A s debt issued by oil and gas exploration and production companies continues to trade at distressed levels, the secondary loan market has focused on the distinct lending structures developed to finance the exploration and production of energy in the United States. One such structure is “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. The contractual method of determining the borrowing base and the nature of the collateral give rise to unique issues that need to be considered when parties trade loans and commitments of this type.
In today’s volatile price environment for energy related commodities, the borrowing bases for reserve-based revolvers – and therefore the amount of commitments available under these credit agreements – have declined dramatically with the price of oil. This decline and the diminished potential for future increases in borrowing bases affect the economic assumptions of parties who trade reservebased revolvers in the secondary market.
In this client alert, we provide a roadmap for market participants as they identify, analyze and attempt to value reserve-based energy loans and commitments.
BACKGROUND: HOW RESERVE-BASED FINANCING WORKS
Oil and gas exploration and production companies use different forms of financings for their project development, liquidity and working capital needs. Below investment grade companies often use loans primarily secured by the borrower’s oil and gas reserves. In the U.S., the energy reserves that qualify as collateral for this type of financing are typically categorized as (i) proved, developed and producing, (ii) proved, developed and non-producing, or (iii) less frequently, proved and undeveloped. In international markets, other types of reserves (e.g., probable reserves) may be used as collateral as well.
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 redetermined periodically (generally twice a year, in the spring and the fall) to take into account changes in commodity prices as well as any depletion of existing reserves or acquisition of new reserves.
In the U.S. market, lenders may have substantial control over the art, as opposed to the science, of redetermining the borrowing base. This level of lender control differentiates reserve-based revolvers from traditional asset-based loans secured by receivables or manufactured inventory. During the borrowing base redetermination process, a decrease in the borrowing base amount typically requires the approval of lenders holding a majority of the commitments. An increase in the borrowing base amount, on the other hand, may require the approval of either a supermajority or all lenders. In non-US markets, individual lenders may not have approval rights over borrowing base redeterminations.
The substantial protection afforded to lenders in the redetermination process typically comes with certain limits and pre-requisites. In order to challenge a borrowing base amount proposed by the borrower or the administrative agent (or another bank charged with the function), a lender may be required to propose its own borrowing base amount within a certain time frame, using customary (or otherwise prescribed) oil and gas lending criteria. The lender’s silence may be deemed consent to the proposed borrowing base. 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.
Borrowers can typically control the identity of the lenders who remain obligated to fund future drawdowns – if a lender sells its commitment to a third party, the borrower may have the right to consent before the third party can purchase the commitment by assignment. To the extent that the borrower does not consent, the lender may sell an economic participation in the commitment, but under the terms of the credit agreement the participant may be barred from influencing the re-determination process (unless the participant holds the entire position of the lender and can effectively direct the lender to take actions in connection with any re-determination).
Obtaining a security interest in oil or gas reserves is complex, but relatively straightforward in the U.S. as compared to many other jurisdictions. In the U.S., 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.1 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.2
TRADING RESERVE-BASED REVOLVERS
Calculating Credit for the Unfunded Commitment
Under well-established trading conventions of the secondary loan market as reflected in the standard terms adopted by The Loan Syndications and Trading Association (LSTA), a purchaser pays a purchase rate multiplied by the outstanding principal amount of a loan, and receives a credit of 100% minus the purchase rate on any unfunded commitment that is “assumed by” the purchaser.3 In a decreasing oil price environment, it is likely that the current borrowing base amount, which is based on the forecasted future value of oil and gas reserves, is now substantially lower than the original commitment amount specified in the credit agreement, and may not soon revert to the maximum commitment levels negotiated when oil and gas traded at pre-crash levels.
As a result, the established pricing convention raises an immediate question for purchasers and sellers of reserve-based revolvers: should a purchaser receive a credit for the maximum commitment permitted under the credit agreement if there is little present prospect that future energy prices will allow a borrower to draw down on the maximum commitment? A seller is likely to argue that no credit above the current available and unfunded commitment amount should be given because the borrowing base re-determination process is unlikely to allow the maximum commitment to be drawn.
Since a purchaser only receives 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.
