Billions of dollars of bad oil and gas loans: A rebuttal

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An article titled "Billions of dollars of bad oil and gas loans" recently published by Oil & Gas Financial Journal suggests that despite the substantial decline in oil prices over the last three years, banks have delayed write-offs by changing the rules as to how borrowing bases have been calculated. The article, which ran in the September issue, goes on to imply the market has been distorted because there have been so few borrowing base reductions and bankruptcies. At its conclusion, the author poses the question how long can this shell game last?

Please note this is not intended as an effort to discredit the author who seems well qualified and has published informative articles in the past. In addition, if I have gathered conclusions from the article that were not purposefully intended, I apologize ahead of time. Regardless, there were certain comments implicating banks which were quite clear. I have a quite different view and want to address some of these topics.

To start, the assertion that many "borrowing bases were not reduced" despite the reduction in oil prices over the past four years is simply not true.

After the mid-year borrowing base season in 2016, 44 out of 63 public companies reported a reduction in their borrowing base. Of those 44, 21 had reductions of at least 30% (based on information from a July 2016 article by Haynes and Boone LLP, 2016 Spring Oil and Gas Borrowing Base Redetermination: The Day of Reckoning, that ran in Practical Law Finance). Again, these are public companies generally with diversity of production and potential access to the equity markets. One can only imagine the number of smaller private companies who were affected.

As to the banks having been overly lenient and "the math doesn't work" given the significant decline in oil prices, I agree that on the surface it might seem odd. However, it's not that simple. Banks can't be robotic by relying on math only to govern credit decisions. Lenders take several factors into account such as whether borrowers could issue equity or sell assets. Understanding that these actions take time to implement, banks selectively granted extensions to borrowing base determinations to some producers. In exchange, lenders received the benefits of anti-hoarding provisions, mortgages on additional properties and the establishment of deposit account control agreements (DACAs). For lenders, these protections might not have been available (or at least delayed) if the borrower was pushed into bankruptcy.

There is an assertion that the rules were changed to avoid large losses. Even if that was true, it didn't work for the period 2015 - early 2016 as three large energy banks took a $3.5 billion reserve against potential oil and gas loan losses (again, based on information from the aforementioned July 2016 article by Haynes and Boone LLP).

When a bank establishes loan loss reserves, scrutiny of questionable loans is maddeningly detailed and subject to many layers of internal as well as external review from regulators. I can't imagine a bank being so naïve as to suddenly change the rules and think it will go unnoticed. In fairness, the OCC has implemented new rules that can affect how lenders set borrowing bases, but it was not the result of banks changing the rules.

As to whether changing the rules created artificial market dynamics and prevented companies from distress or bankruptcy, the facts show a different story. According to the Haynes and Boone LLP Oil Patch Bankruptcy Monitor from December 2016, in 2015 and 2016, 144 North American oil and gas companies filed for bankruptcy.

Considering the number of bankruptcies and the number of companies experiencing borrowing base reductions, market dynamics were certainly affected despite the action, or, inaction of banks.

The article cited numerous examples as to how the rules were changed, but in my opinion, few of the actions would move the needle substantially (if at all) to "prop-up" a borrowing base. In my opinion, these changes could not materially increase a borrowing base. Here, the examples in question.

Increasing PDP reserves through lower decline rates and longer well lives

Unless the total remaining EUR is increased, lower decline rates generally do not result in a higher PV of PDP reserves. Think about it-the math doesn't work. There is one exception to this with recently drilled wells but it seldom happens and the explanation is not worth the detailed discussion.

Adding other PUDs through various means

Changes to PUD values often do not translate into increases in borrowing bases. Many borrowing base calculations are already constrained as non-PDP reserves cannot account for more than 20-30% of the total. For example, if a producer has a $100 million borrowing base but is already constrained, their non-PDP reserves can increase from $80 million to $200 million, but in isolation would contribute little additional value in a borrowing base calculation.

Banks lowered D&C costs, Operating Expenses

Banks are supposed to lower these costs if they have gone down. A reduction in operating expenses is accretive to a borrowing base, but would have to be evidenced in Lease Operating Statements, or, proven reductions in future costs. A decline in D&C will affect PUD value, but is irrelevant if the borrower is already PUD constrained.

Adding more wells to the collateral (although many companies were at 80% or more in 2014)

This doesn't increase the borrowing base since the reserves were already accounted for in prior borrowing base calculations. It merely improves the banks collateral position by mortgaging more properties.

No doubt, in the early part of the decade, banks started relaxing lending standards to remain competitive. But there is no set of rules to protect a bank from the dramatic drop we've seen in oil prices. Once the bottom fell out, new rules of engagement had to be created since banks had very little experience in handling problem RBLs. Banks likely made some mistakes in restructurings, especially in the early stages in 2015 and early 2016. Despite taking some lumps in navigating through an industry restructuring, banks did not conduct "shell games." It's simply not in their DNA. When you add in the regulatory oversight suddenly thrust onto the industry, the risk of being caught playing "shell games" was never an option.

About the author

Larry Derrett is an energy finance consultant based in Houston, TX. He has over 30 years of experience in the upstream, midstream, oilfield services, and trading sectors as a banker, consultant, and VP Finance/CFO. He has served as CFO of ARM Energy, a privately held provider of risk management and physical marketing services to producers throughout the US, CFO of ERG Resources LLC, and as a managing director with CIT Energy, among other roles. Derrett holds a BBA from The University of Texas at Austin.