Reserve Based Lending: How Bad Were the Fall 2015 Borrowing Base Redeterminations? | Practical Law

Reserve Based Lending: How Bad Were the Fall 2015 Borrowing Base Redeterminations? | Practical Law

An analysis of the reduction in borrowing capacity of oil and gas companies under their reserve based loans (RBLs) following the fall 2015 borrowing base redeterminations. This Article examines the factors that may have impacted the lenders' decisions to modify borrowing bases during this period.

Reserve Based Lending: How Bad Were the Fall 2015 Borrowing Base Redeterminations?

by Practical Law Finance
Law stated as of 03 Dec 2015 • USA (National/Federal)
An analysis of the reduction in borrowing capacity of oil and gas companies under their reserve based loans (RBLs) following the fall 2015 borrowing base redeterminations. This Article examines the factors that may have impacted the lenders' decisions to modify borrowing bases during this period.
Upstream oil and gas companies often rely on reserve based loans (RBLs) to finance their exploration and production (E&P) operations. An RBL is a type of asset-based loan where the amount the E&P company is entitled to borrow under the facility is based on, and secured by, the value of its oil and gas assets (whether in the ground or once extracted and sold), as determined from time to time. With the price of crude oil having fallen by about 50% since June 2014, the value of these assets has also fallen. This has placed a lot of financial pressure on E&P companies and other companies involved in the upstream oil and gas sector.
Oil and gas prices are volatile and can change significantly over the term of an RBL facility (typically three to five years). As a result, the amount an E&P company is allowed to borrow under its RBL facility (referred to as the borrowing base) is evaluated and re-determined twice a year (typically in the spring and fall). This ensures that:
  • The borrower's outstanding loans do not exceed the value of its assets.
  • The lenders are fully secured.
  • The borrower's borrowing capacity is commensurate with the value of its assets.
Despite the volatility inherent in oil and gas prices, a redetermination of the borrowing base in an RBL facility is ordinarily a routine exercise. Generally, the borrowing base is changed if the borrower has acquired or sold oil and gas assets or had a material change in the quality of its reserves. For example, it converts a significant percentage of its proved developed non-producing reserves into proved developed producing reserves (see Practice Note, Reserve Based Loans: Issues and Considerations: Categories of Reserves).
However, with the dramatic decline in oil prices since June 2014, many borrowers and investors were nervous about the borrowing base redetermination process coming into this year. They feared that lenders would significantly reduce borrowers' borrowing capacity and remove much needed liquidity from the oil and gas sector.
E&P activities are capital intensive. Exploring and drilling new wells and processing and transporting any oil and gas recovered require significant amounts of capital. As a result, a reduction in a borrower's borrowing base can severely limit its ability to explore, complete (the process of making a well ready for production) and drill new wells. Given that the value of an E&P company is derived primarily from its success in finding and developing new wells, borrowers' fears about the 2015 redetermination process were justified.
However, lenders generally took a wait and see approach during the borrowing base redetermination period in the spring of 2015. Uncertain about the movement of oil prices and perhaps optimistic that prices would rebound, many lenders held the course and reaffirmed many borrowers' borrowing bases. Many market observers predicted, however, that lenders would not be so sanguine during the fall 2015 redetermination period if oil prices remained low. For a discussion of the factors impacting the low oil prices, see Article, LNG Update: Impact of Low Oil Prices on US Export Projects.
With the fall 2015 redeterminations drawing to a close, Practical Law Finance has examined borrowing base redetermination information disclosed by 61 borrowers between August and November 2015 to analyze whether this prediction has borne out and the extent to which lenders revised downward E&P borrowers' borrowing bases. While this represents a small percentage of the RBL market, this information is nonetheless instructive as to the lenders’ approach during this redetermination period.
Our review is based on:
  • Credit agreements and related amendments filed with the Securities and Exchange Commission.
  • Credit agreements and related amendments included in Practical Law's What's Market Credit Agreements Comprehensive Deal Database.
  • Other publicly available information, including press releases, 10Qs and 10Ks.

