(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).
• Continue