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3/24/16 - OCC Revises Oil and Gas Exploration and Production Lending Booklet of Comptroller’s Handbook

The Office of the Comptroller of the Currency in March 2016 updated and revised its “Oil and Gas Exploration and Production Lending” booklet of the Comptroller’s Handbook for OCC examiners to use in connection with their examination and supervision of banks. The updated booklet replaces the April 2014 “Oil and Gas Production Lending” booklet. Similar to the April 2014 edition, the March 2016 booklet addresses the risks associated with lending to upstream oil and gas exploration and production companies and provides guidance on prudent risk management of this lending activity.

The OCC revised this booklet to reflect current markets, industry standards, and practices. Specifically, this comprehensive update is driven by the significant decline in O&G prices and the stress that decline has had on bank portfolios over the past two years.

There are two related themes where the guidance is significantly enhanced: analysis of repayment capacity and assignment of regulatory risk ratings. The March 2016 booklet also provides enhanced guidance and additional details, terms, and clarifications in accordance with current practices and market conditions. Below is a summary of major takeaways.

Key Themes

Repayment Analysis

The 2016 booklet focuses on the assessment of the ability of a borrower’s future cash flow “to cover projected expenses and repay total debt within a reasonable time.” Although the 2014 booklet covered similar concepts, the 2016 update includes an expanded, dedicated section, “Repayment Analysis Processes,” under its “Underwriting Standards and Practices.”

“Prudent E&P loan underwriting requires that lenders have a thorough understanding of the borrower’s operating environment and future cash flow capability,” according to the updated booklet. Given an E&P company’s cash flow vulnerability to a variety of risks, such as sustained low commodity prices, standards also require a comprehensive understanding of the company’s financial position, funding needs, operating leverage, liquidity, and access to capital.

According to the 2016 booklet: “As part of the underwriting process, lenders normally prepare base case and sensitivity case-repayment analyses … to determine whether future cash flow … is sufficient to repay the existing borrowing base commitment within a reasonable time.” A “reasonable” repayment period for a reserve-based lending facility is normally within 60% of the economic life of the proved reserves (or 120% of the economic halflife), and within 75% of the economic life for total secured debt, in the base scenario.

Risk Rating E&P Borrowers

The 2016 booklet expands its coverage of considerations for credit risk ratings, which are directly tied to assessing primary sources of repayment (cash flow from operations) and secondary sources (collateral liquidation, asset sales, and funds from debt or equity issuances). The update says E&P companies should be thoroughly assessed by:

  • current and projected financial position and operating performance
  • cash flow generation and debt-repayment capacity
  • liquidity position
  • access to capital
  • lenders’ controls under facility structure
  • collateral characteristics
  • guarantor or sponsor support, if relevant

The OCC expands its discussion of ratings and offers the following guidance:

  • “Relationship to Asset-Based Lending” highlights the differences between reserve-based loans and assetbased loans and clarifies that these type facilities are not directly comparable. As such, they merit different risk-rating considerations including loss given defaults.
  • “Liquidity Considerations” emphasizes the importance of liquidity analysis as part of financial analysis.
  • “Leveraged Lending Considerations” states that “Interagency Guidance on Leveraged Lending” applies to E&P borrowers who meet the bank’s definition of leveraged lending. For the assessment of repayment capacity for RBLs and total debt, the economic life of the borrower’s O&G reserves is the relevant measure, “rather than the five-to-seven-year period discussed in the leveraged-lending guidance.”
  • “Repayment Test Example” describes an example repayment test, which is critical to risk rating and illustrates the importance the OCC gives to repayment analysis and standardization of practices. The example determines the percent of economic life of the cash flow reserves used to repay total debt.
  • “Assigning Regulatory Loan Ratings” provides examiners with detailed factors and characteristics for consideration in the assignment of special mention, substandard, doubtful, loss, and nonaccrual ratings. The subsection gives an example of classification for substandard or worse E&P borrowers.

The 2016 booklet provides specific guidance on linking repayment capacity, leverage, and reserve coverage to assigning regulatory ratings for E&P loans. Although detailed, “these factors and characteristics are not allinclusive, nor are they meant to be ‘brightlines’ for ratings purposes,” the booklet says. They provide direction for the ratings judgment, which may include any combination of the factors.

The flow chart below illustrates the regulatory-ratings classifications and the quantitative leverage metric. An appendix to this document provides quantitative and qualitative metrics for regulatory-ratings standards. These risk-rating standards apply to all debt levels of the capital structure, including the RBL, second-lien bank debt, and unsecured bank debt.

