As part of our series on legal issues arising out of the plummeting commodity prices, this article looks at one distinct factor in the commodity finance equation: hedging.
Hedging is usually thought of in terms of cash-settled derivatives offered by lenders as part of a broader financial relationship tied together by a credit agreement and perhaps collateral documents. But many other transactions blend hedging and finance attributes. Focus on these different transactions becomes acute during times of financial stress, which drives concerns about enforcing remedies.
Below are several issues we are discussing with our clients in this area.
What does my credit agreement say about prepaids, forward sales and the like?
As alluded to in one of our previous alerts, “Sprinting to Chase Contango,” several analysts are expecting the crude oil forward price curve to dive into steep contango soon, depending on the rates of production decrease, demand increase, and storage availability. This condition causes cash-strapped oil and gas companies to explore transactions that are a blend of hedging and financing.
These transactions tend to involve the advance of funds now in exchange for an obligation in the future to deliver a commodity, or the dollar value of the commodity. They may or may not be categorized as debt under GAAP, and are less likely to be categorized as “indebtedness” or “debt” under the typical credit agreement definitions. They can be structured in many ways, and staying in compliance with debt covenants may be a primary motivation for entering into these transactions. Some credit agreements will have a negative covenant limiting or prohibiting these transactions, whether or not they are categorized as debt. This restriction may come up in the context of covenants that prohibit take or pay or marketing arrangements, which are more common with smaller secured credit facilities than larger facilities with bigger borrowers. In many large syndicated credit facilities, the borrowers have latitude in this area.
What are the remedies of the hedge providers vis a vis the lenders?
Historically, the only hedge providers were banks that were part of a lending syndicate and their remedies were controlled by the lending syndicate acting through its agent. But in recent years a variety of arrangements have cropped up, including the advent of alternative hedge providers with separate rights to take remedies, that are subject in most cases to limitations set forth in an intercreditor agreement with the lending syndicate. This issue becomes particularly important if the alternative hedge provider is able to avail itself of the bankruptcy stay exception. Lawyers wonder about a situation where a collateral agent could be in the middle of a tug of war between the alternative hedge providers, who want to take action quickly in reliance on the exception from a bankruptcy stay, and the lenders, who are restricted from taking action because of the stay and who would not want to see the alternative hedge providers proceeding without them.
Will my credit agreement prohibit risky hedging transactions?
Speculative Hedging Covenants. Some credit agreements have virtually no restrictions on hedging. Some prohibit “speculative hedging” but do not describe what that means. In the absence of a definition, many transactions would fall into a grey area. For example, in the case of an oil and gas producer, selling a call or selling a put is not normally a risk reduction transaction and this type of transactionwould be considered speculative.
But many would agree that if the sale of a call finances the purchase of a put as part of a costless collar transaction, then the sale of a call could in fact be part of a risk reducing transaction and would not be speculative. But producers have argued that, by this logic, selling calls to improve the prices of swaps, or selling puts as part of a three-way collar to increase the price of the call on top, should also be allowed. Once you start down this path it is difficult to say when selling calls and puts crosses from risk reduction into “speculation.”
Caps on Volumes. Some credit agreements contain covenants that set minimums and maximums for hedged volumes, usually as a percentage of expected future production. But if the covenants fail to say “on a month-to-month basis,” then the borrower may have some flexibility to front end load hedges of future production in near-term months (or the reverse). If the covenants fail to say “on a product-by-product basis,” then borrowers have been known to shift hedging around between products, perhaps on a barrel of oil equivalent basis. This may sound reasonable, but taken in the extreme, a borrower could bias its hedges towards natural gas even though more of its expected production is in crude. Since the ratio of pricing between gas to crude has changed radically in the past 12 months, lack of alignment of hedges to production would mean that the company is not as hedged as its lenders assumed. The lack of agreement on what constitutes compliant hedges can put lenders at odds with each other, and can even pit different divisions of the same financial institutions against each other, with the hedge desk eager to place hedges that the lending group feels are not in compliance.
These nuances are rarely delved into until there is fear that borrowers may become aggressive in pursuing transactions that shoot the gaps in the covenant language.
Will Endangered PUDS Cause Hedging Problems?
Under Securities and Exchange Commission reporting requirements, PUD (Proved Undeveloped Reserves) acreage by definition must be developed within 5 years from the initial proved reserves booking, unless specific circumstances are met (see the Securities and Exchange Commission “Final Reporting Release No. 78,Modernization of Oil and Gas Reporting” for precise reserves reporting requirements). With the recent drop in prices, acreage that was categorized as PUD may lose that designation because it is no longer profitable to develop, the company may not have the funding to develop the acreage, or both. If a producer hedged the projected production from these former PUDs, the producer may then be over hedged, requiring either a waiver or termination of the hedges related to the former PUDs in order to stay in compliance with the hedge covenant limitations. Of course there may be other covenants affected, perhaps with baskets, restricting the termination of hedges.
In this price environment, terminating these hedges will undoubtedly result in a payment to the producers who may want to use the proceeds to stem negative cash flows but may instead be forced to prepay debt pursuant to the terms of the credit documents or as part of a consent negotiation, if consent is required for terminating the hedges.
One issue to consider is the distinction between “incurrence-based” hedge covenants and “maintenance-based” hedge covenants. The first would not be triggered until the next hedge transaction, even if there are significant changes to the PUDs as described above. Sometimes, it is not clear whether the covenant is incurrence-based or maintenance-based or when it is tested. Companies frequently have a rolling hedge requirement such that they must enter into new hedges each month anyway. But others do not, which could delay a default related to hedging for some time.
Should We Worry About Counterparty Credit?
When it comes to hedging, for every gain there is a loss. Producers with foresight who hedged heavily before the price drop have huge mark to market assets arising out of these hedges, but this only matters if the counterparty has the credit to pay when they come due. In a low price environment, these hedges are a lifeline, so if a producer’s counterparty is overextended and defaults, it could flip the producer into bankruptcy and set off a cascade of defaults to the producer’s creditors and vendors.
The financial institutions in the hedge market, and the prudential regulators that watch them, should have been carefully monitoring the risk in this area, including stress testing a drop in prices and the extent of resulting exposure from hedges. The “Volcker Rule” and other regulations aspire to segregate these risks from taxpayer-insured deposits. The efficacy of these measures is beyond the scope of this client alert, but it is hoped that these institutions have offset hedge liabilities to energy producers with mirrored hedge assets from energy consumers, either directly or indirectly through intermediary parties.
Alternative hedge providers are less regulated, but still have significant business motivation to manage their exposure. Some of the large oil companies in this space have higher credit ratings than the financial institutions. In theory, producers could have negotiated credit support provisions in their hedge documentation that would require their alternative hedge provider counterparties to provide collateral or other credit support under certain circumstances. In reality, most producers do not have sufficient bargaining power to obtain these kinds of provisions.
Although these questions are being asked, so far we have not heard of any issues in this area. One thing is clear from all these discussions: 2015 will be an interesting year for commodity finance.