As debt issued by oil and gas exploration and production companies continues to trade at distressed levels, the secondary loan market has again focused on unique issues presented by the distinct lending structures developed to finance the exploration and production of energy — “reserve-based financing,” under which a lender’s commitment to lend is based on the predicted future value of the oil and gas reserves of the borrower that serve as collateral for the loan.
This is the summary of an article which appeared in the Journal of Association of Insolvency and Restructuring Advisors, available here, and provides a roadmap for market participants as they evaluate issues in trading reserve-based energy loans and commitments.
Background: How Reserve-Based Financing Works
Oil and gas exploration and production companies often finance their operations with loans primarily secured by the borrower’s oil and gas reserves. These credit facilities are generally sized by reference to a “borrowing base amount,” which is the aggregate forecasted value of the hydrocarbons in the reserves, calculated based on commodity price assumptions and discounted by a haircut applicable to the category of reserves. The borrowing base amount is generally re-determined semi-annually to take into account changes in commodity prices as well as any depletion of existing reserves or acquisition of new reserves. Lenders have varying degrees of control over the re-determination process, depending on the market and the type of reserve. The technical expertise required in the calculation and negotiation of the borrowing base may present an issue for non-bank lenders unfamiliar with arcane borrowing base calculations.
Obtaining a security interest in oil or gas reserves may be complicated in jurisdictions other than the U.S., where mortgages can be taken over real property and mineral rights, and a security interest may be granted and perfected on reserves while they are still in the ground. In the case of a producer bankruptcy in the U.S., the automatic stay under Chapter 11 would prohibit a counterparty under a lease or license from terminating the lease or license without leave of the court, thereby protecting the debtor, and indirectly the interests of the lenders. The laws of other jurisdictions are less clear and certainly not uniform.
Trading Reserve-Based Revolvers
Calculating Credit for the Unfunded Commitment. Under well-established trading conventions of the secondary loan market, a purchaser pays an amount equal to the purchase rate multiplied by the outstanding principal amount of a funded loan, and receives a credit of 100% minus the purchase rate on any unfunded commitment that is “assumed by” the purchaser. In a decreasing oil price environment, it is likely that the current borrowing base amount is substantially lower than the original commitment amount specified in the credit agreement.
Should a purchaser receive a credit for the maximum commitment permitted under the credit agreement if there is no present prospect that future energy prices will allow a borrower to draw down on the maximum commitment? A seller is likely to argue no, because the borrowing base determination process is unlikely to allow the maximum commitment to be drawn.
Since a purchaser should arguably only receive a credit for the unfunded commitment that it actually assumes, whether, and to what extent, a purchaser has control over future borrowing base increases under the credit agreement may be important in determining the amount of the credit a purchaser should get for an unfunded commitment. Counterarguments are also valid, so to the extent feasible, parties may try to strike a risk-sharing compromise, such as a “co-funding” arrangement.
Other Trading Issues. At this stage of the commodities cycle, one of the most important rights of a lender is control over the re-determination of an energy producer’s borrowing base amount. A purchaser’s due diligence should include a careful review of the credit agreement to understand the type of control a lender has over re-determinations. If a re-determination is expected to occur between trade date and settlement date, a purchaser would be well advised to specifically require a right to direct seller to act on the issue.
The control issue is also a concern for both sellers that grant participations, because they will continue to have obligations under the credit agreement as a lender, and participants, because they will bear the economic burden of future funding. It is therefore in the parties’ best interest to negotiate a voting (or consultation) regime that satisfies the seller’s obligations under the credit agreement as a lender and, to the greatest extent possible, avoids and resolves conflicts with a participant in connection with re-determination issues.
Because the value of a reserve-based loan depends on the lending syndicate’s security interest in the reserves, a purchaser of the loan will need to ensure that the security interest will be transferred with the loan and the priority of the security interest will be preserved. In some jurisdictions such a transfer of security interest may require governmental consent because exploration rights with respect to the reserve are granted by those governments.
Reserve-based revolvers present unique challenges and opportunities for participants in the secondary trading market for energy loans. Parties should carefully consider how their economic assumptions will be affected by the borrowing base re-determination process and each party’s ability to control that process, guided by their view on future changes in borrowing base amounts, largely determined by the forward curve of commodity prices.