A?s petroleum prices skyrocketed during the past several years, the risk-reward calculus shifted, and numerous lenders entered the upstream market. This influx of capital resulted in a surge of debt financings for E&P companies from lenders with limited experience in this area of the oil and gas industry.

Some lenders use their standard-form credit agreement when making loans to oil and gas companies. The loan officers are familiar with the widely used form, and it works effectively in secured financings of most borrowers in most industries.

However, a lender’s use of a standard “New York law credit agreement” in the secured financing of an E&P borrower presents several hurdles and pitfalls for both the lender and the borrower. These unique issues are most apparent and problematic in the case of a secured loan to a borrower that is a nonoperating working-interest-owner—which will invariably enter a joint operating agreement (JOA) with the other working-interest-owners. This agreement sets forth the rights and obligations they have to one another.

Most of the pitfalls created by using the customary credit agreement for a loan to an oil and gas company arise in the areas of covenants, and security and remedies. The recent roller-coaster ride in energy prices has no doubt imperiled the ability of some borrowers to comply with inflexible financial covenants in their loan agreements.

For one thing, oil and gas plays are notoriously unpredictable when anticipating cash calls, cash flow, capital-requirement timelines, and so on. This highlights the importance to borrowers of negotiating covenants with which they have a reasonable likelihood of being able to comply under varied market conditions.

From the lender’s perspective, falling energy prices have increased the likelihood of defaults by E&P borrowers in projects that remain viable and attractive. Times like these underscore the importance to lenders of obtaining workable, effective, security and remedies—balanced with the realities of this business. Once a lender has committed funds to an upstream oil and gas play, it may very well find itself forced to go along for the ride.

Covenants

Problems with covenants typically arise because, under the AAPL Model Form Operating Agreement Form 610-1989, which is the most commonly used domestic JOA form used today, most decisions are made and power wielded by the operator—that is, the working-interest-owner charged with developing the play. The operator is usually held only to a gross negligence or intentional misconduct standard.

In the majority of transactions, a single nonoperator does not have the power to cause the parties in the operating agreement to comply with covenants imposed in the credit agreement between the nonoperator and its lender. Following are some examples of covenants.

Insurance. In many standard credit agreements, the lender requires the borrower to maintain specific types of insurance policies with minimum coverage levels, particular deductible amounts and other endorsements. These policies, and their required terms, often differ from the insurance the operator is required to carry for the benefit of the joint account under Article V.9 and Exhibit D of the standard operating agreement.

Thus, many insurance covenants force the nonoperator borrower to reconcile the differences between the policies required by its lender and those already maintained by the operator. In some cases, this can be a burdensome task.

Reconciling these insurance programs raises a host of problems. In addition, the lender invariably requires the nonoperator borrower to cause the insurance carrier to name the lender as an additional insured on each liability policy and as loss payee on each casualty policy.

Even if the insurance carried by the operator for all parties to the JOA is adequate to satisfy the requirements of the nonoperator’s lender, the nonoperator does not have the power to require the operator’s insurance carrier to insert additional insured or loss-payee endorsements on the policies for parties other than itself. This can only be done by the operator, which is not a party to the credit agreement between the lender and the nonoperator and more than likely not eager to tailor his insurance program to meet a particular working-interest-owner’s lending needs.

Financial covenants. Borrowers are often forced to agree to covenants that are unrealistic for a drilling operation. Financial covenants (such as maximum leverage, minimum EBITDA) in credit agreements are tested at regular intervals (usually monthly, quarterly and/or annually). They are often set at constant levels throughout the term of the agreement.

This does not make sense in the context of an operation that requires substantial upfront expenditures (for drilling and completing wells) before any revenue can be generated from producing wells. Several other industry-specific considerations also make an inflexible process both unrealistic and subject to constant “waiver” requests.

Accounting procedures. Most credit agreements require borrowers to use certain accounting principles, typically GAAP, if the borrower is a domestic entity, or International Financial Reporting Standards (IFRS), if a foreign entity. Some of these principles may conflict with procedures required by COPAS 2005 Accounting Procedure, which is attached as Exhibit C to almost every operating agreement. (COPAS is the Council of Petroleum Accounting Societies entity.

Security and remedies

Without careful planning, a lender may not be able to obtain from an oil and gas borrower the level of security it is accustomed to obtaining from borrowers in other industries. A lender may also find it more difficult to exercise its remedies when dealing with an oil and gas company. These problems are not limited to nonoperating working-interest-owners; they apply equally in the case of loans to operators.

Lender step-in rights. Upon the occurrence of an event of default, the typical credit agreement gives the lender several remedies. One is the lender’s right to step into the borrower’s shoes to administer, manage, utilize and sell the collateral, including the borrower’s interest in the oil and gas leases and the production. Another is to perform under the operating agreement on behalf of the borrower.