Not as Bad as Feared

While there was a slight uptick in crude oil prices in May-June 2015 (when prices reached about $64 per barrel for North Sea Brent crude (Brent) and $60 for West Texas Intermediate (WTI) crude), between May and October 31 of 2015, prices averaged about $54 per barrel for Brent crude and $50 per barrel for WTI crude. This is a significant drop from the June 2014 highs of about $112 per barrel for Brent crude and $105 per barrel for WTI crude. For a discussion of the differences between the Brent and WTI crude oil benchmarks, see Article, LNG Update: Impact of Low Oil Prices on US Export Projects.
All commodity price data set out in this Article were obtained from the Energy Information Administration (EIA), the statistical and analytical agency within the US Department of Energy.
With oil prices remaining low, many industry observers predicted that borrowing bases might be reduced in fall 2015 by as much as 40%. While the borrowing bases of many borrowers were reduced, the overall reduction was not as bad as some had predicted.
Based on the RBL credit agreements or other documentation of the 61 borrowers Practical Law Finance reviewed, we found that about:
  • 49% or 30 of these borrowers had their borrowing bases reduced.
  • 18% or 11 of these borrowers had their borrowing bases increased.
  • 33% or 20 of these borrowers had their borrowing bases reaffirmed.
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For more information, see Table, Borrowing Base Redeterminations.
Of the 30 borrowers that had their borrowing bases reduced:
  • 9 had their borrowing bases reduced by less than 10%.
  • 10 had their borrowing bases reduced by between 10% and 20%.
  • 4 had their borrowing bases reduced by between 20% and 30%.
  • 7 had their borrowing bases reduced by at least 30%.
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Of the 30 borrowers that had their borrowing bases reduced during the 2015 redetermination period, the average reduction was about 19%. While noteworthy, this is less than had been predicted.

Why were Borrowing Bases Not Reduced as Much as Expected?

Whether and the extent to which a company's borrowing base is increased, decreased or reaffirmed depends on several factors, including the lenders' risk appetite. There is no standard methodology that all lenders use when calculating the borrowing base of a particular borrower. Furthermore, lenders are entitled to consider such factors as they deem appropriate and necessary in their calculations.
However, borrowers took certain actions in the early part of 2015 that may have influenced lenders' redetermination decisions. These actions include:
Other factors that may have influenced the lenders' redetermination decisions include:
While it is not possible to say with any certainty the weight lenders accord to any of these actions or factors, and no single action or factor is dispositive, they may have improved the borrowers' liquidity positions and financial condition.
Actions borrowers took ahead of the fall redetermination period are not the only reason that borrowing bases may not have been reduced as drastically as some had feared. While lenders do not want to have non-performing loans, they also have a lot of capital they need to deploy. In addition they face a lot of competition from other banks and non-traditional lenders (for example, hedge funds) for investment opportunities. These factors may have made them more willing to work with some of their borrowers and exercise some patience with respect to their borrowing capacity, at least in the short term (see Lender Flexibility).
For more information on calculating the borrowing base in an RBL facility, see Practice Note, Reserve Based Loans: Issues and Considerations: Factors Impacting the Borrowing Base.

Oil and Gas Asset Acquisitions

Some borrowers may have softened the impact of low oil prices on their borrowing bases by acquiring additional oil and gas assets. While acquisitions impact borrowers' liquidity in the short term (and in the case of financed acquisitions, their leverage), this impact may have mitigated by the value obtained from acquiring additional reserves. Borrowers that acquired additional reserves include:

Costs Reductions

To preserve liquidity, many oil and gas companies announced cuts in their capital expenditures (for example, deferring or suspending certain drilling activities), general and administrative (G&A) expenses and lease operating expenses (LOE). (LOE are the costs of maintaining and operating property and equipment on a producing oil and gas lease including labor, fuel and water costs and taxes.) Companies that announced these cuts include Midstates Petroleum Company, Inc., Approach Resources and Chesapeake Energy. All of these companies had their borrowing bases reaffirmed.

