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    Reserve based finance

    A tale of two markets - Part 4

    Reserve based finance

    Jason Fox
    Bracewell & Giuliani
    London

    Dewey Gonsoulin
    Bracewell & Giuliani
    Houston

    Kevin Price
    Société Générale
    London

    This is the fourth and final article in the four-part series examining the evolution, practices and future of the reserve based finance markets in the US and internationally. Parts 1, 2, and 3 appeared in the January, February, and March 2014 issues of OGFJ, respectively.

    Security

    Senior bank borrowing base revolving credit facilities in the US are almost always secured (unless the producer's long-term unsecured debt is at or near an investment grade rating). High yield bond transactions and certain other higher yielding debt products may also be unsecured. In the international market RBL facilities are always secured. The banker's typical mantra on the subject of security is to take security over "anything you can get". What you can get, however, does vary significantly depending on the jurisdiction where the assets are situated.

    The value of security in the US, for onshore fields at least, is possibly the best in the world as it is possible to own the oil reserves when still in the ground meaning that mortgages can be taken over fields and reserves. In most other jurisdictions around the globe the oil or gas is owned by the state with exploration and production companies simply having a licence to extract and sell it (with ownership transferring at the well head during production rather than when still in the reservoir rock).

    In the US, the typical security package consists of a mortgage or deed of trust lien on at least 80% of the value of the producer's proved oil and gas reserves. The 80% minimum is an acknowledgement of the fact that some producers may have their assets strewn across multiple states and therefore lenders must weigh the cost of getting collateral documents for each jurisdiction (including fees and expenses associated with obtaining legal opinions, preparing property descriptions, etc.) with the relative benefit of obtaining a higher percentage of the proved reserves as collateral. In addition to the reserves, US lenders will typically require substantially all the personal property assets of the borrower and any guarantors to be pledged, as well as the stock of such entities (although the stock of the borrower may not be pledged in some instances depending on the bargaining leverage of the owners). Enforcement of such liens can be a relatively straightforward process, although producers may choose to seek relief in bankruptcy court to avoid the taking of such assets by the lenders (and, further subject to the usual constraints posed where a company does in fact go into Chapter 11 of the US Bankruptcy Code). In one important respect the Chapter 11 process provides protection not only for borrowers but, indirectly, for lenders too and that is that during the Chapter 11 process a counterparty to a lease or licence with an oil and gas company cannot terminate the lease or licence without leave of the Court. This contrasts with the position in most other jurisdictions where the occurrence of insolvency or receivership can trigger termination rights so there is the risk that at the very point lenders wish to enforce security the main asset itself could disappear (because the lease or licence can be terminated by the grantor being, usually, the host government).

    The position in International RBLs is more complex and varied and practice is linked to what is possible under the laws where the borrowing base assets (and the companies that own them) are situated. An in-depth analysis on the issues of taking and enforcing security is beyond the scope of this article. However, a few general points are important to note because they are, in the view of the authors, one of the factors that drive the way banks in the international market view RBL. These points perhaps in part account for some of the broader differences in the US and International RBL markets.

    The optimal security package - and what lenders will seek to get if they can - comprises security over the borrower's interests in the borrowing base assets themselves and the shares of the companies that own them together with security over all project accounts, insurances and hedging agreements. In certain jurisdictions where this form of security is available and can be readily taken (such as in England, Wales, and Scotland) it is common for lenders to take a floating charge over all the assets of the group members which own the borrowing base assets. However in many jurisdictions it is not possible to take the full security package for a variety of reasons. In some emerging markets it may simply not be possible to take effective legal security over certain classes of assets. More often the issue is one of consents (either governmental or contract counterparty).

