What a difference a year makes. Last autumn, although oil prices were declining from their June 2014 peak of $112 per barrel (bbl) for Brent crude oil, September 2014 oil prices remained in the relatively robust $90-$95/bbl range. September 2015 oil prices, however, reflect a drastically changed market, with prices beginning the month in the high $30s and fluctuating in the mid-$40s thus far.
The precipitous drop in oil prices over the last year presents a difficult lending environment for banks with substantial energy portfolios. Most oil and gas exploration and production (E&P) borrowers operate with revolving lines of credit that include a borrowing base, which is typically established at the bank's sole discretion. After reviewing the borrower's most recent reserve report, the bank determines the borrowing base-an amount assessed by calculating the discounted present value of the future income the borrower's oil and gas properties should earn. This determination is typically made twice per year: once in the spring and once in the fall.
With fall 2015 borrowing base redeterminations either under way or imminent, energy lenders are not only grappling with dramatically lower oil prices, but are also facing two additional reasons to question whether to reaffirm or lower current borrowing bases. First, oil hedges that helped sustain cash flow for borrowers will begin to roll off at the end of the third quarter and the end of the year. Further, federal regulators are increasingly concerned with banks' energy exposure and may subject the banks to heightened pressure.
Many borrowers were fortunate enough last summer to hedge, or lock in, oil contracts in the $100/bbl price range. These hedges have helped support their cash flow despite waning oil prices. While E&P companies have long used hedging to cushion the effects of falling prices, hedges have recently begun to comprise ever-increasing portions of these companies' cash flow. When the hedges roll off and cash flows decline, many borrowers will struggle to repay the outstanding balances under their revolving lines of credit.
Additionally, federal regulators' increased scrutiny of banks' energy loan portfolios may cause the banks to reduce current borrowing bases. As the Wall Street Journal noted in a recent article, "Banks have been flexible with troubled energy companies to avoid triggering a flood of defaults and bankruptcy filings, but regulatory pressure could force them to tighten the purse strings." (Ryan Tracy and Ryan Dezember, Regulators Warn Banks on Loans to Oil, Gas Producers, subscription required).
Depressed oil prices, the rolling off of oil hedges and increased regulatory scrutiny all signal that the borrowing base increases many banks approved in 2014 are a distant memory. In the current environment, and without an unanticipated increase in oil prices, the reality is that many lenders will reduce their existing commitments to E&P borrowers during this fall's borrowing base redetermination season.
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