Exercising these “step-in rights” would be difficult for most institutional lenders: They do not have the people and technical expertise necessary to evaluate or conduct an oil and gas operation. This remedy may also expose the lender to substantial risks, such as assuming the borrower’s share of environmental liabilities associated with the properties subject to the operating agreement.

Assumption of environmental liability is the rule, not the exception, in the oil and gas business. Simply placing the standard language in the credit agreement absolving an interest-owner of all environmental liability may work with the borrower, but it will do them no good once they have been drawn into the operating agreement.

Recordation. Neither lenders nor borrowers pay sufficient attention to the descriptions of the property covered by the mortgage. Simply attaching a description of the wells and/or leases may not adequately describe the wells—How many Smith #1 wells are there in the U.S.?—nor the acreage related to them.

The wording also may not adequately describe the acreage attributable to those wells, through insufficient lease descriptions or the use of imprecise terms (the “proration unit”). The description may cover more acreage than intended to be mortgaged by the borrower (e.g., the entire lease instead of the producing unit). In many cases, the lender has no idea which well is located on which lease and cannot, therefore, correlate title opinions with reservoir-engineering reports.

Area of mutual interest agreement (AMI). If a lender has to foreclose on the borrower’s interest in the JOA and in the oil and gas leases and wells included in the contract area, the lender may become party to the AMI contained in the operating agreement. (Form 610-1989 does not contain an AMI, but the parties to an operating agreement frequently include an AMI in Article XVI, an optional article at the end of the operating agreement that may contain additional provisions.)

An AMI is an agreement between or among parties to a JOA by which they agree to offer a proportionate share of additional leases or other oil and gas interests acquired by any of them within a specified geographical area in the future to the other parties to the AMI agreement. Becoming party to an AMI agreement is potentially a problem for a lender, especially if the AMI is large, e.g. several counties or an entire state.

If the lender is active in oil and gas financing—through debt or equity or both—it is possible, if not likely, that the lender will acquire—such as through foreclosure—oil and gas leases or related interests in the AMI in the future. Under the AMI agreement, the lender would be required to offer to each other member of the JOA its proportionate share of these leases and interests—on the same terms at which the lender acquired them.

If the lender acquired the leases or interests by a credit bid at a foreclosure sale, it may have acquired them for less than their value as shown by engineer analysis. Therefore, the lender would not want to be forced to offer them to the other parties to the AMI agreement at the same price at which the lender acquired them—possibly for cents on the dollar.

Also, selling the working interest may be more difficult when burdened by an AMI agreement. Remember that the likely buyers are in the business with existing interests of their own.

Reciprocal liens under the operating agreement. In Article VII.B of the standard JOA, each party grants to the others a lien upon any interest owned or acquired in oil and gas leases and related interests, and personal property, subject to the operating agreement. This is done to secure performance of the party’s obligations under the operating agreement.

Each party to the JOA represents and warrants to the other parties that this lien is a first-priority lien, and each party also agrees to maintain the priority of this lien against all persons acquiring an interest in the leases and related interests by, through or under such party.

Nearly every credit agreement contains a negative covenant that the borrower will not create, incur or permit to exist any lien on the collateral other than certain enumerated, “permitted liens.” To prevent breach of such a covenant, E&P borrowers should negotiate inclusion of the operating agreement’s reciprocal lien in the credit agreement’s list of the “permitted liens.”

Similarly, mortgages and security agreements almost always include a representation by the borrower that, upon the filing of the mortgage and security agreement in the appropriate jurisdictions, the liens and security interests that are created will be perfected, first-priority liens upon the covered real and personal property, subject only to the “permitted liens.”

Obtaining subordination from an operator or other working-interest-owners is virtually impossible. And remember, with the exception of Louisiana, an unrecorded operating lien is superior to a later-filed lender’s lien.

Priority of mortgage under state recording acts. Many lenders accept quit-claim language (i.e., all the borrower’s “right, title and interest”) in the granting clause of their mortgages. Depending on the jurisdiction, such language may not give the lender full protection under the state recording acts.

Recommendations

Financing oil and gas companies is fraught with perils for lenders lacking significant experience with the oil and gas industry. These perils, particularly those involving covenants and security and remedies, are magnified in today’s environment of a slumping economy and falling energy prices. These examples are but a few of the many issues to be addressed in tailoring a credit transaction to an upstream play.

H. Martin Gibson Sr. and Stephen Molina are of counsel with Patton Boggs LLP’s Dallas office. Molina is also chairman of the International Committee of the Interstate Oil & Gas Compact Commission. Jason Schumacher and Jonathan Harshman are associates with the firm, also in Dallas.

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