PITTSBURGH—Just when E&Ps thought it was safe to get back into the water comes news of a capital availability barrier that may yet slow recovery.

Tim Murray, managing director and head of energy origination for Houston-based Benefit Street Partners, reminded attendees at Hart Energy’s recent DUG East Conference & Exhibition about the evolving environment regarding tightening capital for upstream E&Ps, saying, “everyone knows that capital is what makes the market go. If you don’t have capital, you can’t show up at the table to buy.”

Capital restriction for energy development originates from a combination of internal events related to the commodity price collapse and external developments, including new rules from the Office of the Comptroller of Currency (OCC) addressing how banks evaluate leverage for their borrowing clients.

Shared National Exams (SNEs) for banking institutions occur each year in May and June. The process has remained unchanged for more than 30 years. However, in March, the OCC proposed new provisions on risk evaluation for bank loans, according to Murray. The net effect, which involves accounting for all debt owed by companies rather than just balance sheet debt, will increase the cost of capital and impose tighter restrictions on energy loans.

The changes occur as classified energy loans approach levels similar to the 2008-2009 financial crisis. Murray said several companies will see existing conforming loans reassigned as “criticized classified,” a category that ranges from debt with well-defined weaknesses that presents the possibility of loss, to debt that is uncollectible and will be written off.

“Even companies that are near investment grade, or investment grade, may end up being criticized classified at the banks,” Murray said. “Why is that important? If a bank has criticized classified loans, two things have to happen. Banks can only have so many, or they have to sell the loans or get out of the business. Secondly, they have to charge a lot more money for the loans.”

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Regional banking firms in energy-producing areas will experience the greatest impact because a larger portion of their loan portfolio is in energy, vs. the large national lending houses.

Meanwhile, high-yield debt, which was a significant underwriter for energy-related projects during the unconventional heyday, has followed oil prices lower with credit-risk premiums widening to levels experienced during the 2008-2009 financial downturn. Consequently, the upstream high-yield market has gone dark for oil and gas operators.

Through May, the upstream E&P segment witnessed 81 bankruptcies involving $52 billion in debt, although only one has involved a company operating in Appalachia, Murray said. For oil services, there have been 71 bankruptcies and $11 billion in cumulative debt through June.

The current financial downturn is the first in the unconventional oil and gas era.

“What’s different about this cycle, vs. the old cycle in the conventional world, is there was a lot more leverage put on with marginal prospect teams on assets that weren’t producing cash flow to pay the debt back. That’s why we’re seeing a lot of stress in the industry today,” Murray said.

“Why more leverage? Because the operators convinced the banks, the public and alternative capital providers like me that acreage was worth $10,000 an acre in lending money,” Murray said. “There was a lot of money lent on acreage, and the issue on acreage is, there is no cash flow with acreage so it doesn’t pay the loan back. If you borrow a lot of money for acreage and you don’t drill it, you’re probably going to be under a little stress.”

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A few upstream companies have found an alternative source of capital via equity issues, which have been a surprise positive for upstream energy companies. However, the majority of equity issuances have occurred in the Permian Basin. E&Ps active in Appalachia raised $2.5 billion via equity issuance in 2015, according to Murray, although 70% of that value was in just two deals.

While equity raises are available to select firms in select regional markets, the financing mechanism falls well short of filling the vacuum created by reduced bank lending and a frozen high-yield debt market. That leaves private equity and mezzanine lenders as the primary source of funding as the industry recovers.

Murray identified $44 billion in mezzanine funds and $126 billion in energy-focused private equity, or roughly $170 billion, available to energy firms via loans or assets sales.

Murray said private equity providers favor a minimum investment of $200 million, which creates a barrier for smaller firms or smaller projects.

That dearth of capital opens the door for alternative financing, including DrillCos, a financing mechanism provided by financial firms that includes an acreage investment, a drilling carry, a reversion feature and a residual interest that establishes a targeted rate of return for the capital provider. The mechanism resembles an industry farm-out or drilling carry as a means to earn interest.

“We're up to 17 DrillCo deals we've looked at in about the last year,” Murray said during the Q&A session of the DUG East A&D panel.

“People say: ‘Why DrillCo?’ When you're over‑levered, the last thing you need is more debt. Obviously, we could come in and buy debt on a discounted basis. We'd come in and prime the debt. We can put equity behind that debt. We're not very happy about doing that. One good option is to do a non‑recourse deal. DrillCos are non‑recourse deals. You take some acreage, which, if it's undeveloped acreage, the banks aren't lending you any money anyway; and you put that in a restricted subsidiary. We make an investment to get the wells drilled.”

Essentially, the financing entity carries the operator for a portion of the drilling costs.

“Once you achieve a certain return, called the reversionary return, it's usually in the mid‑teens; then your working interest flips to a low number and the operator flips to a high number. It gives the operator a chance to get his wells drilled, maybe get a little carry.

Once the financial partner achieves a certain rate of return, the operator gets the well back, and the financial provider retains a tail value.

As for Appalachian financing, Murray sees the industry ultimately getting past capital barriers.

“We still look at this as a market that's constrained by gas takeaway. That's going to be solved,” Murray said. “The Appalachian question is going to be solved, and then you're looking at getting wells drilled before your permits expire.”

And it’s not just Appalachia.

“Someone asked me the other day, they said: ‘Well, gee, you must not be very busy.’ I've been doing this for 20 years in the alternative investment business,” Murray said. “I've never had as many deals in the pipeline--attractive deals--as I do now.”

Richard Mason can be reached at rmason@hartenergy.com.