A GUIDE FOR DISTRESSED DEBT BUYERS
STEPHEN PHILLIPS, COLIN GRAHAM, ORRICK, LONDON
THE RECENT FALL in the oil price is putting significant pressure on oil exploration companies and the corporates which serve them. The decline has been precipitous, and sustained: Brent Crude was trading over US$100 a barrel in September 2014. At the time of writing (November 2015), it is now trading at less than half the September 2014 price. While many companies entered the low price era with cash and plenty of available debt funding, the longer the oil price hovers around $50 a barrel, the greater pressure on oil explorers and producers, particularly those located in the high-cost producing areas of the world such as the North Sea.
Lenders to these corporates, which chiefly provide their loans via Reserve Base Lending Facilities ("RBLs"), are facing some important decisions about their exposure. In Europe and Africa, the most prominent casualty of this environment to date has been the London-listed, but Africa-focused, Afren plc, which collapsed into insolvency in the summer of 2015. Iona Energy Inc., the Canadian North Sea oil company, announced on November 18 that it was highly likely to enter into an insolvency process. The difficulties are also being felt in the oil field services sector with Ceona, the heavy subsea, umbilicals, risers, and flowlines construction contractor, filing for a UK administration on September 18, 2015.
Funds that focus on distressed debt are now looking closely at the sector and seeking opportunities to become involved in a number of ways, for example, via the provision of emergency financings or the purchase of distressed debt at a discount, perhaps with a view of implementing debt for equity swaps. Many such distressed lenders may be unfamiliar with the market norms of RBLs (or be more familiar with US RBLs). This article will set out how these facilities work in the international market (which for convenience we will refer to as the 'Europe, Middle East and Africa or ("EMEA Market"), focusing on some key issues distressed funds should be thinking about as the industry goes through its current stress.
RBL facilities are markedly different in the US and the EMEA markets. Practice in EMEA is primarily based in London and market norms have derived from experience of financing North Sea oil fields, although the use of international RBL facilities has been extended far outside of the initial North Sea market, particularly for funding upstream development in Africa and the Middle East. The norms of the EMEA RBL market are drawn from a mix of UK project finance techniques and US RBL techniques. While many EMEA-focused companies may initially use project financing techniques for initial project development, the RBL is the predominant method of financing, for EMEA oil explorers that have moved beyond the initial development stage.
Another notable difference is that, although the High Yield Bond market is used extensively in the US, it has only been used in an oil-related context in EMEA on a small number of select London-listed companies, including Enquest plc, Tullow plc, and Afren plc. This contrasts significantly with the US where high yield bonds have been used extensively for financing oil related corporates. Finally, there is also a significant bond market in Norway and Sweden which has its own norms and practices and which is used extensively for oil and oil service related companies in that region. This article will therefore focus on RBLs and, in particular, the mechanics and the issues that are likely to arise for those funds seeking to make distressed debt investments in the current low oil price environment. Inevitably the article necessitates a degree of generalization, and it should be remembered that RBLs tend to be heavily negotiated and tailored for each borrower.
KEY CHARACTERISTICS OF AN EMEA EBL
Borrowing Base amount
The key feature of an EMEA RBL is the existence of a "Borrowing Base Amount" that allows the level of availability under the loan to vary over the life of the loan. Typically, loans are reviewed or "redetermined," as the industry usage puts it, every six months. In contrast to US RBLs, which have bullet repayment requirements, and in line with their North Sea Project Finance roots, EMEA RBLs tend to feature amortizing schedules from the fourth year of the loan. The facility is usually revolving i.e. repaid amounts can be reborrowed. RBLs will often allow draw down via Letters of Credit. If the Borrowing Base is reduced (as a result of falling oil prices for example), the Borrower will need to repay the loan in line with the new Borrowing Base although the terms of the loan may typically provide a 30-day grace period (although we have seen as much as 90 days) for this repayment.
In recent months, redeterminations have been in the spotlight. Ithaca Energy has become the first UK company to have its lending reduced from £625m to £515m following a redetermination. In October 2015, Tullow Oil's lenders decided to maintain the availability under its RBL facility at the then current levels.