    In most non-US jurisdictions where the right to explore for and extract hydrocarbons requires the grant of some form of license or concession (or the entering into of a production sharing agreement or such like) with a governmental authority the consent of that governmental authority is needed to take security over the license/concession/agreement. It is almost always the case that governmental consent is needed to enforce security (even if it is not needed to take it). In some jurisdictions, the consent point arises also in relation to taking security over the shares in the company that holds the license (and potentially companies higher up the corporate tree). Where these issues arise obviously the ideal solution is to seek and obtain the relevant consent. However in some jurisdictions this may be difficult, protracted or even impossible. Lenders in the international markets are used to these issues and ted to be pragmatic. In emerging market RBLs it is often the case that financings proceed with no field asset security and lenders rely only on share security, bank account security and security over insurances and hedging agreements.

    Consent issues also not uncommonly arise in relation to contracts with third parties (e.g. co-venturers, offtakers etc.). Where this is the case the relevant consent will have to be obtained (or the relevant contracts carved out of the security package).

    The fact that almost invariably government consent is needed to enforce security (a feature not just of oil and gas financing but of financing assets in many regulated industries) is significant. Because the International RBL model is so robust there are very few examples (in any jurisdiction) of attempting to enforce security and the examples that do exist are usually not public. There have been cases where governmental consent to enforce security in the context of an RBL has been successfully sought but there have also been cases where the host government has not been co-operative, on occasion for arbitrary reasons. Because of this issue (and other issues) enforcement of security over licenses or concessions should never be viewed as an easy option (and particularly so in emerging markets).

    It is for this reason that RBF bankers in the international market place great emphasis on the probability of default and putting in place structures, controls and checks to avoid default and always to get early warning of it. The fact that the collateral cover may be more than adequate to cover the loan it is not an adequate answer to an otherwise weak structure or poorly managed company. Whilst the authors would not suggest that lenders in the US are not also focused on lending under robust structures to well-run companies with good assets, the ability of lenders to effectively enforce security is probably one of the factors why there is greater focus in the US on collateral cover than some of the other factors that receive similar prominence in the context of International RBLs.

    Default in US and International RBL

    Given the very different backdrops to the US and International RBL markets - physical, geological and political (in particular the difficult emerging markets for which much of International RBL debt is raised) and given also the very different lending practices that underpin the two markets, it is interesting to consider and compare the prevalence of default in the two markets. This is difficult to do for a number of reasons. The first is that (as with other classes of lending) defaults under RBL facilities may be serious or may be minor or technical and waived with minimum process or formality. Secondly, defaults are of course confidential and often never become public (save where they result in some insolvency process or the producer is a public reporting company and is required to make a disclosure). Standard & Poor's and Moody's have published reviews of North American RBF Loans dated January 18, 2013 and January 16, 2013, respectively, which showed very low levels of losses in defaults in the North America. Moody's Investors Service published a paper dated February 4, 2013 entitled "Default and Recovery Rates for Project Finance Bank Loans, 1983-2011" which looked at general project finance loans.

    There are no comparative surveys for the international RBL markets so information on default in international RBF loans is somewhat anecdotal and comparative comment on this subject is difficult and must be tentative. Also International RBF Loans are far more heterogeneous than their North American Counterparts so general conclusions on loans spanning multiple geographical locations and representing a mixture of multiple field, single field and producing and undeveloped field loans would in any case not itself be very informative.

    The International RBL market is undoubtedly much smaller by absolute number of deals and number of participant banks, so defaults that result in a full blown work out or actual loss tend to be fairly quickly known to the market. Looking at the International RBL market over the last 20 years, the authors are only aware of a handful of deals where bank lenders have lost money and a similar number of other ones where the borrower has become seriously distressed and a full-blown work out or rescheduling has occurred. The most serious defaults where losses have occurred have been on single field development loans where the field has underperformed expectations materially. Putting aside the single field loan workouts, anecdotally (and allowing for the fact that the International RBL market is smaller) it seems that despite the apparent more aggressive lending practices in the International RBL market (in particular, lending to development projects and lending against probable reserves) the frequency of default may be higher in the US market. However it should be emphasised that losses even in both markets are extremely rare. The authors offer the following possible explanations.