Limited Amounts Drawn Under the RBL Facility

E&P companies that have borrowing capacity under their facilities at the time of the redetermination may have been to demonstrate that they have sufficient cash flow (for example, from the sale of oil and gas), that they are not overly reliant on the RBL facility to finance their operations. This may have contributed to these companies maintaining their borrowing capacity despite the decline in oil prices. Many companies that disclosed that they had significant liquidity under their credit facilities also had their borrowing bases increased or reaffirmed, including Gastar Exploration USA, Triangle USA Petroleum, Laredo Petroleum and Bill Barrett.

Existence of a Successful Hedging Program

E&P companies typically hedge a certain percentage of their production to mitigate the impact of oil price volatility on their balance sheets. Many companies entered into these hedging arrangements when oil was priced at $80-$90 per barrel, well above the average spot price of $52-$54 per barrel over the past few months. Companies that highlighted the success of their hedging programs (and which all had their borrowing bases reaffirmed or increased) include:
  • Gastar Exploration (reaffirmed).
  • Carrizo Oil & Gas (reaffirmed).
  • Chaparral Energy (reaffirmed).
  • Parsley Energy (increased by 15%).
In addition, some companies also cashed their hedges to generate revenues. While this may have provided a short term benefit, if the company is unable to put in place new hedges (albeit at a lower fixed price), this may become an issue in 2016. For more information on oil and gas hedges, see Practice Note, Reserves Based Loans: Issues and Considerations: Oil and Gas Hedges.

Additional Funding Sources

To improve their liquidity positions, some borrowers:
  • Secured additional financing in the second lien market. These companies include Atlas Resources (reduced by 6.7%) and Midstates Petroleum (reaffirmed). Incurring additional debt may be an issue in the medium and long term if the company is not be able to generate sufficient cash flows to meet its obligations under its debt documents. But in the short term, the additional debt may provide these companies with the liquidity (and flexibility) they need to weather this period of low oil prices.
  • Issued additional equity. The borrowers include:
    • Matador Resources Company (reaffirmed);
    • Bonanza Creek Energy (reduced by 5%); and
    • Callon Petroleum (increased by 20%).
Many of these borrowers used the proceeds of the equity issuances and second lien debt to pay down amounts owed under the RBL facilities. For more information on these transactions, see What's Market, Comparison of Oil and Gas Equity Offerings in 2015.
For more information on these funding sources, see Practice Note, Reserve Based Loans: Issues and Considerations: Alternatives to RBLs.

Lender Flexibility

Although low oil prices have adversely affected many borrowers, some lenders were willing to work with their borrowers to help them manage this low oil price environment. This willingness may have been motivated by:
  • The lenders’ need to deploy capital.
  • Competition from other lenders.
  • The understanding that forcing a company into a default or bankruptcy may not be the most pragmatic choice.
In addition, significantly limiting borrower's borrowing capacity may be counterproductive because it prevents them from developing wells which is needed for company growth and to repay the loans.
As a result, some lenders allowed some borrowers to incur more debt or suspended or loosened certain financial covenants, at least in the short term. For example:
  • Exco Resources revised its agreement to reduce the interest coverage ratio from 2x to 1.25x and to remove its total leverage ratio.
  • Atlas Resources revised its credit agreement to, among other things, suspend its maximum total leverage covenant until the first quarter of 2017 and increased its leverage ratio over the next two years from 5.1x to 5.75x beginning in the first quarter of 2017, 5.50x beginning in third quarter of 2017, 5.25x beginning in the first quarter of 2018.

All Was Not Rosy

Although many companies were able to weather the storm, it was not all sweetness and light. Some companies in the sector:
  • Are now subject to tighter covenants.
  • Have engaged restructuring advisors to advise them of their options.
  • Have filed for bankruptcy.

Tighter Covenants

To preserve liquidity and ensure certain borrowers are able to repay their loans, some RBL credit agreements were revised as part of the redetermination process to add new financial covenants or tighten existing ones. These include:
  • Bill Barrett revised its credit agreement to amend its ratio of total debt to EBITDAX (earnings before interest, taxes, depreciation, amortization and exploration expenses) from 4.0x to 2.5x.
  • Clayton Williams revised its credit agreement to extend certain financial covenants that were set to expire in 2016 through the fourth quarter of 2017. These covenants, which were added in February 2015, limit consolidated senior debt to 2.5x consolidated EBITDAX and consolidated interest expense to 1.5x consolidated EBITDAX. For more information, see What's Market, Clayton Williams Energy, Inc. Third Amended and Restated Credit Agreement.
  • Chesapeake Energy revised its credit agreement to add two new financial covenants and to provide collateral to secure the loans (see What’s Market, Chesapeake Energy Credit Agreement).