Typically, the RBL will be based on a portfolio of assets, many of which will be already in production phase, with only a small amount of the Borrowing Base attributed to development assets. Borrowers may wish to add additional assets and this will normally be subject to a majority lender vote. The loan documentation will stipulate which reserves categories will be taken into account in a "Banking Case" prepared by a Modelling Bank.
In the EMEA market, RBLs often take into account "proved" and "probable" reserves. The description of the reserves that will form the basis of the Borrowing Base will be a basket of reserves referred to as "P90", being specifically those quantities of oil with a 90% chance of being recovered, and 'P50', where fields have a 50% chance of recoverability.
Generally speaking, in the US, "probable reserves" are not taken into account in the Borrowing Base determination, and we speculate that this difference arises because in EMEA a combination of regulatory requirements and the nature of agreements between joint operators often mean that it is more certain that probable reserves are actually going to be drilled. In EMEA, the market practice seems to have emerged such that "proved" reserves are included in the valuation in the case of a loan involving undeveloped fields or fields that do not have a continuous production history, and "probable" reserves are included in the case of a loan involving groups of producing fields or fields which have a production history.
Use of ratios to determine lending limits
The Borrowing Base Amount will be reviewed, often twice a year, based on a reserve report and adjustments will be made to the Banking Case by a Modelling Bank. The amount available to be borrowed will be determined by using ratios. The ratios will be negotiated but, often, the ratio might be the lower of a Loan Life Cover Ratio ("LLCR") (the ratio of the net present value of cashflow over the term of the loan against outstanding debt balances) and a Project Life Cover Ratio ("PLCR") against the Borrowing Base Assets. The Project Life Cover Ratio will be calculated in a similar way although, instead of applying the net present value ("NPV") of cashflows over the life of the loan, the cashflows will be modeled over the life of the project.
Decommissioning costs towards the end of the project life can significantly reduce cashflows as money is spent on costly decommissioning liabilities. This is a key concern for North Sea assets in particular, where many fields are nearing the end of their lives and there are regulatory requirements stipulating that the producer must decommission, and provide sufficient financial coverage for, the licensed fields. Facilities vary but it would not be unusual for the Project Life Cover Ratio to be 1.5:1 and an agreed Loan Life Cover ratio to be typically 1.3:1.
Occasionally EMEA RBLs include debt service coverage ratios (net income divided by debt service in an agreed period). We have also seen other covenants used, such as net minimum production level requirements. Compared to the full suite of financial covenants evident in most project financings however, the financial covenants included in RBLs tend to be less extensive, but it would be standard to include a debt to earnings before interest, taxes, depreciation, amortization and exploration covenant.
Assumptions in Banking Case
Where assumptions are used there may be provisions for solving disputes. Either the Majority Lenders will need to agree or an independent expert might be involved where there are disputes. The price assumed by the banks for determining the cashflows is often referred to as the 'price deck,' and it will usually be lower than (typically 75%) the prevailing forward curve of oil.
Over the past year, borrowers have benefitted significantly from oil price hedges. Borrowers may use a number of hedging strategies including zero cost collars and options, and more rarely, swaps. These are financially settled hedges and no physical delivery of oil takes place. In a zero cost collar, the borrower obtains downside protection from low oil prices in return for giving up the upside of a higher price above an agreed strike price. The borrower enters into a call option allowing its counterparty to buy oil above an agreed strike price and at the same time it will enter into a put option where it can force the counterparty to buy oil at an agreed price. This technique involves no payment of a premium.
By contrast, borrowers may also wish to buy options at the cost of the payment of a premium. The borrower can buy an option to sell at an agreed price level. If the spot price of oil is above the strike price of the option, the option is not exercised and the premium has been paid in vain, but if the spot price is below the option price, the option is valuable and it will be exercised. Typically, the spot price will reference Brent crude regardless of the quality of the oil the borrower is actually producing.
In some weaker credits, banks have imposed limits on the amount of hedging that their borrowers can do. In stronger credits, banks simply insist that the borrower adopt a hedging policy.
