For the last decade, shale development has revolutionized the oil and gas industry and the way it is financed. The blanket nature of shale reserves, the tremendous amount of capital required to develop them, high commodity prices and investors clamoring for yield in a low interest rate environment created a perfect storm for overleverage in the industry. The sharp drop in commodity prices and increased regulatory scrutiny occurring over the last 18 months created significant headwinds for oil and gas borrowers and their lenders that finance reserve based loans (RBL) as the leverage model has been fundamentally challenged.
Throughout the most recent cycle, banks continued their standard practice of making senior secured loans based on their conservative price decks (~80% of NYMEX) and advancing 60% to 70% of the bank’s calculated proved reserve value while limiting proved undeveloped reserves (PUDs) to +/-20%. This conservative underwriting practice has served the banks well in previous downturns and, historically, banks have incurred minimal losses on their reserve-based loans.
In the most recent cycle peak, capital markets opened up to the E&P sector and provided high-yield debt, which was generally sized to fill the valuation between senior debt and a company’s proved reserves (1P). From 2010 through 2015, $160 billion of second lien/sub-debt was issued by the industry and purchased by yield-starved investors. This debt was rationalized by the blanket nature of shale reserves (i.e. minimal dry hole risk) and the high cost and capital needs for their development. Companies’ ability to book PUDs was also enhanced by new reserve recognition rules, the five-year and the reliable technology rules, promulgated by the Society of Petroleum Engineers (SPE) and adopted by the SEC for reporting purposes.
Oil Prices Begin to Crack
The veneer of oil prices began to crack leading up to and immediately following the November 2014 OPEC meeting which culminated with Saudi Arabia’s decision to increase production in an attempt to maintain its market share rather than curtail production to prop up prices. This timing coincided with the midpoint of the banks’ fall 2014 borrowing base redeterminations. While some banks tried to compensate on late season redeterminations by scaling back advance rates, the end result was redeterminations that did not adequately reflect the shifting oil and gas price environment.
The spring 2015 redetermination saw a slight rebound in oil prices and encouraged hope for a V-shaped recovery, similar to the 2008 recovery. Since most loan covenants are calculated on a trailing 12-month basis, the covenant compliance calculations included only one quarter of low prices and much of that production was supported with well-priced hedges. The spring 2015 redetermination generally resulted in modest borrowing base reductions of 10% to 15%. During this time, the capital markets remained accommodative, and there was a significant inflow of ill-fated second lien debt that provided liquidity, much of which was applied to reduce senior debt.
Throughout the summer of 2015, commodity prices remained low with highly leveraged, forward-looking companies seeking covenant relief for their senior loans. We also saw sales of non-producing assets such as pipelines, gathering systems and non-producing leases which could generate cash for liquidity without the cannibalization of future cash flow, which would result from the sale of producing assets. The acquisition and divestiture market (A&D) for producing assets remained locked up in all but a few basins. Similarly, the capital markets became disenchanted with the industry due to the depth and duration of the down cycle, and the window shut for availability of high yield bailouts.
E&P’s Cut Budgets
The fall 2015 borrowing base redeterminations proved difficult. Many of the hedges that supported the previous redeterminations were rolling off in a low-price environment. In an attempt to preserve capital, drilling budgets of most E&P companies were paired back, resulting in waning reserves as natural production decline was not offset by reserve replacement from new drilling. Contributing to the malaise in a low price environment, many of the PUD reserves became uneconomic to drill and had to be reclassified from proved (1P) to probable (2P) reserve categories, making them ineligible to be included in bank valuations as banks only lend on 1P reserves. This toxic combination resulted in reduced bank reserve valuations.
During the fall 2015 borrowing base redeterminations, there were many difficult discussions between RBL lenders and their clients. Banks have a strong desire to maintain their long-standing relationships with their RBL borrowers throughout industry cycles. It was obvious to all parties that a heavy-handed approach of forcing borrowers to liquidate assets in the current environment would not benefit anyone (except, perhaps, a potential acquirer).
From a bank’s standpoint, divestment sale proceeds in this environment had the potential to be less than the loan value, while borrowers had no desire to sell off their cash-flowing assets at bargain basement prices. Nonetheless, something had to happen, as the banks were not willing to act as patient lenders to zombie companies (enterprises that currently have sufficient cash flow to service debt but insufficient free cash flow to drill for reserve growth or make substantial debt repayments).
Banks Toughen Regulations
An additional concern for banks was the significant cash flow leaking out of companies as interest payments to junior and subordinated lenders as opposed to senior debt reductions to banks. Over the last quarter of 2015, this situation was somewhat ameliorated through debt exchanges which, in some cases, reduced non-senior debt cash interest expense and, in most cases, pushed maturities well beyond the senior secured debt. The result of the fall 2015 borrowing base redetermination was that many borrowers were given six months to rectify their situation through asset sales and/or recapitalizations.
Coinciding with the oil price decline, bank regulators turned their attention toward E&P lending practices and promulgated rules and standards that changed the way many banks reserve capital for their oil and gas loans. Until recently, many banks utilized split-grading procedures in which they assigned risk grades based solely on the senior debt which they held without regard to second lien and sub debt which lay below the senior secured in the capital structure. Guidance from regulators now requires senior lenders to grade on an enterprise basis, rather than solely on a senior facility basis. As a result, there is significant downward risk-grade migration that increases in the risk-based capital that the banks must hold for those loans. This will result in increased pricing for oil and gas companies.
Rumors have circulated that regulators are displeased with the results of the fall 2015 redetermination and the accommodations that the banks made to their borrowers during that season. Regulators purportedly feel that the banks should have been tougher on their borrowers, pushing harder for pay downs and forcing more defaults. On that note, only few bank regulators truly understand the intricacies of the oil and gas business and the destructive repercussions of short-term reactions to a down cycle in industry conditions, even if the cycle has been materially extended.
The combination of lower prices, hedge decay, natural decline with no reserve replacement, a pricing environment which forces PUDs to fall off the map, along with increased regulatory scrutiny and oversight, has resulted in a difficult situation for oil companies and their banks. As mentioned previously, the second lien and sub debt tranches were sized to fill the valuation delta between senior debt and total proved reserves in a $100/barrel world. With PUDs being reassigned to less financeable reserve categories, a significant valuation gap between total debt levels and reserve values has developed.
For the most part, banks’ senior secured loans to large E&P firms are not at significant risk of loss, and the fulcrum security in a bankruptcy or liquidation will likely be further down the balance sheet. We have spoken with a few banks that have un-hedged, fully funded, gas-producing clients from whom they expect to take a loss. Despite the prospects for 2016 LNG exports, given the current gas storage situation, the unseasonal mildness of this winter heating season and the phenomenal deliverability (30+Mmcfd initial production rates) of the wells in the Marcellus and the Utica, it is hard to craft a scenario in which there will be a meaningful recovery in natural gas prices anytime soon.
One should expect to see a very challenging spring 2016 redetermination season as banks react to regulatory pressure and persistently low commodity prices by requiring their borrowers to enter into conforming RBL facilities. Over the next several months we expect to see a number of forced property sales, continued debt exchanges and/or a significant number of E&P bankruptcies.