Deal Doldrums Lead To Low-Key Energy Lending

[Editor's note: A version of this story appears in the September 2019 edition of Oil and Gas Investor. Subscribe to the magazine here.]

It’s hard to be effusive about energy if you’re in commercial banking and—as has happened in the first half of the year—the economic terrain faces consistent headwinds. Public capital markets have been largely closed for energy, and easy exits have disappeared for private-equity-backed portfolio companies. Uncertainty hangs in the air, and the flow of transactions for banks to fund is down markedly.

Of course, existing lending commitments by bank syndicates continue in place with producers. Many of these were renegotiated and extended in the last couple of years, and so they’re not facing a “maturity wall” in the loan market, said one banking source. But twice-yearly borrowing base redeterminations are based on volumes and price, as is the norm, and the spring redetermination season saw a slump in most natural gas prices.

There are some bright spots in terms of new lending opportunities. A couple of E&Ps have launched IPOs, spinning off assets in the midstream and mineral sectors. Moves to monetize midstream assets have included water infrastructure, helping highlight an underappreciated asset or, in some cases, offering an alternative way to shed noncore E&P assets in a weak A&D market.

But conditions have changed in what once was a fairly cohesive financial ecosystem between public-equity markets, private-equity (PE) investors and commercial banks. Public-equity investors have, as one commercial banker puts it, “boycotted” energy companies that outspend cash flow and come to equity and/or debt markets for funding that in the past opened up opportunities for new credit lines.

Gears ‘not moving smoothly’

The interaction of energy markets “hasn’t ground to a halt, but the gears are not moving smoothly,” said one industry observer. With public-equity markets largely closed, PE sponsors are stepping back from earlier times when “there was always an endgame and a reasonable valuation. To make an investment, you have to have confidence that you know you have an exit. That is what’s lacking now.”

With diminished prospects of monetizing an investment, the earlier “virtuous cycle” of being able to recycle proceeds to PE investors has “slowed down dramatically,” the observer said. “And when the acquisition and divestiture market is slower, and thus there are fewer new transactions coming to market, there are fewer opportunities to syndicate transactions in the commercial banking sector.

“It’s an issue of transaction volume. There is deal activity, but it’s a lower number of new transactions.”

Todd Mogil, managing director overseeing all energy corporate banking in North America for Citi, described the recent capital market environment for the upstream sector as “challenging.” Recent activity year-to-date has been “pretty low,” with an IPO calendar that was “almost nonexistent.” And “quality really matters” in terms of accessing and pricing issues in the high-yield market, he added.

“But whether the market is roaring or challenging, we’re consistently looking for opportunities,” said Mogil. “We’re committed to the space; we’ve got lots of capital committed to the space. We try to be consistent in terms of our strategy, not piling in when things are good and then pulling out when things turn bad. We try to be consistent throughout all markets.”

For favored customers, some of the recent slackness in lending may be showing up in credit terms.

“Bank capital is going to be there for good credits, for good structures and for good stories,” said Mogil. “Some of the pricing power, especially for the stronger credits, has shifted back to the borrower. Banks are willing to trade pricing concessions for structural enhancements. We’re starting to see pricing levels get back to where they were pre-downturn.”

In terms of a catalyst for a pickup in lending activity, Mogil pointed to the need for improved investor sentiment driven by more consistent performance.

“Investors are broadly looking for more consistent performance. Recent underperformance, on both the equity and high-yield sides, has caused investors to demand higher returns or simply look to other places where they can put their money and get consistent returns. There has to be improved performance for generalists to rotate back in, or valuations need to reach a point where people have to pay attention.”

Phil Ballard, managing director in charge of reserve-based lending (RBL) at Citi, said there have been some indications of a pickup in activity, but “the better part of this year so far has been slow.” In key areas—the PE sector launching new portfolio companies and the A&D market— “a lot of dialog that goes on, but transactions have been a little more selective than they have been in the past.”

“It’s really all forms of capital that seem to have retrenched a bit,” he continued. “The private-equity side and the public equity and debt markets are relatively dormant right now.”

What available capital tends to flow into the hands of the larger-cap companies that “can show they have scale and continue to grow their production without outspending their cash flow,” according to Ballard. In addition to being able to better manage capex amid uncertain commodity prices, he noted, the larger names often have greater leverage in negotiating oilfield service and marketing contracts.

Taking less risk

Despite the slow market conditions, Citi and most other banks “are still actively looking to add assets to their book, assuming they are well-structured conforming transactions,” said Ballard. However, they are likely to be “a little more selective and cautious about getting into more challenging situations. The banks just aren’t taking as much risk as they were five years ago.”

