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

Background

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

Discussion

The appeal asserted that the credit had a first lien on all assets, which included proven reserves with an appropriate margin. The oil and gas borrowing base structure was similar to a well-structured asset-based loan (ABL) that is generally assigned a pass rating.

The appeal also asserted that the examiner’s rating appeared to be based on the conclusion that the value of the borrower’s proved developed performing assets was insufficient to repay this debt and the second lien loan.

Conclusion

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

Regulatory agencies recognize that unique attributes of oil and gas reserve-based loans (RBL) result in risk inherent to the oil and gas industry requiring additional risk management practices and programs for oil and gas lending, including some controls that are similar to an ABL. For ABLs, the primary source of repayment is, however, the conversion of working capital assets to cash, whereas for RBLs, the primary source of repayment is cash flow generated from the sale of oil and gas over the life of the reserves.

The appeals panel concluded that the controls in place for a traditional ABL are more stringent than those typically found in an RBL. ABL controls include a first lien on account receivables and inventory that is not shared with any other lending group, dominion of cash through a lock box arrangement or a springing covenant, regular field audits, and periodic collateral valuations.

The appeals panel concluded that the primary source of repayment for an RBL is the cash flow generated from the future sale of encumbered oil or natural gas once it has been extracted. An RBL often shares the cash flow repayment “pari passu” with other debt, both secured and unsecured. In many cases, the other debt (term notes and bonds) requires no principal repayment until maturity. While the structures of RBLs may vary, the facilities generally do not self-liquidate. Disbursements of proceeds, while generally not restricted, are primarily used for capital expenditures pertaining to the exploration, acquisition, development, and maintenance of oil and gas reserve interests. Oil and gas reserve interests tend to be longer term, depleting assets as opposed to accounts receivable and inventory.

The regulatory agencies believe an RBL is subject to additional risks than a traditional ABL and should be evaluated and risk rated through cash flow analysis, although consideration is given to each facility’s structure, controls, and collateral. The primary determinant for the regulatory risk rating is the ability of the borrower to service all debt from operating cash flow, the primary source of repayment.

The appeals panel concluded the primary source of repayment for this credit is cash flow from operations, not the liquidation of collateral (secondary source). In addition, since the first and second lien loans share the collateral and all payments are parri passu, the examiners based their decision on the operations of the company.

The appeals panel concluded that cash flow was insufficient to cover interest expense and partnership distributions. Sales in the first quarter of 2015 were down 50 percent from fourth quarter 2014 sales due to lower production and lower average realized prices. First quarter 2015 earnings before interest, taxes, depreciation, and amortization (EBITDA) included hedging gains and tax credits and was insufficient to cover interest expense and partnership distributions. Cash on the balance sheet declined mainly to fund partnership distributions.

Repayment of this debt and the second lien note was projected to be dependent on the successful development of a second field. The sharp drop in oil prices has made development of the second field uneconomical, and therefore the borrower was delaying the development of the second field. Despite the sharp drop in developmental capital expenditures (capex), 2015 projected EBITDA was well short of planned capex.