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9/24/15 - Reserve-Based Lending Asset-Quality Reviews

Summary

Oil prices have fallen almost 60% since June 2014 following the global oil and gas surplus and concerns about China’s economic slowdown. Most experts do not expect oil and gas prices to see a significant recovery in 2016. As a result, energy companies — particularly companies rated below investment grade — have come under stress. Many energy companies have responded to the slide in oil prices by cutting costs and reducing staff. In addition, some have sought out private-equity investments, and/or have sold land, mineral rights, and other assets they cannot afford to develop.

Banks typically provide reserve-based lending to small- and midcap-exploration and production companies, which involves understanding how the oil and gas property’s interests, reserves, and cash flows are allocated within the capital and ownership structure. Banks that finance the exploration, development, and production of oil and gas companies assume the risk associated with the borrower’s ability to successfully find oil and gas reserves, extract the oil and gas from the ground, and deliver it to the midstream market for a profit. Repayment capacity is subject to a wide range of risks, including being vulnerable to weather conditions, commodity-price volatility, changing government regulations, geopolitical events, and infrastructure or labor-market shortages.

As a result of sustained price declines, bank energy-loan portfolios are currently under significant stress. The price decline affects any large lender to the energy sector, including regional and international banks. Asset-quality risks include the recent size and duration of price declines in oil and gas, reduced access to liquidity in the bank-loan and capital markets, the degree of leverage at oil and gas production companies, and the level of expense and sophistication of each company’s production operations.

The 2015 Shared National Credit review process — conducted by the Office of the Comptroller of the Currency, Federal Deposit Insurance Corp., and Federal Reserve System — focused significantly on energy exposures that may result in matters requiring attention around asset quality and effectiveness of practices. The OCC’s Spring 2015 Semi-Annual Risk Perspective highlighted its concerns and increased focus on the energy industry: “Examiners will also assess banks’ actions to assess, monitor, and manage both direct and indirect exposures to the oil and gas sector, given the recent decline in oil prices and the potential for a protracted period of low or volatile prices.”

In April 2014, the OCC issued guidance for bank examiners and national banks on the risks and expected risk management practices in oil and natural gas production-lending activities. The guidance provides a comprehensive view of production lending for the exploration and production segment of the industry of which reserve-based lending is a key component. The guidance addresses inherent risks associated with oil and gas lending and describes supervisory expectations and regulatory requirements for prudent risk management. Publishing the guidance reflects the increased level of scrutiny examiners and regulators apply to oil and gas lending and the specific requirements for safe and sound risk management practices. Asset-quality concerns in the current low-price environment serve to intensify that scrutiny.

Key Questions

Under the current energy-stress environment, banks need to ensure that they have a deep understanding of the current and potential risks in their energy portfolios across all lending types. The following key questions should be answered for their energy portfolios:

Have the risk-appetite, concentration-limits, and risk-acceptance criteria been revised for the current environment?

Is the transfer process to workouts well-defined and working appropriately?

Do internal-risk ratings and regulatory ratings accurately reflect the current stresses?

Do reserving and impairment charges reflect the current environment?

Asset-Quality Approach

Because reserve-based lending is directly tied to the price of oil or gas through a borrowing-base mechanism, the following paragraphs specifically focus on this type of lending structure. It is important to note that reserve-based lending is common practice in energy financing for all lender types — regional or multinational banks — but generally more for small and midcap producers. The credit evaluation will be different for loans to the larger, stronger-rated producers, i.e., companies that tend to be solid “double B” or investment-grade credits that are not dependent on the bank borrowing-base loan market due to the greater financial flexibility that comes from size, asset diversity, and access to capital markets.

At the bank-portfolio level, factors to be considered include the degree of risk correlation, (e.g., by pricing, location, basin, dependence on capital spending, breakeven cost, and/or nature of the reserve as it impacts the accuracy of forecast volume and costs).

Venn Diagram: Borrowing Base, Liquidity, and Financial FlexibilityMany features of borrowing-base loans are standardized by bank-credit policies and procedures, as well as common-market practices. Standardized features include pre-determined advance rates against reserve categories, price decks benchmarked against commodity-market forward curves, and asset-coverage tests. However, there are aspects that are unique to reserve-based lending and individual oil and gas borrowers, including analysis (e.g., the severity of stress scenarios), commodity-hedging strategies, and documentation standards (e.g., covenant structures). In addition, lenders may be senior-secured or may be exposed at other levels in the capital structure (e.g., second lien, mezzanine). In the latter case, the analysis framework described below remains highly relevant to understanding the increased potential for distress.

The analysis required to determine the quality and likely path to repayment for a reserve-based oil and gas loan should take into account three primary categories: (1) borrowing-base sizing, (2) liquidity, and (3) financial flexibility.

