The Banks Take Stock

Along with the 50% swoon in the price of oil in recent weeks comes a reconfiguring of bank price decks. For heavily levered E&Ps facing borrowing base redeterminations this spring, that does not bode well. However, commercial reserve-based energy lenders are not yet pushing the panic button. At least not broadly.

“It would be a lie to say things haven’t changed, but for companies that are well-hedged, there is a possibility their borrowing bases don’t move,” according to Tim Brendel, senior vice president and oil and gas segment leader of Green Bay, Wisconsin-based Associated Bank. “A lot of these E&Ps have done a fantastic job in 2014 of increasing reserves and production, so the net effect of lower pricing and hedged production could create little difference, and in some cases an increase to the borrowing base.”

That, granted, might be a best-case scenario. Many producers balked at hedging over the past year because of the backwardation of the market, and others pulled hard on their bank revolvers and tapped high-yield debt markets to drill at top speeds. One thing is certain: Everyone will feel reserve valuations squeezed this spring.

“Simply look at where pricing is and the obvious consequence is we anticipate borrowing bases to come down,” said Brendel. “There is some expectation that you’re going to have clients borrowed in excess of whatever that new borrowing base might be.”

By how much remains to be seen, as commodity prices are fluid and year-end reserve adds were pending at press time. But the math suggests a significant drop in borrowing bases if banks stay true to their price decks.

“These numbers are going to be less,” Mickey Coats, executive vice president and manager of energy banking for BOK Financial Corp., the parent of Bank of Oklahoma and Bank of Texas, said. “Is it 50%? I don’t know, but it’s probably going to be at least 20% to 40%.”

Under-Hedged, Over-Levered

Associated Bank’s borrowing base is attributed solely to proved reserves, and predominately proved developed producing, with a 65% advance rate on cash flows discounted on a PV-9 ratio. In late January, the bank was applying a $50 price deck, with a look to the strip for forward months. That compares with a mid-$80s price deck in October.

Who’s at risk of falling below the line? “Those companies that don’t have any form of hedged production that are more heavily utilized under their borrowing bases,” Brendel said.

Brendel is not waiting on redetermination dates to get in front of clients. Instead, the bank is working with clients ahead of borrowing base season, typically from March to May, to ensure liquidity.

“We’re making sure this new world order is acknowledged by both sides, and that expectations are set on the front end. We’re talking with clients about their capex plans and what they’re seeing from a lease operating expense standpoint. We want to make sure our clients are planning, and that they meet us in the middle with plans to conserve their liquidity.”

While headquartered in Wisconsin, Associated Bank’s energy lending group is situated in Houston. CEO Philip Flynn, a 30-year veteran of energy lending at Union Bank of California previously, launched the energy group in 2011. It now has 50 clients and $1.1 billion in credit commitments, 100% in the E&P space.

“We’re making sure our guys are weathering the storm,” Brendel said. “The positive is that the reserves are still in the ground, only the price you apply to them has changed. Whereas revenues might take a haircut, we’re working with clients to make sure they have a plan in place to rectify that.”

Riders On The Storm

BOK’s Coats, based in Tulsa, Oklahoma, likewise doesn’t anticipate wide-scale carnage during this spring round of redeterminations. With more than 300 clients and $5.8 billion in energy commitments—about 25% of the bank’s total—on average the group had roughly half of that advanced, “so there is some ability to absorb that big price drop,” he said.

“If you assume in the last six months these companies added some value from drilling, which would improve their reserve base, then take into account the drop, they’re probably OK this go-round.”

Coats said larger E&Ps and midsize regional operators will generally be able to ride out the turbulence due to greater access to capital or asset sales. BOK is, however, working with small companies and smaller mid-size companies caught unhedged and over-levered.

“It’s not a great percentage,” he said, “No one wanted to hedge a year ago, and we’re talking with people that have been in the business a long time and should know better. Easy to say that now.”

