It rarely happens that getting back to “business as usual” feels like someone just made your day. But for commercial banks serving energy clients, an outlook that has stabilized and is now improving feels better than just good; you’re back to discussing markets again, even recalling how poor conditions looked at one time. Normal means less stress. And no one wants to step too hard on the gas and risk an accident, let alone another pileup.

Energy banking is back to being “healthy” goes one frequently cited observation. Another describes the sector as enjoying a “positive” environment. A third suggests that the market is in balance. Commodity price decks at energy banks have moved higher, but at a prudent pace. Problem loans persist, but are far fewer and closer to resolution.

Marc Cuenod, executive vice president, division head of oil and gas in the Wells Fargo Energy Group, indicated that little, if anything, has changed in terms of the company’s energy strategy.

“We continue to look to do new business with good management teams that have good assets and strong equity backing. And that never really changes,” said Cuenod. “We’re committed to this business, and we’re committed to growing it. We’re a little unique in that we’ve always banked the spectrum of companies, from private-equity-backed start-ups to significantly sized public companies.”

But that’s not to suggest that the bank has been marking time as the energy climate has improved.

“The appetite for new business is strong, and that’s been the case through the majority of 2017,” said Cuenod. “There’s a strong market for good management teams with good assets. You see that in the syndicated loan market. Syndicated deals are getting done on a regular basis. It’s a significantly more positive environment now, with a significantly more positive outlook.

“I wouldn’t characterize it as a sharp, rapid ascent in business, because we’re not seeing the activity levels that we had seen in earlier times,” he continued. “But from what we see when we syndicate new loans, there’s quite a bit of interest from the traditional energy lending banks. There’s a strong desire for good—and I mean good—new loans.”

Redetermination

In a positive sign for the commercial banking sector, news flow on the fall redetermination season—largely complete as of early December—has been notably scarce as compared to the headline-grabbing news of the past year or two.

“Generally, it’s been a nonevent,” commented Cuenod. “There weren’t a lot of issues; there were no real surprises. The percentage of industry loans you’d consider troubled has gone down considerably. The problems loans are contained, and they typically make up only a very small percentage of the total loan book for any bank. They’re not a stumbling block to doing new business.”

And higher—and more stable—commodity prices have obviously helped provide a greater degree of clarity in establishing borrowing base levels, noted Cuenod.

“Prices moving up have certainly helped borrowing bases. With the stabilization and improvement in prices, looking out and projecting borrowing bases is much more certain than it was,” he said. “When we had a lot of volatility in prices, it made it really hard even for companies to look forward and say, ‘This is what I think my borrowing base is going to be.’ The fact prices have stabilized and improved has clearly made the process a lot more manageable.”

In terms of new business opportunities, some broadening of activity by basin is underway, said Cuenod.

“The Permian and the Scoop/Stack have certainly been the hot areas and probably will continue to be for the foreseeable future,” he noted. “Also, we’ve seen some resurgence in the Bakken. Companies will go into plays where they can grow reserves and keep costs down. It sounds simple, but if you can buy an asset, operate it more efficiently and keep costs down, that’s where the opportunities are.”

While the energy group led by Cuenod has many public company clients, the majority of its clients are private E&Ps. Some of these may be on the lower end of the spectrum, but size alone is not the key factor in establishing a banking relationship, according to Cuenod.

”I wouldn’t say there’s a particular threshold as to size,” he said. “It has more to do with where we think it’s going to go. It could start very small; someone who doesn’t have enough of an asset base to warrant a borrowing base yet. But it’s where we see the trajectory of growth going. It’s not uncommon for us to engage with people who we think are going to grow and develop over time.”

Mike Lister, who is based in Dallas, leads J.P. Morgan’s commercial banking division as it relates to clients outside the major global integrated producers. As a result, his group’s client base is made up predominantly of noninvestment-grade E&Ps that employ a reserve-based loan structure. In addition, the group covers the midstream and oilfield service sectors.

Lister described the outlook for energy banking as positive but stopped short of calling conditions “very positive,” in recognition of a few remaining workout credits still being resolved.

