Although Ohio lenders that finance companies in the oil and gas industry will encounter some of the same due diligence issues found in other industries, the oil and gas business is a world of its own. We advise our lending clients to conduct diligence in the oil and gas industry in the same manner as if they were buying the company, perhaps just not to the same degree, because lenders typically have some collateral to help them recover a portion of their investments from oil and gas customers that stumble. Nevertheless, lenders need to understand the world of oil and gas if they wish to avoid mistakes and prosper.
First, lenders must understand that the shale oil and gas revolution has inspired a new generation of entrepreneurs, some of whom are making their first foray into the oil patch. This entry will be difficult for companies with little or no experience or existing relationships. Even well-established oil and gas companies may know very little about the laws, regulations, and geology of Ohio. To properly evaluate risk, the lender's first task is to learn about its prospective borrower. Does the prospective borrower have experience in the industry, with this particular play, in this state, or with a given technology, such as drilling horizontal wells? Do they understand the regulations applicable to their businesses? These are just a few of the critical questions lenders should ask.
A lender should also consider the economic and business climate to determine whether the borrower's budget and estimated time to complete a project are reasonable. Regulatory bottlenecks and shortages of supply should be expected as the shale revolution sweeps across the country. For example, in 2012 unusual demand for guar gum, used as a thickening agent in drilling mud, sent prices to more than ten times their usual level and cut into the bottom line of operators. Likewise, insufficient pipelines and refining capacity in northeast Ohio have forced oil and gas operators to shut in dozens of wells that would otherwise be producing. These kinds of issues should be anticipated by an experienced borrower and a savvy lender.
Next, lenders need to understand the language of oil and gas and what is meant by a farmout agreement, assignment of interests, joint operating agreement, area of mutual interest, overriding royalty, working interest, net revenue interest, held by production, and deep rights. These are just a few terms that are commonly used to define the rights and obligations of parties to an oil and gas transaction. Like any language, one learns the language of oil and gas through education and experience.
Lenders must also understand the assets unique to the oil and gas industry. For example, the primary assets of many oil and gas companies are leases, wells, royalties, reserves, and contractual arrangements. Under applicable law, these assets may be treated as real estate, mineral rights, as-extracted collateral, general intangibles, accounts, equipment, fixtures, production payments, net-profits interests, partnership interests, royalties or a combination of the foregoing. The value and nature of these types of assets is more difficult to measure than typical equipment, inventory, and real estate. The value of oil and gas assets can fluctuate significantly depending on commodity prices, contract law, regulations, and the solvency or experience of the operator. A lender should understand the various categories of reserves, including "unproved possible reserves" on one end of the spectrum, and "proved developed reserves" on the other, how these reserves can change, and how such a change can affect an oil and gas company's balance sheet.
It is essential for lenders to engage experienced counsel to ensure that the due diligence is properly conducted before extending credit secured by oil and gas assets. Federal and state agencies, judges and legislators have been scrambling to keep pace with the advance of technology. The result has been many new laws, decisions and proposals within the last few years that have serious consequences for the oil and gas industry. For example, within the last year judges have ruled on such critical issues as whether a local government has the authority to regulate oil and gas drilling, whether drilling permits can be appealed, and whether payment of a delay rental effectively maintains a lease. Likewise, the Ohio legislature has passed sweeping changes to Ohio oil and gas statutes in each of the last three years, and a new round of legislation is pending. State and federal agencies have been just as busy.
Experienced counsel can also advise a lender about specific kinds of due diligence and whether other consultants, such as a petroleum geologist or environmental consultant, should be engaged. For example, in many oil and gas transactions, leases and existing wells are the primary asset being transferred or they are the lynchpin to all further activities and development. Experienced oil and gas counsel will know how to search and interpret agency records for existing wells, what problematic lease provisions to look for, and other common pitfalls that should be detected and avoided.
Lenders often employ unique lending concepts for the oil and gas industry, such as reserve-based financing, project financing, or mezzanine financing with an equity kicker (often in the form of an overriding royalty interest), or volumetric production payment financing. All of these arrangements have been developed to account for special attributes of the oil and gas industry and oil and gas assets. Lenders need to develop a working knowledge of these tools.
Overall, the key to successfully lending to the oil and gas industry is being part of the industry by learning to speak the language, knowing the business climate, understanding the regulatory and legal structure and, of course, doing the proper due diligence on your prospective borrower.