T?he bank-loan redetermination season is ending, and some E&Ps simply aren’t going to make it. Blame it on deflated equity markets, a lack of debt capital and oil and gas reserves worth much less now than they were last year. The down-cycle is eating some producers’ lunch, despite previous sturdy stock value, good assets and responsible management.

Recently, Ohio-based Triad Energy Corp. filed Chapter 11 after its stock fell from $4.49 per share to 12 cents. Crusader Energy Group Inc. of Oklahoma City is faring no better in its attempts to right a $5-million borrowing-base deficit. The producer’s stock has fallen from $7.57 to a penny, and it recently filed Chapter 11 after failing to pay an $833,000 installment toward clearing its $5-million revolver deficit.

Production Enhancement Group Inc. (PEG) of Houston saw its stock fall from 70 cents per share to eight cents, and recently received a notice of default from its senior lender following the company’s failure to make its March 30 principle and interest payment.

Those payments and all other obligations under the senior facility are “immediately due and payable.”

Also, Houston-based Saratoga Resources Inc.’s stock slipped to 10 cents from its 52-week high of $4.50 per share. The company filed Chapter 11 and is seeking debtor-in-possession financing. Elsewhere, New Orleans-based Energy Partners Ltd. is undergoing Chapter 11 restructuring after its stock fell from $16.50 to eight cents.

The majority of those who made it through are borrowing against commercial banks’ more conservative oil and gas price decks while finding scarce capital amid rising costs.

In April, the Treasury Department’s latest monthly survey of lending activities at the nation’s biggest banks showed nine reported increases, 12 reported declines, and the median for lending activity dipping 2.2% in February. “The report noted that the relatively steady overall lending levels observed in February “likely would have been lower absent the capital provided by Treasury.”

Price decks
On the other side of the fence, bankers are keeping a close eye on forward strips, adjusting loan covenants and keeping in constant contact with producer clients.

In March, Dallas-based Texas Capital Bank was lending against an oil price of $42.50 per barrel and gas at $4.75 per thousand cubic feet (Mcf), but those decks are a moving target.

“We look at long-term projections to determine where our decks should be,” says Chris Cowan, executive vice president and manager of energy lending. Texas Capital has been lending to the energy industry for more than a decade, with more than $500 million committed to domestic onshore producers, mostly based in the Midcontinent.

“When commodity prices move up significantly, our decks will tend to be below market prices,” he says. “As we increased our deck, our sensitivity case became increasingly important in determining what we would ultimately lend. Now our base case is approaching the same levels we used in our sensitivity case when the markets were at their highest.”

When in mid-April the financial sector began to show early signs of stability, energy-lending price decks began to stabilize as well, says Houston-based BBVA Compass’ senior vice president and lending manager for energy banking Dorothy Marchand. BBVA Compass has been lending to energy producers since 1995 with some $2.8 billion in commitments to companies operating onshore the U.S., nearly 80% of which is in upstream oil and gas.

“Today we are lending at $4.50 per million Btu for gas, increasing to $5.25 in 2010 and $6 for 2011 and beyond,” she says. “If gas continues to drop, we expect to adjust the near-term gas deck.” BBVA Compass’ oil price deck for lending is $40 per barrel, increasing to $45 in 2010, $50 in 2011, $55 for 2012 and $60 for 2013 and beyond.

Union Bank, based in San Francisco, is loaning against $40 per barrel for oil now, escalating to $60 in 2012, says Carl Stutzman, Dallas-based senior vice president. “Lending for gas is $4, increasing to $6 within five years.” The firm has been lending to energy for 25 years and has $5.2 billion committed to oil and gas in North America.

Previously known as Union Bank of California, the firm changed its name to Union Bank in December 2008 and is a wholly owned indirect subsidiary of Mitsubishi Financial Group.

“We tend to keep our price decks about the same as our major competitors. Essentially, the market is telling us what our price decks should be,” says Stutzman. “For our bank, and for banks generally active in the sector, we never really chased prices up to levels they reached this past July and August. But we have all made downward adjustments in our oil and gas price decks.”