“We’re at the later stages of the restructuring process for distressed credits, which is a good thing,” he said. “Banks are continuing to release loan loss reserves that were taken in late 2015 and most of 2016. That’s a very healthy, normal move in a cyclical industry: to take the loan loss reserves when you need to, and ideally, release those as companies recover.”

The unfolding of that process has “had a big impact on banks’ appetite and willingness to lend as an industry,” noted Lister. “And the banks that hit the pause button during the downturn—that didn’t extend credit or proactively reduced exposure to the industry—have returned to the market.”

Gaining market share

During the downturn, J.P. Morgan was able to gain market share, according to Lister, helped by top management’s support and private-equity sponsors’ fundraising success. “We were fortunate to have a senior management that understands the cyclicality of the industry,” Lister said. “We were extremely active, even in 2016, and booked some extremely well-structured, well-priced credits. We had the full backing of senior management throughout the downturn—to be prudent, but to grow the book. We extended a lot of new credit.

“We continued to grow the E&P client base throughout the downturn. The majority of it was private-equity-backed portfolio companies, newly formed by top-tier private-equity sponsors. There had been some significant private-equity funds raised pre-downturn, so the timing was good. The private-equity-backed teams continued to invest throughout the cycle, and we continued to extend credit.”

In recent months, the trend of working with private-equity-backed companies has broadened to include operators not just in the E&P space but also in the midstream sector. In mid-2016, Doug Gale joined the J.P. Morgan energy team in Dallas as executive director and works with midstream businesses.

“We’ve definitely grown the book of business and extended new commitments of late,” said Lister.

With J.P. Morgan enjoying an unusually wide view of the overall bank market, given its strong market share and role as agent bank for many credit facilities, its insights on the redetermination season are of interest. With some two-thirds of redeterminations completed as of early December, about 40% showed an increase in borrowing bases for the next six months, while 40% were unchanged and 20% declined.

“It’s a different picture than it was one and a half years ago,” he commented. “Commodity prices are certainly helping. Just the fact we don’t see material declines any more means, in effect, we’re adding credit to the system.” A scarcity of news reflects “it’s a nonevent. That’s what you want; it’s a good thing.”

With improved market conditions, one of several loan rating guidelines introduced by the Office of the Controller of the Currency (OCC) in March of 2016—measuring debt using a total leverage metric rather than the traditional senior secured debt metric—appears to have faded as a hot button. For certain participants in 2016, it was viewed as a “red line” if a client’s total debt approached a 3.5 multiple of EBITDA, putting at risk a “pass” rating on a loan under the new guidelines.

Lister differed from such a narrowly defined understanding of the 3.5x total leverage test in place.

“From an individual credit standpoint, we’ve always focused on total leverage,” he said. “Overall, the 3.5x leverage metric is probably the right one to focus on, but it’s not the right answer for every deal. As a matter of prudence, 3.5x is probably a good starting point to really scrub the numbers. For every ‘turn’ you go over that metric, you’ll have to have conviction and justify why you’re doing it.”

The type of asset, coupled with the experience of management, is among the factors considered in a leverage test, noted Lister. For example, a loan against an asset that is weighted heavily toward proved-producing reserves, with production showing a low decline and output hedged out several years, would be more likely to pass a test at a higher debt metric, he said.

A&D activity

In terms of funding opportunities related to A&D, the market has yet to regain its prior robust activity levels, according to Lister.

“On the E&P side, you definitely need that market to be functioning to drive additional growth, and it’s not fully back. The volume of A&D deals has declined steadily each quarter throughout 2017. It’s a slow market right now. We’d love to see that market get more active, because when management teams get private-equity backing, form a new company and bid on assets, that’s our chance to extend a new credit facility and help raise capital.”

With higher and more stable oil prices, the improved overall market tone and fundamentals have resulted in some reductions in banks’ pricing for reserve-based loans (RBL), according to Lister. (Pricing is quoted in basis points over LIBOR, the London Interbank Offered Rate) .

“In reserve-based loans specifically, we have seen pricing start to come in from the higher levels back during the downturn,” he said. “We’ve seen the pricing grids for E&P RBLs come down from the prior highs by, on average, anywhere from 25 to 50 basis points. We’re not all the way back to the levels at the top of the market. Banks are willing to reduce pricing, although structures are more conservative.”

