Reserve-based finance is a generic term used to cover finance where the loan is collateralized by the value of a company’s (or project’s) reserves and where repayment of the debt comes from the revenue derived from sale of the field or fields’ production.
Kevin Price, Société Générale, London
Lending structures vary across different markets but broadly falls into four main categories:
- Development finance (upstream project finance) where the money is lent to finance ‘construction’ of a new ‘greenfield’ oil (or gas) field
- Reserve-based lending where money is lent against an existing producing oil field
- Borrowing base where money is lent against and repaid by revenue from an aggregate ‘basket’ of oil fields
- Mezzanine - a generic term for funds provided that fall between the senior debt and equity categories
Background
Reserve-based finance is a long established product suite in the bank market. The US market is perhaps the oldest market for reserve-based financing, and US banks were the first to recruit engineers from oil companies. Despite this, the US domestic lending market is atypical of the global market.
US banks have been providing production-based loans (often to small borrowers) for many decades, but the product in the US has typically been restricted to proved, developed, and producing reserves (PDP), with limited value given to proved undeveloped reserves (PUD). Many times value is only added when there is significant PDP value and diversification of well stock, fields, and revenue.
By contrast, the loan market in the North Sea has its origins in large-scale project financings of the early 197’s when the basin was being opened by the majors and large independent oil companies.
Historically, the UK banks in the North Sea market have been comfortable lending against undeveloped reserves. The loans benefited from the provision of a guarantee put forth by a large corporate sponsor until the field had passed a technical ‘completion’ test, at which point the loan would become limited in recourse to the project field, which by that time would be producing.
In recent decades, however, reflecting the changing ‘demography’ of oil companies in the North Sea, the market has increasingly provided project loans to smaller sponsors.
With small companies the value of the pre-completion guarantee has been reduced by the fact that the sponsoring company had limited value outside of the project being sponsored. Banks effectively take reservoir risk on undeveloped reserves from day one of the loan.
Governments in North Sea countries like the UK and Norway approve the smallest detail of development plans, and all offshore facilities and developments are sized to accommodate mid-case (P50) outcomes (roughly equivalent to proved and probable reserves). This degree of regulation combined with the sizing of the field facilities and appraisal and development drilling campaign to accommodate the P50 outcome has helped in making the North Sea reserve-based lending market the most aggressive in the world.
Over the decades, various sub-categories of product have evolved as banks rolled out new variations on ‘classical’ US and North Sea structures into different markets. The ‘norms’ of lending in terms of reserve categories, leverage, structure, and security can vary considerably between markets and are determined by:
- What is possible in the legal framework of the particular market in terms of security
- Which bank or banks originally opened up the new market (and in turn which mature market model, US or North Sea, their lending structures were based on
- What the liquidity for syndicating the loan (selling the loan to other banks) is like in that market (reduced to the lowest common denominator amongst participating banks)
There can, for example, be considerable differences in classification criteria for reserves used in the cashflow projections.
Overall structures in different markets often achieve the same ends by different means. Most structures used are tried and tested, and loss history in this business has been very good with relatively few bad loans. Losses suffered tend to be more closely related to reserve risk than any other factor.
Main facility categories and modifications seen in different loan markets
The products that generally follow the lifecycle of an exploration and production company are summarized in Figure 1.
The product used depends on the market, the status of the field’s development (its maturity), and the number of fields.
Figure 2 compares the different products developed in different markets (North Sea and USA) at different stages in an oil field’s development and shows how the variation in the spread of reserves reduces with the maturity of an oil field from pre-development though to a low-reserve spread in a long-term producing field.
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Upstream project finance term loans
Field development finance - loans to large sponsors (investment grade)
This business has its origin in the North Sea in the early 1970s with loans like the Forties Field project finance loan in 1975. The market has evolved over the decades, and now such loans are routinely performed in emerging markets
These loans have many of the features common to large project financings; however, many of the issues that relate to a naked project risk (e.g. contract structure, reserve risk, etc.) are greatly mitigated by an investment grade pre-completion guarantee from a large sponsor.