If a lender (i.e., the purchaser who acquires the commitment by assignment) has an absolute right not to agree to fund an additional commitment based on an increase in the borrowing base amount, as is the case with some agreements in the U.S. reserve-based market, a seller may argue that the purchaser is only assuming the unfunded commitment calculated based on the existing borrowing base amount. On the other hand, as discussed above, a purchaser may respond that a lender’s right to object to an increase in the borrowing base amount may not be absolute, and in any event the purchaser’s vote may be insufficient to block an increase of the borrowing base amount. Under those circumstances, a purchaser may be forced to “assume” the unfunded commitment up to the original commitment amount. This is a real economic issue, one which may result in a gap between the expectations of sellers and purchasers.
If the spread between the seller’s offer and the purchaser’s bid is too wide on the purchase price credit issue, parties may try to strike a risk-sharing compromise. For example, a seller may be willing to “co-fund” any future draw and agree to remain liable to contribute (at the rate of 100% minus the purchase rate) a portion of any future draw on the unfunded commitment in excess of availability based on the existing borrowing base amount. This way the seller can avoid giving an up-front credit to the purchaser and effectively pay that credit only if the available commitment is increased through the re-determination process and the additional commitment is drawn down. The downside, of course, is that the seller may not be able to de-recognize the commitment from its books, and may continue to take the credit risk of the purchaser.
Most importantly, identifying the effect that redetermination of the borrowing base may have on calculation of the purchase price before committing to a trade will allow a purchaser and a seller to ensure that they agree on the purchase price calculation. They may need to negotiate and possibly modify the standard trading terms to reflect a fair resolution of this important issue.
Controlling Re-Determination as a Purchaser
At this stage of the commodities cycle, one of the most important rights of a lender is control over the redetermination of an energy producer’s borrowing base amount. Therefore a purchaser’s due diligence should include a careful review of the credit agreement to understand the type of control a lender has over redeterminations.
Secondary market purchasers should also be aware that under the trading conventions adopted by the LSTA, during the period from trade date to settlement date a purchaser does not technically have a right to vote (or otherwise participate, or control the seller’s participation, in the re-determination process), although this right may be extended by the seller as a courtesy. If a re-determination is expected to occur between trade date and settlement date, a purchaser would be well advised specifically to require a right to direct the seller to act on the issue.
Controlling Re-Determination as a Participant
Borrower’s consent is usually required for transfers of commitments by assignment. If a distressed borrower is wary of accepting new (and possibly aggressive) lenders into the lending syndicate, a purchaser may need to acquire the debt by participation. A participant’s vote, however, may be restricted under the credit agreement. For example, a credit agreement may permit a participant to vote only with respect to limited matters, which may not include re-determination of the borrowing base. Even if a participant can vote on redetermination matters, there could be practical limitations on the participant’s vote, to the extent that the participant does not hold at least a majority of the lender’s own position in the loan, since a lender usually takes most, if not all, actions according to a majority vote of its participants (and itself if it continues to own a portion of the loan).
The control issue is also a concern for sellers that grant participations, because they will continue to have obligations under the credit agreement as lenders. It is therefore in the seller’s 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 redetermination issues.
Transferring Security Interest
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 the U.S. this is straightforward because a collateral agent typically holds the security interest on behalf of all current and future lenders. In a non-U.S. jurisdiction, however, transfer of the security interest could present issues. For example, governmental or third-party consents may be required for the transfer, and such consents may not be forthcoming. In addition, a transferee of the security interest may lose priority if it acquires the loan by a novation structure.
Maintaining Priority Status of Security Interest on Hedging Swaps
Lenders in the bank group may provide swap products for the borrower to hedge commodity price or interest rate risks. These swaps are typically secured on a pari passu basis with the loans under the credit agreement and therefore share the backing of the reserve-based collateral. When a lender sells its loan position, it should carefully analyze the impact of the sale on the priority status of its hedging swaps. If the seller no longer owns any loan position, any new swaps that the seller provides may not be secured under the credit agreement even though its existing swaps may continue to benefit from a pari passu security interest.
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. While the market’s view on future changes in borrowing base amounts, largely determined by future commodity prices, will serve as a rational basis for any pricing model, each trading counterparty will need to ensure that their individual rights and obligations under their documentation will be consistent with that model. Modification or clarification of the LSTA standard terms may be necessary to re-allocate the risks, control, obligations and rights between parties to a secondary trade.