Lister also struck a positive note on the E&P sector’s surge in senior note offering in fall 2017.

“From a bank perspective, it’s a very positive sign when energy companies can access the public debt market for longer-term capital at very attractive prices,” he said. “We may have a paydown and lower interest income short term, but it’s a great thing to see for the market.”

Bryan Chapman, who is based in Houston, has seen markets fluctuate and energy pricing move up and down over a 30-year career in energy lending. Chapman is market president of energy lending for IberiaBank Corp., which has been in business since 1887. Chapman helped start the firm’s energy lending business in 2009, and he expects continued growth this year. His client base is “100% sub-investment grade, first lien secured,” he said.

In terms of pricing for RBL credits, “we saw some price increases in 2016 and the early part of 2017 during the downturn,” he recalled. “But as we approached the end of the cycle last fall, we saw some of the stronger RBL credits—especially those that had navigated the downturn without any issues—get some reduced pricing in the fall redetermination season. It was a select number of high-quality clients.”

For Chapman, 2017 was a very busy year, with opportunities concentrated on A&D activities. The overwhelming majority of these were related to private-equity-backed companies making acquisitions, he said, as existing E&Ps sought to deleverage or sell noncore assets to focus on one or two basins. From a robust activity level for much of the year, A&D activity slowed down “decidedly” in the fourth quarter.

In terms of new business, Chapman pointed to private-equity-backed companies involved in Permian Basin infrastructure projects, as well as E&Ps in the Permian, Stack, Rockies and Marcellus.

In the buildout of infrastructure in the Permian, the MLP model is, in some cases, disadvantaged in having to raise equity without having a source of cash flow from the project to distribute for up to, say, 18 months, observed Chapman. By contrast, a private-equity-backed company can deploy capital in a project without an immediate need for distributions, he noted.

Chapman also pointed to E&Ps taking on less second lien debt from banks, as well as less mezzanine financing, and using more preferred equity in the capital structure. The preferred equity “doesn’t get caught up in the OCC calculations, because it’s not debt, whereas if you use second lien debt, it does raise an issue. You’ll use much less second lien and mezzanine, and more preferred, if companies need to fill out the capital structure to close an acquisition.”

John Lane is the manager of energy lending with First Tennessee Bank, which made a timely entry into energy lending in the latter part of 2014. Since then, the bank’s growth includes a merger it closed in November that raised the bank’s assets to $40 billion from $30 billion. As the energy group’s business has matured, its average commitment has increased from $10- to $20 million to $25- to $30 million.

“Interest in financing oil and gas opportunities on a first lien basis has definitely increased, but I wouldn’t say dramatically so,” Lane said. “There are still some troubled deals, but capital is readily available for deals that make sense. Price decks are coming up ever so slowly. The banks aren’t chasing the futures strip. Nobody is running out and moving bank price decks significantly higher because oil is at $57 per barrel.”

Lane cited a “more positive attitude” toward energy. For lenders, “the mindset is ‘let’s get back to growing the loan portfolio,’” he said. And for borrowers, the feeling is they’re “getting back to a more constructive market, where they can look at acquisitions and their facilities for capital expenditures and have some assurance they’re actually going to be successful in getting deals done.”

While First Tennessee is expanding its customer base and growing its book, gains have been offset in part by some of the stronger credits paying down loans as they access the high-yield market, Lane said.

“Some of those paydowns were early in the year, and the facilities stayed unfunded or lightly funded over the summer, before borrowing started again as the year wore on,” he said. “That’s an aspect of the market we just have to work with. As long as the high-yield market is that attractive, you can hardly blame companies for wanting to lock in the cost of capital.”

With a bigger post-acquisition balance sheet, allowing for larger customer loans, First Tennessee is targeting an energy book of 3% to 4% of the bank’s total loans in the long term, according to Lane.

Quality deals

Is First Tennessee’s energy group focusing on specific basins or sectors?

