An already scantily clad debt market became even more threadbare in 2020, leading oil and gas companies and lenders in the space to find alternative solutions in the New Year.
The number of banks willing to risk exposure to the oil and gas sector has dropped and some institutions have pulled up stakes completely, panelists said during a January panel hosted during IPAA’s Private Capital Conference. E&Ps can expect tighter reserve-based lending (RBL) structures and smaller capital raises as investment vehicles such as volumetric production payments are dusted off.
Phil Ballard, managing director and head of reserve-based lending at Citi, said oil and gas spent the past 12 months surviving an existential crisis. As many as a third of banks decided to exit reserve-based lending because of their losses or the perception of a perpetually wobbly market.
Others are unwilling to underwrite a transaction because of the ongoing volatility in the commodity. As Citi talks with other bankers, Ballard said he sees the universe of banks willing to add new exposure at perhaps 10.
Further, the smaller universe will likely complicate transactions for companies putting together A&D deals.
“Two years ago, we probably could have pulled together 20 [or[ 25 banks, you know, in a new transaction,” he said. “Obviously, you could do a much larger transaction and feel pretty comfortable underwriting the risk.”
Ballard said banks willing to take on new exposure could build a “new money deal in the $350 million to $400 million range. So those aren’t huge facilities. [But] they are huge now.”
Banks sidelined by market conditions may return to the sector after more stringent, de-risking elements are brought to lending productions, he said. That would include less aggressive borrowing bases, less leaning into proved undeveloped assets and tighter lending structures.
Jack Smith, head of oil and gas leveraged finance at J.P. Morgan, said banks have clearly learned that leverage in the sector needs to be lower, price volatility is inevitable and hedging is a good thing.
“Market capacity should slowly come back, but we’re expecting it to take a while,” he said.
J.P. Morgan will consider underwriting loans, but only to companies that closely match the bank’s expectations.
“It's going to have to really fit the box well,” Smith said. “It's going to have to be of a manageable size, especially on the RBL side. But with the bond market opening back up, as long as we can kind of minimize the timeframe until we go to market to de-risk the position, I do think we'd be willing to step up for some underwrites for the right size and right structure deals.”
Smith nevertheless said he’s seen a busy start to the year and “deals we couldn’t have gotten done for the vast majority of 2020 are now able to get done. So, it’s been a great way to start 2021.”
Bryan Walker, managing director at Sixth Street Partners, said that oil and gas companies need to seize the optionality their business models allow. The RBL market became too stretched and operators became accustomed to the financing as permanent rather than as working capital.
“Relying on it to the degree they did, I think things got to a bit of excess,” he said. The fallout from 2020 will “push operators and the market generally to design and come up with alternatives solutions that better fit the needs of the space and do so in a way that allocates risk and shares the risk appropriately.”
Walker said some creative financings were put together in 2020 despite the incredible obstacles at hand. He grouped those into balance sheet oriented solutions and structure asset level solutions.
“On the balance sheet, we’re talking unitranche first lien term loans, which can be applied in the context of refinancing to fund development, finance acquisitions,” he said. “It offers the simplicity of being a one-stop-shop solution, but you don’t have to manage a large syndicate of banks and then go out and raise junior capital and negotiate in creditors and so forth.”
Unitranche refers to middle market loans ranging from $50 million to $500 million originated by three to five lenders, according to Richards Kibbe & Orbe LLP law firm. The unitranche facility is provided under a single credit agreement, with a single set of security documents, and does not add first and second lien facilities.
Sixth Street has also deployed asset-level financing mechanisms, which provide capital to operators for refinancing, development or making acquisitions. The funding “doesn’t burden the balance sheet with debt but also doesn’t require taking on diluted equity,” Walker said.
In June 2020, Antero Resources Corp. closed an overriding royalty interest (ORRI) transaction with Sixth Street for proceeds of up to $402 million. Antero said it would use the proceeds to repaying revolver borrowings.
The funding provided Antero with “a solution, directly at the asset level that provides them with significant upfront proceeds, but it doesn’t … cause any sort of equity dilution,” he said. Asset level funding can be structured “in the context of overrides, working interest assets, even midstream assets that are owned and operated by upstream companies.”
The ORRI provided Antero with $300 million of upfront proceeds and up to $102 million of additional proceeds for a 12-month period. The ORRI was comprised of a 1.25% ORRI in all producing wells and a 3.75% ORRI in wells completed on existing acreage during the next three years.
Following a 13% internal rate of return and 1.5x cash-on-cash return to Sixth Street, Antero will have an 85% reversionary interest in the ORRI and Sixth Street will have a 15% remainder interest.
The predictability of oil and gas asset cashflows allows for “a lot of different ways to sort of allocate and reset those cash flows in a way that limits the burden on the operator’s balance sheet, but also limits the dilution from an ownership perspective,” Walker said.
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