Just like Santa Claus, commercial banks have a list. That list tells them which companies they will lend to and how much each company can borrow.
Oil and gas companies usually need loans to operate and survive, so these lending determinations can be crucial. If banks cut back on lending to the industry, drilling can grind to a halt, companies can fail, jobs will be lost.
Now there are signs that banks might be ready to do just that.
Dramatically lower oil and gas prices and tighter credit have already started to bring change to the oil and gas industry, said Ron Meisler, corporate restructuring partner for Skadden LLP in Chicago.
“You’re seeing the transformation already because there must have been at least a dozen bankruptcies filed so far,” Meisler said. “Those companies were highly levered and they didn’t have room to kick the can further down the road.”
Skadden – once known to just about everybody as Skadden Arps – employs nearly 2,000 attorneys and has been called Wall Street’s most powerful law firm. Its specialties include advising companies on financing, restructuring, and acquisitions and mergers.
If the banks’ lending determinations limit a company’s access to capital, that company can find itself in a serious financial squeeze, noted Frank Bayouth, corporate partner for Skadden and head of the firm’s Houston office.
“As you go further down the path of distress, you have fewer options. And it may be that acting today is not the best decision,” Bayouth said.
But, Bayouth added, executives need to be aware of all their options and act decisively when necessary.
“You don’t want to get three months further along the path and regret that there were things you really should have done, and it’s too late,” he noted.
A Few Challenges
To make a lending determination, a bank looks at a company’s reserves and production together with a “price deck,” a table combining past, current and forecast oil and gas prices. Future prices will help determine whether or not a company is able to make interest payments on its loans.
“In a nutshell, what they’re doing is taking a look at the price decks they have. Each bank has its own price deck,” said Meisler.
To evaluate a company’s assets and operations, a bank can look at the company’s published reports, outside engineering reports and often its own estimates of reserves and production.
“Banks often have their own engineers who determine the validity of the estimates,” Meisler said. “They also are looking at their own books.”
All those pieces of information help guide banks in determining how much money will be loaned to oil and gas companies.
Today, Meisler and Bayouth see three problems facing the industry.
♦ Low oil and gas price levels.
Late-2015 production prices weren’t just low, they were about 50 percent less than prices a little over a year earlier.
Nobody knows where oil and gas prices will be two or three years from now. So far, banks don’t appear to be too pessimistic about future oil and gas prices.
But you can bet that banks won’t be super-optimistic in their price projections, either, and those projections affect how much money the industry can borrow.
♦ Expiring price hedges.
By using hedges that lock in production prices over a long period of time, a company can avoid some of the pain of falling prices. Banks consider price hedges in evaluating a company, but eventually those hedges will expire.
“Hedges will figure into a borrowing base consideration,” Meisler said. “The hedges worked great for 2015, but as we enter 2016 the hedges are rolling off.”
♦ Regulatory pressures.
Even before the oil-price downturn in late 2014, government agencies in the United States were warning banks to reduce their exposure to the oil and gas sector.
The Office of the Comptroller of the Currency, the Federal Reserve and the Federal Deposit Insurance Corp. reportedly have warned commercial banks to limit their loan exposure to highly leveraged, risky oil and gas companies, Meisler and Bayouth noted.
“They are putting pressure on banks because they are concerned the banks may have a lot of exposure to risk,” Meisler said.
But at the same time, “the banks don’t want to be seen as the reason that liquidity is being sucked out of the industry,” he added.
Banks review their lending determinations and go through a redetermination period twice a year, once in the spring and once in the fall.
It looked like the banks were going to treat the oil and gas industry with a fairly light hand and not yank away credit in fall 2015, but it was too early to judge final results, Meisler said.
“We don’t know how the fall (2015) redetermination is going to turn out. That chapter has yet to be written,” he said.
The important spring redetermination period will come in March to mid-May 2016, and the industry will be watching the banks’ lending decisions closely.
“In the secondary market, funds have deployed capital in the first nine months of this year and a lot of money has been lost. The amount of capital that’s going to be available going forward is uncertain,” Meisler said.
“The capital market constraint is going to be very important,” he noted.
Banks using a company’s reserves as a basis for extending loans don’t lend against 100 percent of the reserves, as a safeguard against lower future prices.
“Once the bank comes up with a reserve amount, it will loan against 65 percent of that,” Meisler said. “If you think about it, banks want to be well over-collateralized for protection against any steep drops in commodity prices.”
When a bank makes a loan based on a company’s oil and gas reserves, it’s known as a “reserve-based loan.”
“A reserve-based loan is extending credit based upon the production itself, based on the producing wells,” Meisler explained.
“And we’re talking about revolving credit, which is different from your typical home mortgage,” he continued. “This revolving line of credit has a maximum limit you can borrow. As a company does development, as it drills, the limit can and should increase if the new wells you develop are successful.”
For example, if a company has a maximum revolving credit limit of $1 billion and a borrowing limit of $450,000, the company can ask for an increase in the borrowing limit – if it has done more drilling, put more wells on production and established more proved reserves, he said.
There’s a catch, though, because companies have to obtain capital to drill and establish new reserves.
“For the companies, they are in a bit of a bind,” Meisler said.
A company needs liquidity – money – to drill and turn prospects into proved reserves and production. The banks lend money based on the estimated reserves and production the company already has.
It’s a conundrum: An oil company has to have money to develop more reserves and production, but needs more reserves and production to establish a higher borrowing base.
When a company finds itself with limited access to liquidity, or possibly cut off from traditional commercial bank lending completely, it can face unattractive options even if alternative lenders are available.
“You’re looking at alternative lenders who might have alternative motives,” Meisler said. “When borrowing from alternative lenders, the risk profile of a company materially increases.”
Higher interest rates and other less favorable terms are just two of the problems. A lender might extend credit hoping it can gain equity if a company fails to meet repayment obligations, a tactic called “loan to own,” according to Meisler.
“Another way a company can raise cash is to sell assets,” he noted. “The problem is, the companies want to hold on to their assets that are most valuable. The assets that aren’t as valuable won’t bring in as much liquidity.”
What should a company do if it finds itself with a serious liquidity problem?
How can a company best protect its investors, directors, executives, stakeholders and employees?
“A company in that position should be hiring advisers,” Meisler said. “These questions are very complicated.”