Redetermination Season: The Sequel

Tom Murray, managing director and global head of energy for West LB AG, says, “Before now, there was a very active institutional loan market, which was more like a bond market with a desire to get all-in yield as opposed to fees.”

Each spring and fall, oil and gas producers wait, some with trepidation, for their commercial lenders to redetermine their borrowing bases. Will their revolving credit facilities, backed by oil and gas reserves, be reduced, thus limiting capital for drilling plans? Or will they be increased, freeing up capital for drilling, exploration and acquisitions?

Through 2007 and 2008, many forward-thinking producers cast a distrustful eye at upward-spiraling oil and gas prices, foreseeing a fall, and continued to look for ways to reduce costs. Others quickly took advantage of the high commodity prices and hedged their oil and gas production with whichever institutions would take that bet. After energy demand fell off a cliff in fall 2008, those producers were able to monetize their hedges, if necessary, and hunker down to wait for the next upturn.

This past spring, the industry witnessed quite a few borrowing-base reductions. Although producers had plenty of reserves, and had been replacing and adding to them through 2007, the value of those reserves, used as debt collateral, slid.

Nonetheless, most producers came through the spring redetermination season intact. Many geared down drilling programs to operate within cash flow. Some tapped unused dry powder or issued equity or debt to fund E&P. A few sold noncore assets.

“I was surprised at the level of expectation in the spring that the upstream sector was going to be significantly impacted by the borrowing-base redeterminations,” says Ian Schottlaender, managing director and head of oil and gas, North America, for Germany-based commercial bank and advisory firm WestLB AG.

“There was a market expectation in the spring that there would be forced sales as a result of redeterminations, and that never really came to pass.”

WestLB uses conservative oil- and gas-price outlooks and declined to drastically readjust its forecasts to the significantly higher prices during the runup in 2008. “As a result, we did not have to adjust downward as much as the market expected. We had no portfolio companies that required a reduction of their borrowing base,” he says.

Will commercial lenders be as accommodating as they were in the spring? Some say yes, as capital has thawed and is available at more reasonable prices than it was during the financial crisis. Also, some institutional investors are returning to the markets and competing with commercial lenders.

Yet, despite lowered borrowing bases, producers will likely continue to turn to their commercial bankers instead of secondary debt markets, says Tom Murray, managing director and global head of energy for WestLB.

“Before now, there was a very active institutional loan market, which was more like a bond market with a desire to get all-in yield as opposed to fees. Now, there are fewer investors in the institutional loan market. Many hedge funds and firms managing collateralized-loan obligations no longer exist. The market is materially smaller, so commercial banks are still taking up the differential,” he says.

Gas prices and hedges

“There was a market expectation in the spring that there would be forced sales as a result of redeterminations, and that never really came to pass,” says Ian Schottlaender, WestLB AG managing director and head of oil and gas, North America.

This fall, oil prices are hovering around $70, the marginal price per barrel, but gas prices are bouncing off the bottom. At press time, the cash price was as low as $3.26 per million Btu, and was expected to remain that way for at least the short term.

“The earlier redeterminations were oil-stress related,” says Chris Cowen, executive vice president for Texas Capital Bank, with headquarters in Dallas. “They will be gas this time around. The biggest issues are gas prices and hedging. As long as the market stays in contango, we’ll be able to solve value issues by hedging in the futures market.”

Cowen is confident the bank’s clients have sufficient cash flow to service debt with hedges put on earlier in the year. “We’ve already been through the gas deals twice, but the larger institutions who truly stick with the semiannual outlook may have some surprises,” he says.

John Walker, president and chief executive of Houston-based EnerVest Ltd., also believes that gas prices pose a clear and present danger to producers’ financials. He was heard at Summer NAPE to say, “We could see another gas basis blowout, like when the Rockies’ netbacks fell to $0.05 per thousand cubic feet (Mcf).”

Mickey Coates, senior vice president of Tulsa-based bank BOK Financial Corp., is optimistic, thinking this fall will be a relatively mild borrowing-base season. “The biggest issue for us will be producers that are mostly gas-oriented.”

Todd Berryman, regional vice president and manager of energy lending for Bank of the West, in Denver, agrees that the fall season will be much like the spring, but adds, “We should see some downward determinations for gas (producers), particularly for companies that did not hedge.”

Lenders examine key criteria for borrowing-base redeterminations, including debt ratio, reserve replacement and, in the current environment, exposure to low gas prices.

Others, like Carl Stutzman, Dallas-based senior vice president for Union Bank of California, say the fall season will be tougher than the spring. “We were spared some pain in the spring due to reserve adds from active drilling programs, hedges and deleveraged events with certain borrowers. This fall, I think we’re going to see the negative impacts of a lower gas price deck and reduced drilling and reserve adds.”

Schottlaender says he “would be surprised if there aren’t significant hedge positions being put on for that reason,” and says futures curves are still “quite steep” and “very favorable to oil producers.” Those who are longer oil should be able to replace the hedges they had.

“There is a lot of current press about the prompt-month gas price. And it is low; there is no doubt about it. There is a gas glut now. But the curve is steep. We take a term outlook, whether it is our own price forecast or we are giving credit to the hedges. The $3 per Mcf is today, but it is not a term outlook,” he says.

Schottlaender contends that because gas prices are weak on the front end of the curve, gas producers might have to enter two- or three-year hedges. By doing so, they can largely replace what they had last year, plus or minus 20%, although many higher-priced gas hedges are expiring.

As far as how low gas prices will go, nobody knows. Mark Fuqua, senior vice president for Comerica Bank in Dallas, believes banks will be using gas-price forecasts as much as 10% lower this fall, compared with the spring. (For the latest price decks, see “Energy Lenders’ Price Decks,” Oil and Gas Investor, September 2009.)

Drilling and reserves

As gas prices fall, so does the rig count, which was down by 50% at one point earlier this year. Therein looms a major problem.

The drilling slowdown raises the question of whether producers are adequately replacing their reserves to ensure healthy collateral. The dramatic reduction in drilling activity during the past six months could be reflected in borrowing-base reviews. Nonetheless, E&Ps continue to announce production reductions due to continued low gas prices.

In September, Houston-based Newfield Exploration Co. announced its intention to curtail a sizable 2.5 billion cubic feet of gas equivalent from its third-quarter production. Although some 75% of the company’s expected third-quarter production is hedged at nearly $8 per Mcf, it will curtail production “due to low gas prices.” However, Newfield expects its full-year 2009 production to be in the upper half of its previous guidance range.

Says Fuqua, “Lower capex will translate into less reserve replacement. But on the positive side, costs are lower for both lease-operating expenses and capex. Also, drilling in some areas has yielded strong reserves per well.”

Not all reduced reserves are a result of low-drill rates or delayed well completions. “There have been a number of recent transactions that have, either through asset sales or acquisitions, increased some of our borrowers’ reserves and reduced others,” says Schottlaender, despite the fact that since the spring the bid-ask spread has been very wide, primarily due to prompt-month gas prices versus the long-term curve.

He believes there might be some modest necessity selling, but eventually the buyers, with their access to capital, must recognize the long-term curve. Buyers should not expect to get reserves as cheaply as they might have in the spring. “Today, the bid-ask spread appears to be narrowing, given the recent activity level.”

Murray advises E&Ps to evaluate their financial positions early. Borrowing-base redeterminations are fairly standard and routine, he says. Producers should be able to predict where they come out.

“They have an opportunity, if they self-analyze before the release of their mid-year reserves report to the lenders, to know whether they should be adding a few more hedges or the like to cover any potential shortfall in the calculations,” he says.