Meanwhile, most banks are lending at higher rates. “It’s not uncommon to see a 5% to 6% rate on a good energy loan,” says Cowan. “We certainly won’t lend anything at a rate close to prime in this market.”

Marchand agrees. “For many banks, the cost of capital for themselves is quite high at this time. If a bank needs to issue debt, it is going to pay a hefty margin over Libor (London Interbank Offered Rate).”

Fortunately for BBVA Compass, its owner is Banco Bilbao Vizcaya Argentaria, a $39-billion-market-cap Spanish bank. While competitors and large Wall Street players took massive write-downs in 2008 due to the financial crisis, BBVA earned profits of about $7.4 billion, making it the second-most profitable financial services firm worldwide. With some $62.3 billion in assets, the firm plans to expand its U.S. presence, particularly in Texas where 60% of its national bank deposits are held.

“We have deposit-gathering branches all over the world, so our cost of capital is lowered by that deposit-generation capacity,” says Marchand. “While competitive, we might not offer the highest rates of interest, because we don’t have to be aggressive. But we do require more of a relationship with our borrowers in the form of deposits and other products.”

Texas Capital also pursues relationship banking over one-off transactions. “We typically are the only lender for our clients and look to provide all services to them,” says Cowan.

But with syndicated loans, relationship-building is not so easy. “Because of the deposit requirement by many banks, it is difficult to put together a new syndicated deal,” says Cowan. “Finding more than two or three banks to deal together is difficult because we all want the deposits. The number one struggle for any financial institution today is liquidity, so we have to be very deliberate in what we do.”

And there is another problem with large bank-group facilities—some were based on higher price decks. “Some of the larger transactions were structured more aggressively due to the level of competition. It’s those big deals that are now having the most problems,” says Cowan. “We never really took our oil deck over a long-term price of $60.”

Meanwhile, although Texas Capital prefers one-on-one, BBVA Compass Bank deliberately seeks to build relationships through syndicated opportunities. In fact, bank-group deals make up about 75% of BBVA Compass’ portfolio. Union Bank also participates in bank-group deals. “It’s about 60% of what we do,” says Stutzman. “We are usually the lead for an average $100- to $250-million deal, or we are a sole lender for an average $25- to $50-million deal.”

As administrative agent for a bank syndicate, Union worked with Enid, Oklahoma-based Continental Resources to increase its debt facility by $300 million. “It was no small feat in today’s market,” says Stutzman, “but they have great assets and management, so from a risk profile, it presented an attractive opportunity.”

Marchand is also seeing quite a few high-quality E&Ps looking to expand and extend existing facilities. Thus far in 2009, BBVA Compass significantly increased its relationships with Cimarex Energy, Whiting Oil & Gas and Rosetta Resources, and added new relationships with Continental Resources and St. Mary Land & Exploration, to name a few.

Pinning down numbers
Union Bank recently completed its budget-planning exercise for 2009. “This year was probably the most uncertain year we’ve had, in terms of trying to pin down some numbers for growth and what the industry is going to look like in the short term,” says Stutzman. “There are just so many variables out there, it’s hard to get your arms around it.”

It’s the same for borrowers, who have to tailor document-generating efforts for specific banks. In this market, static numbers on balance sheets, income statements and audits are simply not enough.
Cowan says Texas Bank doesn’t always require a third-party audit report, but does want to spend time with clients in their offices and with their accountants.

“The bottom line is, I want to see their plans, have them work with our in-house petroleum engineers, and then sit down and figure out what works best for them and for us,” he says.

Management that is well known and has expertise in its region is key, says Cowan. “However, if we don’t know a prospect, we take time to look into their background. I see these groups every day. There are a thousand ways to cut a deal in oil and gas, and just as many ways to make a mistake. The oil and gas industry is full of entrepreneurs and we’re willing to work with new management teams, but we are diligent in determining with whom to move forward,” he says.