BOK in January ran a $53 oil price deck, reviewed monthly, compared to $85 six months prior.

Customers are most anxious about where the borrowing base will be set, he acknowledged, and how much liquidity they will have afterward. With high-yield bond markets “pretty dried up,” they are stress testing cash flows against various scenarios, he said. “A lot have already started to pay down principal amounts.”

Kyle Hranicky, Wells Fargo executive vice president and head of the Wells Fargo Energy Group, believes it’s “too early” in the cycle to make a call on the impact of spring borrowing base redeterminations, but expects a soft landing for most companies.

“You’re going to see a wide range of outcomes depending on the individual situation,” he said. And while he does expect borrowing bases to decrease, “in most cases, it won’t be in huge percentages and most companies will be fine.”

Hranicky, based in Houston, said that his bankers are in touch with most of Wells Fargo’s 550 oil and gas clients, which are first responding by managing capex and G&A expenses.

The Wells Fargo Energy Group, one of the larger energy lenders, has approximately $35 billion in credit commitments to the oil and gas industry. It was running a $50 calendar 2015 price deck in January, to be re-evaluated at the end of February.

What is different in this cycle compared to 2009, Hranicky said, is the amount of high-yield debt issued in the industry.

“So much of the shale drilling was financed through the high-yield market. There was a lot of opportunity with high-yield debt being inexpensive, and the markets took advantage of that. Now, there is significant high-yield debt behind us as a senior lender, which on the one hand provides a layer of capital behind the banks, but on the other hand has increased overall leverage to the industry compared to the last cycle.”

Will banks be pressured to relax or amend covenants in this spring borrowing base season?

“It’s probably too soon,” said Brendel, who doesn’t foresee relaxed covenants just yet, noting that any companies experiencing borrowing base deficiencies will have anywhere from four to six months to come into compliance under the current covenants. “We see this as a short-term phenomenon.”

For those that are unable to meet covenants due to lack of cash flow, Coats said BOK will be as creative as possible in seeking solutions, including looking to guarantors to add assets, a forbearance period, or a joint venture or equity partner.

“The last thing a bank wants is to take back and own oil and gas assets,” he said. “As long as that borrower is cooperative and working toward a solution, we understand the cycles and will give them time to catch up.”

The Coming Fall Season

That scenario could change, though, if situations don’t improve through a second borrowing base season and prices don’t begin to rebound.

“People are preparing as if this [downturn] could last a bit longer, six months or more,” Coats said. “That’s where you could see some pain inflicted, especially to small and mid-size companies.”

During the 2009 recession, prices rebounded by the second borrowing base review and saved a lot of operators. But this downturn feels different, he said, due to lack of control of international dynamics, in particular the role of Saudi Arabia. “I don’t see prices going up quite as fast or as high” as in 2009, he said.

In that case, producers will be forced to make hard decisions.

If low prices persist and hedges roll off, Brendel added, “we will continue to deal with these issues come fall.” Should that happen, he still doesn’t anticipate mayhem. “I feel confident that we’re going to be able to work with our borrowers and come up with plans that are amenable to allow the borrowers to continue to conduct their business and make sure the bank is protected.”

According to Wells Fargo’s Hranicky, “If prices hang where they are, the fall is going to be a lot tougher.” With capex cuts this spring, production and reserves are likely to be lower for the fall redeterminations, he noted.

“For companies with steep decline curves—which is prevalent in shale oil drilling—if they don’t reinvest enough capital to maintain flat reserves and flat production, that’s going to have a big effect on borrowing bases in the fall.”

While the first half of 2015 will likely see muted M&A activity, the latter half could be a flurry as E&Ps look for other means of liquidity.

“There may not be much activity for three to six months as people just hunker down to see what’s going to happen,” Coats said. Following that, he expects cash-starved companies to use A&D to right themselves, and strong, healthy companies to be ready and waiting to take advantage of the downcycle. “From a positive point of view, hopefully we as a bank can get involved in some of that acquisition activity from the stronger companies.”

