By David Yager, November 23, 2016
Entrepreneur. Consultant. Journalist. Political Activist.
“It is picking up now but I can’t make payroll with the increased work. Got a spare million laying around?”
This is the email response from an old buddy last week who has run his own oilfield construction company for over 30 years. I asked him if business was picking up and yes indeed it is. But when the oilfield services (OFS) industry ends up in a hole this deep you don’t just walk out. You crawl if you make it at all. Many never will.
Early this year my friend’s long-term banker called his $2 million operating line without warning. Although he had been with the same lender for years, loyalty was meaningless. OFS is cyclical but there had been enough good years for the owner to take some profits out of his company. That’s the plan when you go into business for yourself. But as was not uncommon for successful private companies during this slump, his senior secured lender decided the risk of staying with this customer in this market was greater than the benefit of past or future business. So the operating line was terminated. Pay up immediately or we’ll seize your assets and shut you down.
With all credit markets locked down tight for OFS and with a very short time frame, my friend had to pay it out personally with his own cash. Fortunately, he’d remembered to hang on to some of the money from the good times and came up with $2 million to keep his life’s work alive. Now the phone is ringing and he’s hiring. But he has no working capital and no cash. His former banker has that. This is yet another roadblock on the bumpy road to OFS prosperity.
Like almost everybody in OFS looking to borrow money, the only financial statements relevant to lenders are for the last two years which, of course, have been in a state of continuous decline. Not only have debt markets clamped down on oil and gas lending in general, they have also tightened up on operating lines of credit secured by accounts receivables. Receivables from credit worthy oil and gas company clients is about the closest thing to cash a company has. Historically, this has been the easiest asset class to borrow against. Not in 2016.
Unless you’ve worked in this peculiar business, most don’t understand the challenges OFS faces to finance day-to-day operations. In many businesses every sale transaction is cash upon delivery. Pay either before or immediately after the product is delivered. Think of retail anything or home repair or maintenance services. For utilities you often must pay in advance. Cash management for normal businesses – defined as getting the money relatively quickly to pay for labor, inventory, products and delivery – is a challenge but nothing like the struggle OFS must endure.
In this sector you do the work today and hope to get paid in the same season the work is done from delivery to payment. A season is defined as 90 days, like the 91 days from the first day of winter to the first day of spring. This varies from client to client and hopefully three months is the outer end of the gap between sale and cash. Most larger public companies disclosing these things manage their finances to work this down to a 60 to 70-day average. These outfits are usually headquartered in Calgary and have staff dedicated to administer the job ticket/invoice/collection process. Smaller private companies operating in rural locations are often forced to wait 100 days or longer to get paid. If there is a worse business in the western world for this appalling cash management challenge, please advise the writer.
The problem is OFS must pay for fuel, labor and subsistence immediately. While you may work for Imperial/Esso, Shell, Husky or Suncor/PetroCanada and they will always pay you eventually, that doesn’t mean you get a break on credit terms for fuel purchased today to get your people and equipment to their point of purchase. Labor and subsistence are due every two weeks. Depending upon expendables and operating supplies, OFS may be working out of inventory meaning they have pre-purchased their products. Now the vendor must wait months for the cash to restock operating supplies or inventory.
This is exacerbated by a market in which there is little or no profit. Most in OFS are working at cost or the tiniest of margins. Once you add in fuel, labor and expendables which must be paid almost immediately or come out of inventory, what other expenses are there? Real profit for equipment maintenance and replacement is a thing of the past. For OFS to deliver as activity improves companies must find the working capital they don’t have or can’t borrow to float their customers. Though nobody ever says so, it is no great privilege to subsidize clients who only hire once you agree to work for nothing.
Feel free to kick me when I’m down! I’m used to it!
There are options to a traditional operating line of credit from a bank or credit union. They are all expensive but not necessarily unsurmountable.