In the case where such a ‘risk transfer point’ (from the project sponsor to the lenders) is present in the structure, the primary credit risk relates to the quality and comprehensiveness of the completion test and the credit quality of the guarantor.
Lending structure / parameters
Figure 3 shows the structure of a typical project loan in the international market. Debt is typically constrained by three factors, the project life cover ratio, the loan life cover ratio, and the reserve tail.
Project loans are traditionally term loans though many structures these days term out and swap to revolvers once the completion test has been passed.
The NPVs for loan life and project life are divided by cover ratios to obtain the debt amount. Typical cover ratio’s vary across markets but should be bespoke to the underlying asset and generally higher for single field loans. Single field loans for non-producing (development) assets are nearly always restricted to P90 or proved (undeveloped) reserves.
Average cover ratios vary across markets and are typically higher than those seen in a borrowing base due to the concentration on one asset, but lower ratios can be acceptable where loan life is short compared to project life (i.e. leverage is low compared to the asset value).
The completion test is one of the most important features of the structure. Such tests are often highly technical and are negotiated between the bank engineers and the borrower. They represent the decision point for the transfer of risk from sponsor to lenders.
Field development finance - loans to smaller sponsors (sub-investment grade)
These loan structures have developed from the large sponsor structures having their origins in the North Sea market, they are less common than larger deals and the majority are done in developed markets. Deals have also been done for smaller to medium-sized sponsors in emerging markets, however.
In many ways these transactions are a purer form of project finance because the fundamentals of the project are particularly important with the credit not having the mitigation of an investment grade guarantee prior to project completion because of the smaller size of the sponsor the pre completion guarantee from the sponsor will have additional covenants attached on additional indebtedness, restrictions on disposals, and potentially negative pledges so as to maximize the benefit of such guarantee.
Liquidity for cost overruns will be an additional credit risk perceived by banks where the sponsor / guarantor is small - this can often be provided by a cost overrun tranche of debt subordinated to the senior facility.
Classic project finance credit risk assessments on contract structure and contract counterparties are particularly important in deals where the borrower is operating the fields and where the borrower is a minor joint venture partner. Contract risks can be mitigated somewhat by the presence of a major operating oil company managing contract and project risk.
Reserve risk is particularly important. The level of appraisal of the financed field is key in determining the likelihood that the project will be financed because, due to the sponsor’s small size, the bank will be directly exposed to the reservoir from day one.
Completion tests are less important than in large sponsor loans because the banks have already effectively taken project risk from first drawdown; however, the tests still serve to prevent cash leakage from the borrower until the banks are comfortable that the project is performing. They are important in ensuring cash is trapped in the borrower and equity not diluted until the project is completed.
While these deals require great care and skill, this sector presents attractive opportunities for banks with a high degree of oil industry expertise with the ability to structure such complex transactions.
Borrowing bases and revolving facilities
Borrowing bases differ fundamentally from project loans because they typically contain more than one asset. This results in diversification and lessens the reliance on the performance of any one field or reservoir (see Table 1). They typically revolve - allowing repayment and redrawing of the debt up to a facility cap. Included assets (fields) can be brought into and taken out of the borrowing base ring fence, subject to certain conditions, making the structure suitable to fund asset acquisitions.
| US market (Gulf of Mexico model) | International OECD market (North Sea model) | International non-OECD market (African model) |
|---|---|---|
| Reserve ownership | Cap on non-OECD assets | PSA, concession, service agreement |
| Little or no value to assets out of US | Normally secured by shares pledges and debenture but no mortgages | No security on reserves, licenses, or assets |
| Security on the reserves and the assets (mortgage) | P50 / 2P for borrowing bases | Share pledge and control over accounts and payment flows |
| Normally secured / unsecured for larger companies | P90/ 1P for single assets | Borrowing base and development finance |
| Proved reserves only considered | P90/ PUD for development finance | Proved reserves normal, probably by exception |
| Borrowing base only, no development finance | Post-tax cash flow | Cover ratios typically intermediate between 1.65x for BB or 1.75x for DF |
| Pre-tax cash flow | NPV @ cost of debt | 10-15 year history depending on country |
| NPV @ 9% or 10%^ | Cover ratios lower in range of 1.5 PLCR depending on structure | |
| Cover ratios up to 2x | 30 year history | |
| Cashflow half life test possible | ||
| >35 year history |
The borrowing base assets are typically (but not always) predominantly producing, lessening reliance on any completion or development risk. In some facilities a significant portion of income may be from third-party tariff revenue, further diversifying revenue sources and overall risk. The structure is a flexible one for medium-sized oil and gas companies with several producing fields. At the larger end of the spectrum they are fundamentally secured (or in US loans sometimes unsecured) corporate credit facilities.