Ratio

Pass

Special Mention

Substandard or Worse

Definition

 

Potential Weakness

Well-defined Weaknesses

Funded Debt/EBITDAX

<3.5X

3.5-4.0X

>4.0X

Funded Debt/(Funded Debt + Equity Capital)

<50%

50-60%

>60%

Committed Debt/Unrisked and Undiscounted Proved Reserves.

<65%

65-75%

>75%

Enhanced Guidance

Prudent Risk Management for E&P Lending

Regulatory guidance on prudent risk management and examination procedures as laid out in the 2016 booklet are not a substitute for sound underwriting and effective risk management policies and procedures at each bank. They do, however, help inform the content of such policies and procedures. Specifically for O&G, the importance of determining the economic life of the reserves gives rise to the specialized lending standards needed for sound practices as discussed throughout the 2016 booklet.

In the updated edition, the OCC elaborates upon prudent risk management measures.

Additional Underwriting Standards

The March 2016 booklet includes the following additional or expanded underwriting standards:

  • In addition to fiscal-year and quarterly financial statements, lenders should periodically assess the borrower’s lease operating statements, which should include production details and cost information.
  • As part of their due diligence, underwriters should evaluate the borrower’s business plan, which should include financial projections and a detailed capital-expenditure program.
  • “Projections should include one or more realistic downside scenarios or sensitivity analysis that estimate the impact that sustained changes in market conditions would have on borrower’s repayment capacity.”
  • Risk-adjustment factors applied by the engineer to proved nonproducing O&G reserves should be “fully supported.”
  • Cash flow discount rates used in reserve valuation should “reflect an appropriate risk premium over the riskfree rate of return.”
  • In-house engineering reports or reviews of external reports should be prepared in an appropriate manner “to support timely semiannual borrowing base redeterminations.”

Hedging

The 2016 booklet has a separate section on hedging as part of its “Underwriting Standards and Practices.” It recognizes commodity hedging “as a risk management tool … used to help ensure stable and predictable cash flow, maintain liquidity, and manage credit risk.” The update adds: “Borrower hedge positions are incorporated in cash flow forecast and reserve valuations, which may provide increased borrowing base capacity.” The downside of over-hedging relative to production requires an understanding of the interaction between derivatives and timing of the production from underlying reserves.

The 2016 booklet outlines appropriate documentation and diligence practices around hedging, including:

  • “Hedge counterparties governed by a multiparty, intercreditor agreement often are secured pari passu with the bank group lenders.”
  • Banks should be able to approve any hedge counterparty’s creditworthiness.
  • Limits in the credit agreement for commodity hedges should be set relative to projected production.
  • Limits should be in the credit agreement “for the cancellation or prepayment of any hedges to which value was attributed in the engineered loan value.”

Engineering

Incremental features relevant to engineering are minor, as the 2014 booklet provided a comprehensive discussion of engineering requirements. The 2016 booklet primarily re-orders the critical points and provides the following clarifying standards:

  • “Credit agreements usually require two engineering evaluations per year, including an annual independent engineering evaluation performed by an approved and qualified engineering evaluation firm hired by the borrower. The borrower typically prepares a semiannual interim evaluation as an update to the annual independent evaluation. In both cases, these reports should be thoroughly reviewed by the bank’s internal engineering department or an external independent engineer hired by the bank, to ensure the reserves are valued properly.”
  • “The bank’s engineer reviews the reserve report for estimates of operating costs and expected ultimate recovery of reserves, production rates, and capex needed to convert reserves into the [proved developed reserves subcategorized as producing] category. The bank’s engineer makes technical adjustments based on his or her professional judgment. Examiners should assess whether adjustments are well supported and documented.”
  • “Banks commonly construct their commodity price deck at a discount to the current [New York Mercantile Exchange] futures curve and consider industry price deck surveys. Individual borrower pricing used in the engineering analysis is adjusted up or down from the base price deck by oil and natural gas price differentials.”

Stretch Borrowing Base

The 2016 booklet introduces the concept of a stretch borrowing base: “A ‘stretch’ occurs when the bank agrees to provide the borrower with an RBL commitment that materially exceeds the lendable amount as determined by the bank’s underwriting criteria and loan policy. … Bank approval of the stretch should be supported by documented risk mitigants. … If the stretch is not well-supported, the advance should be considered in the risk-rating assessment.”

