Meeting oil and gas financing needs

With global supply and demand continuing to tighten and geopolitical unrest escalating, oil prices have been pushed to all-time highs. As oil prices hover above $70 a barrel, there is increased excitement and enthusiasm in the oil patch.

Chris Cowan, Texas Capital Bank, Dallas and Jonathan Gregory, Texas Capital Bank, Houston

Higher oil and gas prices have brought an influx of new players and capital to the exploration and production industry. New technology coupled with the higher prices is also unlocking previously unexplored opportunities. This resulting heightened state of exuberance has attracted billions of dollars of available investment capital to the industry. Nonetheless, this is a cyclical business and we must not forget the past. At the first sign of a downturn in commodity prices, much of the new capital will quickly retreat in search of the next hot opportunity.

Choosing your financing wisely

In today’s environment, there are more options than ever for companies seeking funding for their oil and gas operations. Because energy is one of the hottest markets, money is in abundance. Private capital providers, hedge funds, and mezzanine lenders continue to enter the market, and banks have and continue to add energy lending services.

Energy management looking for funding should be cautious, though. There is not a one-size-fits-all answer. Companies are best served by finding a lender or investor that shares their business philosophy and caters to their market size, as not all sources of capital are appropriate for every producer or project. Keep in mind as well that the costs and types of capital available will vary according to risk and the experience of your company.

The options for capital formation are many, but not all capital providers are committed to the market long-term. The energy market is ripe with trend investors like hedge funds and private capital investors who will move their money elsewhere if prices for oil and gas take a dramatic drop. Borrowers must know their risk when using funds from investors who are chasing the hottest trend and not committed for the long haul.

Historically, the most stable source of funding for upstream businesses is bank loans; and it is also the least expensive cost of funds. For the borrower, it can be the least risky source if they choose the correct lender. Selecting the right lender and developing a strong relationship before inevitable changes occur in the market is important.

Oil and gas companies looking to form a relationship with a bank should ask the following questions:

Is the bank committed to the oil and gas industry?

Oil and gas companies will want a bank that has experienced energy lending officers and an energy division with in-house petroleum engineers on staff. It is also important for the bank to have roots in the oil patch, as well as senior management that has been through a few energy cycles. Finally, you’ll want to know if the bank has been lending to the oil and gas sector for years or did they just enter this market when times became very good.

Does the bank understand my business?

Find out if it has a client portfolio that is similar to your type of company and if its lending officers have worked on deals similar to your needs. For example, if you’re an owner-managed, middle-market company pursuing an acquisition, you’ll want a bank with expertise in this sector. Start-up oil and gas companies will want to find a bank that is also entrepreneurial.

Does the bank have the financial strength to stay committed in a downturn of the energy industry?

Besides capital adequacy and liquidity, you’ll want to know how much of the bank’s total loan portfolio is committed to oil and gas. Ten percent is a good ratio, but 20% could spell trouble for your loan if energy prices drop significantly and the bank, as a result, decides to reduce its energy exposure. Diversification directly affects a bank’s ability to stay committed to your loan.

Is the bank a right fit?

Assuming that the bank is focused on your market segment, you’ll want to know if it is relationship or transaction oriented. Does the bank typically originate loans or is it generally a participant? A bank that typically participates in large transactions will be less flexible in helping the small- to middle-market borrower. Find out if the bank can meet your current and future needs.

Does the bank staff have expertise in the oil and gas industry?

If a bank has in-house engineers and technical analysts, as well as lending officers with years of experience in the energy field, its staff will be most adept at creating financing opportunities that meet your specific needs. A bank should be able to grow with you and add value as trusted advisors because its lending officers understand your business. Don’t underestimate the benefit that the right combination of a bank in-house engineer and lending officer can bring to your company now and in the future.

Does the bank value non-producing reserves?

Banks, in general, will lend money primarily on proved developed producing (PDP) reserves and most will allow for some value to be given to other categories of reserves such as proved developed non-producing reserves (PDNP) and proved undeveloped reserves (PUD). This is especially important if you are looking to utilize bank financing for property development or drilling. On a case-by-case basis, many banks will provide an over-advance against non-producing reserves. Take the time to understand the way these policies are applied as it can make a big difference in what kind of financial partner you choose.

How does the bank view hedges?

Most banks will encourage hedging at some level and will help their customers put them in place. The practice of hedging to lock in long-term prices on production will not only help you avoid market volatility, but can assist in securing capital. Experienced energy lenders can also help in this area. For some institutions, hedging is a large fee generator. So make sure that the bank you are working with has your best interests at the forefront and is looking at hedging from a credit perspective only. This could be difficult to determine, but doing the research is worth your time.

What are the bank’s loan policies and procedures?

Understanding the bank’s key lending policies and procedures is imperative. Small and middle-market energy companies typically do not want to spend the money for the preparation of audited financial statements and third-party engineering reports. Every lender has minimum requirements in these two areas and that needs to be understood upfront. Besides knowing its engineering technique or methodology and types of financing available, gain knowledge of the bank’s philosophy on exposure, reliance on PDP reserves, typical advance rates and standard loan covenants. Finally, learn about the bank’s oil and gas pricing assumptions and how these are determined and applied.

The best advice is to look for funding from a bank that can tailor its solution to meet your capital needs and has a similar business strategy to yours. And don’t overlook the importance of being comfortable with the relationship. This is a long-term commitment.

Securing bank capital

Banks have been using reserve-based financing for more than 50 years. Lines of credit are generally based on PDP and PDNP reserves, which are used as collateral to secure the loan. Loans are from 2 to 5 years, with re-evaluation of the pledged reserves occurring every six months. This allows lenders to properly manage their risk and clients to maximize their borrowing capacity.

You can find a bank that will add value by having its engineers provide the engineering evaluation on existing reserves, as well as knowledgeable bankers who can assist in creating the capital to meet your financial needs. For example, if you need $20 million in capital to acquire oil and gas reserves and the bank can only provide a $15 million loan, you’ll be best served if the lending officer is experienced in the industry and can help guide you through your options for completing the transaction.

For small- to middle-market borrowers buying existing oil and gas properties or looking to expand development or drilling, the bank will not only want an evaluation covering your PDP, PDNP and PUD reserves, but will also look at your experience in the industry. Lending officers will want to know the reputation of the borrower, as well as understand the financial situation of the principal(s). Management’s track record of finding and growing oil and gas reserves is extremely important. Bankers will want to know if the borrower has experience in creating value, especially in a down market.

As your first choice for capital formation, look for a bank with experience in energy lending, not one that is taking high risks. If prices for oil and gas suddenly plummet, the consequences could be devastating for a borrower doing business with a bank that disregarded solid reserve evaluations and appropriate loan structures in order to grow. Find a bank with consistent loan policies and procedures. These will affect its ability to work with you through the energy cycles - in good times and bad.

Bankers with long-term experience in the industry will first want to learn your specific business and philosophy. This will best enable them to create a financing strategy that meets your specific needs - not a one-size-fits-all solution. They’ll also know all of the funding options.

The bank’s commitment and diversification are important to having a long-term relationship that meets your needs rather than a one-time transaction. A bank that is in it for the long haul will grow with you, not just provide you with immediate capital. Finding the right banker who understands your business and can grow with you will enable you to secure a loan that is best for your company and provide a winning scenario for both parties.

The authors