    Less corporate leverage and simpler capital structures

    International RBL deals typically prohibit or heavily restrict other financial creditors sitting alongside the RBL lenders whereas US RBL ones do so less. The presence of different classes of creditors and additional leverage through the use of second lien facilities and high yield bonds creates additional cross default risks in the US market which are typically not present to the same degree in the international market. In a more complex capital structure there is more risk of cross default.

    More structure

    As described earlier in this article, International RBL deals tend to be more structured than US ones (sculpting of amortization, monitoring through documented cover ratios, more restrictive covenant package etc.). There is more focus in the International RBL market on the probability of default rather than simply ensuring adequate collateral cover to be confident the loan will be paid out on enforcement (enforcement of security being relatively easy in the US both compared to emerging markets and compared to developed markets where enforcement cannot in any event occur without host government support).

    Most loans to listed entities

    In part because of the focus on offshore fields and the usually greater technical challenges associated with upstream development in the EMEA region as compared to the US (the deep water Gulf of Mexico discoveries of course being an exception to this) there are no "mom and pop" companies in the International RBL market. It is this end of the market which seems to contribute disproportionately to default in the US. In the International RBL market, loans to private companies of any kind are relatively rare compared to the US meaning most borrowers have some access to public equity capital markets. A related point is that larger companies, while having bonds in the capital structure, often use that capital to maintain large amounts of undrawn liquidity available on their borrowing bases, whereas smaller companies if unlisted, will not have bonds but have second lien debt instead which will often be fully drawn having been used to fund an acquisition; therefore they will have less unutilised headroom on their borrowing base.

    Most loans against assets with multiple partners

    In many (though certainly not all) of the countries where assets financed in the International RBL market are situated, projects are undertaken by consortia so there is the combined expertise of a group of companies behind many projects (with the checks and balances that go with that) as well as close monitoring by host governments that have granted the license or concession. It is perhaps notable that a disproportionate number of the known single field loan losses were for companies that were sole developers or small JV partner groups of the relevant field. The undeveloped nature of some fields and their invariable offshore nature also mean companies can get trapped with development delays and cost increases more easily than in the US where onshore fields allow capex to be cut quickly. It remains to be seen how the surge of unconventional field development and the need to continue drilling to offset rapid PDP declines may affect default rates and losses in future however the very high level of hedging associated with these loans suggest risks other than price may be needed to cause problems.

    Lower Price decks

    The more conservative price decks (currently) used in International RBLs mean that price deck changes tend to be less sharp than in US RBLs. So the Borrowing Base Amount is less volatile to hydrocarbon price movements (reducing the risk for the borrower of sudden debt capacity reductions). In the US it seems that some defaults have been caused by a liquidity crunch caused by hydrocarbon price volatility. In many cases , well-hedged companies are insulated at least for a time. But for unhedged production, the resulting drop in cash flows can be significant and have a devastating effect on the producer's borrowing base. Even where this may be manageable in itself, if the borrower has other creditors to service this can lead to cross default with other parts of the capital structure. Because of the degree of diversification of asset base and well count on most US loans, reservoir underperformance has been a lesser issue than price drop in causing a reduction in borrowing base and attendant liquidity squeeze than it has on international loans.

    Is a paradigm shift about to occur?

    Both in the US and elsewhere the RBL product has proven to be a robust financing technique that has stood the test of time through different economic and commodity cycles and through the turmoil in the financial markets of recent years. In the international market there have been some evolutions in what and how banks are prepared to lend, but the basic features of the product have changed little since the first portfolio RBL facilities came on the scene in the early 80s. In the US, competition among capital providers continues to result in new and creative structures depending on the asset risks, but on the whole the primary borrowing base revolving line of credit remains the mainstay debt product for upstream energy companies.

