The same merger trend that has spawned supermajor oils has prompted a consolidation of financial institutions, which threatens to reduce the number of oil-patch bankers that will lend independents $1 million or less. So where within the banking community can the small producer turn? These producers will make it past the receptionist at six of the 10 bank energy lending departments contacted by Oil and Gas Investor. (See chart.) Comerica Bank-Texas and Hibernia National Bank in New Orleans each like to make loans of at least $2 million. The magic minimum for Bank United and Southwest Bank of Texas is $3 million. While banks undeniably have to pay attention to lending economics, they will still listen to a good story. All 10 bankers contacted emphasize they want to hear from experienced management teams that have a definite focus on growing their oil and gas companies, and whose success will help grow the bank's energy lending department. Comerica senior vice president and division manager V. Mark Fuqua in Dallas says his bank is willing to work hard on financing for companies with potential. For example, it helped Matador Petroleum Corp., which in 1998 exchanged a large block of properties for equity. As a result, Unocal Corp.'s Spirit Energy 76 owns a minority interest in Matador. "A Dallas-based independent, Matador started borrowing from us about five years ago with a $5-million line of credit. They've grown through a balanced program of acquisitions and development with some exploration," Fuqua says. "At times, we have chosen to be aggressive to give them a good borrowing base so that they would have plenty of dry powder. We did that because of the company's track record and its quality management. Matador has performed as promised, resulting in a credit facility in the neighborhood of $50 million." Startup companies will have the hardest time finding a lender, not counting family and friends, unless the company's managers are already known to a particular banker. Michael "Mickey" Coats, senior vice president with the Bank of Oklahoma, established an initial $10-million facility for Brighton Acquisitions Co. in Tulsa to acquire a package of working interests and overrides from a utility. The loan was made in about two weeks. "This was the initial acquisition for this startup company. We knew the principals, and we were very confident because we had seen them build companies a couple of times," Coats says. "Brighton Acquisitions heard of a deal during Thanksgiving. We were able to get the facility finalized by December 16." With funding, Brighton closed the utility acquisition, rolled up several smaller transactions and had some left with which to continue to grow. Stephen Kennedy, vice president and manager of energy lending for Houston-based Southwest Bank of Texas, says small independents are underserved by banks because of size limitations. "It's difficult to find any bank that will look at a deal under $5 million. As banks continue to merge, the minimum loan numbers get bigger." Southwest Bank started its energy lending business in 1997 with a minimum loan requirement of $1 million. It raised its minimum to $3 million, citing the cost of doing business for the client and the bank. "We do not want the expense of doing a deal to be such that a customer is unhappy with the bank on the day we close. That is not the way we want to begin a relationship," he says. "We arrived at our minimum through experience. Deals that have financing requirements of less than $3 million generally will have some undesirable characteristics, like a concentration of value in relatively few wells." Borrowers looking for loans under $3 million need to consider the cost of doing business, Kennedy says, adding it can cost a company $10,000 to get its financial statement reviewed by an accounting firm. The cost of a loan also includes engineering and legal expenses. "You put the three of those together, and it becomes cost-prohibitive at less than about $3 million." But then again, the beauty of a loan may be in the eyes of the particular lender. "The Bank of Cherry Creek's average loan size is about $300,000 to $400,000," says Allen Rheem, vice president of Cherry Creek's oil and gas division. "We consider loans starting at $100,000, but if we have a preference, we would like to see loans of at least $250,000." The Sturm Bank Group in Denver owns the Bank of Cherry Creek and its Wyoming counterpart, American National Bank in Casper. "Right now, our primary customers are independent producers, and they may or may not operate. About 95% of our customers are in the Rocky Mountains, basically from Montana through New Mexico," Rheem says. Both Rheem and Coats emphasize the importance of stability to their customers. Neither changed lending parameters after the latest downturn. "We may have periods where some of our customers might be in a little bit of trouble like several months ago, but we're consistent and we will work through those times, which we did," Rheem says. The Bank of Oklahoma and its sister bank, the Bank of Texas, are subsidiaries of BOK Financial Corp., a Tulsa-based bank holding company whose biggest shareholder is George Kaiser, principle owner of Kaiser-Francis Oil Co., a private Tulsa independent. "We basically market the idea that we are in oil and gas lending for the long term. We are owned by an energy guy," Coats says. "We don't make big sweeping changes because of the peaks and the troughs." The Bank of Oklahoma never gave credit for proved undeveloped reserves, he says. "A lot of banks give some credit to PUD reserves. We have always loaned primarily against proved developed producing reserves, with a small amount given to behind-pipe reserves in certain situations." Frank T. Smith, Bank of Texas executive vice president and manager, says Kaiser's motivation for branching beyond exploration and production into banking stemmed from concerns about the disappearance of the regional bank, first in Oklahoma and then in Texas. "He believed a niche existed for banks catering to smaller oil and gas independents not on the radar screen of the larger bank players." The Bank of Texas targets the middle-market, usually privately owned, company that is underserved by the large money centers and the super-regional financial institutions, Smith says. Bank of Texas is based in Dallas but looking for opportunities in other cities such as Houston and Midland. It lends primarily to producers, but also seeks opportunities with gas gathering and processing companies. "Our target loans are between $5- and $20 million," Smith says. "We will look at deals between $1- and $5 million when we see some real growth potential, either through the core properties or because of their acquisition strategy." He will consider lending to startups of people with proven track records, such as someone who successfully grew a company, sold it and is starting another. Charles Spradlin, senior vice president of Citizens Bank's oil and gas loan department, considers it a privilege to have an oilman, Larry T. Long of The Long Trusts, an independent in Kilgore, Texas, as the bank's board chairman. "The accounting and banking logic fits most