Bankruptcies in the oil and gas segment have slowed during the fourth quarter, but observers believe the combination of heavy debt loads and little hope of outside funding will mean the last few months have been a respite and not a sign of things to come.

According to the bankruptcy monitors assembled by the law firm Haynes and Boone LLP, there were three bankruptcies reported in the upstream segment during the fourth quarter through the end of October compared to 35 in the prior two quarters. In the oilfield services segment, there were nine bankruptcy filings in the first month of the fourth quarter, or one-third of the total from the third quarter alone.

While the noticeable decline in bankruptcies could be considered a reason for optimism, a significant number of both producers and oilfield services companies are still struggling with difficult debt situations. For that reason, the number of Chapter 11 bankruptcy filings could surge in the final weeks of the year.

"There are still weaker players out there who are going to need to seek refuge," said Charles Beckham, a partner in Haynes and Boone's energy practice. "There's going to be continued carnage on the oilfield services side."

When the 2014 to 2016 oil price collapse occurred, a number of companies who had overloaded their balance sheets with debt filed for bankruptcy — a record 70 companies in the upstream sector filed in 2016 alone. While some of those companies were able to recover and others cleaned up their balance sheets on their own, many fell right back into the same trap of heavy debt with the idea prices would improve in 2019 and 2020. With the COVID-19 pandemic causing demand destruction and another price collapse, the scenario is repeating itself for producers.

"The thought was, 'We fixed our balance sheet and we are now fully capable of competing,' with the idea that commodity prices would rise in 2019 and 2020," Beckham said. "Prices haven't gotten there yet. Whatever has been done in the past two or three years has been done with the idea that commodity prices would be higher, and now they have a problem."

Haynes and Boone partner Buddy Clark said the situation is not much better in the oilfield services sector, where larger companies are facing the prospect of bankruptcy as business dries up.

"It's a lower cost of entry in oilfield services; all it takes is two guys and a truck. But these are not mom and pop [bankruptcy] deals. These are major players," he said.

While some companies in the upstream sector have agreed to acquire competitors during the fourth quarter, the Haynes and Boone partners were pessimistic on the idea of a consolidation spree occurring. With debt issues and a lack of investor support hanging over many companies, the idea of a flurry of moves was deemed unlikely.

"Public companies are not rewarded for consolidation," Clark said. "There are some, anecdotally, mergers out there, but the idea out there is to hunker down, reduce costs and don't you dare talk to your banker."

At a recent conference hosted by the Dallas and Kansas City Federal Reserves, Wells Fargo Managing Director for Energy Credit and Risk Management Chris Holmgren said banks had essentially shut out the upstream segment after years of disappointment.

"[Shale production] growth masked poor returns," he said. "From 2019 into this year, there was a growing realization that, in spite of investing billions, the returns were not at expected levels."

Even after the 2014 to 2016 price collapse, Holmgren said, lenders were willing to support producers looking to expand their operations in shale plays. But over the past two years, those same lenders have decided that they would get out of the sector if possible.

"[Upstream] has gone from an excess capital position to de-capitalization," he said. "Banks are losing money and investors are stuck in investments they can't get rid of."

Holmgren explained that the nature of unconventional drilling and the differences from conventional drilling extended to funding as well. Funding methods that had been used for decades for conventional drilling were significantly less useful when it came to more expensive, complex and uncertain shale production.

"The core reserve-based lending model began to break down. It became not successful in grasping the risks involved in shale development," he said. "Lenders began to realize that they made decisions based on exaggerated potential."

In order to regain the support of investors, Holmgren said, unconventional producers will have to hedge more of their production, hedge it longer and use their free cash flow to pay off debt.

"We have to get back to basics. … The focus has to be on cash flow and the idea that cash flow will be used to reduce debt," he said. "Equity remains very difficult for the [exploration and production] space. It remains closed."