Sal Patoli drills down on reserve based oil & gas financing

Reserved Based Finance may be an unfamiliar term to those not involved with energy finance. Can you explain what it is and what advantages and risks are associated with it?

Reserved Based Finance is a technique that allows oil & gas producers to leverage the future value of reserves based on a third-party assessment of proved reserves. This sort of financing is the most cost efficient and can facilitate Producers’ growth in the long term if utilized prudently with enough equity in the enterprise. While the structure is inherently exposed to the commodity price risk, a conservative and traditional Reserve Based Finance facility often includes a hedging component that partially mitigates the price risk.

Reserved based lending in the U.S. is essentially secured corporate lending focused on the estimated future value of production. These facilities are structured as secured corporate revolvers to be used mostly for working capital, minor workovers and/or acquisitions, and are often termed “borrowing-base loans.”

In many countries across the world outside the US, in addition to secured corporate borrowing bases, the Senior Bank market provides project finance loans for the construction and development of new oilfields.

These upstream project finance loans have a very long, well established history - close to 50 years in the case of the UK North Sea, for example - and allow an oil company to leverage its equity contribution to a project once a field is “sanctioned,” meaning all joint venture and regulatory approvals for development have been received and the project is irrevocably committed to by all investors and stakeholders.

The key difference between these types of loans is that the Borrowing Base loan is structured as a corporate finance based mainly on existing production and with high degree of flexibility in the use of loan proceeds and corporate financial management.

An Upstream Project Finance loan, on the other hand, is not a corporate loan; it is a loan focused specifically on an individual or group of defined, sanctioned projects and has a much higher degree of control (the loan can only be drawn for specific defined costs, control on project cash proceeds, etc.) and monitoring than traditional corporate borrowing bases.

Societe Generale provides both traditional corporate production based Borrowing Base loans and Upstream Project Finance loans across the world and in the US.  

The oil business has recently emerged from a prolonged slump that was difficult for many E&Ps.  What are some of the changes that resulted in terms of how banks now finance these energy companies?

The US industry certainly has fewer banks that are lending to E&P companies because of the downturn. On the other hand, there emerged a new group of entrants represented by credit funds and other institutional debt investors that filled the gap between bank capital and private/public equity capital, which introduced new financing opportunities for E&P projects.

One of the welcome changes is more oversight from the OCC (The Office of the Comptroller of the Currency) and other bank industry regulators, which has instituted new guidelines that have resulted in greater transparency into corporate E&P loans structured by banks, which in turn is making lending to E&Ps less risky.

How specifically have these new guidelines impacted bank lending to E&Ps?

Prior to the update of the OCC guidelines, banks typically focused on the bank debt of an E&P company’s balance sheet.  Now, the focus is on the entire capital structure and how leveraged the enterprise is. In other words, the OCC has required that banks focus on the probability of cross default from other creditors and the total leverage as much as recovery in the event of default.

We, at Societe Generale, have always focused on the enterprise level leverage rather than simply the senior bank financing.  But now, following the new guidelines, lenders have moved toward the more comprehensive approach to credit assessment.  We think it’s important to focus on and analyze the entire capital stack versus simply just the bank debt portion

What else has changed since the down-turn in terms of managing the risks of lending to E&Ps?

All stakeholders -  the companies, the sponsors, the investors -  know what the banks are willing and able to do and what we cannot.  This has resulted in E&Ps having lower leverage relative to the pre-crisis era and embracing better risk management.  Continued cost reduction remains a focus for E&Ps even after the recovery in commodity prices. Hedging to lock in capital expenditure programs is also an important consideration, despite the backwardation in the commodity forward curve.

Lastly, we now see much tighter leverage covenants and a focus on the quality of the underlying assets such as the operating breakeven cost, the materiality of the oil or gas basin, and the company’s history in that specific basin.

How did the wave of bankruptcies during the down-turn impact the relationship between banks and E&Ps?

This is a relationship focused business. But at the same time, we are focused on the risks we are exposing Societe Generale to.  In tough situations, we, like everyone else, must focus on the recovery of the bank’s capital. But we emphasize taking a holistic and constructive approach.  At Societe Generale, the banker who originates the deal and manages the relationship, manages the relationship through the tough times, as well, alongside our asset recovery specialists. This allows for consistency, transparency and the advantage of drawing on both the client and industry knowledge of the banker as well as the workout and restructuring expertise of our asset recovery colleagues.

Societe Generale has been a lender to E&Ps with operations in the Gulf of Mexico.  Is there a difference in how a bank assesses the risks for offshore assets in comparison to onshore? 

We are active both onshore and offshore. The US onshore Reserve Based Finance market is very mature and has many bank participants. Most of the oil companies and most of the oil and gas reserves in the US are onshore.

In most other countries around the world where we finance the industry, the oil and gas production and fields are mostly offshore. So we are very comfortable lending in the US offshore market.

The offshore loans we execute include US-secured corporate Borrowing Bases for existing production and, as has been done in multiple other countries around the world for decades, upstream Project Finance loans for sanctioned green field projects. 

The “Project” loans are far more specialized than traditional secured corporate loans and comparatively limited to banks that have the project finance expertise to assess the construction and project execution risks in addition to the industry specific risks, such as geological risk, reservoir performance, platform performance, off take, weather and other related risks.   

All our reserve-based corporate lending, whether offshore or onshore, adheres fully to the OCC guidelines. 

It’s important to emphasize that Upstream Project Finance, also called Development Financing, is not a secured corporate loan; it is a project finance facility, which is highly structured and tailored to the sanctioned, committed, specific project, and is very different from secured corporate lending of traditional US secured borrowing bases in many ways.  Apart from reservoir specific risks, it has more in common with other types of project finance than with US borrowing base loans. 

With independent oil and gas companies increasingly replacing the ‘majors’ in the US Gulf of Mexico, we’ve seen an increasing demand for this kind of capital.  This also has been the case with most other maturing, offshore petroleum provinces around the world, like the North Sea and West African margin basins where project lending of this kind is very well established.

Societe Generale has originated, and successfully closed several of these project loans and syndicated them to other project finance banks active in upstream oil and gas in the US.

Importantly, Societe Generale has an excellent track record in this type of finance, executing them in more than 20 countries around the globe.  In some international markets, project loans of this kind now frequently surpass a billion dollars in size with upwards of 10 or 15 project finance banks participating.   Our clients put a lot of trust in us and our credibility in structuring offshore transactions and our track record for successful financing and syndication.

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