U.S. RESERVE BASE LENDING: A BRAVE NEW WORLD 68 TH ANNUAL OIL & GAS LAW CONFERENCE Presented by: Dewey J. Gonsoulin, Jr. I. Introduction A. Focus is on Upstream Energy Finance B. Basics of Reserve Based Lending C. History Prior to the Downturn D. Factors Leading to the Commodity Price Decline E. Reactions by Borrowers and Lenders During the Downturn F. Changes in the Upstream Energy Finance Market G. Limits on Prognostications 2 1
II. Overview of Reserve Based Lending A. Loans supported (and usually secured) by oil and gas assets B. Very good track record great product when properly structured 1. Borrowing Base Revolving Loans 2. Development Term Loans C. Primary Risks to Lenders 1. Price risk 2. Production risk D. Mitigants 1. Conservative Underwriting 2. Hedging 3 III. History and Cycles A. Mid 1980s were terrible B. Recovery and then a relatively short downturn in late 1990s C. Next major downturn was 2008 2009 D. Great run of almost 30 years of successful reserve based lending E. This downturn was different 4 2
IV. 2010 2014: A Great Time for Borrowers and Lenders A. Positive metrics set the table for strong growth B. Price recovery fueled by increased demand C. Strong production growth D. Increase in reserve based lending 1. Energy lending is a safe bet strong historical recoveries 2. Strong income potential upfront fees, M&A advisory, investment banking fees 3. Benign regulatory environment model is validated so no reason to change 5 IV. 2010 2014 (con nued) E. Great time for borrowing using debt to fuel growth made good economic sense 1. Favorable interest rate environment fed policy kept rates low 2. Secured lending options broad array of products available to borrowers 3. Capital markets debt 6 3
V. Capital Markets Debt A. Huge growth during this period B. Attractive to lenders/investors 1. Better return than treasury instruments 2. Tangible asset is attractive 3. Strong track record of recovery 4. Lots of fees for underwriting banks C. Attractive to borrowers 1. Long term nature of debt instrument 2. Ability to reload revolving credit facility 3. Tremendous amount of capital available 7 VI. The Downturn A. Begins in Fall of 2014 B. Supply side problem vs demand side C. Very deep and very prolonged D. Both oil and gas prices fall E. Paralysis no one knows how long it will last 1. Borrowers start to hunker down 2. Banks advise against asking for anything 3. Some companies are affected almost immediately because of lack of hedging and other problems (overleveraged) 4. A very few deals were done early, but markets are otherwise essentially frozen 8 4
VI. Downturn (continued) F. Spring 2015 redetermination 1. Borrowing base reductions are not too bad because of hedging 2. Prices start to rebound creating a window of optimism G. Dead cat bounce prices fall during summer of 2015 1. It becomes apparent that the downturn is going to last 2. Inventories remained high a. Companies kept drilling b. OPEC refused to cut back 3. Some aggressive lenders got burned here 9 VII. Gearing up for the Fight A. Companies assess their financial situation 1. Timing of potential defaults 2. Liquidity situation 3. All of this points towards how much time until you hit the wall B. Lenders prepared as well 1. Almost all credits impacted 2. Reorganization of workout groups 3. Different approaches some decide to exit the space 10 5
VII. Gearing up for the Fight (continued) C. Covenant problems 1. Leverage ratio typically first covenant breached 2. Reaction by lenders depended on situation 3. Liquidity (and how long it lasts) is major factor D. Cash is king 1. Few ways to obtain it though 2. Hedging 3. Capital markets 4. Asset sales 5. Loans 11 VIII. Restructure Problems for Lenders A. Collateral issues 1. Required mortgage percentage 2. Bank accounts B. Defensive draws 1. Revolving credit facilities were a great source of liquidity 2. Availability existed because of prior pay downs 3. Window to draw down was limited a. Looming covenant breaches b. Borrowing bases likely headed down 12 6
VIII. Restructure Problems for Lenders (continued) 4. Provides valuable liquidity a. Cash can buy time for a restructuring b. Used as bargaining leverage with lenders c. Pre funded DIP facility 5. Lenders hated it exposure increases at worst possible time 6. Funding challenges 7. Cash often left the system not collateral in many deals 13 IX. The Lenders Counterattack A. Frustration over increased exposure and lack of cash collateral B. Anti cash hoarding requirements 1. Minimizes amount of excess cash permitted on balance sheets 2. Draw condition 3. Mandatory prepayment 4. Implemented widely by banks, but lots of disagreements over importance and effectiveness C. Collateral improvements 1. Liens on bank accounts and cash 2. Increased mortgage percentage requirements 14 7
X. Spring 2016: A Period of Transition A. Many companies restructure their debt B. Large number of bankruptcies C. Commodity prices creep up and appear to stabilize D. Capital markets improvement first equity, then debt E. Mergers and acquisitions activity increases 1. Bid ask spread narrows 2. Growing confidence that bottom has been reached 15 XI. New World Order A. Market participant changes 1. Borrowers some are gone, but survivors are stronger 2. Lenders some have cut back, but positive signs exist B. Regulatory changes 1. New OCC underwriting criteria and guidelines published (March 2016) 2. Changes in classification 3. Implementation of new underwriting criteria 4. Regulated banks may be more conservative in underwritings 5. Potential opportunity for unregulated lenders 16 8
XI. New World Order (continued) C. Loan documents 1. Anti cash hording provisions here to stay? 2. Changes in collateral requirements 3. Financial covenant alterations 4. Mandatory hedging D. Role of sponsors 1. Good support for lenders during downturn 2. Relationships appear strong 3. Signs of increased activity 17 XII. Conclusion 18 9