Reserve based finance

EDITOR'S NOTE: This is Part 1 of a four-part article examining the evolution, practices and future of the reserve based finance markets in the US and internationally. The series will run in the January, February, March, and April issues of OGFJ.

The Reserve Based Finance (RBF) market can broadly be divided into two subgroups based on the norms of their respective deal structures as well as the location of the participating lending banks (or, in the case of the global banks, relevant lending offices). First, there is the North American market, which is comprised of the United States and Canadian markets but which excludes Mexico. Secondly, there is the international RBF market which is centered in London and covers most markets outside the North American market (and which includes the EMEA countries in particular). In discussing the North American market, most of the focus is on the United States; while the Canadian market has its own specifics, it is nonetheless very similar to the larger US market. Similarly, while the Asia Pacific reserve based finance markets have some differences and regional peculiarities, they have their origins in and are broadly based along loan structures originating in London. To date, the limited number of upstream debt financings in Mexico and South America have been largely domestic financings or arranged in the North American market rather than the International RBF market but going forward this may change. This article will discuss the evolution of these two markets, the differences between them, and the reasons why these differences may be reduced or eliminated over time.

The International RBF market has been a thriving and expanding one for almost 40 years. Originating in the UK North Sea it has expanded over subsequent decades across the globe but its center today, in terms of the banking teams active in it, is still predominantly London. The North American RBF market, the world's largest, predates the International RBF market. The bulk of the transactions that comprise this market involve US assets and are originated in, and serviced by, Houston-based banking teams.

Despite the fact that a number of market participants (in particular the global banks) have historically been active in both markets, these two markets have nonetheless travelled separate and different paths, and the resulting financing techniques and structures that have evolved are different. One has to look at the history of how the two markets originated and developed to understand why they are so different. As noted above, however, there are a number of factors pointing to a possible convergence of these two worlds. This article consists of four parts.

Parts 1 and 2 examine:

• The background to the development of the two markets
• Facility structures, sources of debt for the upstream sector
• Amortization and reserve tails
• Reserve analysis and bankable reserves
• The Banking Case and assumption determination

Parts 3 and 4 examine:

• Debt sizing and cover ratios
• Loan facility covenant packages
• Hedging
• Default
• The future of RBF and possible convergence of markets

Background to the development of the two markets

The upstream debt financing market outside of North America began in the 1970s when independent oil and gas companies entered the North Sea arena and the first large North Sea discoveries got to the stage of needing development finance . The catalyst for the entry of new independent oil and gas exploration and production companies into the market was the then UK government initiative of encouraging UK players into North Sea exploration and development. A number of the international oil and gas majors from regions outside of the UK were taking large portions of North Sea acreage, and this was becoming unfavorably viewed by the UK's Department of Trade and Industry who wanted to see "UK PLC" more involved in this new and important UK industry. To address this concern, some of the oil and gas majors began to team up with UK industrials (such as Associated British Foods and the Thompson publishing group), many of which had no previous involvement in the oil and gas sector. As a result, new subsidiaries were formed by those UK industrials to take small stakes in fields alongside the majors.

Once the North Sea fields matured to the stage of needing their development financed, a number of these UK industrials turned to the bank market to project finance the development of individual fields. The trend continued as a number of stand-alone UK independent exploration and production companies were formed by senior executives breaking off from the majors in particular the newly-privatized Britoil (which became part of British Petroleum). Initially, they too were undertaking single-field project financings, but as these fledging businesses grew and matured into companies with portfolios of upstream assets at different stages of the exploration, development and production cycle, the demand arose for a more flexible financing technique which would give debt capacity to both producing and development fields (and allow debt capacity to change as the borrower's assets and their profile changed). Through such a financing technique the projected cash flows from both development projects and producing fields could be used to finance the new development projects (as well as further exploration).

The technique of lending against producing oil and gas assets was already long established in the U.S. market, and so the scene was set for the development of a new hybrid financing technique in the UK, which became known as "borrowing base" finance. This new lending structure drew together elements of both (a) the early North Sea single field project financings (based on term facilities structured around net present value driven cover ratios of the specific oil and gas reserve asset), and (b) the US reserve based lending techniques of providing revolving credit facilities that are sized principally by the net present value of a portfolio of producing assets. This international version of the US borrowing base product was pioneered in London by the US bank Manufacturers Hanover around 1983, and following this, a number of other UK, continental European and US banks began to play in the small niche North Sea bank debt market. The UK RBF market, however, has always been rooted in financing development projects rather than financing proved producing assets, and it is this feature which continues to be a principal difference between international reserve based lending and the North American reserve based finance market.