The "Reserve Tail" is often a feature of EMEA RBLs. The Final Maturity Date will be the earlier of an agreed long stop date and the "Reserve Tail Date." The Reserve Tail Date is the date by which a specified amount of the initial agreed reserves that are taken into account in the first Banking Case (often about 25%), remain to be recovered. The Reserve Tail will be reviewed and will possibly be re-set, at the time of each Banking Case review. The Reserve Tail Date may therefore increasingly come into play in the current oil price environment as it may be possible that fewer reserves are economic, and so this may in turn hasten the trigger of the agreed threshold.
ISSUERS FOR DISTRESSED DEBT FUNDS - LCS
EMEA RBLs often allow borrowers to utilize Letter of Credit ("LC"), and typically one bank will act as a "Fronting Bank" for the purposes of issuing an LC. LCs are often provided by upstream developers to satisfy the requirement by the UK government to cover possible decommissioning costs. If the LC is drawn, then the Fronting Bank will be obliged to make payment regardless of whether the indemnifying lenders make good on their obligations under the facility to pay back their pro rata portion to the Fronting Bank. Accordingly, the loan documentation may require that the Fronting Bank's consent is required for a change of lender, and/or that a non-bank lender deposit collateral with the Fronting Bank. Distressed debt funds, which typically buy term loans that are fully drawn, may find this unusual.
One alternative for non-bank funds wishing to purchase exposure to the RBL market might be for the purchase to be structured as a participation such that the 'selling' lender retains the legal interest and the fund purchases the economic interest via a participation agreement. This may not be ideal, as many distressed debt funds often seek to avoid the use of participations because they generally wish to obtain a 'seat at the table' and prefer to deal direct with a borrower in situations where either a vote is required or where the loan is being renegotiated. Participations are often structured to pass on all voting rights, although the lender of record may often seek to retain the option to veto an instruction in certain circumstances, such as when the instruction may have a detrimental effect on the reputation of the lender.
KEY POINTS-INTER-CREDITOR DYNAMICS
Unlike leveraged finance structures, in which certain norms in inter-creditor agreements relating to the relative position of senior and junior lenders have been developed, there is a lack of uniform practice for oil industry financing. Hence, it is far harder to make assumptions at the outset about the relative positions of RBLs versus other parts of the debt structure. However, once a company has moved beyond its initial exploration phase, during which it may be solely equity funded, an RBL may be its sole major source of finance for the development phase. As companies get bigger, they may introduce additional debt structure into the capital. For example, Afren plc issued high yield debt, project finance, and RBL debt.
In typical leveraged finance structures, it is often the case that, in an enforcement scenario, senior lenders are able to instruct a security agent during a share pledge enforcement process in order to release the security, guarantees, or even the primary obligations of the debt of junior creditors in the debt structure. This is done in order to provide a buyer of the shares with a company free and clear of debts and encumbrances. We have seen such structures replicated in inter-creditor agreements relating to EMEA oil companies. It is, however, far harder to make generalizations as to how the current market dislocation will play out in a severe downscale scenario, as there is a lack of standardization in the finance structures in comparison to leveraged finance structures. Note also that, in the smaller single asset producers, RBL lenders will usually insist on provisions that restrict any other debt in the capital structure.
Over the past 10 years in the North Sea, the provision of asset security in RBL lending has been rare and, generally speaking, RBL lenders' security packages in the North Sea have been reduced to share pledges throughout the group. In the rare circumstance that RBL lenders have received asset security from group companies of borrowers in the form of a debenture, in a default scenario, this would allow RBL lenders to appoint a UK administrator who will have powers to sell the assets.
Although largely theoretical as we mention above, it is worth noting that the UK government operates an "open permission" system that allows UK license holders to grant security over the license without seeking the consent of the UK government. In a rare case where security has been granted over a license, the government's consent would, however, be required for a sale of the license interest resulting from enforcement. Accordingly, in practice, in a typical scenario where there is no asset security but share pledges, we would expect any security enforcement strategy would focus on the enforcement of share pledges at a high level within the group.
In the African projects that we have seen, asset security is rare for a number of reasons, including restrictions in the granting instruments, provisions in applicable hydrocarbons law, and also because of the risk of triggering consent payments to the host government. Lenders will therefore often content themselves with share pledges over the license holders. Even then, the hydrocarbons regulations of the host state may provide that a license will terminate if the granting instrument is transferred or deemed to be subject to a change of control without government consent in the required form.