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Security
Security is a fundamental concept in banking. While good security itself is not a reason to lend, it is regarded by bankers as an important fallback mechanism in ensuring debt repayment.
Security can be offensive - the actual ability to enforce and sell an oil or gas field, or primarily defensive - the ability to stop another creditor from getting ahead in the queue in the case of a borrower’s bankruptcy.
There are significant differences in the ability to get security in different markets.
The US domestic lending market is one of the few markets where it is possible to get asset-level perfected security, i.e. a mortgage over the underlying oil or gas field.
While in the US it is legally possible for an oil company to own the underlying reserves, reserves in most other countries are owned by the state. The oil companies essentially lease the right to extract the reserves in return for paying the government taxes or sharing the production with them. These rights cannot typically be assigned or transferred without prior governmental approval, which, in most cases, is extremely difficult to obtain.
In most emerging countries, the benefits of security on domestic assets (licenses, contracts, or other producing assets) are also limited. In many cases the domestic law has not developed enough to fully encompass the underlying legal concepts seen in developed markets.
In other more politically benign parts of the world, the UK North Sea for example, where the law is fully-developed and tested in terms of its ability to cover the concepts of security, oil field security levels may still be lower than can be achieved in the US.
In most markets outside the US, security therefore focuses on shares pledges over the borrower or asset owning operating companies, and negative pledges, together with security in cash proceeds and accounts. Security is primarily defensive in nature.
Broad differences in cover ratios and security and reserves between the markets are shown in Table 1.
Convergence of markets and arbitrage between them
Currently the dichotomies in the markets are starting to converge. International borrowing bases are increasingly common and diversified borrowing bases with high non-OECD asset components are now largely 2P based.
International companies with a heavy US asset base, but with a significant international component to their portfolios, are starting to raise debt in the North Sea markets. Raising debt in these markets allows the borrower to benefit from higher leverage through the use of 2P reserves in borrowing bases. This trend is expected to continue - especially for non-US domiciled oil companies.
Other lending structures
Mezzanine and Subordinated Debt
Mezzanine is used as a “catch-all product” where normal lending “rules” prevent other debt products from being used. For example, funding a working capital facility prior to formal development approval for a field close to government sanction.
Products vary from “stretch debt” where lower cover ratios are used to provide additional leverage, compensated by and slightly higher margins, to true mezzanine where funds / liquidity facilities which may be provided before a field has had final development consents. These are often provided as a bridge to a refinancing taken out by a subsequent senior debt facility.
Enhanced return to the lender may be provided by an overriding royalty in the field’s revenue or warrants on the company’s stock in order to share in the value created by taking the extra repayment risk.
Conclusion
Reserve-based finance in international markets varies significantly from the domestic US market structures.
Reserve classification criteria guidelines vary between markets and the acceptability of a certain classification of reserve is related as much to the degree of certainty of development as to the specific underlying technical risk, and in turn, to oil industry regulatory and syndication parameters in different markets.
Borrowing base loans are fundamentally different from project loans due to the primarily producing nature of the reserves and the diversification of the underlying sources of cash flow.
Structures and products are tried and tested over many years in different markets, and default history is good for the sector as a whole, loss history in event of default is closer related to underlying reserve risk than to any other factor.
About the author
Kevin Price [[email protected]] is managing director and head of reserve-based finance at Société Générale and is responsible for the bank’s reserve based financing activities outside North America. He has over 20 years’ experience in the upstream oil and gas and finance industries. Price has held various positions with British and European banks both as a technical advisor and as a senior banker responsible for arranging and structuring international borrowing bases and oil field development financings.
