Following dramatic falls in oil and gas prices in 2008-9, and 2014-6, the market is right now experiencing a more unexpected shock driven by a myriad of factors, not least COVID19 and the OPEC meeting of 5th-6th March 2020 resulting in actions by Saudi Arabia and Russia (amongst others) to increase rather than curtail production.
Independent O&G companies, both globally and particularly in the US, are often reliant on debt finance in the form of a reserve based lending (RBL) or borrowing base facility for a substantial part of their funding requirements. In general the higher leveraged a company the greater the challenge to manage the exposure in a downturn. RBL lenders are typically commercial banks, however the list of potential debt investors in E&P companies has grown in recent years in terms of traders, debt arms of large contractors, and funds. On the other hand there is increasing pressure on banks and other investors to either not to be lending at all towards upstream O&G activity (similar to the move witnessed in willingness to lend to coal projects in recent years) or for banks to apply new sustainability testing and reporting covenants where lending capacity is still available.
A downturn can feel like a double-hit (or worse) to independents because their borrowing capacity often becomes constrained at the same time as they experience a liquidity crunch from falling revenues. At the same time the amount of security that needs to be posted under decommissioning security agreements for a particular field may increase and/or the timing for when security first needs to be posted under such agreements may accelerate.
RBL facility debt capacity mechanics and related issues
RBL facilities are sized against the expected future cash flows from specified producing or late stage development assets. They typically have a legal maturity of 5-7 years and amortise after 1-2 years, either fully or with a balloon payment. They are usually refinanced well in advance of final maturity.
Borrowing capacity under an RBL facility is typically redetermined every six months with the banks having a large degree of discretion as to the assumptions, both economic and technical, that feed into the process. Stronger borrowers can mitigate this to a degree through protections such as:
- specifying the reserves to be taken into account from specified assets;
- requiring use of economic assumptions no more restrictive that those used in comparable financings (or similar wording to that effect);
- recourse to expert determination in the case of disputes,
however these can never protect against a material fall in oil prices.
A key economic assumption for the redetermination process is the “price deck” used by banks to model future oil prices. This is always at a discount to mid-market forward curves. Borrowers can mitigate against this by hedging future production, which if done with a sufficiently credit worthy lender under the RBL facility enables the hedged price, rather than the price deck, to be taken into account in the redetermination in respect of the hedged volumes. However hedging a material part of production becomes difficult more than 12-18 months forward and creates its own risks.
Hedging liabilities on a mark-to-market or close out basis can quickly become a material part of picture or even outsize exposure under loan or bond instruments, and hedging carried out by RBL banks ranks pari passu with RBL debt.
Subject to hedged volumes, borrowers should expect the price deck and therefore borrowing capacity to reduce as part of the next redetermination exercise following a downturn, with payment down to the new borrowing base amount typically required a short time afterwards.
Failure to pay results in a near-instant event of default. Other defaults under RBL facility documentation may also be triggered in a depressed price environment as there is typically a lengthy representation and covenant package, for example delivering clean financial statements or other information, triggering balance sheet/cashflow/negotiating with creditors insolvency events, material adverse change and cross default.
Occurrence of a default under an RBL facility will typically trigger cross-default under the borrower’s other debt instruments, and vice versa default under these is typically a default under the RBL facility. Other debt may include junior/mezzanine facilities, prepayment facilities and bonds. Waivers in respect of a default under bonds are typically difficult to obtain in practice due to identifying beneficial ownership and because of the processes proscribed under the bond documentation.
The international RBL market has reacted to previous downturns with the inclusion of the following in documentation either standard or more common:
- regular group wide liquidity testing covering all expenditure (including exploration and appraisal expenditure);
- restrictions on the proportion of borrowing base assets that are not producing;
- subordination of bond debt until maturity of the RBL facility.
Silver linings in the storm
Some more positive observations are:
- The international RBL market has a relatively low historic default rate, largely due to conservative debt sizing and detailed due diligence undertaken on project risks and likely cash flows. Insolvencies of RBL borrowers are more common in the US market, however there are many material differences there with the RBL product and its place in the capital structure, typically alongside a high yield bond or second lien loan which effectively insulates the RBL banks from first loss. The US market is dominated, in volume at least, by highly leveraged domestic shale-focussed companies. In the US market the banks typically have more control over adjusting the borrowing capacity, higher price decks which struggle to resist market price falls, and a better security position potentially encouraging banks to enforce knowing that they can in practice quickly liquidate the underlying assets without requiring government or other third party consents.
- Banks participating in RBL facilities typically do so through specialist teams including O&G engineers who have seen downturns before and have experience in assisting their customers through them, knowing that the market is volatile and peaks always follow troughs. Banks are wary about putting large parts of their portfolios in default by over-reacting in terms of reducing the price deck upon a redetermination. Experience has shown they can be pragmatic both in resetting the assumptions to be used upon a redetermination and in granting waivers to allow borrowers breathing room to come back into compliance with the facilities terms.
- Unlike the 2008-9 downturn there is no or virtually no pre-development sanction debt in the market which complicated the restructurings of some independents and the time and ultimately was a significant factor in the insolvency of Oilexco.
Practical steps for borrowers
Borrowers may wish to consider the following:
- Requesting waivers, potentially conditional upon achieving any of:
- an equity raise
- a debt raise, either pure new debt or as a debt for equity swap, however debt will typically be difficult to raise for example because bond markets are closed or accordion facilities are not committed; stretch senior or junior RBL debt may be feasible
- A corporate or asset sale/disposal, or similar arrangements such as sale and leaseback of floating or pipeline infrastructure
- cutting back on expenditure to the extent not contractually committed or otherwise with the consent of field partners, contractors and host governments
- Maintaining good communications and relations with banks, including requesting waivers sooner rather than later to beat any anticipated queues of similar requests from other borrowers
- Bank flexibility to transfer debt. Typically this does not require borrower consent after the occurrence of a default. Specialist debt traders look to acquire debt in secondary markets and may be considering loan to own strategies and be unwilling to negotiate waivers. In some cases borrowers may not be aware of who the lenders are if trades have been done through a sub-participation, credit default swap or other derivative or synthetic product.
- Restrictions on incurring and servicing intra-group debt, as required treasury flexibility may conflict with restrictions in RBL and other loan documentation.
- That selling assets or carrying out a restructuring that results in a change of control in the borrower may trigger termination or pre-emption provisions in concession agreements and other project documents, potentially leading to loss of assets or use of management time and money negotiating consents. US companies going through a chapter 11 process benefit from the automatic stay on terminating contracts however there is no equivalent for English companies (nor for many other jurisdictions commonly relevant in the international RBL market) nor may the stay be respected by entities with no assets in or business in the US.
- That in a distressed scenario in many jurisdictions directors’ duties change from a focus on shareholders to creditors, with effects including that security and other arrangements may be vulnerable until hardening periods have expired, and that lenders are nervous about the risk of being deemed shadow or de facto directors if they are directing the work-out strategy of their clients. Most E&P companies have an international business where a most conservative approach will apply in practice taking into account the law of each relevant jurisdiction.
- Reviewing hedging strategy and options, including whether any hedging in the money can be monetised early.
Many of these points are relevant for lenders, and there are many issues in addition for lenders to consider including the practicalities of enforcing security and related interfaces with governments, joint venture partners and other stakeholders.