(To see Part 1 just scroll down after this article).

So how do bankers and energy producers deal with the large amount of debt that is on the balance sheet of almost ALL junior and intermediate producers on the Toronto Stock Exchange (TSX).

Both groups are realizing they could be in for a prolonged slump in energy prices, especially natural gas producers, meaning low to NO positive cash flow for most to even service debt, much less grow. (I mention two oil weighted juniors with no debt at the end of this article.)

Backing up one step, how did these companies get in this position?  In a rising price environment, debt is cheaper than equity – you can pay off debt and get rid of it, but once you issue equity it’s forever.

The Canadian management teams are truly excellent explorationists.  With modern technology and experienced people, many teams (or at least, the ones I follow) regularly ring out 80-90% success rate in their drilling exploration. 

But what they do, and the bankers encourage it – they instantly lever up the newly found production with new debt – and purposefully kept their debt ratios high, to keep new equity issues low.  The idea is that one day they will issue shares to pay off the debt, but later when their production and stock price is much higher.  You just have to pay off the debt before the music stops (i.e. when commodity prices collapse).  Very few companies did that.

Lenders understand these price cycles always have troughs, it’s just that this could be longer and deeper than most.

So during these times, banks are liberal in their price decks, which means they run their financial cash flow models on prices like $6 gas and $50 oil – prices that are not “realistic” in this market.  If they do use realistic price decks, then two thirds of their oil and gas client base is under water, and somebody in the bank could say HEY! Call the loan or something.

Just like banks don’t give out full lending to these companies when oil is $140/barrel and gas is $8/mcf, they cut the companies some slack during low prices.  Banks also lend on reserves, not just cash flow, and because the price decks being used to calculate reserves are based on 2008, which are now VERY unrealistic, that helps the producers as well.

Banks normally run price decks every 6 months, and have reviews with management then as well.  That is now happening every quarter and if the company is on watch by the bank, even more often.

Calling the loan is a drastic last step that helps nobody.  In any vertical market, it serves the bank little purpose in bankrupting their client. And as soon as a bank takes over an asset, its value drops immediately.

A more realistic scenario is that the lender will send in a monitor to the company, and do a very thorough “audit” of the company – get an up-to-the-minute look at the financial situation.  In a good relationship, the company has been pro-active in dealing with their lenders.  But it still happens that management teams don’t do that, and then when the proverbial !@#$ hits the fan, they present the banker with a few ideas of which there is very little choice.

But most lenders have good relationships with their client energy companies.  The most likely action is the lender might reduce the loan facility for a company.  So if a company is fully maxed out on a $100 million debt facility, the bank might tell the management team that is now being reduced to say…$70 million.

So this team now has a few choices:        

• 1. Raise equity. The good companies can still raise equity – Storm (SEO-TSX), Progress (PRQ-TSX), and Breaker Energy (WAV-TSX) are all natural gas companies who have (surprisingly, in my view) been able to raise equity in a declining commodity price environment. Small companies – anything under 700 barrels per day equivalent let’s say (boe) – will likely NOT have this option.
• 2. Do a convertible debenture (CD – which is debt that can be converted into equity at a higher share prices sometime in the future).
• 3. Find some other subordinated debt. A private lender might loan the company some money a short term basis at very high rates – 20% + – that is interest only and secured by one particular asset
• 4. Sell assets, or partial interest in assets. As I mentioned in my previous column, OPTI-Canada (OPC-TSX) sold 35% of their oil sands project to Nexen (NXY-NYSE; TSX) to get rid of debt and add working capital.

Ithaca Energy (IAE-TSXV) is a junior explorer which took on huge debt to put its oil and gas discoveries in the North Sea into production.  They raised $75 million in equity last October at what was then a ridiculously low price of $1.50.  The stock was $4 just over a year ago.  Now it’s 35 cents.  They then sold a portion of their assets to another oil company active in the area, Dyas Exploration (listed in England) for $65 million, and got Dyas to take over the debt that Ithaca had with another bank, the Royal Bank of Scotland (RBS). 

(RBS had some of their own financial problems this year, causing grief for their energy clients like Ithaca and Oilexco (OIL-TSX). Oilexco, a very high profile North Sea exploration company whose stock went from $5 to $30/share this year, was unable to restructure its debt and their operating subsidiary has since declared bankruptcy.)

But Ithaca has been creative – and successful – in handling their debt, and are likely survivors, as their first production comes on stream next month, in March 2009.  Too bad they turned down a $3.25 takeover offer in June 2008 (INVESTOR LESSON: ALWAYS sell a stock of a junior whose management team turns down a takeover – immediately! In my almost 20 years of investing I cannot think of a single time management has been able to create more value on their own afterwards)

• 5. Merge with another company with a better balance sheet.
• 6. Agree to be bought out by a larger company. See above investor lesson.
• 7. Reduce or stop drilling.

In Canada, the two largest lenders are the Alberta government, through the Alberta Treasury Branch (ATB), and National Bank (NA-TSX).  The ATB is not a lender of last resort, but they generally do experience an increase in business during the price cycle troughs we are now in.

A few companies have made the tough decisions already, but many have not.  I can smell the sentiment for the junior oils improving in the market, but most Canadian producers are heavily gas weighted.

Two oil weighted Canadian listed juniors with no debt are West Energy (WTL-TSX) and Painted Pony Exploration (PPY.A-TSXv)