Sidley Austin: Debt Financing Returns to E&P Space

Daniel Allison is a partner in the energy and global finance practice of Sidley Austin. He is based in Houston.

Oil and gas upstream companies have seen debt financing return to the sector in the last few years. Although many traditional lenders have left the market, new funding sources have spurred upstream lending. These new sources of capital—including regional banks—have funded recapitalization and new development programs. These funding sources continue to evolve and present new opportunities and considerations, but some questions remain. 

Although there is more access to debt investments in oil and gas companies, the traditional stalwart of reserve-based loans (RBLs) from big box banks remains limited. Many of the largest traditional lenders for RBLs have reduced their participation in these products or exited the industry entirely.

Instead, a number of alternative financing sources have stepped in to address the decrease in traditional RBLs and take advantage of a strong borrower market. Regional banks are the most similar lenders, as they have historically participated in RBLs so it’s simple for them to step into this opportunity because they never really left. More recently, though, they have taken lead roles in originating and running their own deals. Many of these deals are club style with a lot of familiarity among the smaller group of lenders compared to largely syndicated RBLs. 

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Where the deal exceeds the limited size that a club of regional banks can provide, we have seen another development—the split senior lien, with both a regional bank revolver and a private credit term loan. These deals typically have a very large term loan component that is placed to a small group of private credit purchasers. However, many of the private credit purchasers cannot (or prefer not to) fund the frequent and unpredictable borrowings that are typical of the RBL revolver, so in private credit facilities, there is typically also a “super senior” revolver provided by a regional bank or a small club of lenders.

Enter the ABS

A newer alternative method to obtain larger amounts of debt financing or recapitalization is the oil and gas asset backed securitization (ABS). This debt product has been developed in just the last five years, and in that time, it has grown in popularity and become more streamlined. An ABS is a highly structured financing product that is marketed primarily to investors that are required to invest in investment-grade debt. Through many of the restrictions and structuring features, an upstream issuer that is not otherwise investment grade can issue investment-grade debt. Because an ABS is not set up for frequent drawings, many operating companies will retain some assets outside of the entity that issues the ABS to support a small revolving line of credit for their operator entity and future expansion projects.

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The last development is the resurgence of some other debt-like arrangements that were popular among producers many years ago. In particular, volumetric production payments (VPPs) and drillco arrangements have become more common again for the first time in nearly a decade. To date, these have appeared more in small deals than in their respective heyday, but they also have come in as alternative debt-like financing options.

What to consider

In considering which type of debt facility makes the most sense in the world of alternatives to the RBL, it is important to consider both the initial burden and price, as well as the ongoing burden and costs for each facility. For instance, if deal size does not accommodate a club deal RBL, a producer would be selecting between a private credit term loan and an ABS transaction. 

The closing costs for a private credit term loan and an ABS transaction should be fairly similar.  While the costs of execution of an ABS facility used to be significantly higher than other debt instruments, the process and timing have both become more efficient, and it is now in the same ballpark as other types of financings (though still slightly higher).

In terms of ongoing costs, the interest rate on investment grade notes is lower than the current benchmark plus margin that is available in private credit. However, in a decreasing interest rate environment, that differential may decrease over time, and ongoing interest payments saved in an ABS could vanish compared to a floating rate a few years down the road.

Structurally, there are differences between the two; for instance, a private credit term loan would be at a floating interest rate plus a margin, whereas the ABS transaction would be at a fixed interest rate that is set at issuance. Additionally, there are typically very lengthy call protections on the notes issued under ABS facilities, whereas private credit deals have short, if any, call protection. Some ABS transactions are portable, but many have limitations that make portability unfeasible. As such, it is worth considering whether there may be a need to redeem the notes prior to their maturity. 

Reporting requirements

Lastly, the reporting requirements tied to the various types of financings should be taken into consideration. Most of the types of debt available to upstream companies have similar reporting requirements, although ABS facilities typically require monthly reporting in order to run the cash flow waterfall and distributions monthly (as opposed to quarterly reporting in other debt facilities).

On the other hand, private credit deals typically have much tighter covenants pertaining to operations, and this can affect decision-making through the life of the loan. And in many instances, private credit restrictions occasionally require waivers or amendments from the lenders, which typically have fees involved. 

While there have been multiple improvements and innovations in the debt financing available to upstream producers, each has its strengths and limitations. When considering which debt product is best, it is worth considering the initial closing dynamics as well as the ongoing burdens or limitations that each product creates. The return of debt capital to upstream producers is a necessary and welcome development, and it is worth staying in tune with the perks and downsides of these new products as they promulgate.