New Hurdles

Is the bar now higher? “The way we do our loans has not changed,” Brendel said. “The only thing that’s changed is the pricing assumption.” If the hurdle is higher, he said, it’s from scrutinizing for quality assets with low F&D costs. “They have to have economic returns and create proved reserve value. That’s certainly the hurdle.”

Coats said BOK Financial’s hurdle stood at status quo as well, price deck excepted. “We’re not changing our policy” as to new loans, he said. “They may get more scrutiny, but if they fit within our policies, we’ve got our doors open to do business.”

Under the new pricing scenario, however, companies in high-cost plays might find it hard to meet the bar. “If the expense-to-income ratio of the property set is greater than 50%, we don’t loan on that property set,” he said.

Even with a headwind, Hranicky remains optimistic. “As a whole, I feel good that as an industry we have many management teams that have been through multiple cycles. The vast majority of our clients understand the severity of the situation and how to adjust their cost basis to survive cycles. They’re hunkering down and preparing for the next six to 18 months.

“At the end of the day, liquidity is king in these cycles.”

While bankers might be playing it cool at this early stage of an energy downdraft, stretch lenders are seeing activity begin to pick up. One such capital provider is CLG Energy Finance LLC, a Dallas-based stretch/mezzanine loan originator affiliated with Beal Bank.

“There is certainly more urgency for refinancings; there are assets coming to market, for sure,” CLG director Mark Tharp said.

Companies that leveraged up at $100 oil and were having trouble making money at $90 now have more debt than they have equity value in their assets, he added.

“Clearly, there are companies that feasted on easy credit and are over-leveraged, and as a result they are facing significant headwinds,” Tharp said. “Unless we see oil going back to $90 to $100 in the next 12 months or so, affected companies and their existing debt-holders will have to find solutions. Although we try to find solutions for all commercial lending needs, these are the types of opportunities that are coming to us now, and we expect to see more of this activity if commodity prices remain at current levels.”

CLG will consider transactions backed by the entire basket of proven reserves, rather than just PDP, but at higher rates due to the assumption of increased risk. And because CLG’s affiliate banks are not traditional commercial banks, CLG can advance capital quickly and with flexibility.

In one representative transaction, CLG originated early financing for a small but early mover in the Eagle Ford Shale. CLG initially underwrote less than $30 million, but that increased to close to $100 million as the reserves base grew. The company was sold later at a substantial premium.

That deal was in good times, when companies had more options to access capital. Today, companies are proactively having conversations with workout lenders and bankers to try to work through cash-short situations. “Some will be able to do that; some won’t,” Tharp said.

He sees increased activity from small to mid-size private companies and small publics. Companies that look strong now because of hedge positions may have difficulty managing the pricing environment as existing hedges roll off, he said. “If we’re still in a lower-price environment, even if they’re not in the market today, they may be in the market a year from now. The longer we stay below $60, the more challenging it will become.”

Does he see panic? “No. I think companies are probably wisely and intentionally doing everything they can to ensure they can manage this pricing situation,” he said.

While the price volatility has locked up the A&D market, he sees signs of thawing, and companies with strong balance sheets are likely waiting to review these assets.

“It’s the circle of life in the oilfield,” he said, noting that CLG can originate financing for its affiliate banks for any deal up to $700 million, with a sweet spot of $50 million to $300 million.

Describing Beal Bank’s capital as extending beyond the realm of a typical reserve-based lender because of its ability to recognize value in proven undeveloped reserves, the need for mezzanine is returning to the fore. A “fast and loose” credit market during the past couple of years made it more difficult to deploy capital, he said, but the change in the market has suitors calling.

“We have a history of being the people companies turn to when other lenders may have left the market,” Tharp said. “Great collateral is great collateral in any price environment, but that doesn’t mean you should finance it the same way.”