In effect therefore, our experience is that a share pledge enforcement will be subject to government consent, although this may not be the case where enforcement of a share pledge is of a 'topco' within the group. Each jurisdiction tends to be different, and lenders will need to review the applicable granting instrument and hydrocarbon laws before taking enforcement action even against 'topcos' high in the group structure. Lenders will also need to consider the provisions of any joint operating agreements that incorporate preemption rights in favor of new defaulting partners, if a joint operator has defaulted or changed consent provisions. In practice, therefore, lenders and borrowers will seek to avoid insolvency processes at license holder level as failure to do so will almost inevitably result in value destruction.
KEY CONTRASTS BETWEEN US RBLS AND EMEA RBLS
Many RBLs will relate to assets in Emerging Markets countries and this means there is far less certainty regarding the treatment of secured lenders on an enforcement or insolvency context (in comparison with the US). Often, instead of security over the oil in the ground, which is permitted in most US states, market lenders in EMEA countries may only be able to take security over licenses or production sharing arrangements (as discussed previously).
Compared to long-standing US precedent, treatment of lenders in emerging market jurisdictions is less tested. As a result, lenders in EMEA have taken less comfort from the value of the sales of the assets and tend to focus more on the potential cashflows from those assets over time. Accordingly, in the US, lenders focus on the value of assets so that lenders may seek to test current ratios (i.e. assets versus liabilities) as opposed to project life or loan life cover ratios.
Absence of Reserve Tail and Longer Tenors
Generally speaking, the tenors of US RBLs tend to be a maximum of five years as opposed to up to seven years in some EMEA RBLs. The "Reserve Tail" concept, which may extend the life of an EMEA RBL, is not generally seen in US practice.
Banks in EMEA RBLs tend to impose more specific triggers based on licenses and joint operating agreements, in comparison to US RBLs.
Project accounts regime
Given the uncertainty of legal enforcement procedures in some EMEA jurisdictions compared to the US, lenders tend to insist that the loan documentation contain a requirement that cashflows be routed through specific accounts. In EMEA RBLs, there will be requirements that all receipts are deposited into secured proceeds and revenue accounts. There may also be a requirement, similar to that found in many project financings, for the maintenance of debt service reserve accounts among other accounts requirements.
In US RBLs, banks tend to have far more discretion in the redetermination of the Borrowing Base, as any increase tends to be a 100% lender determination whereas, in EMEA, the Technical Bank's determination will stipulate whether the Borrowing Base has increased or decreased with a majority lender vote to endorse or reject the Technical Bank's view.
We expect further distress in the market if the current oil price prevails into 2016. Capex spending is being slashed and the pressure on oil companies is ricocheting into the seismic sector, drillers, and other oilfield service companies. In the exploration and production sector, we would further expect the "fulcrum security" where the "value breaks" in a restructuring will be in the RBL Facility. Expect a distressed debt market to develop in the upstream and oilfield services sectors as the existing lenders in that sector seek to exit those loans although, to date, lenders have generally tried to maintain their exposure and to support their borrowers.
Where, following redetermination events, RBL lenders reduce their loans in line with prevailing market prices, we expect there may be an opportunity for distressed funds to provide additional financing to finish off capex spending, but that any loan offered in these circumstances will be at interest rates far greater than the industry has been used to. We have, thus far, seen only sporadic evidence of loan selling in this market. We expect, however, an acceleration in loan sales and in distressed M&A as the logic of the oil price forces consolidation in the industry. Furthermore, we expect more restructuring activity in 2016 and, sadly, that insolvencies will rise.
As a former British Prime Minister once said, "The kaleidoscope has been shaken, the pieces are in flux, soon they will settle again." The settled order is the energy industry has been shaken; we shall soon see a new structure emerging.
ABOUT THE AUTHORS
Stephen Phillips is co-head of the European Restructuring team at Orrick and is based in London. He has extensive experience in advising banks, bondholders, and corporate groups on restructuring, corporate, and banking matters.
Colin Graham is a partner in Orrick's London office and a member of the Energy & Infrastructure Practice. He has 18 years' experience working on the development of projects in the energy, power, and resources sectors.