Recent deals have brought more attention to the nascent market of oil and gas securitizations. While oil and gas price increases have opened up traditional sources of capital, the securitization structure is a new tool to add to the traditional sources of financing such as the increasingly volatile leveraged lending market and public debt and equity markets. Many producers are now interested in how these transactions are structured and practical considerations as to whether to implement this new type of structure.
A securitization is a highly structured financing designed to issue notes with amortization that matches a predictable cash stream. The assets that give rise to the cash stream are transferred into a newly formed special purpose vehicle (SPV) to isolate those assets from operating and corporate risk of the sponsor group. The general securitization structure has been around for decades and is a common investment structure for certain institutional investors that require investment grade notes and steady amortization and interest payments.
The market for oil and gas securitizations is a recent development that is now picking up momentum. In the context of an oil and gas securitization, the assets are the proved, developed producing (PDP) reserves of hydrocarbons to be marketed and sold in the future. In addition, to make the cash stream more predictable, the SPV will enter into hedges to mitigate price risk for the hydrocarbons to be sold. The market for oil and gas securitizations is developing for both a complete or a partial securitization—in the former, 100% of the sponsor’s interest in the PDP assets is transferred, whereas in the latter an undivided percentage (less than 100%) of all of the PDP is contributed to the SPV.
While a securitization transaction is highly structured and legally isolated, the SPV is still a wholly owned limited liability company of the sponsor group and remains on the books of the sponsor group for accounting purposes; for tax purposes, the transfer of the assets is typically a non-event if the assets are moved from one disregarded, wholly-owned entity to another.
Who should consider this structure?
The two different types of oil and gas securitizations that are developing have different potential targets. For a complete securitization, it may be attractive to a sponsor group that would like to have a capital-raising event to either provide proceeds to equity or to raise funds for the development of another project or other undeveloped assets. For a partial securitization, it can be attractive to any sponsor group that would like to diversify their sources of capital and their capital structure. By contributing a portion of the PDP assets to a securitization, the sponsor group could achieve a better blended advance rate for their debt portion of their capital structure at a price similar to issuing high-yield notes.
What type of assets are the best candidates for this approach?
The type of assets that are appropriate for a securitization will depend on the type of securitization and the structure of each securitization (related to the two types of PDP securitizations that are becoming prominent). In general, however, the most important characteristic of suitable PDP assets is a predictable cash flow profile, taken as a whole. This may be accomplished through diverse (geographically), mature wells or by a relatively similar set of assets with steady production expectations. To achieve an investment grade rating for the notes (which is a precondition for the target investors), there must be predictable production, pricing and, to the extent possible, predictable costs and expenses that could materially affect the cash flow coming into the account of the SPV.
Why this structure is gaining traction
For investors, the cash flow profile of oil and gas PDP is relatively predictable, so production risk is a tolerable variable for investors and ratings agencies. With hedging, the predictability and investment grade rating make the investment in these assets a safe way to get slightly above market returns on their investment in securitization notes from other more traditional asset classes. The market for these investors is extensive, so there is a large demand that is always looking for investment grade investments at a marginally better return.
For producers, the securitization structure is attractive due to fluctuation and decrease of certain markets for investment in hydrocarbon production. This tool, depending on the approach that is selected by the sponsor, can either be a way to diversify the capital structure of the company at an attractive price or to raise funds in a situation where other markets may be less favorable. In other cases, the whole interest securitization can be an effective way to realize a present return on assets that are not desirable for further development.
Other practical considerations
The securitization structure is still new to most producers, so many have questions about what life under the structure would be like. In general, the operator will continue to operate the assets and report to the investors, similar to the reporting requirements of a reserve based loan. However, the reporting requirements would be more robust than a typical loan, particularly around monthly cash flow statements. The securitization requires detailed accounting of revenue and disbursement of funds through a waterfall controlled by a third-party trustee.
In addition, the securitization structure typically has a period of non-call or make-whole, so rapidly repaying the notes would be costly, if not precluded. However, most securitization structures are portable for the transfer of the sponsor company as whole, i.e., if the operator and manager entities were also transferred with the SPV. Thus, a sponsor should be aware of the difficulty of removing the structure immediately after implementation.
As the oil and gas securitization structure and market continue to develop, securitizations will likely become more attractive to more investors and sponsors. The two types of securitizations are beginning to develop into a “market” precedent, which should continue the momentum of these transactions.
Daniel Allison is an energy finance partner in the Houston office of Sidley Austin LLP where he advises clients on complex commercial lending and other finance structures. He has represented clients involved in oil and gas securitizations.
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