Back to the future for reserve based finance amid downturn
Jason Fox and Olivia Caddy, from Bracewell & Giuliani, consider the debt markets for E&P companies and the changes to the financial landscape since the last oil price rout
Looking back in recent history, one sees an oil price downcycle every six or seven years almost as regular as clockwork, but each time it happens it takes the world by complete surprise. This time is no exception.
Whilst the drop has not been as steep as was seen in the last oil price rout in 2008/2009, when the price of Brent dropped from $145 to $35, we do seem to have entered a new oil price environment and its ramifications are far reaching – well beyond the oil and gas sector and it’s symbiotic partner the oilfield services sector.
Some of us will say that we have seen it all before. But the truth is that every time is different. The last oil price collapse coincided with the global financial crisis and was, in essence a demand side collapse whereas, conspiracy theories aside, it is generally acknowledged that the recent oil price falls have been driven by oversupply. Current global growth is a not altogether unhealthy estimated 3.5% per annum.
These differences are significant. There is no shortage of money – debt or equity – to deploy to upstream oil and gas projects. Both are abundant. However abundant does not mean readily available and undoubtedly a number of sources of debt are choked off at present.
A new mindset
There have been some significant changes in the landscape in the way exploration and production (E&P) companies in the Europe, Middle East and Africa (EMEA) region fund themselves since the oil price turmoil of 2008/09. In that era, with a very small number of mainly Nordic exceptions, almost all E&P companies which had got to the stage of being able to access the debt markets had only debt in the form of bank facilities. In the vast majority of cases, these were reserve based finance facilities (RBLs).
The landscape started to change in 2011 when Afren (now notable for being the most promi-nent distressed situation in the EMEA E&P market) blazed the trail by raising the first US high yield bond by an EMEA E&P company. A number of other prominent E&P companies have now accessed that market to raise term debt sitting alongside their core RBL facility.
In parallel over the same period the previously niche Norwegian bond market developed as a broader platform where a range of companies have issued bonds (in many cases to achieve greater leverage and take out their RBLs). “Diversity of sources of funding” was the mantra and a number of companies took the option of issuing bonds, generally US high yield, Norwegian or private placements, and the unprecedented liquidity for the sector shifted the balance of power from lenders to borrowers enabling them to do this.
So there are now a number – though not a large number – of E&P companies with quite complex capital structures, a feature which is common in the case of US E&P companies where it has long been common to see companies with multiples tiers of bank debt as well as bonds. Also in the last 24 months a number of mainly US private equity houses and credit funds, some specialising in distressed debt, have established funds for the EMEA region and established London teams.
The net effect of this creates a number of new dynamics for the E&P sector which were not present in 2008/09.
First, there are a number of companies with quite complex capital structures and where a stretched or distressed situation is no longer in the hands of a bank group as the sole financial creditor (a scenario which has contributed to the near absence of real corporate failures in this sector in EMEA in the past). In the case of some companies, activist credit investors – some of whom are buying into distressed situations with short-term objectives – may now play at the table in directing the course of events when a company can no longer comply with its covenants.
Secondly, some companies having availed themselves of what the then exuberant bond markets were offering and the more lax controls the bank markets were imposing are operating with much higher leverage than what we saw in EMEA in 2008/09. The presence of bonds in the debt structure which are not subject to regular redetermination (ie resizing) in the way RBLs are means that some companies who do not have imminent bond maturities have more time to react to the new oil price environment. However, by the same token, those that have imminent bond maturities find themselves in a very difficult place with the debt capital markets for independent issuers being, at the time of writing, all but closed.
On the positive side, there are some new “alternative” sources of finance in the mix.
In the past there has been an almost complete absence of a junior debt or, in US terminology, “second lien” market, something which is an important part of the market in the US. This is partly because the senior bank lending market in the US confines itself to the much narrower parameters of lending against only proved resources and then, in large part, only those which are developed. A number of the funds that offer this sort of credit in the US are now evaluating this opportunity in the EMEA market. Undoubtedly there are E&P companies who need this sort of stretch debt to bridge short-term funding needs and there are lending groups who would – subject to appropriate intercreditor protections – willingly have them alongside.
Some companies have been turning to the “pre-payment facility”, where an oil trader buys future production from a field in return for an upfront payment. A number of distressed and healthy companies have turned to this as a source of finance. Sometimes it has been used as a form of “stretch debt” to increase leverage beyond normal bank lending parameters.