In the latest RBL redetermination season in the spring, approaching 50% of producers had borrowing bases reaffirmed, with the balance of Citi clients seeing their borrowing bases split roughly equally between increases and decreases, said Ballard. The price deck used by banks in general is relatively flat. For Citi, the prompt Nymex month is set at $51 per barrel, rising over seven years to $53.

Not surprisingly, those actively drilling for liquids in the Permian Basin tended to make up the greatest portion of those with increases in borrowing bases. Haynesville Shale operators, benefiting from strong drilling results and premium natural gas prices due to its location, also tended to see increases. For natural gas-oriented E&Ps, those able to grow reserves enough to offset a drop in value due to lower gas prices were able to maintain borrowing bases.

Stable and higher oil prices

What would help spark a wider and more intense level of activity in the energy lending space?

“What we need to see is stability in oil prices at a higher level,” said Ballard. “Also, we would welcome some positive news from the industry that it can maintain and grow its production without outspending cash flow. The criticism of institutional investors is that companies are growing, but not adding value. They want to see real signs that the industry is adding value.”

Similarly, J.P. Morgan managing director Mike Lister emphasized, “We bank the industry, come high or low prices. We expect the cyclicality. As a firm, we’ve covered the oil and gas industry for over 50 years. We like to think it’s about client selection, picking the right management teams and being there for them through the ups and downs in the cycle.”

Based in Dallas, Lister leads J.P. Morgan’s corporate client banking practice within the commercial banking division as it relates to clients outside the major global integrated producers. The client base is made up predominantly of domestic noninvestment-grade E&Ps that employ a reserve-based loan structure, but also includes companies in the midstream and oilfield service segments.

“We have a large and active client base across all three verticals,” said Lister. “We have thoughtfully expanded our loan commitments in each vertical over the past three years. From a syndication standpoint, we still see loan demand for well-structured transactions for E&Ps that have demonstrated their ability to operate efficiently at lower commodity prices. J.P. Morgan and the market as a whole remain focused on keeping E&Ps within the normal lending metrics of asset coverage and cash flow.”

Midstream stability

Given the critical nature that midstream infrastructure plays in moving oil, gas and NGL from the wellhead to the end consumer (e.g. utilities, the petchem sector, refineries or even offshore markets), the midstream sector has offered more stability in terms of the flow of credit opportunities, according to Lister. “In many cases, it’s like a tolling arrangement. There’s risk as you build out systems, but once you’re operating gathering and processing assets in a basin, you typically have contractual minimum volume commitments or acreage dedications, so it’s easier to project future cash flow.”

Moreover, “valuations have held more firmly,” he said. “That’s why you’ve seen some of the public and private players in the upstream sector, who have built out a midstream business embedded in their ownership structure, spin out the midstream assets via an IPO or sell to a third party given the valuation differential between E&P and midstream asset. And it’s a scale game, so you’re also likely to find larger infrastructure funds or PE funds willing to put more capital to work on the midstream front.”

Bryan Chapman, market president of energy lending with IberiaBank Corp., noted widespread industry awareness of “the issues and changed dynamics due to what is pretty much a boycott of public capital markets” for those E&Ps seeking funding beyond internally generated cash flow. In addition, “the A&D activity has tapered off,” he noted.

With public-equity markets generally “not being supportive of growth strategies,” producers are under pressure to “live within cash flow and return some of that cash to investors,” said Chapman. “And, of course, they want you to do that without over-leveraging the company, because then you’ll trade at a steep discount. It’s a tough challenge, and companies are having to make that transition.”

A silver lining

However, the fewer financial instruments available to producers may offer something of a silver lining to commercial bankers, according to Chapman.

“If companies, particularly those backed by private equity, are having to transition into prosecuting a development program and building up production that is able to support a borrowing base, there will be more companies having to grow production,” he said. “And with fewer assets being monetized, that can create a pretty attractive environment for energy loans from a commercial bank.”

Chapman referenced reports that some private-equity sponsors were withdrawing commitments to portfolio companies that had yet to make an acquisition “because they’re trying to preserve that liquidity to invest in companies that are more mature in their development, since they’re likely going to have to support those portfolio companies over a longer period.”

In addition, by “rolling up” management teams operating in a single basin to create scale, sponsors can create “a better profile of a company able to prosecute a drilling program and increase its PDP” (proved developed producing) properties. “Whenever markets come back, the companies that are buying are probably going to want a much higher PDP component than they’ve had in the past,” he observed.

“A lot of PE sponsors are consolidating their portfolio companies to create ‘basin champions’ that have a better chance of doing an IPO or ‘merger of equals’ when capital market conditions change,” he added.

