MANAGEMENT PERSPECTIVE HOW TO AVOID PITFALLS IN FINANCIAL RESTRUCTURING

Jon O'Sullivan
Senior Manager
Ernst & Young
Dallas

Natural gas prices have dropped so low that U.S. producers have curtailed production, slashed capital spending, and cut staff to the bone.

The outlook for the rest of 1992 and beyond is bleak.

Gas futures prices are hovering at about $1/Mcf, and spot prices are not too far ahead of that. More important, many producers have significant debt on their books and either don't have the cash to meet scheduled payments or are not sure whether spending precious cash to pay lenders is the best use of their money.

Many producers have even sold some of their best assets to meet operating needs or to pay debt.

Does that sound familiar? Whatever the ingredients of your particular situation, there are two things you can be sure of:

You are not alone.
The depressed U.S. oil and gas industry is not likely to get better any time soon.

This situation is all too common in the latest downturn in the oil and gas industry.

Unfortunately, what also is all too common is the need for managers to meet financial challenges associated with the need to negotiate with lenders to survive a financial crisis. The question is: What can management do to put itself in the best position to work with lenders while still maintaining control of the company and its best assets?

CURRENT OUTLOOK

Perhaps the most common sin of oil and gas managers is failure to understand how the present state of affairs affects the future of the company. Simply stated, management fails to build a realistic business plan that can be used as a basis for negotiating a successful restructuring.

Absence of a plan causes managers to be controlled by short term events. Putting out flash fires becomes the norm with no strategy to eliminate the source of the problems.

Therefore, the first step in any restructuring is to lay out a business plan that can cope with a poor market outlook.

Development of a plan forces managers to assess the current situation, quantify its effect on near term and long term goals, and develop strategies to achieve those goals.

WORKING IN A BATTLE ZONE

The effects of trying to survive in the oil and gas industry today without realistic plans for survival are like walking into battle without an overall strategy for victory. Each problem is a potential catastrophe.

The result of simply reacting to problems as they occur may work for a time. But in the absence of a miracle, such as a sudden and prolonged increase in prices, time and cash usually run out.

Management's efforts to cope with falling prices, idle assets, or limited capital often result in a siege mentality. The company is under sudden attack, and every possible effort must be taken to survive.

The problem today is that the drop in prices and the U.S. rig count are not sudden attacks. Those problems started a decade ago.

Rhetoric such as "Stay alive 'til '85" and "Pray to heaven 'til '87" were indications of the expectations of the duration of the downturn.

Today, no jingle-like slogans abound. The downturn in the oil industry has never been so deep or so sustained. Nevertheless, many managers have waited until a cash crisis occurs before reacting.

So what are the results of the siege mentality caused by a cash crunch?

The fastest way to raise cash to avoid a crisis is to sell the company's best operating assets. Whether those assets represent a field with a strong upside, a pipeline supported by favorable contracts, or a refinery with good economics, they are the assets that offer the most potential for immediate cash flow.

However, those assets have the most promise for growth. Unfortunately, by trading a long term asset to satisfy a short term need the company has just taken one asset away from its ability to accomplish a successful reorganization.

Reducing operating costs is another way to save cash in the short term.

For most companies without the benefit of foresight to conduct process improvement studies or rightsizing analyses, this means across the board staff reductions. Too often this takes the form of purging departments.

Rarely is it done with the benefit of quantitative or qualitative analysis. In most cases, no effort is made to correlate reduction in staff and a reduction in required work effort. This results in overworked staff, inequities in job function, reduction in efficiency, and low morale.

Cutting outlays for exploration and development also is a common method of conserving cash. The reality is that if economic returns on a project are favorable at current prices, it's a project worth pursuing.

Each of those steps is a viable, useful option in a well planned environment. However, when approached with little or no planning, they only postpone hard times and destroy a favorable position for negotiating with lenders.

INDICATORS OF A PROBLEM

Before approaching a restructuring, management must first recognize the signs that lenders look for in diagnosing the company's problems. There are a few simple characteristics that are consistently symptomatic of a management team that will find itself in trouble when the going gets tough:

Absence of a realistic long term plan shows that management has not focused its attention on the financial viability of each asset of the company.
Lack of timely, meaningful production and operating reports shows that management is not focused on the goal of achieving the best results from its operating assets. Often this essential information is the first casualty when management cuts costs--if these reports even existed at all.
In an operating environment in which business is not managed in a focused or directed manner, management is spending most of its time putting out fires. As a result, little or no time is spent directing and leading the organization toward a profitable segment of the industry.
The constant search for the big fix might take the form of an acquisition of a great property, pipeline, or refinery. Or it simply may be the next big deal. Unfortunately, all too often these efforts turn out less favorably than expected due to a hurried environment and a lack of due diligence.

The challenge is to recognize that long term problems require long term solutions. More important, lenders often view these characteristics as "red flags" in the debt restructuring process.

