Developing solutions for energy SMEs

The heady days of oil at $147 a barrel will now seem a distant memory for many small to mid-cap oil and gas companies. An increasing number of them face rising payments to service debt facilities taken on during the boom to fund ambitious growth strategies or, indeed, the need to pay down debt facilities as the value of the collateral for such facilities – the cashflows from their oil and gas reserves – has plummeted. And all this in an environment where lending banks are increasingly under pressure to pull in loans and reduce balance sheet exposures. Many of the companies affected have some difficult choices ahead if they are to weather the storm and it is those choices (together with the attitudes of the lending banks) that will have a significant impact on the success, failure or consolidation of companies in this sector. This article examines some of the debt structures (focusing, in particular, on borrowing base facilities) taken on by small to mid-cap oil and gas companies, and considers some of the options which may be available to deal with and manage debt repayment obligations.

During the period of bumper oil prices, many oil and gas companies took on substantial amounts of debt to finance the development of upstream assets. A lot of this debt is in the form of borrowing base facilities (“BBFs”) under which the amount capable of being borrowed from time to time is calculated by reference to net present value of cashflows from their reserves, which of course varies according to oil and gas prices. The borrowing base is typically redetermined every six months and a repayment will be necessary if the outstandings exceed the new borrowing base amount. BBFs are structured as reducing revolving facilities so that after perhaps the first couple of years of the term of the facility, the lenders’ commitments step down every six months, coincidental with the redetermination of the borrowing base. So in fact any repayment will be the greater of the amount required to reduce the outstandings to the new borrowing base amount and the amount needed to reduce the outstandings to the reduced aggregate commitments of the lenders.

BBFs typically have a term of between five and seven years (subject to a reserve tail date, if earlier), so the step down in commitments after any initial grace period is likely to be fairly steep. Traditionally, BBFs were built around a portfolio of assets with a good mix between producing and non-producing assets, giving considerable comfort that the borrower would have sufficient cash flow from producing assets to meet any committed expenditure, service interest and pay down principal as required on redetermination dates. More recently, the BBF model was adapted for companies with a much bigger development element in their asset portfolio, resulting in a financing more akin to a project financing, though without the full panoply of controls typical of a traditional project financing.

An invariable principle under BBFs, however, is that to qualify as borrowing base assets, the assets in question must at least have received final development plan (“FDP”) approval. Historically, lending banks would not fund appraisal expenditure in respect of pre-FDP assets. But in an apparently benign environment of high commodity prices and deep liquidity, facilities to fund such expenditure became available. These facilities are called Undeveloped Asset Backed facilities (“UDABs”) or Pre-Sanction Facilities (“PSFs”) and have typically been made in conjunction with a BBF or at least as a precursor to a BBF, albeit only by a small number of specialist banks. Debt structures generally became more complex, possibly involving several layers of different types of debt including senior, stretch senior, mezzanine, UDAB/PSF and corporate level (and hence structurally subordinated) convertible bonds. Multi-layering of debt was used to increase leverage for the purposes of allowing small to medium-sized companies to acquire fairly large portfolios of assets or to fund fairly sizeable developments. Having said all that, the fundamentals of reserve-based financing have remained fairly conservative compared to forms of lending in other sectors; the available debt amounts under BBFs calculated by reference to the six-monthly projections have not in themselves been excessive, and under UDABs/PSFs the value ascribed to each barrel of oil in the ground is only a very few dollars. The problems have largely arisen where groups have incurred exploration and appraisal expenditure on non-borrowing base assets and that expenditure is not included in the projection. The expenditure may be incurred by a member of the group which is not a BBF borrower but, nevertheless, it represents a drain on the cash of the group which might otherwise have been available as “equity” to support the development activities which are taking place within the ambit of the BBF.

During the development boom in 2007/2008, capex commitments were entered into, which in some cases are now proving difficult to curtail quickly. The upshot is that, with the fall in oil and gas prices resulting in lower borrowing base amounts, a significant number of oil and gas companies are finding themselves in a liquidity trap. Some companies are in the fortunate position of having sufficient cash reserves, or production rates, to enable them to service their debt obligations in the near to medium term. For others, however, the liquidity trap referred to above means they need to consider urgently solutions to service their debt obligations. These solutions can involve the renegotiation of facilities, raising equity from current shareholders, raising cash from a strategic investor or mergers with other companies. Probably the most obvious option for borrowers is to renegotiate repayment terms. However, in the current economic climate, and given the difficulties which many of the lending banks themselves are in at the moment, they are not able to be as accommodating as they might have been in more normal times to requests from borrowers for debt service holidays and reschedulings. Accommodation may be forthcoming, but it will probably come at a significant cost, and may be on the condition that a “for sale” sign is put up by the borrower over some of its crown jewel assets, with the proceeds being used to pay down the bank debt. A quick∞fire sale of assets, while not ideal, may be the only option for some if debt facilities are being slowly but surely recalled. The problem with this strategy is that the price gained for such assets may be at a discount to their value as a result of the need to inject cash quickly.

For some companies the problems associated with restructuring of debt will lead them to look at raising equity, either through existing shareholders or via a third-party injection of cash from a strategic investor. Raising equity from existing shareholders is, however, difficult in the current market. Not every small or mid-cap oil and gas company is in the enviable position that Tullow Oil (a FTSE 100 company) was at the start of 2009. Tullow successfully raised £402m by way of a placing of shares in order to, among other things, fund exploration and development opportunities in Ghana and to commercialise its assets in Uganda. It is worth remembering that Tullow was able to do this off the back of major exploration and appraisal success in both Ghana and Uganda.

An injection of cash from a new strategic investor is also an option. Such cash might be injected for shares (in which case there is the issue of how existing shareholders will react to the dilution) or it may be injected at the asset level. In autumn 2008, Dyas (a wholly owned subsidiary of SHV, the largest privately owned conglomerate in The Netherlands) acquired a 25.25 percent interest in Ithaca Energy’s North Sea oil and gas assets, and also stepped into the shoes of RBS under Ithaca Energy’s UDAB facility. The next few months will be a crucial time for several small to mid-cap oil and gas companies faced with onerous debt repayment obligations, and there may well be difficult times ahead if the credit situation does not improve and oil prices do not rise. For some, lending banks will continue to provide finance and shareholders (or new investors) will agree to inject new cash. There is no doubt, however, that the sector has taken a hit in the last few months and many are speculating that there are some good deals to be had for larger companies with the cash and the desire to purchase a bolt-on company (or asset portfolio) with attractive production, reserves or resources. 2009 may well see consolidation in the sector and certainly more surprises in these uncertain times.

Ashurst is a leading international law firm advising corporates and financial institutions, with core businesses in mergers and acquisitions, corporate and structured finance and the development and financing of assets in the energy, transport and infrastructure sectors.