Liquidity management priority

Historically, banking relationships have “always been very, very important from a liquidity management perspective,” recalled Chapman.

Traditionally, he said, E&Ps would “make an acquisition, maybe issue some equity, perhaps issue some high yield to partially fund the acquisition, and then pay down their revolver. Then, as they ran a drilling program, outspending cash flow, they’d start drawing on the revolver. And once they were at half to two-thirds drawn against the revolver, they would term it out in the high-yield market.”

However, against the current backdrop, which is “not as growth-oriented, not as acquisition-oriented,” such a series of transactions will likely no longer apply, according to Chapman. “The current environment requires people to think differently. CFOs are very much focused on liquidity management and refinancing risk in light of current market conditions.

“If you’re a company, whether public or private, and you have some unsecured term debt that’s maturing over the next two to three years, you may have to suddenly switch your focus to: ‘How am I going to address that re-financing risk? Do I need to underspend my cash flow and use that to pay down my credit facility, so I have enough dry powder to take out a maturing high-yield issue if necessary?’”

As an example, he said, if a company issued debt a couple of years ago—and because of weakness in oil and gas prices the debt is trading at a discount to par—the market is signaling to the issuer that it will have to offer a higher coupon if it wants to refinance the debt. In turn, the issuer would have to carry a larger interest burden, he noted, contributing to a higher cost of capital.

“The one thing that the banks are not going to do is to extend the maturity date of a revolver beyond the maturity of a large subordinated debt repayment obligation,” warned Chapman. “The banks are in the first lien position. They want to be the first debt to mature in the capital structure.”

Where has IberiaBank made major inroads in growing its loan portfolio in a market beset by cross-currents?

Midstream ‘more than doubled’

“The midstream sector has been a big draw that wasn’t there four or five years ago,” said Chapman. The midstream sector made up roughly 15% of the energy portfolio at the end of 2014 vs. 85% for the upstream sector. Since then the midstream sector has “more than doubled” to about one-third of the IberiaBank energy portfolio vs. some two-thirds for the upstream sector.             

Buddy Clark, co-chair of Haynes and Boone LLP’s energy group, joked that commercial banking in energy has gone from being “boring and great” in 2018 to “too boring” this year.

“Deals are slow. Access to public markets is really slow, and that’s the engine that drives transactions when people are buying and selling properties. Without the deals, there’s not the need for a lot of financing,” he said. “But the major energy banks are open for business and looking for deals.”

Haynes and Boone conducts a twice-yearly survey of borrowing base redeterminations. The latest, conducted in February, showed that the greatest segment of respondents—among both borrowers and lenders—expected borrowing bases to stay constant. The second-largest segment, tilted toward lenders, expected a decline in borrowing bases of between zero and 10%.

While the formula for RBL loans is basically unchanged, “the banks are more selective,” said Clark. “The banks have to a degree become more conservative on their calculations for borrowing bases for proven reserves. In particular, they’re giving little to any credit for undeveloped reserves, because the market’s not giving any credit for it. I think the advance rates for PDP reserves are fairly consistent.”

In some cases, producers may have little urgency to take on a larger credit facility, even if their borrowing bases would make them eligible, according to Clark.

“For those E&Ps adding PDP reserves, the banks are going to increase the borrowing because it is essentially formulaic,” he noted. “But what we’re seeing is that borrowers that don’t need access to additional capital are not asking for their borrowing bases to be increased, because they pay an unused fee on the amount they don’t have drawn down.”

In addition, the gridlock in the A&D market may also hold back E&Ps from pushing for a revised facility.

‘Nobody to flip it to’

“There’s no point going to a bank to get funding to drill more wells on your property if your goal is to buy and flip, and there’s nobody to flip it to,” he observed. “Even E&Ps with a lot of locations are not necessarily accessing capital to build reserves until they can see an exit. With current market sentiment, adding reserves on its own through incremental debt is no way to increase share values for E&Ps.”

This is by no means to understate the importance of banking relationships to both borrower and lender.

“These revolvers are usually now five-year maturities, and the only thing that gets repaid prior to maturity is the interest,” he said. “The expectation of both the bankers and the producers is that one year before maturity they will refinance this credit and roll the principal and extend the maturity. Both the banker’s and the producer’s idea is often that they’ll continue to grow the credit until somebody merges with the producer and pays it off.

“You don’t want to wait to refinance within one year of maturity, because it then goes into current obligations and can really ruin your financial ratios,” according to Clark. “Often these credit facilities get amended with every acquisition or substantial sale of assets. So that’s usually the goal: to keep that maturity out there at least one year. And still further out will make CFOs more comfortable.”

