HAVE WE SCRAPED THE BOTTOM OF THE BARREL?
THE PROSPECT of long-term low oil prices looms large over domestic exploration and production companies. Prices have declined dramatically from the peak in June 2014 of $112 per barrel for Brent crude to the $30 to $40 per barrel range we are seeing today. While the number of oil and gas companies filing for bankruptcy over the past year numbers around 20, many more are in the process of hiring - or have recently hired - restructuring advisers. Others have been flagged by ratings agencies and analysts as over-leveraged, high-default risks.
Low commodity price levels continue (for what many increasingly believe will be a prolonged period) and favorable hedges started to roll off at the end of 2015 and continue to do so into 2016. It was against this background that the oil and gas industry, facing high degrees of uncertainty and varying levels of distress, entered into the fall redetermination season of 2015.
BORROWING BASE REDETERMINATIONS DEFINED
Drilling for oil and natural gas requires large amounts of capital. In a process referred to as reserve based lending (RBL), many small- and mid-cap E&P companies establish asset-based revolving lines of credit governed by a borrowing base tied to the present value of the company's proved oil and gas reserves with banks or a syndicate of banks to fund both drilling costs and working capital.
One-third of oil production in the lower 48 United States is produced by companies that have reserve-based loans. The reserve base for the loan is calculated by multiplying the volume of oil and gas in proved developed producing properties (PDPs) by a set price deck. Proved developed non-producing (PDNP) and proved undeveloped (PUD) properties are given some value in determining the reserve base as well but these properties can typically only account for 25% of the borrowing base. Borrowers are also given dollar-for dollar credit for their hedges.
To ensure the banks continue to be adequately secured during the term of the loan, lending documents usually require borrowing bases to be re-calculated twice per year, once in the spring and once in the fall. Historically, biannual redeterminations have not been major events for a company, with increases and decreases often attributable to recent acquisitions or divestitures by the borrower or significant increases or decreases in production since the last redetermination. With the decline in oil prices and hedges coming off now or shortly in the future, redeterminations are taking on increasing significance for both the banks and their borrowers.
EXPECTATIONS AND DRIVING FORCES
Heading into the fall redeterminations, predictions of an industry credit crunch were not unfounded.
In October and not long after the first redeterminations were announced, Wells Fargo, the fourth-largest bank in the United States, announced that it had cut energy credit lines by 15%. E&P companies were primed for similar, if not more severe, results from the pending redeterminations with their respective lenders.
Furthermore, borrowing base reductions made during the spring redeterminations were much milder than expected. Prevailing thought was that banks had taken a "wait and see" mentality in round one of this year's redeterminations, but with fall approaching, hedges were beginning to roll off, and there was a more widely accepted realization that prices would remain lower over a longer period of time. In addition, the banks were expected to use a lower price deck during fall determinations, perhaps in part at the behest of government regulators.
The Office of the Comptroller of the Currency (OCC), the Federal Reserve, and the Federal Deposit Insurance Company (FDIC) are taking a more active role in watching the reserve-based borrowing practices of the major banks. OCC officials met with major banks to discuss their lending practices. The early July meeting between the banks and regulators concerning the North American RBL market - the world's largest such market - was held in Houston, where the bulk of transactions comprising such market originate and are serviced by Houston-based bank teams.
Though government officials did not speak with any level of specificity about the discussions that occurred, the perception following the summit was that the agencies believe that reserve-based lending involves a high level of risk. Heading into fall redeterminations, companies feared that the increased governmental scrutiny had the potential to negatively impact borrowing base calculations and other reserve-based lending practices in the future.
However, predictions of large borrowing base reductions during the spring for the most part did not hold true: although the relatively lenient spring redeterminations led many analysts and industry insiders to worry banks would make significant reductions during this fall's redetermination season, oil and gas companies saw a mere 4% decrease in bank loans.
Instead of substantial reductions, many of the borrowers saw their borrowing bases reaffirmed or only moderately reduced.
A few borrowers saw much more dramatic decreases. Oasis Petroleum lost 10% of its borrowing base, SM Energy lost almost 17%, and Atlas Resource Partners LP had 6.7% shaved off of its previous borrowing base. The most dramatic reductions hit small E&P companies, which rely heavily on RBL facilities for financing the acquisition and development of their oil and gas reserves: Emerald Oil saw a 40% reduction to its borrowing base, while PostRock Energy Corp. experienced a $37 million decrease, a 48% reduction to its spring borrowing base.
Several others have had their spring borrowing bases reaffirmed, and the bulk of those companies experiencing increases did so as the result of asset acquisitions or changes to their lending facilities.
HOLDING OFF CREDITORS: HOW COMPANIES AVOIDED BORROWING BASE REDUCTIONS
Despite analysts' expectations that RBL-related problems would emerge this past fall, short-term bank liquidity remained more stable than expected. Multiple factors may have played a part in softening the blow of fall redeterminations.
Many of the companies that had borrowing base increases or reaffirmations substantially increased production following spring redeterminations, thus increasing PDP values and offsetting the declining oil prices. In other cases, management restructured their hedges, taking gains from their current hedges and entering into new, lower-priced hedges for the coming year. Finally, some companies pledged additional collateral to compensate for the downward market forces, allowing them to maintain their existing borrowing bases.
REDETERMINATIONS AND FUTURE PROJECTIONS IN AN UNCERTAIN MARKET
Despite regulatory agency concerns regarding RBL, some suggested that banks might have shown flexibility this time around because government regulators were on edge, fearing any repeat of the 2008 financial crisis. However, with annualized prices rolling into weakness, producers will need to be vigilant to maintain stable liquidity.
In the next round of redeterminations, there is a widespread belief that the trend of including new or modified restrictive covenants in amended RBL agreements will continue. Analysts have already begun predicting that spring 2016 redeterminations could push liquidity lower on anticipated production decline. With producers' sharply reduced completion activity in recent weeks, oil production may be set to fall - and proved developed producing additions are unlikely to match organic declines. Even assuming no price deck changes in the banks' favor, without significant commodity price improvement, the spring 2016 redeterminations could be much tougher and may finally trigger the increased consolidation in the industry that has been long-anticipated by many.
Acknowledgement by the authors: Our colleagues David Reiner and Elizabeth Cromwell contributed to this article.
Originally published in Oil & Gas Financial Journal
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