“Basically we’re targeting quality,” said Lane. “It’s not basin-specific, or shale-specific, or resource play-specific. For us, conventional assets make sense if the management team is the right one to own those assets. And it’s the same for shale, whether it is Permian, Scoop/Stack, Bakken or Marcellus. And the same for oil or gas.”

Steve Kennedy, executive vice president and head of energy banking at Amegy Bank, described the outlook as “improving” after spending most of 2016 “working out problem loans.” His group entered the downturn with energy making up 8% of the total loan portfolio of its parent, Zions Bancorporation, which acquired Amegy in 2005. The energy weighting is now down to “about 5%.”

Amegy’s energy loan portfolio held “just about even” in 2017, with new credits roughly offsetting paydowns, according to Kennedy. Additions to portfolio reflect a “decent amount of growth in the upstream secto,” but to an even greater extent new business developed in the midstream sector. In addition, Amegy booked one new deal in the oilfield service sector.

According to Kennedy, Amegy has “substantial amount of room” to do further deals in upstream, midstream and oilfield services. “We’re able and willing to do all the good deals we see.” As for the oilfield sector, “we understood the volatility in oilfield services and knew that substantial amounts of equity would be required to offset the risk. But, in this downturn, we learned that level was even higher than we originally thought,” he commented. The deal, led by Amegy with one participating bank, has “a very strong equity sponsor.”

New business has been developed beyond unconventional plays, such as the Permian, Scoop/Stack, Marcellus and Haynesville, said Kennedy. Examples are Hilcorp Energy Co.’s purchase of San Juan Basin assets and the purchase by Terra Energy Partners of Piceance Basin assets. “All of those companies want to make some use of senior bank debt,” he said.

Like others, Kennedy said some high-quality E&P customers were enjoying an improvement in senior bank debt terms.

“If there was a 50 basis point increase just after the downturn started, I think some companies have already gotten maybe 25 basis points back at this point. There wasn’t a huge move up. It was only about 50 basis points to begin with, so it doesn’t have to come back far to get back to the pre-downturn levels.”

A View From The Top

It’s not obvious that a private-equity (PE) sponsor should be immersed in what’s happening in the commercial banking sector. But if you’re overseeing a score or more of portfolio companies, each in need of a banking relationship, you’re likely up to speed already. And with economies of scale kicking in for a larger collective client, why have each company go over ground you’ve already ploughed?

“We’re dealing with banks every day. We’ve got a credit facility in the market every week, or every other week,” said Wil VanLoh, CEO of Houston-based PE sponsor Quantum Energy Partners LLC. “Clearly, we have a lot of volume. When we effectively aggregate our purchasing power across all our portfolio companies, our credit facilities are probably larger than most large-cap public E&P companies.”

VanLoh said the Quantum portfolio companies had benefited from “considerably” improved terms as a result of its aggregate purchasing power. But how have market conditions in energy lending as a whole changed recently?

Pricing grids “are starting to relax some, meaning they’re pricing deals at tighter spreads to LIBOR,” he said. As an example, spreads over LIBOR, which in the downturn had widened to more than 300 basis points—and up to 350 basis points at their height—were now back below 300 basis points. Spreads were around LIBOR plus 250 to 275 basis point in general, with higher-quality credits priced around LIBOR plus 225 basis points—still higher than pre-November 2014 spreads of 200 to 225 basis points.

“Things have gotten back to business as usual,” said VanLoh. “Money is flowing again. There’s plenty of availability in the bank market, although I think the banks are being more selective and not as willing to take on some of the lower-quality credits. It’s not nearly back to the way it was pre 2014.”

VanLoh is cautiously optimistic that the industry may be able to turn over a new leaf of discipline.

“There’s a lot more discipline on all sides right now. There’s discipline at the banks, there’s discipline on the part of the company management teams. To the extent private equity is involved, the private-equity guys are more disciplined than they were before. All that will be healthy for the industry.

“I think people have realized the folly of overlevering an E&P company and, especially, overlevering and not hedging. Tens of billions of debt got wiped out. Interestingly, not a lot of bank debt did; it was mostly in high-yield bonds. The real losers were the high-yield bondholders.”