Clark holds out hopes for better days in the A&D market for commercial bankers. The question is when. Clark wrote a book on the history of oil and gas lending in 2016 titled, “Oil Capital: The History of American Oil, Wildcatters, Independents and Their Bankers.” The industry has “seen this rodeo many times over,” he said.

The steep selloff in crude prices in the fourth quarter of last year “gave everybody another dose of reality. We’re not going back to the go-go days any time soon,” he said. “It’s difficult. We’re in that portion of the cycle where there’s not a great emphasis on exploration or on acquisitions. But the industry repeats itself. I’ll guarantee you it will come back. The question is when.”

[SIDEBAR]

STEADY ON COURSE

While it may not seem obvious to discuss commercial banking trends with a private-equity (PE) sponsor, Oil and Gas Investor was reminded of an observation by Quantum Energy Partners some 18 months ago. The Houston-based PE sponsor said if one aggregated the purchasing power across all its portfolio companies, its “credit facilities are probably larger than most large-cap public E&P companies.”

With that perspective in mind, OGI visited with Quantum managing director Tom Field, who said, “Quantum’s collective portfolio companies were now operating close to 30 rigs, making our firm one of the most active drillers in the U.S. If viewed as a single entity, the Quantum-backed portfolio companies would be the equivalent of a large independent oil and gas company.

“We deal with multiple banks, and the banks that we deal with are very active,” said Field. “We have billions of dollars of capital drawn in what I would call ‘regular way’ RBL credit facilities. We are constantly in the market. For instance, we just upsized or closed three credit facilities in the last few weeks. In addition to upstream platforms, we have several midstream and mineral platforms, most of which utilize credit facilities.”

Field emphasized, “How important it is to us that our banks have a deep understanding of the oil and gas industry. We view the banks as true partners in helping build and grow our portfolio companies.”

An example is pad development, involving anywhere from about two to 20 wells drilled on a pad, said Field.

“On a multiwell pad, we may start spending capital to build the pad and then drill and complete the wells in excess of a year before we bring the pad online and see cash flows,” he said. “That’s somewhat new for the banks, too. So we put our heads together with some of our key banking partners to figure out a construct that recognizes that dynamic and allows for a prudent amount of leverage.”

With close to 30 rigs being run by its portfolio companies, Quantum’s “organic” level of activity has been as high as it’s ever been, according to Field, referring to the ongoing development of its existing portfolio companies’ asset positions.

“Given the current state of the A&D market, plus the general desire of acquirers to buy assets that are approaching, if not already, cash-flow neutral or positive, we’re generally taking our asset positions further along the development continuum, which may mean a longer hold period,” said Field. A hold period of three to five years previously may now be four to seven years, for example, he added.

“Our banks are playing a very important role for us as our borrowing bases grow, and we continue to deploy capital from the RBLs, as well as from cash flow, to continue developing our assets,” he said.

How comfortable is Quantum and its banking partners that the assets will find an eventual market?

“At a high level, it comes down to your conviction in the undeveloped inventory that you have,” said Field. “If you have a high degree of confidence that you’re going to achieve attractive rates of return with your wells, putting capital behind that program makes a lot of sense. And you need even more conviction if you‘re pad developing, because then it involves a larger amount of capital being invested before a group of wells come online.”

Field acknowledged that recent market sentiment may have shifted somewhat so it is “less focused on having decades of inventory and more focused on high-returning inventory and cash flow.” However, he said there will always be a market for very high-quality inventory with a low breakeven that can generate cash and repeatable, attractive rates of return.

“We work with our management teams to construct an asset base that any acquirer is going to say, ‘That’s going to the front of our queue for development,’” said Field. “We think there is always a market for an asset whose profile allows it to jump to the top of a buyer’s undeveloped inventory stack from a returns standpoint.”

In selecting assets to develop, Quantum is indifferent as to commodity, according to Field.

“We don’t see a difference in terms of a willingness to develop oil-weighted assets rather than gas-oriented assets,” he said. “Banks have their price decks for both commodities. They run the price decks and do the analysis for the conforming borrowing bases. And we get credit for hedging. Both our oil-weighted and gas-weighted companies’ reserves are growing substantially.”

Feedback from certain banks has been that they were becoming “more selective,” said Field. “Our banks are telling us they’re increasing exposure to what they deem to be high-quality companies and high-quality private-equity sponsors, while reducing their exposure to those they deem otherwise.” For Quantum, pricing grids are largely unchanged recently, with spreads over LIBOR “generally at 225 to 275 basis points, depending on borrowing base utilization.”