For BBVA Compass, clients are asked to bring realistic expectations along with their financial statements, says Marchand. “Pricing on loans, including interest rates and upfront and commitment fees, has adjusted to the current market. Some clients are under the misconception that the cost of capital should be, for them, what it was six months ago, because they are just as strong as they have always been. But that is no longer the case.”

Also, while BBVA Compass has in-house reservoir engineers, in some cases the bank does require third-party reports, depending upon the quality of client-provided production history and the nature of the property set. “We also closely look at the management and its technical expertise, because some are strong on the financial side but lack technical expertise.”

Stutzman says that Union Bank is open to lending for new opportunities but the deal has to make sense from a credit standpoint, be a conforming deal that can demonstrate strong sensitivities to downside pricing pressure and include enough ancillary business to meet risk-return hurdles.

“Today, depending on the size and sophistication of a solid company with good assets and a proven management team, the biggest deals we can see getting done in our space are about $500 million,” he says. “Like everyone in this industry, we are being pretty darn picky about what we do. For example, public companies are going to attract more capital.”

Sweating the details
Stutzman favors E&Ps with a strong equity backstop behind bank debt. “The days of doing 80% leverage on acquisitions are long behind us,” he says. “Also, we like to see production histories and decline curves, third-party engineering reports and audited financial statements. We are really sweating the details on due diligence, probably more so than ever.”

Union prefers deals front-loaded with opportunities for commodity hedging, treasury management and interest-rate derivatives “so we can point to the ancillary income to flesh out the overall profitability of the relationship,” he says.

Meanwhile, spring borrowing-base redeterminations are still “the talk of the town in the banking industry,” says Cowan. “The good news is, at least half of our clients are sitting on unused lines of credit. Within the other half, we do have some stress, but almost every one of them will be able to amortize any overage in a few months.”

Marchand says that, while prices were high in 2008, many BBVA Compass clients shored up their balance sheets and put themselves in a liquid position, helping to withstand the downturn for a year or two.

“In January, we reviewed our entire energy-group portfolio to categorize the risk of our upstream and midstream clients,” she says. “We now have a good sense of the higher-risk clients that may need some restructuring work. But most of our clients are going to weather this borrowing-base-review period quite well. With oil prices stabilizing, I think that bodes well for the next review in the fall.” She notes that several of the bank’s clients proactively initiated redeterminations early to make reassuring announcements to the market.

Stutzman also has confidence in the majority of his energy clients. “Fortunately, many of our clients still have a lot of availability under their lines of credit, so they will not have to amortize their debt.”

Where there are problems, the bankers stand ready to offer solutions. Cowan observes that remedies for stressed clients will be guided by several parameters. In some cases hedges can make a difference, depending on the gas-oil mix, the life of the reserves, how much production was hedged and at what price and for how long, and the amount of free cash flow left to the producer.

“We’ve been able to work with our clients and put good plans into place to weather this downturn,” he says.

Marchand finds that, for those that will need workouts, amortization and asset sales solve the problem in many cases. In her experience, demanding immediate payment of the entire overage strictly in accordance with the credit agreement can be counterproductive. “We prefer to give them time to identify and market noncore assets in a non-fire-sale manner. They typically aim to sell those that have the least borrowing base value relative to upside someone else would be willing to acquire. We are starting to see these types of sales.”

Stutzman suggests that, in addition to asset sales, some E&Ps could reduce leverage by redeploying cash flow from drilling and into debt reduction to get in sync with lowered borrowing bases.

“As an alternative, we can lend mezzanine,” he says. “In a few cases, we look at the over-advance and arrange a mezzanine strip to cover the chunk that is not supported by the senior, first-lien debt. We have offered that on a number of occasions, and we are working on one right now. Also, the mezzanine allows us to properly price that strip of risk.” He notes that, while hedging is another way to add value, the bank price decks are so close to the future strip that clients aren’t getting a lot of uplift on their borrowing-base values.

After the spring borrowing-base season, Stutzman expects to see a fair amount of oil and gas properties on the market. “The big question is, what will be the level of interest and will the capital that has been sitting on the sidelines find the right asking price waiting?”