Borrowing bases for US E&Ps seen slightly down but with little output impact

Highlights

E&Ps have already pared down costs, activity, spending

Lower output, reserves, may work against some borrowers

Oil companies want to grow, but macro demands austerity

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Houston —
Borrowing bases for upstream companies may be slightly lower on average during the current round of bank redeterminations, but that won’t necessarily mean much change in near-term production since operators will likely keep a tight rein on spending if oil prices stay at current levels.

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Banks lend money to E&P operators based on oil and gas reserves – specifically, on conversions of proved undeveloped acreage to proved developed reserves. But less overall drilling in the last eight months from the coronavirus pandemic, resulting in less E&P reserve builds, in some cases could affect borrowers’ bank lines, Tom Watters, managing director at S&P Global Ratings, said.

“When you convert undeveloped to proved, developed reserves, you get more credit or weighting in your borrowing base,” Watters said. “That could probably hurt operators this time around since they weren’t doing that; they were focused on production and cutting capex meaningfully, to get through” a period of low oil prices.

Dismayed when oil prices plummeted in early March 2020 from $46/b to the teens and $20s/b in April as the pandemic decimated oil demand, upstream operators have already done substantial work to improve their balance sheets.

They slashed capital budgets, streamlined costs, scaled back drilling, paid down debts, focused on building cash flow, limited production, and hedged their oil and gas output where feasible – all of which could improve their standing with lenders.

Those austerity measures have forced E&Ps to live within cash flows, and many have pledged to continue doing so into the foreseeable future.

Investors want E&Ps to live within cash flows

The issue during the current bank redeterminations season when banks are reevaluating E&P company borrowing bases – the second period in a twice-yearly process – is that “oil companies basically want to grow … [but] with the money generated from their current business” rather than borrowed funds, Steve Hendrickson, president of Ralph E. Davis Associates, an Opportune company specializing in reserve engineering and geosciences, said.

Meanwhile, oil prices have improved from historic lows during the last round of bank reevaluations about six months ago.

Consequently, “we expect most oil-focused E&Ps to see their borrowing bases reaffirmed [during current] redeterminations,” KeyBanc analyst Leo Mariani said in a Oct. 7 investor note. “We think lower production in Q3 2020 will generally be offset by higher commodity prices versus this past spring.”

Oil-focused producers with lower debt, more resilient production and better hedge protection for 2021 are “most likely” to see their borrowing bases reaffirmed, Mariani said. But companies with little to no 2021 oil hedges, higher leverage and declining Q3 production are likely to see “modest cuts.”

Lenders consider a number of factors in their reassessment of upstream companies’ borrowing bases, but reserves are generally given the heaviest weight.

Banks can also require E&Ps to reduce leverage as part of the lending process. During the 2015-2016 industry downturn, lenders began to require E&Ps to remain below about 3.5x net debt/EBITDA, although these days companies are voluntarily opting for even lower levels.

Mariani cited Earthstone Energy’s borrowing base, cut 13% earlier in October to $240 million – likely, he said, on 14% lower production in Q2 2020, potentially lower Q3 2020 output and “almost no activity planned for second-half 2020.”

Earthstone said Oct. 1 its credit facility was also amended as part of its redetermination, providing more flexibility to make acquisitions, a minor interest rate increase on outstanding borrowings, limitations on cash held and tighter restrictions around paying dividends and making distributions.

Earthstone targets low leverage ratio

“We continue to target a leverage ratio at or below 1x net debt to adjusted EBITDAX at year-end 2020, driven by our well-hedged production profile, success in achieving reduced costs and limited capital expenditures,” Earthstone CEO Robert Anderson said.

In contrast, several independent E&P companies have announced their borrowing bases were reaffirmed in recent days.

Small Permian-focused Centennial Resource Development said Oct. 13 its bank group, led by JPMorgan Chase, had reaffirmed its $700 million borrowing base.

“We believe this outcome reflects our high-quality asset base and recent reductions to field-level costs,” Centennial’s CEO Sean Smith said.

Also, Appalachian gas producer Range Resources in early October learned its $3 billion borrowing base was reaffirmed under its existing revolving credit facility.

International law firm and bankruptcy specialists Haynes and Boone on Oct. 13 released its semiannual Redeterminations Survey for fall 2020, which found more than half of the 142 respondents expect 10%-20% decreases in borrowing bases. Most leaned toward the lower figure.

“Though [that level is] not as deep as the 20%-30% decreases respondents expected in the spring, they will still be very impactful to most producers,” Haynes and Boone said.

Respondents included lenders, oil/gas producer-borrowers, financial institutions, private equity firms and professional services providers. Nearly half of survey participants were oil/gas producer-borrowers, Haynes and Boone said.

Apart from the pandemic, some analysts say the current state of the oil patch, after years of overspending and overproducing that hasn’t been profitable enough and contributed to price volatility, is now at a reckoning point that will cause behavior changes and create value going forward.

“Investors aren’t happy right now about continued borrowing, equity infusions and then finding there’s no real way of getting the money out because of poor investments made,” Hendrickson said. “There are real challenges for some companies given the assets they have and where [commodity] prices are.”