Expanded Discussion of Allowance for Loan and Lease Losses

The 2016 booklet provides additional details on ALLL. “Banks should segment O&G loans in their ALLL analyses when the exposure represents a meaningful level of risk,” according to the revised guidance.

The booklet further states: “An E&P loan should be considered impaired when … it is probable the bank will be unable to collect all amounts due … according to the contractual terms of the loan agreement. … An impaired collateral-dependent loan should be measured for impairment based on the fair value of the collateral. … The fair value of O&G reserves should be based on the risk-adjusted NPV of total proved reserves, unless more appropriate and supportable comparable sales information is available.”

Overview of O&G Businesses

The “Business Description” provides a current comprehensive view of the O&G business with more detail than the 2014 booklet. New sections include “Price Considerations” and “Reserve Depletion” highlighting these factors as major business risk drivers. Details on distinctions between O&G reserves and on categories of proven reserves have been expanded and enhanced with technical language.

The “E&P Funding Sources” section includes extensive revisions to reflect current market funding sources and expectations as to structural features including facility term and covenant structures and levels.

Description of RBLs

Incremental details on the structure of RBLs include:

  • Sets expectation of facility terms to be three to five years
  • Provides description of typical financial covenants:
    • Cash flow leverage ratio is defined as senior-funded debt over trailing 12 months EBITDAX.1 Typical range is 3.5x and normally does not exceed 4.0x, unless the covenant is increased to account for an acquisition with step-downs.
    • Interest coverage is defined as TTM EBITDAX divided by TTM interest expense. Proposed ranges are presented at 2.5x to 3.0x levels.
    • The current ratio is defined as current assets divided by current liabilities less current maturities, requiring at least 1.0x to 1.25x coverage.
  • Introduces the concept of second-lien notes sharing in collateral

Funding Sources

The booklet enhances descriptions of selected funding sources:

  • Second-lien debt are term loans that “may rank pari passu in right of payment with first-lien debt,” and “are often structured as five-year maturities with interest-only payment requirements.”
  • Mezzanine debt are loans that may be based on collateral coverage or cash flow ratios.
  • Bonds typically include high-yield bond offerings with 10-year maturities and interest-only payments.
  • Regarding equity, the OCC cautions that complex corporate structures require E&P lenders to “have more specialized expertise and monitoring systems.”

Summary

The March 2016 “Oil and Gas Exploration and Production Lending” booklet of the Comptroller’s Handbook provides similar guidance to the April 2014 booklet. The primary difference, however, is an emphasis on common themes establishing clear processes for repayment analysis and providing accurate risk ratings. In addition, the 2016 booklet builds on 2014 supervisory guidance on prudent risk management for lending to the sector, and offers additional details, terms, and clarifications in accordance with current practices and market conditions.

Contact Us

For more information on the new regulatory guidance, please contact:

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

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


 

Appendix:

OCC Oil & Gas Booklet March 2016 Regulatory-Rating Standards

Criteria Special Mention Substandard and Worse Factors
General
  • “The borrower has potential weaknesses that deserve management’s close attention.”
 
  • “Borrowers have well-defined weaknesses generally characterized by current or expected unprofitable operations, inadequate repayment capacity, inadequate liquidity, or marginal capitalization.”
  • “A substandard [reserve-based loan] is inadequately protected by the current sound worth and paying capacity of the borrower.”
  • “There is higher probability of payment default, and repayment may depend on collateral or other secondary sources of repayment.”
 
QUALITATIVE FACTORS
Loan Structure
  • “Loan structure possesses inadequate bank monitoring and lender control (for example, no or not meaningful covenants, excessive headroom, or too few covenants).”
 
  • “Loan structure weaknesses provide for inadequate bank monitoring and lender control (for example, no or not meaningful covenants, excessive headroom, or too few covenants).”
 
Cash Flow from Operations and Debt- Repayment Capacity
  • “Cash flow from operations is declining, total debt repayment capacity under the ‘base case’ forecast is marginal, or financial performance to plan has not been achieved.”
 
  • “Cash flow from operations has significantly deteriorated, and total debt repayment capacity under the ‘base case’ forecast is insufficient.”
 
Covenants
  • “Borrower is approaching covenant limits or has experienced recent covenant waivers or resets.”
 
  • “Borrower breached covenant limits or needs covenant waivers.”
 
