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Appeal of Shared National Credit (SNC) (Third Quarter 2015)

Background

An agent bank appealed the substandard ratings assigned to a revolving credit and term loan during the 2015 Shared National Credit (SNC) examination.

Discussion

The appeal asserted the facilities should receive special mention ratings due to positive cash flow, elevated but acceptable leverage, ample liquidity, and appropriately structured financial covenants.

The appeal stated that the SNC write-up incorrectly reported a negative free cash flow (FCF) because 2014 FCF covered cash interest expense and maintenance capital expenditures (capex) by 1.56 times. The examiners’ FCF calculation included discretionary growth capex and distributions.

The appeal asserted the borrower had elevated but manageable leverage going into 2015 with modest senior secured leverage. The borrower was also taking a series of actions to reduce leverage through asset sales and strategic alliances. Finally, the covenant package included market standard covenants. While there is not a leverage test, this is consistent with many similar borrowers. The semi-annual borrowing base redetermination is the most important and meaningful structural element as it ensures the adequacy of collateral and sufficiency of cash flow from the asset base to repay senior secured obligations.

The appeal stated that a high level of liquidity coupled with the company’s intent to operate within its cash flow is more than adequate to support operations.

Conclusion

An interagency appeals panel of three senior credit examiners concurred with the SNC team’s originally assigned risk rating of substandard.

The appeals panel acknowledged that discretionary capex and distributions to unit holders should be excluded when determining FCF. Fiscal 2014 financial performance, however, has little bearing on the company’s future ability to repay as the drop in oil and natural gas prices occurred late in 2014 and early 2015. Because of this, the panel placed primary focus on the impact the price drop had on the value of oil and gas reserves and the corresponding effect on the borrower’s ability to repay total debt.

The appeals panel concluded that total debt was in excess of reserve valuations indicating that the company could not repay total debt from existing reserve production and hedge income. An April 1, 2015, engineering evaluation, performed after the price decline, indicated an unweighted (unrisked) present value of the cash flows discounted at 9 percent (PV9) value of future net revenues including hedges would be less than total outstanding debt at March 31, 2015. Weighted reserves, adjusted for increased production risks associated with proved developed non-performing and producing undeveloped reserves, were valued below total outstanding debt at March 31, 2015. The company was heavily reliant on its ability to increase reserves through new exploration drilling, sale of assets, or participation in strategic partnership alliances to increase cash flow to repay total debt.

The appeals panel concluded that the borrower’s ability to strengthen operations through exploratory drilling was uncertain given future liquidity demands. The company had availability on its borrowing base revolver, but borrowing base availability was expected to decline as hedge revenue rolls off. The borrower may also draw on the line to cover any future borrowing base shortfalls at a subsidiary in accordance with a parent support agreement with the subsidiary. Additionally, the borrower was obligated to return funds previously advanced by the subsidiary to the borrower. Based on the borrower’s balance sheet cash at March 31, 2015, funding for the subsidiary would most likely occur through draws on the borrower’s revolving credit.