The goal then must be to create an environment focused on long term survival. Once management recognizes that the most productive course of action is to alleviate the company's debt requirements through a negotiated process, it must resolve to divorce itself from the past and look to the future.

SURVIVAL CHARACTERISTICS

Successful negotiation and execution of debt restructuring begins with a few basic ingredients:

Establish a positive operating environment created by management, specifically the president or chief executive officer. Strong leadership provided by this individual accomplishes several goals. It:

Communicates to every employee the importance of the restructuring process.
Communicates management's commitment to lenders.
Provides a visible leader of the effort.
Establishes the survival mentality and communicates goals to employees. These goals include maximizing the value to shareholders, buying time to restructure, and completing a successful restructuring.

Establish a good relationship with lenders. The required ingredient generally means treating lenders like a partner. This partnership approach includes:

An open line of communication.
Avoidance of negative surprises.
Providing timely, accurate production and financial information.
Achieving goals and objectives.
Maintaining honesty and integrity.
Treating all lenders alike.

All too often, managers in troubled financial situations make one critical mistake: They tell lenders what they want to hear, only later having to retract their statements.

In the process, each one of the ingredients in the partnership approach is violated. Unfortunately, this mistake destroys the credibility of management and can ultimately result in a Chapter 11 bankruptcy filing rather than an out of court restructuring.

UNDERSTAND THE ALTERNATIVES

Management of a distressed company has several alternatives to present to its lenders. Each one must be considered, taking into account the company's financial condition.

A liquidation Of Producing assets to meet debt obligations in the current industry environment promises little opportunity for recovery to lenders. Current prices for proved reserves have been further depressed due to spot market prices for. oil and gas production. Although a liquidation analysis is useful for educating a lender, it rarely delivers the highest returns.

A Chapter 11 filing requires time, lawyers, accountants, and potentially investment bankers for all parties and plenty of cash to pay those costs. In addition, a filing can jeopardize customer relations.

Although protection provided by the courts may become necessary, Chapter 11 is a measure of last resort that usually erodes the value of a company and results in lower returns for all parties.

An out of court restructuring provides several advantages, including an expedient, less expensive process, the ability to control the process, flexibility to address each creditor separately without alarming customers, and avoidance of negative press and ultraclose scrutiny.

A complete understanding of each alternative provides managers the understanding to select the most appropriate approach and forms a more informed basis for negotiations.

THE PROCESS

Once a company has identified the need to restructure its debt with lenders and established the management and operating team to address all the issues associated with a restructuring, there are several initial tasks to work through. The goal is to ensure that the company has enough time to successfully negotiate a debt structure that will allow it to survive until the industry recovers.

The first task in a troubled environment is often referred to as "stopping the bleeding."

This refers to identifying areas that are draining the company of its cash. When a company has debt related to previous development projects or acquisitions, this may include notifying lenders that interest or principal payments may not be met as scheduled.

Alternatively, this may require shutting in production that does not generate enough cash to cover costs or deferring a current development project until the situation is stabilized.

In either case, this step affords the company a short period during which management can assess the viability of all operations.

The next task is to quickly develop a cash management system that will project the company's daily or weekly cash position for the next 60-90 days. This requires input from production personnel about the level of daily or weekly production, marketing personnel about determining when products can be sold, and accounting personnel who will determine when cash will be received.

In addition, all expenses must be estimated to determine the amount of cash that will be used for operating and current costs over the period.

Once a cash flow forecast has been developed and communicated to lenders, the company can begin evaluating the effectiveness of each operating asset in relation to its contribution to the future of the firm.

This analysis entails determination of future cash flows of the asset, the value of the asset if sold on the current market, and an estimate of indirect costs such as overhead required to maintain the asset.

After each operating asset has been evaluated, the company should evaluate whether there are any assets that do not fit into an overall strategy for the future. For example, if the company anticipates operating in gas transmission in Texas, Louisiana, and Mississippi, it may not be strategically efficient to operate a refinery in California.

The next--and perhaps most important task--is determining the company's ability to build a business plan that encompasses results of its analysis and the strategic direction of the company. This includes choosing assets that will be kept or sold, developing the overhead structure to support those assets and related operations, and defining the best organizational structure to ensure implementation of the plan.

Once the business plan has been established and the related prospective financial forecast developed, the company is in a position to begin the process of deciding how it will negotiate a workable debt structure. This requires constant communication with lenders and an understanding of alternative financial structures.

After a final negotiated plan has been agreed to by all parties, debt agreements have been amended to reflect the changes, and a new capital structure has been established, the company should take steps to implement a monitoring system that will allow it to report the results of the restructuring effort for a period of time, normally until the debt is repaid,

Many of these steps may have to be performed concurrently rather than sequentially. A team approach may have to be used in which one group tries to stop the bleeding while another group starts to develop the plan.