Liquidity and Cash Flow
  • “Liquidity and cash flow are diminished and marginally sufficient to fund operations and meet the borrower’s projected operating and capital plan.”
  • “The borrower has a history of overadvances and demonstrates marginal capacity to cure such over-advances.”
 
  • “Liquidity and cash flow are insufficient to fund operations and meet projected capex.”
  • “The company may need to sell assets or operations due to weak or distressed financial condition.”
  • “The borrower has a history of overadvances and cannot cure existing overadvances within six months.”
 
Engineering Evaluations
  • “Engineering evaluations may be outdated, be incomplete, or use assumptions that are inconsistent with the current market environment or the borrower’s current financial plans.”
 
  • “Engineering evaluations are outdated, incomplete, or use assumptions that are not consistent with the current market environment or the borrower’s current financial plans.”
 
Advance Rates and Mix of Reserves
  • “Advance rates and the mix of reserve categories used to determine the borrowing base exceed the bank’s limits or industry standards.”
 
  • “Advance rates and the mix of reserve categories used to determine the borrowing base exceed the bank’s limits or industry standards.”
 
Equity Capital
  • “Borrower’s equity capital has declined in response to the company’s deteriorating financial condition.”
 
  • “Borrower’s equity capital has declined in response to the company’s deteriorating financial condition.”
 
QUANTITATIVE FACTORS
Leverage Metrics
  • “Leverage metrics have increased or exceed industry norms.”
    • “Total funded debt ÷ EBITDAX is generally greater than 3.5x.”
    • “Total funded debt ÷ the sum of total funded debt + equity capital is generally greater than 50%.”
    • “Total committed debt is between 65% and 75% of the total unrisked and undiscounted proved reserves.”
     
 
  • “Leverage metrics have materially increased or exceed industry norms.”
    • “Total funded debt ÷ EBITDAX is generally over 4.0x.”
    • “Total funded debt ÷ the sum of total funded debt + equity capital is generally over 60%.”
    • “Total committed debt is greater than 75% of the total unrisked and undiscounted proved reserves.”
     
 
Projections
  • “Bank projections indicate the borrower’s future cash flows repay the borrowing base commitment under the RBL within 60% to 75% of the total proved reserve’s economic life or repay total secured debt within 75% to 90% of the total proved reserve’s economic life.”
  • “When either case is true, the borrower’s repayment capacity may be marginal.”
 
  • “Lender financial projections indicate the borrower’s future cash flows either repay the borrowing base commitment under the RBL, or some other RBL amount … beyond 75% of the reserve’s economic life, or repay total secured debt beyond 90% of the reserve’s economic life.”
 

Substandard or Worse Criteria

When well-defined weaknesses exist, the following criteria should be applied to determine the appropriate regulatory rating classification.”

  • “The portion of the loan commitment(s) secured by the [net present value] of total risk-adjusted proved reserves should be classified Substandard.”
  • “The remaining balance secured by the NPV of unrisked proved reserves should be classified Doubtful when the potential for full loss may be mitigated by the outcome of certain pending events, or when loss is expected but the amount of the loss cannot be reasonably determined.”
  • “The combined Substandard and Doubtful portions should not exceed 100% of the unrisked NPV of proved reserves.”
  • “The portion of the loan balance that exceeds 100% of the unrisked NPV of proved reserves and is clearly uncollectible should be classified Loss.”

Loans should be placed on Nonaccrual status if:

  • “The loan is maintained on a cash basis because of deterioration in the financial condition of the borrower.”
  • “Payment in full of principal or interest is not expected.”
  • “Principal or interest has been in default for 90 days or more unless the asset is both well secured and in the process of collection.”

These risk rating standards apply to all debt levels of the capital structure, including the RBL, second-lien bank debt, and unsecured bank debt.

Evaluation of Risk-Adjusted NPV

“The evaluation of the risk-adjusted NPV should be based on historical production and cost data (decline curve analysis engineering), using current market pricing, market-supported cash flow discount rates, and supportable adjustments that account for the inherent production, operating, development, and market risk of the reserve categories, particularly for unseasoned proved producing, proved nonproducing, and [proved undeveloped] reserves. Adjustments should be well supported and reflect current market conditions.” “The collateral evaluation for regulatory classification purposes should include all proved reserves that serve as collateral, subject to market and production risk adjustments. … The evaluation should include hedge positions, but should not include probable or possible reserves.”


FOOTNOTES

1. EBITDAX is defined as earnings before interest, taxes, depreciation and amortization with depletion, exploration, and abandonment expenses added back.