One is “factoring” accounts receivable where you sell invoices to a financial services company today and get most of the cash immediately. There is no long-term debt obligation. Once you’ve proven the work was done and the client is credit worthy, send the invoice to the factoring company and they will send you something in the range of 95% of the invoice immediately. Most don’t advertise their total fees on their websites but it is very pricy compared to a standard operating line. One website only offers this for “net 30-day” invoices meaning some of these capital providers won’t even consider the “I’ll pay you when I get around to it” system OFS and its clients operate under.
Whether or not factoring is an option really depends upon your margin. If you’re working at cash cost this is not solution in the long term. Factoring is likely a better short-term solution on a case-by-case basis than a long-term corporate finance alternative. But those who provide this service recognize this and market it as such.
Another challenge with this form of working capital is customer relationships. Once they have purchased an invoice some factoring companies are merciless in collecting their cash. This has resulted in client backlash against OFS vendors using this financing tool. The idea clients would not only not pay in a timely fashion but penalize their suppliers who are looking under every rock for working capital seems like cruel and unusual punishment. But that’s the current business environment and the peculiar relationship between OFS and their clients.
The second is merchant banks or what is classified as “subordinated debt” or “sub debt”. Here finance companies provide working capital to businesses but for collateral they will take either a secondary security position (behind a secured lender) or even an uncollateralized loan. That’s it for the good news. The bad news is sub debt is always pricy, often in the 18%+ range, and the borrower still must prove it is credit worthy meaning it can present a business plan demonstrating the ability to pay it back.
Another alternative, and perhaps possible in today’s marketplace, is a frank and intelligent discussion with clients about working capital challenges resulting in sensible and mutually agreeable accelerated payment terms. Clients claim they want good prices AND good performance. OFS can easily make the case they can’t afford either given the strength of their balance sheets after two years of price cuts and revenue declines. Even the negotiation of an assured 30-day payment schedule would help.
OFS managers say laid off workers are hesitant about returning to the ‘patch. No wonder. Wait until they learn the struggles their potential employer is having figuring out how to pay them.
The final option, and one only available to a select few, is raising debt and equity capital though significant equity dilution by issuing shares. On November 23 Savanna Energy Services Corp. announced it was selling 13 million common shares at $1.45 per share to Alberta Investment Management Corporation (AIMCo) which will raise nearly $19 million before fees. Savanna stock traded at $9.10 a couple of years ago. In addition, AIMCo has agreed to make available up to $200 million in the form of a second lien senior secured credit facility. This is accompanied by some warrants. AIMCo will own from 11% to 16% of the company depending upon how many warrants are exercised.
This sort of capital injection is only available to larger, publicly traded companies with significant capital assets. Lots of owners would be happy to sell equity but there is little interest in smaller companies without liquidity.
But no matter where the cash comes from, companies able to raise working capital to fulfill client demand as the market recovers will most certainly have a competitive advantage.
There has been a lot of commentary published about how oil companies have their costs under control, productivity has jumped and U.S. light tight oil can rebound quickly with oil prices. This is based on the premise that OFS, like a big-city fire department, has a trained, paid and qualified staff on standby pumping iron in the company gym waiting patiently for the phone to ring. Nothing could be further from the truth. In the same way that downsizing OFS was awful, ramping up the supply chain to workable levels also has its challenges. Most who put forward the thesis of a quick production rebound don’t understand how the business works. This will take time and money. Both are in short supply coming into what operators would like to be a more active winter drilling season.
That said, having business improve and having to find people and figure out how to pay them is a better problem than the massive and painful two-year contraction of the entire OFS sector. As is always the case OFS will figure it out. But it certainly won’t be easy. Wouldn’t hurt if the customers could throw drilling and service a working capital bone of some sort, or at least have an open and honest discussion with their vendors about their challenges.
About David Yager – Yager Management Ltd.
Based in Calgary, Alberta, David Yager is a former oilfield services executive and the principle of Yager Management Ltd. Yager Management provides management consultancy services to the oilfield services industry in a number of areas including M&A, Strategic Planning, Restructuring and Marketing. He has been writing about the upstream oil and gas industry and energy policy and issues since 1979.