As ever, timing is everything and there are a number of factors which will determine the degree of distress that the oil price fall causes and how it impacts individual companies.
First and foremost of course is the big unknown factor of how long the low oil price environment sustains and how steep is the contango, which is critical in the structure of RBLs which discount future cash flows as the measure of debt capacity. Of course, there are as many different views as there are commentators on the subject.
Secondly, the timing of debt maturities and, in particular, bond refinancing overhangs will play a key factor with the debt and equity capital markets all but closed to independents for the present.
Thirdly is the position of hedging – how far companies are hedged and, therefore, the impact of the oil price fall is delayed. In this instance, there are huge market divergences with (for very good reason) producers being more hedged than those with large developments projects. EMEA companies are generally far less hedged than their US counterparts, but some have been well hedged over horizons of a year or so. There have been cases of companies unwinding “in the money” positions to assist short-term funding requirements.
There is one other factor which is playing out this time around which is a new feature and again is due to timing.
In 2008/09, the failure of the then most active explorer in the North Sea, Oilexco North Sea, in part due to cash-flow issues not related to the borrowing base assets, focused the attention of the bank market to having greater visibility on the consolidated corporate cash flow of their borrowers to give an early warning where the debt-to-resource value may be there but there are nearer-term liquidity gaps. The result of this is that it is now standard for RBLs to include a liquidity test where the borrower must demonstrate adequate liquidity on a look-forward basis, usually 12 or 18 months. In some cases, it is this liquidity test that is proving the first trigger for lenders and creating defaults earlier than would otherwise have occurred. Unfortunate for the borrowers concerned, but exactly what these provisions were designed for.
Perhaps the biggest “unknown” in all of this will be how the bank lending community behaves in the upcoming RBL redetermination processes. At the time of writing, the jury remains out on many of those.
Lenders generally have wide discretion on where to set the price deck and with that the ability to put off or accelerate problems. In most cases it is a majority lender (66.67%) decision and things will gravitate to the highest price that that quorum will accept. In some cases there are “most favoured nation” type provisions to protect a borrower from adverse treatment in the setting of the price deck as compared to others.
In almost all cases, there will be an obligation on lenders to act reasonably, although in a world when in a period of less than a month we had Citi forecasting $20 oil and Eni’s chief executive Claudio Descalzi talking about $200 oil (albeit on different time horizons), the term “reasonably” has probably never had the potential for broader definition.
But there are potentially difficult issues for lenders and borrowers here. In the past, disputes over banking case assumption setting has been all but non-existent, but there is potential for dispute if relationships break down. Let’s hope it does not come to that. This has been avoided in the past but we are in an ever more litigious environment and many situations have more stakeholders than we have seen in previous down-cycles.
It remains to be seen how much distress will be seen for EMEA E&P companies and its long-term effects on the credit markets for the sector. The RBL structure is a tried and tested one and has proved remarkably robust through previous cycles. Undoubtedly it is not in distress or at risk of going out of vogue. Because of the complexity of RBLs, the extensive controls they give lenders and the numbers of potential triggers, defaults (often technical in nature) in the sector have never been that rare and consents and waivers are commonplace.
However, restructurings are relatively rare and the number of cases where banks have actually lost money (secondary debt market trading aside) has been minimal. Will this time be different? There are currently a small number of very distressed situations where there will almost certainly be losses. Most of these cases were known problems well before the recent oil price collapse. In most of these cases, the losses will be experienced by bond investors not bank lenders.
For the most part, however, and where the banks are the sole financial creditors, it seems likely that there will be (as we have generally seen in past cycles) collaboration between lenders and borrowers to an orderly consensual solution.
We have already seen some companies agreeing with their lenders a temporary loosening of their leverage covenants. In part this is probably just good old fashioned husbandry by participants who are long-term players in the market, not short-term arbitrageurs. In part it may be because of the very difficult issues that arise in trying to enforce security over upstream assets.
The drivers and dynamics of bond investors may however be different and the likelihood is that in the first serious oil price down-cycle since the bond markets properly arrived in the EMEA upstream arena, most bond investors will have little appreciation of the issues that arise on an insolvency or receivership of upstream assets in EMEA jurisdictions. The issues are radically different from and more difficult than what they will be used to in the US. Where there are complex capital structures there may be some disasters.
It will be interesting to see if, as a reaction, bank lenders revert to a more cautious position in relation to permitting third party financial creditors to sit alongside them.
No doubt, however, we will be back to the future again soon enough.