Since those early days the international RBL market has developed from its North Sea roots to become a market where oil and gas fields across Europe, the Middle East, the Far East and Africa are financed. The market continues to grow and now comprises in excess of 30 active bank participants (although only a small percentage, perhaps between a third and a half, of these will routinely take true material upstream development risk ). There are also a small number of non-bank funders recently entering the market consisting of funds from non-bank financial institutions and diversified industrial conglomerates.

As noted above, the US upstream finance market started much earlier than its international counterpart. The market had its origins in early US asset based lending practices and the earliest examples of this type of lending can be traced back to the 1940s when many of the pioneers of the Texas oil industry such as H.L. Hunt and Clint Murchison were building their fortunes. The first institution to adapt asset based lending to the oil industry by securing hydrocarbon reserves seems to be lost in history, but certainly banks in the US were the first to hire petroleum engineers and develop internal expertise at the valuation of reserves. Though the amount of money involved in the petroleum industry was larger than the earliest examples of asset based lending, the business was well suited to fit the framework of the emerging asset based lending market. Oil and gas production was risky, rapidly expanding, and involved thousands of small, unproven, debtors with large needs for working capital. Banks and finance companies, wary of individual debtors who were themselves unproven, were willing to lend against proved, developed, and producing reserves. Critical to the development of reserve based lending in the US was the ability of banks to have asset-level perfected security through a mortgage on the underlying field because of the unusual circumstance that it is generally possible for the debtor to own the hydrocarbons outright. Moreover, because even small operators usually produced from several wellheads and reservoirs, the ability to place multiple properties into an asset class, the reserve base, allowed for diversification both internally to the loan itself and across an institution's oil and gas loan portfolio.

The US market expanded significantly in the 1970s as oil prices increased. Because income tax rates in the US were relatively high, companies used different structures to try to minimize these higher taxes. Lenders on the other hand were concerned about getting control of the cash associated with production proceeds. The result was a type of project financing that whereby the lenders would loan to an entity that had a specific set of producing assets that generated cash flow that would be paid directly to the lender. In the early 1980s, however, lenders became more competitive and the modern day borrowing base structure emerged. Borrowers were now allowed to receive their production proceeds directly and revolving lines of credit became the norm.

Facility structures, debt sources for the independent sector

Description of the International RBF market

With some limited exceptions in specific local markets, RBL facilities have become the financing technique of choice for international (i.e. non-North American) independents raising debt. With the exception of single field project financings (structured as amortizing term loans), facilities are almost always structured as amortizing revolving credit facilities. There are also a small, but increasing, number of corporate loan credits in the upstream sector. With the exception of the Norwegian Bond market and Sweden, there have to date been very few bonds issued for the international upstream independent sector since, as explained below, the High Yield debt markets are smaller and less developed outside North America.

RBL facilities

The vast majority of sub investment grade independents outside of North America use RBL facilities as their prime or, more often than not, only source of debt finance. Facilities are almost always revolving and fully amortizing over their term. The borrower is able to borrow the lower of the "Borrowing Base Amount" and the amortizing "Facility Amount". The superimposition of a fixed amortization schedule over the fluctuating Borrowing Base Amount is in marked contrast to US RBL facilities, which typically have bullet repayments (subject to certain mandatory prepayment events) where the bank market takes a refinancing risk. This amortization feature of the International RBL market is an overhang of the early "project loan" history of the market. Facilities usually have a term of around five years, though on occasion the tenor may be up to seven years (and in some markets such as the Middle East, even longer). The Borrowing Base Amount will typically be determined twice a year using an agreed "Projection" or "Banking Case"(to be discussed further in Part 2), and will be determined by applying the lower of a Loan Life Cover Ratio and a Project Life Cover ratio to the discounted cash flows of the Borrowing Base Assets. Sometimes Debt Service Cover Ratios also apply.

The Borrowing Base Assets will typically be a combination of development and producing assets (with the ability to add or remove assets subject to controls and, typically, an approval of 2/3 of the bank group (by Commitments). Sometimes there is a limit to the portion of the discounted cash flows that can be derived from development assets. Where the Borrowing Base Assets include significant undeveloped components, then structural features of development or project loans will increasingly apply. No two deals are identical and there is a continuum between, at one end, a development loan for a single undeveloped field which may have additional features to ensure sufficient liquidity of the borrower and protections to ensure the borrower has sufficient funds to complete the project and, at the other end of the spectrum, a borrowing base of a well-diversified portfolio of producing fields and a more flexible covenant structure. Pure development financings (provided on a term rather than a revolving basis) to companies with no producing assets at all are still common. Wider portfolio borrowing base facilities, however, far outnumber such traditional development loans as most companies taking a development loan eventually graduate to a wider borrowing base as they go through their life cycle.