    Undoubtedly in an ever more globalized market place, the question of whether it is logical for there to be two very different parallel worlds for financing in the upstream oil and gas sector is coming to the fore. Increasingly the same banks are operating in both market places and increasingly so too are oil and gas companies and private equity sponsors.

    The catalyst for a coming together of the two markets may well be the coming need to finance the development of deep water fields in the Gulf of Mexico, a number of which are leased by smaller independent exploration and production companies backed by private equity sponsors that will be looking to maximize leverage through development bank financing (as they have successfully done with other non- US oil and gas fields). The international bank market has decades of experience of such financings, and banks and bankers are eager to provide such finance in the stable legal and political environment that the US offers. Similarly, as finance directors of US independents start to understand what lenders are offering their counterparts in the international market there will undoubtedly be demand for debt sized against US assets to be raised in the International RBL market (there have been some examples) and/or demand by borrowers for some of the more attractive features offered by the International RBL market. Below we examine some of the challenges to be overcome and drivers that will push change.

    The Gulf of Mexico (GOM)

    Upstream financing offshore, even in the shallow waters of the Gulf of Mexico, has been relatively rare and an acquired taste for domestic US banks. A relatively small subset of the US domestic banking market has been comfortable with financing offshore projects. There are many reasons for this.

    First, the size of the market means there is plenty of opportunity to lend to onshore assets with lower perceived risks. Second, the unique nature of GOM and gulf coast reservoirs often with rapid decline water drive mechanisms1 may make even PDP prediction less reliable than for more established onshore conventional plays. Third, hurricane concerns have also played their part in the risk assessment matrix of prospective US banks. Fourth, historically the US offshore upstream industry itself has been dominated by bigger companies capable of financing their activities with other forms of capital than secured bank debt.

    Even where loans have been provided they have been based, as in the onshore markets, primarily on proved developed producing reserves available only after the cost intensive development drilling and platform infrastructure has been put in place. Finally, more recently, the issues surrounding Macondo may cause greater concern among lenders and lead to a trend away from offshore lending.

    Finance markets are, however, like any other kind of market. They react to forces of supply and demand. Outside of the US, banks have moved to meet the demands of their oil and gas customers as those demands have changed over time. As described earlier, International RBLs began in the North Sea. Then, as independent exploration and production companies expanded into emerging markets and found and exploited reserves there, banks began to lead against assets in these markets. Over time the field discoveries have got bigger, the water and rock depths deeper and the associated cost of development greater. Recent examples of this trend, where companies raised finance to fund their share of capex on large undeveloped fields include, Niko Resources (D6 gas field offshore India) in 2007, Kosmos Resources (Jubilee oil field offshore development Ghana) in 2009 and more recently Delek Drilling (Tamar gas field offshore Israel) in 2012.

    This trend will continue and the authors believe the next basin to be financed with this kind of debt will be the deep water of the GOM.

    Factors driving change in the GOM

    Several changes will mean that there now will be increasing demand for offshore development capital in the GOM in the next few years.

    First, post Macondo, GOM drilling has recommenced with a vengeance particularly in the deep water / deep rock Tertiary plays. This has resulted in a series of apparently very large discoveries. At the same time the regulatory oversight framework for safety and environmental aspects has had a major overall (and been tightened in many respects). It is now very similar to the framework observed in many other highly regulated developed markets like the UK and Norway.

    Secondly, as in the expansion of development finance in the North Sea and then the wider international arena, it is the "demographic" changes of the oil companies, developers and investors that will drive the financing markets response. A significant portion of GOM exploration is being undertaken by independents and many of these are privately-owned or have a significant component of private equity in their shareholder base. Where such companies have been involved with significant discoveries they now have to finance the appraisal and ultimately the subsequent development. With gross well costs over $100 million in some cases, even a 10% non-operated JV interest can quickly lead to a need for a large amount of capital. With no revenue to service interest coupons, the High Yield markets will not be an option for some companies. With no asset base other than a large discovery, the only source of potential bank debt such companies can turn to is the upstream project finance market - a market that does not currently exist within the domestic US.

