A more favorable commodities market for oil and gas prices often has led to more U.S. drilling activity, but producers into 2024 may face volatility and less-than-enthusiastic lenders, according to a new survey by Haynes and Boone LLP.
The law firm’s semi-annual Borrowing Base Redeterminations Survey found that exploration and production (E&P) companies may not seek reserve-based lending (RBL), even with the stronger commodity prices.
Lending redeterminations are done twice a year, as the value of an upstream E&P’s oil and natural gas reserves changes with prices. An RBL is structured as a revolving loan, with credit availability based on the current value of the reserves. The survey of more than 100 executives who work at E&Ps, financial institutions, private equity firms and professional services firms found an unlikely market for a lot of borrowing base increases this fall.
“Volatility continues to be a common word in any oil and gas industry call, and there’s no sign of that fading soon,” Haynes Boone partner Kraig Grahmann, head of Energy Transactions Practice Group, said.
“Our most interesting finding may be that despite lingering RBL market pessimism, participants in the RBL financing market are showing new interest in funding drilling and completion programs, which is a change from prior years, where lenders closely scrutinized developmental capital expenditures.”
Declining RBL Market?
The latest survey, the firm’s 18th since 2015, was conducted following the third quarter run-up in commodity prices, which researchers noted was driven by global demand and the ongoing conflict in the Middle East.
A “meaningful decrease” in lending is expected in the coming year for those E&Ps that want to use commercial bank RBL capital as a financing source.
“Instead, industry executives expect to use equity and debt from capital markets more in 2024 than in prior years,” Haynes Boone researchers noted. “From spring to fall of this year, expectations of use of debt capital markets increased from 5% to 8%, and equity capital markets tripled from 2% to 6%.”
According to the survey, almost one-half (49%) of the respondents said RBL lenders were “slightly interested” in funding more drilling, while 7% said lenders were “very interested.” Another 25% were neutral. More than one-third (35%) expect to see only a 10% increase in borrowing bases this fall. Slightly more than 40% expect no change at all.
NGI’s Patrick Rau, who directs Strategy & Research, said, “generally speaking, producers are still working on bringing down their debt levels, so that would argue for them not tapping into revolvers as much.
“I completely agree that producers are using cash flow from operations (CFO) as their key financing mechanism. Producers in general right now are only reinvesting about 50% of their CFO these days, and Wall Street expects that ratio to decline even further in 2024.”
Another element unlikely to change is the increased hedging percentages that first popped up last spring, according to the Haynes Boone survey.
About one-third of the respondents said they expect borrowers to hedge 50% of their future oil and gas production over the next year, while close to one-quarter said 60% would be hedged.
Strong ‘Underlying Fundamentals’
Grahmann, who shared more insight about the survey with NGI, said the lending market has evolved as the Lower 48 E&P industry has transformed.
“The underlying fundamentals of the upstream oil and gas business are strong,” Grahmann said. “Global tensions underlying fundamentals are strong. Unfortunately, those fundamentals don’t translate into a lot of reserve based lending availability for oil and gas producers. The underlying RBL market is tight despite those fundamentals.”
RBL rates are floating rather than fixed, usually with a margin similar to a base rate or prime rate plus a certain margin.
Executives who are considering taking out loans keep their eyes on the direction of interest rates “when deciding whether or not to borrow,” Grahmann said. “That being said, even with the higher interest rate environment we are seeing right now, the RBL is probably still a lower cost of capital than other capital sources available to borrowers…I don’t think a higher interest rate would be materially impactful on a company’s decision” about whether to borrow.
As there have been several big-ticket E&P mergers announced in the last few weeks, could companies lean on their revolvers to make some deals?
“I think they might lean on them a little bit,” Grahmann said. “It’s a good question to ask because…that was something we saw more in 2012, 2013 and 2014, where a company could reliably draw pretty heavily on its revolver to make an acquisition.” An E&P then could go to the debt markets or the equity markets and pay down the loan.
“Even though we’re seeing improvement in the use of debt markets and equity capital markets, it’s not so robust yet that I think a company would be willing to heavily use a revolver as sort of a bridge financing to get to the acquisition baseline,” he added.
“And certainly, lenders are not going to be very supportive of a situation where a borrower is so heavily utilizing a revolver that, if there’s a future decrease, it could be in troubled territory.”
Curbed Enthusiasm
Grahmann also was asked about the prevailing mood of the U.S. E&P industry. During the recent third quarter conference calls, management teams have not appeared as enthused about their future oil and gas prospects as they were in the mid 2010s.
The changing mood has everything to do with the maturing Lower 48 unconventional industry, according to Grahmann.
A lot of the E&P management teams in place today began their careers during the “more exciting” period from 2010 to 2014, as the Lower 48 transformed the world’s global energy supplies through hydraulic fracturing and unconventional drilling.
“The U.S. basically reinvented itself with respect to energy resources through hydraulic fracturing,” he noted. That made resources more commercially available. “And so it was an exciting time, because you could basically go out and discover and develop a new play that people thought was uneconomic.
“You could build your asset base, to the point with plenty of financing available. You could basically fund the drilling budget or an acquisition budget that was way in excess of your cash flow…
“And now, it's a much more boring sort of positive cash flow generating business model, which helps you withstand volatility, but it doesn’t have the excitement of 10 years ago…We always love exotic deal structures,” and “reforming debt structure is not is not as exotic as say when you need to really stretch and raise a bunch of debt capital.”