normal businesses, but it is not for the oil business," Spradlin says. "Startup or growth-oriented oil companies really are not geared for normal banking practices. Energy banking is not really taught in a book. It's something that you live with and grow with." A petroleum engineer himself, Spradlin makes loans ranging from $50,000 to $5 million with the typical loan being about $200,000. His customers come from throughout the state of Texas and are generally independents who have carved out a niche. "We were making loans when oil was $10 and when oil was $25. We do it the same way," Spradlin says. "Our customers are breathing a sigh of relief with the better prices because we had stretched out some of our loans by as far as 10 years." Citizens Bank has not had a foreclosure or lost money on an energy loan, Spradlin says; some customers extended the terms of their loans during the last downturn. "Our customers were still able to make their interest and principal payments, but they didn't have extra cash to do anything else with, like improve their properties." Murray E. Brasseux, executive vice president and manager of Compass Bank in Houston, estimates that $1-million loans comprise about 10% of the lending department's activity, although Compass is willing to do more loans of this size. Brasseux's department helps companies locate equity dollars by introducing his customers to people, sometimes other Compass customers, who can provide equity. "We had a group that made an acquisition that was a little large for them, and they didn't have the operating skills really necessary to do it. We introduced them to a client of ours who was able to come in and purchase half the property and serve as the operator. That helped both clients," Brasseux says. Compass Bank has adjusted the percentage of proved undeveloped reserves that it will loan against. "Previously, we said 20% of the present value could consist of nonproducing reserves, and we did not really differentiate between behind-pipe and proven undeveloped," Brasseux says. "We'll still go 20% nonproducing, but we don't want PUDs to exceed half of that." Southwest Bank has always limited PUDs to 10%. "Proved undeveloped reserves can evaporate in a hurry," Kennedy says. "When prices decline, proved undeveloped reserves sometime completely disappear because they become uneconomical to drill...I think everyone learned in this downturn the negative effect of lending too much on PUDs. We don't want that sort of risk profile." Gardner Cannon, Bank United senior vice president and director of energy lending, agrees he would rather lend against behind-pipe reserves than undeveloped reserves. "We're not too excited about proved undeveloped as a basis for a loan, but proved developed nonproducing, now that is something we look carefully at," Cannon says. "We give little or no credit on PUDs." Houston-based Bank United is a newcomer to the energy industry not well known outside the real estate lending market yet. "But there is an active movement to diversify Bank United, and energy is one of the areas that is of prime importance," Cannon says. Bank United acquired Midland American Bank in April 1999 and its small portfolio of energy loans. "We've just really started here in Houston with energy lending," Cannon says. "Business looks very favorable right now. You couldn't be starting at a better time with oil prices doing what they are." He expects Bank United's energy borrowers will be small independents wanting loans of $3- to $30 million. "Bank United is starting with a clean book here in Houston. We don't have any problems to push in front of us, and we don't intend to accumulate any," Cannon says. "We are going to make reserve-based loans in a business-like, conservative manner." Norwest Bank of Texas allows 25% of the borrowing base to be comprised of behind-pipe reserves and PUDs, says Mark McKinney, Norwest senior vice president in Midland. "They've got to have the capital, or the ability to borrow the money to develop those reserves, before we give credit for undeveloped. But we do look at those, and we also do some mezzanine lending. It's really more project financing through a subsidiary, Wells Fargo Energy Capital. Through that arm, we do make loans more predicated on nonproducing reserves...They are higher-risk loans, so we price them appropriately." McKinney says mezzanine lending is available to help customers in ways that the conventional bank's energy lending department cannot. The goal is to help those customers grow so they can qualify for bigger conventional loans at Norwest. "For instance, a regular energy bank customer had a lot of good prospects, and they had gotten up to the $5-million borrowing level, but they could not get beyond that for lack of enough proved developed producing reserves. So, we took them into our mezzanine company and essentially did some project financing for them," McKinney says. "Over a two-year period, they were very successful on a couple of wells in Louisiana. They actually borrowed up to $50 million for a very brief time, made some asset sales, brought their debt down and had enough PDP reserves to move the deal back to just a conventional production loan," McKinney says. His clients got through the downturn fairly well, he adds. Because Norwest offers hedging services, many of its significant borrowers were hedged to some extent. "There were some clients that were unhedged that did kind of get their nose bloodied, but we haven't had that many workout deals," McKinney says. Norwest also is considering getting into production payment financing and has hired someone having experience in this field. Lyndsay Job, Hibernia senior vice president and manager of the energy-maritime division, says Hibernia Energy Investment Corp., a subsidiary of Hibernia's holding company, offers mezzanine financing and equity capital to exploration and production companies. Hibernia Energy Investment is managed by Robert C. Stone Jr., a petroleum engineer. "We have E&P mezzanine clients who do their secured borrowing with other energy banks. Will our mezzanine or equity investment efforts lead to an opportunity to take out that senior lender? I don't know, but at least we are in their financial picture and recognized as a provider of capital to well-managed small-cap companies," Job says. During the past four years, Hibernia has developed a portfolio of small energy equity investments and mezzanine project loans. The deal structure centers on nonrecourse, secured transactions bearing a relatively high coupon interest rate plus an overriding kicker. "We are a niche provider with a small capital base. Our deal size focuses in on relatively small transactions that are low risk," Job says. Spradlin says the lesson from the downturn is that it's better to be an energy lender with oil and gas prices increasing rather than decreasing. "The independent producer learned that it's better to have a mix of oil and gas production plus quality properties that generate cash flow when prices are low." Regardless of the cycles, oil and gas companies will always need capital. All 10 bankers say they are in oil and gas lending as a long-term business.