Record-high oil and gas prices may be a welcome blessing for independent producers, but for energy lenders, it's a slightly different story. With swollen levels of cash flow in their pockets, upstream operators don't need as much credit as they did a few years ago. In addition, they're now paying down existing bank debt at a much faster clip. Also, the lenders that serve this sector are having to contend with an M&A-shrunken customer base. The result: less deal flow for oil and gas banks, and the need for those lenders to be more flexible in their credit terms to remain competitive. As one commercial banker readily concedes, "This is a borrower's market. They're the ones dictating the terms. And they're tough because they know they can get those terms." But let's give credit where it's due. Energy bankers are a resilient and creative lot and many of them have come up with new approaches to simultaneously stem the tide of slackened loan demand and improved earnings. Some of their approaches: more participation in larger, syndicated credits; broadening their lending footprint beyond their traditional backyards, and initiating more profitable mezzanine or second-lien credit transactions. Three banking groups successfully doing this are Tulsa-based BOK Financial Corp., the Denver-based energy-lending group of U.S. Bank, and Royal Bank of Scotland through its RBS North America structured oil and gas finance group in Houston. Multi-pronged BOK Financial Corp., a multi-bank holding company with assets in five bank subsidiaries including the Bank of Oklahoma and the Bank of Texas, is employing a multi-pronged strategy to grow its energy-lending relationships, and that strategy is already beginning to pay dividends. Since June 2004, the Bank of Oklahoma and the Bank of Texas have collectively added 10 new E&P clients and three midstream customers, ballooning their aggregate energy commitments by some $80 million. Today, the two banks have a combined $2.5 billion worth of commitments to the oil and gas sector, $1.43 billion of that spread among 175 upstream companies. "We're primarily an E&P lender, and although borrowing activity in that sector has slowed during the past two years, we expect to continue to expand existing upstream credit relationships and add new ones," says Mickey Coats, BOK Financial Corp.'s senior vice president and managing director in Tulsa. Just how is that going to be achieved? "Historically, our banking organization has focused on one-bank credits of $20 million or less, or small club deals-that has been our bread and butter," says Coats. "But recognizing how tough energy-loan activity now is, we've made a conscious decision to expand our lending horizons by participating in some of the bigger bank syndications for the larger-cap E&P names." That, however, is only part of the organization's growth strategy. While the Bank of Oklahoma is already a dominant energy lender in its namesake state, the Bank of Texas-a much newer BOK Financial franchise-has a lot of daylight in front of it, in terms of its ability to add new relationships, Coats points out. "Texas is a big market, and by bringing our history in energy lending to the Bank of Texas, that franchise has the opportunity to make a lot of inroads in the oil and gas sector. Put another way, when you're a smaller guy, there's more to go after." Currently, Coy Gallatin, manager of the Houston- and Dallas-based energy group for the Bank of Texas, is focused on that effort. Meanwhile, Coats anticipates increased energy-lending activity out of the Bank of Oklahoma's Denver office, headed by Tom Foncannon, given the high level of resource-play activity now going on throughout the Rockies. What should also help BOK Financial maintain profitability in the sector are the hedging products its banks are offering borrowers, plus the stepped-up pace of MLP (master limited partnership) and other midstream credit transactions those banks are now experiencing. All these events aside, Coats concedes that it's now a borrower's market in the energy sector, and that banks are having to be more flexible in their lending terms. Today, he notes, banks are providing longer terms on loans-five-year revolvers versus historical three-year facilities. In addition, oil and gas lenders are becoming more aggressive in their advance ratios on reserve-base loans, sometimes advancing as much as 65% or higher against proved, developed, producing (PDP) reserves. "Also, in our case, energy-loan agreements, which used to have upwards of five covenants attached to them, now typically have two covenants: a minimum working-capital requirement and a nominal debt/annual EBITDA (earnings before interest, taxes, depreciation and amortization) coverage ratio." Among recent upstream lending transactions, much of the banking organization's credits have been geared to private independents. Typical is a $13-million loan by the Bank of Oklahoma to Staghorn Energy that enabled that Tulsa-based operator to acquire Midcontinent oil and gas properties. In the case of the Bank of Texas, it recently arranged a $15-million revolver for Momentum Energy that refinanced the Midland-based producer's existing indebtedness at another bank and funded the operator's development drilling in the Permian Basin. During the next six months, however, Coats expects more loan paydowns from E&P borrowers as cash flows from current high oil and gas prices begin flowing into their pockets. "It's going to be hard to stay ahead of that," he admits. "But by participating in more syndicated credits, expanding our energy relationships through the Bank of Texas and the Denver office of the Bank of Oklahoma, and emphasizing our hedging abilities and products to customers, we should still experience growth." Two-tiered credits The Denver energy group of U.S. Bank-which handles all the energy lending activity for that $200-billion-asset-sized, Minneapolis-based bank nationwide-has managed to grow its commitments to the domestic energy sector from $1.2 billion at the start of 2004 to a current level of around $1.8 billion. More than $1.1 billion, about 62%, of those commitments are geared to the E&P sector through credit relationships with 41 producers. The balance of the bank's energy commitments is with 21 midstream companies and seven refiners and marketers. But adding new business hasn't come easy of late. "While the E&P component of our energy portfolio is up by about $300 million from a year ago, we've concurrently experienced overall loan paydowns in the energy sector of about $350 million," says Mark E. Thompson, a vice president in U.S. Bank's energy industries division in the Mile High City. Cases in point: Antero Resources Corp. and Medicine Bow Energy Corp., two private Denver-based operators with which the bank had respective loan commitments of $41 million and $28 million, recently sold their assets, correspondingly, to XTO Energy Inc. and El Paso Corp. To offset events like these, the bank-already a top-tier lender to such visible Rockies-based producers as Bill Barrett Corp., Whiting Petroleum Corp. and Delta Petroleum Corp.