    There will be a number of challenges for this new finance market to become established. Some of those are external and some internal to the bank market itself.

    External challenges include

    Technological: The envelope is being pushed ever further including the depth of water and rock, thereby causing significantly higher well cost and increasing the possibility that such costs can rise even more significantly over the planned development budget.

    Reservoir: Risk is increased by several factors. First by the lower seismic resolution and increased depth conversion challenges at the increased depths. Secondly, by the lower level of appraisal wells drilled because of the high costs involved and the oil company's desire to optimize project IRR. Finally by uncertainty in the new plays of drive mechanisms and resultant prediction of decline rates.

    Regulatory: The GOM offshore regime is highly regulated. Drilling rights are dependent on leases granted by the Bureau of Ocean Energy, Management, Regulation and Enforcement. Understanding how the regulator views the interests of finance institutions and how it is likely to react in the event of a company having financial strain will be important to any bank entering this market. For a regulator, the maintenance of safe operations will rightly always be the overriding concern where a company operates the field but prospective financiers will want to know that a lease or license will not be "pulled" suddenly when a company is in trouble (thereby rendering valueless the banks security). Interestingly as explained in the section above on Security, US Chapter 11 provisions designed to protect the borrower actually help lenders in the protections they offer in this regard.

    Internal challenges for the bank market

    First, the expertise in development oil field finance for sub investment grade borrowers (where the borrower has little of value other than the undeveloped field itself) resides primarily in the international arena.

    Secondly, most banks active in upstream finance have separate divisions in North America and outside and in the relatively few cases where North American banks are active in upstream oil and gas lending outside of North America the credit approval, management, risk and syndication functions are often separated between North American markets and international ones. The same is often true for European banks. Only in the case of a few banks (Société Générale is one of these) does all of the upstream finance go through one single global business management chain with a complete overview and understanding of both markets.

    These internal structural and policy divisions in many institutions can act as an impermeable membrane that prevents the flow of expertise from one part of the institution to another and lead to a strange situation (in some cases) where an institution can theoretically happily finance an offshore development in West Africa but is incapable of doing so in North America.

    The larger the deal the greater the need for a large number of banks and the greater these challenges will be to overcome. For this reason we believe the first deals of this kind will be at the smaller end of the spectrum and be extended by "clubs" of banks. From there one can readily see that other banks will not want to miss out on this market and the pool of willing senior bank participants will expand.

    Despite all the challenges the authors have no doubt that the bank market, supported by the right advice, will do what it has always done – innovate and adapt itself to meet the needs of its clients.

    About the authors

    Jason Fox

    Jason Fox is a partner with Bracewell & Giuliani in London. He has over 25 years' experience advising on upstream debt financing and has advised on over 100 RBL financings.

    Dewey Gonsoulin

    Dewey Gonsoulin is a partner with Bracewell & Giuliani in Houston. He has over 22 years of experience advising on upstream debt financings.

    Kevin Price

    Kevin Price is a managing director with Société Générale in London and serves as the Global Head of Reserve Based Finance. He has over 25 years' experience in upstream oil and gas and finance. As a petroleum geologist he worked for independents and majors. For the last 17 years he has been a banker specializing in upstream oil and gas. He joined Société Générale in 2006.


    1Offshore GOM fields and onshore Gulf Coast fields may have large aquifers underlying them. When the oil is extracted the aquifer will flow into the former reservoir rock creating a drive that helps "push" the oil out. While this can lead to very healthy production rates (high well productivity) it can lead to very rapid decline rates meaning the reserves are produced out very quickly. Predicting declines can be subject to uncertainty and so can recovery as the aquifer can also influx on the lateral sides of the reservoir as well as from the bottom up leaving by-passed oil that is not "swept".

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