It is common to prescribe in the loan documentation a convention and pre-agree which reserves categories are taken into account in the Banking Case. It is also typical to provide that only proven reserves are taken into account until a field has a satisfactory production history (though there have been cases where probable reserves are used even for development projects) and for proven and probable reserves to be taken into account for producing fields. Possible reserves and contingent resources have played no part in RBL financings (though may occasionally form the basis for other types of bank facilities).

Figure 1 illustrates the inter-play between the Facility Agreement and Borrowing Base Amount in a simple case where no assets are added or removed to the borrowing base. The amount actually available for drawing is illustrated by the black portions of the vertical bars.

Figure 2 illustrates a more complex case where, in Q3 2016, a new asset is added to the borrowing base. This increases the Borrowing Base Amount. It also has the effect of pushing back the Reserve Tail Date and consequently the Final Maturity Date of the facility. The Reserve Tail Date concept will be further explained in Part 2.

Corporate loan facilities

There are cases where exploration and production companies reach a particular size and their producing fields become more significant to their valuation than their development assets. When this occurs, companies often move from RBL facilities (where the facility size is based largely on projected future net cash flows) to more traditional corporate facilities where facility size is determined by reference to (backward looking) financial covenants such as debt to EBITDA or debt to EBITDAX (i.e. EBITDA minus exploration expenditure). There are, however, only a small number of such facilities on a relative basis when compared to the number of RBL facilities. Sometimes corporate facilities are sized against reserves (so the debt must not exceed the reserves on the basis of an agreed "dollars per barrel" formula) or, occasionally, even contingent resources. The advantage of these loans for the borrower is they look back at last year's earnings when determining repayment and availability and thus, don't immediately constrain the debt available in case of a commodity price drop (as a forward looking NPV based loan would). The disadvantage from a banker's perspective is just that - the repayment covenant bites some time after the cash position of the company has worsened. For this reason such facilities are normally available only to larger companies with significant production bases either as the sole bank debt in the capital structure or, occasionally, as a small incremental corporate liquidity line (subordinated to the borrowing base) for companies whose main line of credit is provided by an RBL facility.

Second lien or junior loan facilities

Whereas "second lien" plays a significant role in the US upstream market, it is rarely seen in the international markets. Such facilities (referred to in the international market as "junior facilities" rather than "second lien") have become even more rare in recent years. Unlike the US where the second lien facility will typically be fully drawn at closing (often in connection with an acquisition), the international market version instead typically takes the form of corporate liquidity lines provided to give additional liquidity on top of the borrowing base. Sometimes these contingent liquidity lines are stapled to a development loan to ensure sufficient liquidity to complete the project in the event of an unexpected cost overrun on the project. In the international market, the same banks as the senior bank group (or a subset of them) will provide this additional debt capacity (usually based on lower cover ratios but otherwise much the same structure and covenant package as the senior facility). Occasionally, they are provided on a corporate loan (EBITDA) basis for a higher margin. The product is usually very different from the US second lien loan structure which, as will be further described in Part II, is usually structured as a non-amortizing second lien secured term loan with more aggressive lending against the borrower's proved reserves (i.e. less "risking of reserves" than first lien senior debt).

Mezzanine loans, bridge loans, pre-development sanction loans

Unlike in the US where there is a vibrant mezzanine market (in part filling the gap created by the absence of a senior bank debt market for development projects) there has until recently been an extremely limited mezzanine market for exploration and production companies outside of the North America market. Facilities tend to be bilateral and, sometimes, provided as pre-IPO finance by investment banks who link the debt to an IPO mandate. The absence of a healthy mezzanine debt finance market has proved problematic for the smaller start-ups which have not yet achieved the track record or reserves necessary to meet the requirements of RBL lenders. There are some signs however of North American financial institutions and other funds who are active in this market identifying this as a gap, and the international market seems set to see greater liquidity here. This is one example of the differences between the North American and international markets shrinking. Further examples are provided below.

Short term bridge facilities are quite frequently made available to independents in the context of financing an acquisition of assets. They typically have a duration of approximately one year and a bullet repayment at maturity. Usually the intention is that they will be repaid from a longer term RBL facility (but the short time frame for the acquisition and demands for certainty of funding sometimes dictate that an RBL facility is not suitable as the source of funds for the acquisition).

Pre-Development Sanction loans against contingent resources, another form of bridge financing, are a specialized sub sector of the international market where a few major banks will provide loans to companies against the "value" of a discovered and appraised field not yet sanctioned for development. Such loans are usually made with the expectation that the subsequent development sanction will be forthcoming from the host government and that the bridge will be repaid from the proceeds of a development loan. These bridges, which are essentially "pawn brokering" against the value of the asset, are small compared to the asset value and are normally restricted to very large strategic discoveries where the likelihood of the discovery not moving forward to development is very low. These deals are also mainly "club" deals as the expertise, comfort, and knowledge to do them is restricted to a subset of the wider reserve based finance market.