-is aggressively expanding its upstream client base through a three-pronged approach: backing more private upstream start-ups like Enduring Resources and Cordillera Energy Partners; participating more in large, syndicated credit facilities; and calling upon potential E&P clients in the Midcontinent and Texas Gulf Coast regions. In addition, even though loan-pricing spreads have declined an average 50 basis points since early 2004, the bank has remained flexible on this issue-and that flexibility, combined with greater syndication involvement, is helping profitability. "This year, we found ourselves participating in a number of Tranche A and Tranche B loans," says Thompson. The Tranche A portion of this type of credit conforms to a bank's normal lending parameters for reserve-based loans, he explains. "The Tranche B portion-usually a bridge to a capital-markets transaction, an asset sale or development-drilling activity-is a stretch piece of credit that exceeds normal reserve-base lending parameters and for which there is higher loan pricing." Recently, the lender participated in a two-tranche, $200-million credit for Bill Barrett Corp., a transaction led by JPMorgan Chase. The Tranche A portion was $175 million; Tranche B, $25 million. Earlier, this past March, U.S. Bank co-agented for Delta Petroleum a similar $160-million, two-tranche syndicated loan-a bridge to a public-debt offering by that company. That same month it co-agented a $55-million, two-tranche syndicated credit for a private Denver operator acquiring Gulf Coast coalbed-methane properties. Focusing on the latter transaction, in which the Bank of Oklahoma also participated, Thompson points out that the two-tiered credit-with $40 million in the Tranche A portion and $15 million in the Tranche B part-was a significant step up from the private operator's previous borrowing base of some $16 million. "However, we saw this facility as a bridge to an anticipated increase in the company's borrowing base once its development activity got far enough long. Indeed, six months later, the loan was fully conforming and we did away with the Tranche B portion." Among more traditional E&P loans, the bank this fall plans to establish a $150-million credit facility-with an initial borrowing base of $75 million-for a Denver operator that will be going public before year-end. Says Thompson, "This is a client that four years ago had a borrowing base of only $8 million." Besides financing equipment leases for producers like XTO Energy, Forest Oil Corp. and Cimarex Energy Co,, the bank is also growing its portfolio of midstream credit facilities. "These opportunities often tend to come to us as the result of operators making acquisitions of natural gas-gathering systems that require financing," says Thompson. "The nice thing about midstream credits is that the loan-utilization rates tend to be higher than with reserve-base facilities." Mezzanine minded With assets of more than $900 billion, Edinburgh, Scotland's Royal Bank of Scotland (RBS) has a strong U.S. presence through RBS North America. That New York-based arm of the bank has offices in Boston, Chicago, Los Angeles and Houston; in the latter locale, its energy group has operated for 25 years, focusing on investment-grade energy companies. However, the bank's North American non-investment-grade oil and gas lending effort didn't get off the ground until 2002 when it acquired Shell Capital's producer-finance portfolio which then held $200 million worth of upstream energy commitments. "Since that time, we've grown those commitments to nearly $1 billion," says Jim McBride, managing director and head of the bank's North American structured oil and gas finance group in Houston. In the U.S. alone, those commitments are spread among 25 E&P clients-40% of them private operators-with credits as small as $15- to $50 million and underwritings well north of $100 million. How has it managed such growth? "We've tended to focus on producers with development-drilling opportunities in unconventional resource plays in the Lower 48-where the cost of those opportunities typically outstrips the cash flows of those operators," says McBride. "This has meant, in many cases, an emphasis on mezzanine-debt and second-lien financings." These structures, he explains, allow E&P companies to borrow more cash than might otherwise be available through traditional reserve-base loans; also, they allow producers to avoid having to go to the long-term public debt or -equity markets. By definition, mezzanine-debt facilities permit much higher advance ratios against an operator's PDP reserves versus traditional reserve-based loans; at the same time, they also give some credit for an E&P company's proved, undeveloped (PUD) reserves. In return, the bank earns a higher-than-average coupon on the debt plus an equity kicker in the form of an overriding royalty interest in the oil and gas properties being developed. A second-lien facility, whose coupon fits in pricing between senior bank debt and mezzanine debt, allows a producer incremental borrowing capacity-above that of a revolver-without the traditional expense, terms and conditions usually associated with subordinated financing. "Recently, we've been involved in discussions with a private Dallas independent to provide up to $75 million in mezzanine financing for the development of an extension to its northeastern Texas Barnett Shale play," says McBride. Within the past year, the bank also set up a $20-million mezzanine facility for a private Corpus Christi-based operator, enabling that client to aggressively pursue a 40-well development-drilling program in the Frio play along the Texas Gulf Coast. The banker adds, "Just as the Barnett Shale has jumped in daily gas output-from 80 million cubic feet a few years ago to more than 1 billion today-we think there'll be other marine-shale developments in the Lower 48 that will provide us similar financing opportunities over time." Meanwhile, in Canada, the lender is currently in discussions with a producer on a $200-million, second-lien financing for an oil-sands development program. Says McBride, "In the future, we believe there's going to be as much as $40 billion spent on oil-sands development in Canada, so this is another energy-financing growth area for us. In addition, in terms of coalbed-methane development, Canada is probably about 15 years behind the U.S. Again, drilling dollars will be needed." Besides its emphasis on the lucrative mezzanine-debt and second-lien financing markets, the bank remains focused on traditional lending. Case in point: at the end of August, it was joint lead arranger and book-runner on a $500-million senior credit facility for the E&P subsidiary of a Houston gas transmission company. That credit allowed the subsidiary to fund a significant portion of its $800-million purchase of Midcontinent oil and gas assets. The pricing on the credit: 150 to 200 basis points above Libor.