P company to protect its equity value in a downturn against the value diminution resulting from a high debt load. To achieve this goal, the company's hedging program should be managed such that a graph of its debt and hedge data points falls close to or above the unit slope line on the DEVA Plot. We believe this analyzer tool could assist evaluators, such as a corporate manager or an equity research analyst, in their analysis of the adequacy of an E&P company's hedge volumes vis-à -vis its debt load. The DEVA Plot could also be used for a comparative peer group analysis at one or more points in time. Using this tool, we found the practice of partially hedging only near term production to be insufficient for the purposes of equity value immunization for a majority of the Appalachian companies we researched.

So what are the best practices that come out of our research? To protect equity holders from the potentially value diminishing effect of debt, a financially leveraged oil and gas company must manage its hedge book such that the total hedged volume stays aligned with its debt load on the DEVA Plot. We urge the managers of a financially leveraged company to utilize the Devashish Method of Equity Value Immunization by (I) identifying a suitable area on the DEVA Plot, near or above the unit slope line, based on their company's asset mix, financial leverage, and business goals, and (II) adopting a disciplined hedging policy to keep their company positioned in that area of the DEVA Plot. An analysis of quarterly hedging data shows the Leaders engaged in such practice through a continuous hedging program which kept their hedged volumes aligned with their leverage profiles. A consequence of adhering to a continuous hedging program through the price cycle is the dollar cost averaging of hedged prices – which appears to be an implicit goal of these Leaders. Hence, a disciplined hedging policy must involve committing to a continuous hedging program without factoring in personal views on the future direction of commodity prices. Furthermore, a borrower would benefit from adding to its hedge position timely, in conjunction with any increase in its debt load. As evidenced by the actual historical experience presented in Appendix 3, any time gap between the incurrence of additional debt and the layering of hedges exposes a borrower to the risk of a slide in commodity prices thereby making hedges less effective in preserving the debt repayment capacity of the borrower. In the context of the Appalachian companies analyzed, the implementation of our recommendations would require a majority of these companies to hedge significantly more volumes than those they have hedged in the past.