Considering Restructuring Options

The reduction in borrowing bases also resulted in a borrowing base deficiency for some borrowers including:
  • Nighthawk Energy (deficiency of about $25 million).
  • New Source Energy (deficiency of about $25 million).
  • Post Rock Energy (deficiency of about $37 million).
  • Emerald Oil (deficiency of about $19.6 million)).
A deficiency occurs when the amounts outstanding under the facility exceed the borrowing base. When a deficiency occurs, the borrower must either repay the deficiency amount within a specified period or add additional assets to the borrowing base to improve the valuation (see Practice Note, Reserve Base Loans: Issues and Considerations: Re-Determining the Borrowing Base).
Some of these companies have engaged restructuring advisors to advise them of their options including negotiating with their lenders, reducing more costs and, failing all else, filing for bankruptcy.

Borrowers in Bankruptcy Proceedings

Although lenders were willing to work with some borrowers, that was not always possible. Many companies in this sector were overleveraged and were forced to file for bankruptcy. Since the beginning of 2015, more than 30 companies in the oil and gas sector have filed for bankruptcy including:
  • Escalera Resources Co. (filing date November 5, 2015).
  • Republic Resources (filing date October 31, 2015).
  • RAAM Global Energy (filing date October 26, 2015).
  • Miller Energy Resources (filing date October 1, 2015).
  • Samson Resources (filing date September 16, 2015).
  • Continental Exploration (filing date September 2, 2015).
  • American Standard Energy (filing date August 3, 2015).
  • Milagro Oil & Gas (filing date July 15, 2015).
  • Sabine Oil & Gas Corp. (filing date July 15, 2015).
  • Saratoga Resources (filing date June 18, 2105).
  • Dune Energy (filing date March 8, 2015).
  • American Eagle Energy Corp (filing date May 11, 2015).
  • Cal Dive International (filing date March 3, 2015).

Looking to the Spring 2016 Redeterminations

While the fall 2015 redeterminations were, on average, less severe than many had expected, there are concerns that the pain may have simply been delayed a few months and the day of reckoning for upstream oil and gas companies will come in the spring of 2016. There are several reasons for these concerns, including:
  • Oil prices are expected to remain low through 2016. According to the latest forecast of the EIA, Brent crude oil prices are expected to average about $56 per barrel in 2016 with WTI crude averaging about $5 per barrel lower (see EIA Short-Term Energy Outlook (November 2015)).
  • Bank regulatory pressures. Bank regulators continue to be concerned about underwriting standards for syndicated leveraged loans. The quest for yield may have caused lenders to take certain risks that may not be sustainable in the long term. In addition, with the rapid (and sustained) fall in oil prices, regulators are also concerned about the lenders' exposure to the oil and gas sector. To comply with the 2013 Leveraged Lending Guidance, lenders may not be as flexible in 2016 as they have been in 2015. For more information on these issues, see OCC: Semiannual Risk Perspective (Spring 2015) and Shared National Credits Program (November 2015).
  • The expected increase in interest rates later in 2015. While this increase is not expected to be significant, it will have an impact on E&P companies' borrowing capacity.
  • The rolling off of hedges. Many of the hedges that cushioned the impact of falling oil prices on borrowers during the fall 2015 redetermination period will not be available in 2016 and many of these hedges may not be replaced. For borrowers that are able to secure hedges past this year, they may not be at prices that enable them to meet their operating costs and make debt service payments.
  • Companies may have cut back enough. To preserve liquidity, many companies cut back on their operations (including deferring or suspending development drilling, cutting administrative overhead and laying off employees). There may not be more room for additional cuts. Moreover, to be profitable, E&P companies must explore and develop new oilfields and wells. Cutting further into these operations may limit their ability to replace depleted oil and gas reserves, placing many companies in a vicious cycle.

Borrowing Base Redeterminations

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