Reserves Based Lending: Uncertain times for E&P companies
With the price of oil turning negative for the first time in history in recent weeks, many cash-strapped independent oil and gas companies will be thinking of how best to manage their on-going working capital needs over the next 12 months.
For those E&P companies with existing reserves-based senior credit facilities (or “RBL”) questions may arise over how lower projected future cash flows will impact their ability to draw on further credit and/or perform their obligations under their existing loans. In recent weeks, we have seen many client companies scale back their drilling programs to reduce capital outlay to weather the current storm.
E&P companies that may be concerned about the existing commitments under an RBL financing structure should consider the following points:
Under an RBL arrangement, loan amounts available to a borrower and repayment sums can be varied periodically based on redeterminations of the borrowing base amount in line with the borrower’s future projected cash flows. As a result, the borrowing amount for an E&P company may be revised down in challenging oil and gas markets, where projected future cash flows are significantly lower. As E&P operations are capital intensive activities (exploration costs, drilling new wells, processing and transportation all require significant amounts of capital), the reduction of borrowing capacity can severely challenge the on-going commercial viability of such operations.
Although E&P borrowers may have reason to be cautious about borrowing base redeterminations occurring during severely challenging markets lenders will often take various factors into consideration, including if a reduced borrowing base would prevent an E&P borrower from developing its assets (i.e. undeveloped reserves) necessary to produce future cash to meet its repayment obligations – a commercial lender may view this as counterproductive in the circumstances and decide to maintain the borrowing base as part of its ‘wait and see approach’.
Lenders will also typically require E&P borrower companies to hedge a certain percentage of their production to mitigate the impact of oil price volatility on their balance sheets. This ensures that borrowers can repay a proportion of the loan from the proceeds of sales from producing assets at an agreed fixed price. As a result, E&P borrowers will have some downward protection from the price of oil to maintain sufficient cash reserves for repayments. Nonetheless, it may be prudent to approach lenders to see if there is any scope for discussions to restructure repayments as they may be sympathetic in the current climate.
Material Adverse Change
RBL loan documentation will typically include material adverse change clauses (or MAC clauses) and additional representations from the borrower that no material adverse change has occurred since the date of its most recent financial statements. Subject to the wording of a MAC clause, or if the representation is made on a repeating basis, a breach may amount to an immediate event of default giving the lender the right to accelerate its debt. However, in practice, and due to uncertainty over the interpretation of MAC clauses, commercial lenders will be unlikely to rely on MAC clauses alone to decide if an event of default has occurred. It is more likely that breaches of loan repayment terms or financial covenants will typically be used by lenders to accelerate their debt and enforce security over the borrower’s assets.
Although the prospect for a sustained period of depressed oil prices may be a cause of alarm for E&P companies with RBL arrangements, lenders are unlikely to take any immediate steps to restrict credit lines for borrowers. However, it is important for borrowers to take active steps to engage with their lenders and to keep them appraised of their cash levels, risks of potential non-compliance with their financial covenants or how the current crisis is impacting their businesses. As previous crises have dictated, lenders may take a pragmatic view during challenging markets and thus be prepared to waive certain conditions necessary to support E&P borrowers through the current crisis. However, RBL facilities are and will be under careful review as the lenders and borrowers assess the impact to their businesses from the recent oil price collapse and as the Covid-19 situation continues.
Should you wish to discuss any issues touched on in this note please feel free to contact Peter Kohl, Joan Yu, Peter Wilkie or your usual contact at the firm.