1. Borrowing Base

The borrowing-base analysis is intended to understand the loan-to-value ratio and provide insight used to predict whether the next redetermination will produce a size reduction that could trigger covenants to pay down the loan to the new availability level. Twice a year (typically March 1 and Oct. 1), reserve-based lenders do a “redetermination,” which involves a formula that recalculates how much oil and gas companies can borrow, taking into account how much the companies have, what they have hedged, and where oil and gas prices are expected to be. The current redetermination is generally expected to reduce borrowing availability for most oil and gas borrowers, creating increased liquidity stresses. The borrowing-base redeterminations coming this fall are going to hit the small- and midcap-exploration and production companies harder than the larger-cap companies, as smaller companies tend to rely more heavily on bank debt. Also, the analysis provides insight into the likelihood of reserve restatements/write-downs that could create liquidity issues and impact access to capital.

  • Realized Commodity-Price Assumptions: Pricing factors to consider include base and downside forward-price decks, location basis, quality basis, and price and basis hedging.
  • Capital Spending: Capital-spending analysis should include detailed drilling and other capital-program sizing and timing, assessment of necessary expenditures to maintain cash flow, and degree of certainty that funding will be available, track record, and degree of control (i.e., operator or not).
  • Reserve Classification: Underwriting haircuts should be reviewed to determine discounted reserve value (i.e., discounted cash flow of projected cash flow after debt service) based on reserve classifications (i.e., proved developed producing, proved developed nonproducing, and proved undeveloped).
  • Engineering: Engineer reviews should review reserve “risking” based on geology and data quality, production volumes under price scenarios, type and quality of decline curve and cost data, fixed- and variable-development and lifting costs, and evaluation of differences, if any, between reserve estimates by the bank engineer and company engineer. In addition, the analysis should determine if the experience and independence of the in-house engineering function are consistent with recent OCC and other guidance.
  • Other Model Standards: Other analysis should include asset-coverage tests (i.e., net present value of cash flow available for debt service over proved reserves), discount rate, and roll-forward reserve production, among others. Note: These tests are contained in risk-acceptance criteria and/or engineering standards.
  • Other Diligence: For other diligence, the analysis should confirm off-take and processing capacity, transportation constraints, environmental diligence, management’s track record and capability, and operational experience (and, if not property operator, financial and performance due diligence on third party operator). The analysis should also understand flexibility to take actions detrimental to the priority of the bank’s lender class. These many affect the standard base or stress-forecast scenarios used in the discounted cash flow or may be considered as individual risk factors if not adequately constrained by risk-acceptance criteria.

2. Liquidity

Liquidity analysis is important to understand sources of funds for capital spending and ability to service debt and downsize the reserve loan as needed under base and stress scenarios.

  • Borrowing-Base Sizing: The borrowing-base analysis should review the borrowing-base sizing and availability at the current and upcoming redeterminations. The maturity of the underlying facility should also be considered, as refinancing may be difficult. For example, is the universe of potential lenders contracting to a degree that could impact sizing beyond changes of the borrower’s fundamentals? Note: this will highlight the differences, if any, between bank’s risk-acceptance criteria and underwriting standards versus market.
  • Structure of Covenant to Resize: The covenant-structure analysis should determine the amount of time a borrower has to affect the pay down and the constraints following a borrowing-base downsize that reduces availability below the drawn amount.
  • Access to Liquidity and Covenant Requirements: Liquidity analysis should determine availability of funds to meet required pay downs from committed or other sources — a critical risk factor in the current low-price environment. Assessments of downside scenarios and the ability to meet liquidity covenants may give warning indicators to liquidity issues.

3. Financial Flexibility

Financial strategy and flexibility of the overall operational needs should be assessed, including access to external sources, to judge financial flexibility. This analysis should review the degree to which the borrower has multiple options to address financial stress and the degree of certainty in the ability to execute these alternatives.

  • Asset Sales: Asset-sale analysis should review the attractiveness of portions or all assets, depth of buyer market, precedent transaction valuations, and availability of buyer funding for an acquisition.
  • Ability to Finance Elsewhere in the Capital Structure: Analysis should review public equity, private equity, various forms of second-lien debt, and sale of royalty interests and production payments.
  • Capital and Operational Spending Flexibility: Operational-flexibility analysis should review the impact on operating cash flow and access to capital.
  • Management Ability to Execute: Evaluation of management is critical to determining whether management has the ability to execute financing alternatives and the drilling plan.

Promontory Services

Promontory’s asset-quality review of energy portfolios commences with an evaluation of individual loan counterparties and then analyzes portfolio vulnerability due to risk concentrations. Our team of former bank regulators and energy lenders will provide a comprehensive review of a bank’s energy portfolio risk management and asset quality.

We can assist a bank’s management to answer the following key questions concerning the current stress environment: Have the risk-appetite, concentration-limits, and risk-acceptance criteria been revised appropriately? Do internal-risk ratings and regulatory ratings accurately reflect the current stresses? Is the transfer process to workouts well-defined and working appropriately? Do reserving and impairment charges reflect the current environment?

Contact Promontory

For more information, please contact any member of our team:

Jeff Glibert
Managing Director
jglibert@promontory.com
+1 212 365 6990

Wayne Rushton
Managing Director
wrushton@promontory.com
+1 202 384 1015

Margaret Cheever
Director
mcheever@promontory.com
+1 212 542 6853