American Oil and Gas Reporter - July 2020 - 37

Reserves-Based Lending

Reserves are the common stock of the oil and gas business.
The value of that stock rises and falls with commodity
prices, and crucially, directly affects reserves-based borrowing
determinations. What do you see ahead for reserves-based
lending (RBL) as fall redeterminations approach? How could the
dynamics shift should prices continue to edge upward?
MORRIS: Unless oil prices increase considerably more over
the next three-four months, more decreases of borrowing bases
seem likely in the fall redetermination season despite the oil
price recovery since April. While I do not expect significant
changes or new developments in bank RBL methodologies for
the upcoming redetermination season, I anticipate at least four
key themes.
First, many oil and gas companies curtailed or suspended
drilling and completion activity in the first and second quarters. As
a result of this lower activity, coupled with the natural production
decline of producing wells, proved developed producing (PDP) reserves, which receive the highest advance rates or lowest risking in
the sizing of an oil and gas RBL, will decrease compared with the
just-concluded spring redeterminations. Whether higher oil and
gas prices will be enough to offset the present-value impact of
lower PDP reserve volumes remains to be seen.
Second, existing and newly booked proved undeveloped (PUD)
locations in mid-year reserve reports will face increased scrutiny
by banks. Which PUD locations are projected to generate rates of
return in excess of the lenders' hurdle rate thresholds? Are the
projected well costs, operating expenses, and production volumes
reasonable and supported by historical data? These are only a
few of the questions that bank engineers and credit professionals
will be considering as they evaluate midyear reserve reports.
Third, banks will carefully evaluate each borrower's liquidity,
expected cash flow, leverage and commodity hedge protection.
Does the borrower have enough liquidity to justify borrowing
base credit for its PUD reserves?
Finally, some companies may have to trade borrowing base reductions for financial covenant relief from their bank groups,
while other less-challenged companies may face pressure from retrenching banks to decrease their borrowing bases. Banks will be
especially motivated to reduce exposure to RBLs of companies
that are anticipating high leverage (greater than 3.5 times) in 2021.

With operators continuing to face a high degree of business
risk, many companies are highly leveraged and would be
vulnerable should prices come under renewed pressure. How
would you describe the general sentiment among banks with exposure to oil and gas? Could today's market environment permanently alter the risk/reward metrics for bank RBL programs?
MORRIS: The capital markets have very little appetite for oil
and gas equity and debt exposure, and the U.S. market for oil and

gas properties remains exceptionally weak. In addition to an oversupply of oil in the first half of 2020, the industry still is suffering
from COVID-19-related demand destruction. Many "oily" independent companies had very little of their 2020-21 production
hedged prior to the price rout. For these and other reasons, I think
the sentiment is negative among the banks engaging in oil and gas
RBL. Many may be wondering what OPEC and Russia will do
when global demand eventually recovers.
If oil prices increase significantly in the near future and oil
production ramps up again in the Permian Basin, will natural gas
benchmark prices or basis differentials suffer due to the resulting
increase in associated natural gas production? Are there gasfocused companies that are vulnerable to this potential shift?
I am not bold enough to predict permanent changes in the oil
and gas business, particularly the financing of it. Eventually,
bankers will retire, institutional memories will fade, and oil and
gas prices will increase enough to embolden banks and other
investors to become more aggressive. However, in the foreseeable
future, I would not be surprised to see banks re-evaluate their
guidelines for assigning loss given default (LGD) percentages
to oil and gas RBL and conclude that LGDs should be higher.
Typically, loans with higher LGDs have higher interest rate
margins. Indeed, we already have seen loan pricing increases in
conjunction with spring redeterminations.

How are banks responding to the financial pressures associated with lower commodity prices, reduced reserves
valuations and ratcheted-down borrowing capacities?
MORRIS: Most banks are responding rationally to lower commodity prices and stressed collateral coverages, seeking to restructure
loans when doing so yields a materially higher expected recovery
than forcing a sale of the collateral properties in the current market.
Out-of-court restructurings are possible and will occur. However,
if a borrower has junior debt and/or midstream obligations in the
capital structure, out-of-court solutions will be more challenging,
if not impossible. Whatever the case, I expect the banks to be more
active/vocal in all restructuring situations, and not just those where
the secured revolver is clearly the fulcrum.
There may be some vulnerable producing companies that
struggle to reduce leverage even when oil prices recover if,
during this downturn, they lose significant borrowing capacity
that otherwise could have been available to fund drilling and
completion spending in excess of operating cash flow. In
addition to having little borrowing base availability, such a
company will have high leverage (total debt to EBITDAX in
excess of 3.5), which can make it difficult to raise new/increased
commitments from commercial banks even if proved reserves
support a borrowing base increase.
If oil prices continue to recover and the global demand outlook
improves, I think some of these vulnerable companies, particularly
those with good acreage, will attract a lot of interest from investors.
JULY 2020 37

American Oil and Gas Reporter - July 2020

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