Bonds

With the exception of Norway and Sweden, bonds currently play only a small (but increasing) role in the artillery of debt products for independents outside the US. Institutional High Yield debt market for smaller European (sub investment grade) oil companies is newer, less deep and less developed than its US counterpart. Historically, this is partially is due to structural differences and differences in the classification of reserves across the markets as SEC registered HY securities ("Registered" or 144A with "registration rights" under the US Securities Act section of the US High Yield market accepts only SEC "proved" reserves - a classification that has little use to non-North American listed / domiciled companies). Increasingly, however, companies are accessing the non-Registered USD HY markets which do not restrict companies to SEC criteria.

Significantly, Tullow Oil, a large European-based independent oil company, recently successfully launched a USD HY Bond into the non-Registered 144A market. This followed on from two issues by Afren plc, a London-listed independent focused on Africa. This trend is something the authors expect to see more of from independent exploration and production companies with assets and operations predominantly located outside North America.

Over the last decade and particularly during 2013, there has been in increase in the development of the "Norwegian" bond market. The market, originally denominated in kroner and used to finance Norwegian rig and oil field service companies from Scandinavian domiciled investors, has expanded considerably, funding international upstream oil and gas companies from a wider investor base with USD. This expanding market currently provides the main (but still much smaller) alternative to RBF facilities for international sub-investment grade independents. Service companies, however, still represent the majority of issuers into this market currently.

Bond markets and their investor base aside, other intangible factors have also played a part in limiting the incidence of bond debt for exploration and production companies in the international market.

Security on enforcement outside of North America is often less certain and normally dependent on State approval. International lenders are therefore far more sensitive to cross default risk than their North American counterparts. In the international bank market, lenders have traditionally taken the view that if they are providing a reserve based facility to a company, then they are the company's funders and they do not want the additional risk and loss of control that would arise if the company had a complex capital structure with many other classes of debt.

Having said this, High Yield issues by non-US independents are on the increase—a feature of the international market that appears set to move closer to its US counterpart as international exploration and production companies, with the help of bank rating advisory teams, educate investors and rating agencies on the differences (reserve classification/legal jurisdiction/country risk) relating to the business of international oil companies.

In Part 2 of this series, the authors will examine facility structures and sources of debt for the upstream sector in the North American market, amortization and reserve tails, reserve analysis and bankable reserves, as well as The Banking Case and assumption determination.

About the authors

Jason Fox is a partner with Bracewell & Giuliani in London. He has over 25 years' experience advising on upstream debt financing and has advised on over 100 RBL financings.

Dewey Gonsoulin is a partner with Bracewell & Giuliani in Houston. He has over 22 years of experience advising on upstream debt financings.

Kevin Price is managing director with Société Générale Corporate & Investment Banking in London and is their Global Head of Reserve Based Finance. He is responsible for all of the bank's reserve based finance activities both internationally and throughout North America. Price has over 25 years' experience in the upstream oil and gas and financing industries. He started his career as a petroleum geologist and spent 12 years working in the oil industry for independents and majors before moving into upstream finance.

¹This article contrasts "U.S. RBL" facilities with "International RBL" facilities but, for the most part, the comments regarding U.S. RBL facilities apply also to Canadian ones.

²For the purposes of this article "reserve based finance" or "RBF" is the generic term used for all types of finance based on the value of or cash flows from underlying reserves. "RBL" is used specifically refer to senior bank debt within the wider RBF spectrum.

³The first significant discovery of oil within the United Kingdom continental shelf was in 1966 but it is generally accepted that the first major North Sea project financing was not until 1972 when BP financed their interest in the Forties Field. In fact this financing was structured as a forward sale (with the lenders paying up front the purchase price of oil to be delivered following project completion). The first financing took this form in part because of doubts at the time over whether under English law you could have a loan where the obligation to repay was not absolute but these doubts were overcome and the Forties field financing was followed in 1974 by two financings for the Piper Field. The first by Thompson which was a limited recourse loan (where the actual obligation to repay was contingent on cash flow from oil being available to make repayment) and the other, by Occidental, which was structured as a loan convertible into a production payment on completion of the field development.

⁴Large well known "branded" corporate names with established management teams and long track records have in recent years succeeded in getting large (several billion dollar) borrowing base loans syndicated to large (>20) bank groups where the profile of the included assets was dominated by undeveloped fields. However, these are still exceptions where the included undeveloped fields are or were "world class" in terms of their size and in some cases where peculiarities of the fiscal regime (e.g. tax allowances) mitigated some aspects of development risk. Many of the institutions backing these companies would be unlikely to back less established companies on a smaller single field development.