OCC Issues Handbook on Oil and Gas Exploration and Production Lending

Oil and gas exploration and production companies (E&P Companies) are in the news because they are restructuring or filing bankruptcy as a result of the fall in oil and gas prices. On March 16, 2016, the Office of the Comptroller of the Currency (OCC) issued the Handbook on Oil and Gas Exploration and Production Lending to provide guidance to bank examiners and banks addressing loans to E&P Companies.¹ The Handbook is also helpful to lawyers representing E&P Companies because it provides guidance on when loans to E&P Companies must be classified as non-accrual, and when the loans must be reserved against. Lenders tend to be more flexible if a loan is performing than if it must be placed on non-accrual and/or reserved against.

E&P loan underwriting standards share many of the same characteristics as those for lending to commercial enterprises in other industries. This paper addresses those areas unique to E&P loans. Most loans by banks to E&P Companies are secured by mortgages and liens on the borrower’s reserves, and the amount of the commitment is based on a borrowing base calculated as a percentage of the borrower’s proved reserves. The borrowing base generally is re-determined twice a year. These reserve based loans (RBL) differ from other asset-based loans because the collateral is not as liquid as loans secured by accounts and inventory. In addition, the cash flow to pay off the RBL requires additional expense to get the oil and gas out of the ground and may require capital investment to keep the oil and gas flowing. Sale of the reserves may take up to one to two years during which production will probably need to be maintained in order to keep the leases active. Unlike traditional asset based loans, a decline in the borrowing base of an RBL does not necessarily coincide with reduced funding needs.

Cash flow from operations is the primary source of repayment for most E&P loans with secondary sources from collateral sales, other asset sales or funds from issuance of debt. Therefore, the Handbook provides that E&P Companies should be evaluated through an assessment of current and projected financial condition and operating performance, cash flow and debt repayment capacity, liquidity, capital strength, collateral protection and guarantor or sponsor support.²

E&P Loans are subject to the Interagency Guidance on Leveraged Lending. Risk rating for leveraged loans relies on the use of realistic repayment assumptions to determine a borrower’s ability to de-lever within a reasonable period. However, a borrower’s ability to repay the RBL and total debt are assessed relative to the economic life of the borrower’s oil and gas reserves, rather than the five to seven year period discussed in the leveraged lending guidance.³ The Handbook provides a sample repayment test to determine whether the borrower has the capacity to repay total secured debt from excess cash flow within a reasonable time. The example test looks to the cash flow available for debt repayment of the beginning borrowing base commitment of the RBL and then total debt compared to the economic life of the proved reserves.⁴

The Handbook provides that an E&P loan should be considered impaired when, based on current information and events, it is probable the bank will be unable to collect all amounts due according to the contractual terms of the loan agreement. For regulatory reporting purposes, an impaired E&P loan should be measured for impairment based on the fair value of the collateral. Generally, the fair value of the reserves should be based on the risk-adjusted net present value of the total proved reserves unless more appropriate comparable sales information is available.⁵ The Handbook sets forth the factors to be considered in rating a loan special mention, substandard, doubtful, loss and non-accrual. Whether the leverage metrics have increased or exceed industry norms is among the factors to be considered for classifying a loan. The factors to be considered in classifying an RBL as substandard include:

• Whether total funded debt divided by EBITDAX⁷ is greater than 3.5x;
• Whether total funded debt divided by the sum of total funded debt and equity is greater than 50 percent; and
• Whether total committed debt is between 65 and 75 percent of the total unrisked⁶ and undiscounted proved reserves.

The factors to be considered in classifying an RBL as substandard or worse include:

• Whether the repayment of the RBL is beyond 75 percent of the proved reserve’s economic life or repayment of total committed debt is beyond 90 percent of the proved reserves economic life;
• Whether the borrower has breached covenant limits or needs covenant waivers;
• Whether the borrower’s liquidity and cash flow are insufficient to fund operations and meet projected capital expenditures;
• Whether total funded debt divided by EBITDAX is over 4.0x;
• Whether total funded debt divided by the sum of total funded debt and equity capital is over 60 percent; and
• Whether total committed debt is greater than 75 percent of the total unrisked and undiscounted proved reserves.

Banks typically limit the contribution of proved developed nonproducing reserves (those shut in and behind the pipe) and proved undeveloped reserves in the calculation of the borrowing base. However, the Handbook provides that the collateral evaluation for regulatory classification purposes should include all proved reserves that are collateral subject to market and production risk adjustments.⁸ Similarly, while most borrowing base calculations exclude the first six months of production, the collateral evaluation for classification purposes should be as of the same date of the evaluation. The evaluation should include hedges, but it should exclude probable and possible reserves.

The balance of an RBL that is in excess of the value of the collateral for regulatory ratings up to the value of the unrisked proved reserves should be classified as doubtful when the potential for loss may be mitigated by the outcome of pending events or when loss is expected but the amount of the loss cannot be reasonably determined.⁹ The portion of the RBL that exceeds 100 percent of the unrisked NPV of proved reserves should be classified as loss. Similar to other commercial loans, an RBL should be placed on nonaccrual if the loan is maintained on a cash basis because of deterioration in the financial condition of the borrower; payment in full of principal or interest is not expected; or principal or interest has been in default for 90 days or more unless the asset is both well secured and in the process of collection.

The Handbook provides guidance for lenders and borrowers dealing with financially distressed E&P Companies. Generally, RBL’s are treated the same as commercial loans for determining regulatory ratings and impairment with some important differences. RBL loans are risk rated for leveraged loan purposes by looking to the remaining economic life of proved reserves after the RBL and total debt have been repaid rather than the 5 to 7 year period used for most leveraged loans. Similarly, the comparison of the RBL and total debt to the proved reserves economic life is one of the factors which determines whether an RBL is impaired, doubtful or loss. For purposes of impairment, the reserves should include all proved reserves that are collateral adjusted for market and production risk, the first six months of production and hedges. While it was issued shortly before the next redetermination of RBL reserves, the Handbook will probably have some effect on the redetermination process and values.