The impact of the coronavirus on oil & gas financing
The combination of the global coronavirus pandemic and a very serious fall in oil prices has put the sector in uncharted territory.
One particular issue is the effect of these huge events on the loan facilities already provided to oil & gas producers in the UKCS.
We act for a number of borrowers who are independent producers in the market and who have debt packages from a number of lenders. The reserves base lending (RBL) market has been very liquid for the last few years and there has been a good level of competition that has to some extent pushed pricing down. Many producers have been building up cash reserves, and servicing of debt (in terms of both capital and interest payments) has generally not been an issue. In the last week or so the combination of the COVID-19 crisis and the collapse of the oil price to below $30 (at the time of writing) has created “perfect storm” conditions likely to put short term pressure on this otherwise healthy situation.
Borrowers may be concerned that their lenders may be looking at their loan documentation to consider if any of these circumstances may leave them in default. There is indeed the possibility that certain defaults may be coming into focus for lenders, but perhaps the bigger concern is that the relative healthy cashflow performance of oil & gas producers may leave them open not to formal enforcement action but instead to efforts to reduce their lenders’ credit exposure from available cash resources.
A couple of key points should be considered here:
- Almost every RBL facility will have compulsory commodity price hedging requirements. This means that the borrower group will enter into arrangements to ensure that a sufficient proportion of the proceeds of their production is received at a fixed price, to allow their projected income to meet the repayment obligations under the loan documents. Therefore in the short term, the dip in market prices should not have an immediate impact on cashflows for most producers with RBLs. The “hedging counterparty” (which is often an affiliate of a senior lender in the RBL syndicate) will in effect make up the difference between market spot rates and the price fixed under the hedging arrangements. It’s important to bear this point in mind as it feeds into a number of other related issues.
- However, most loan documents for UKCS financing deals will have a number of provisions where the “perfect storm” conditions may have an impact. For example:
- Reporting requirements. As restrictions on travel, ability to have meetings and offices being openings tighten, borrowers will have to look at the deadlines by which they have to deliver financial information and reports from advisors and technical consultants. Advisers may not be able to carry out the required work in the timescales set out in the loan agreement and this could lead to a default arising.
- Supply chain disruption and force majeure. RBLs will often have undertakings and related events of default that may come into play where a key supplier to the project is no longer able to perform under the relevant contract. If a supply contract has a force majeure clause that is capable of being triggered by the disruption caused by COVID-19 (which will always depend on the precise wording in question), the resulting delay in performance could result in a default under the borrower’s loan agreement. Even without force majeure being triggered, factual inability to perform will cause the same problems for producers. While such defaults are often further qualified so that the relevant interruption has to have a “material adverse effect”, this may be another ground on which lenders could seek early repayment or enforcement. Separately, very material interruption to the supply chain could give rise to production interruption, which in turn will (in one form or another) be a default under the loan agreement. RBL borrowers therefore need to be thinking about and reviewing their supply chain contracts now.
- Material Adverse Change. UK/European RBL loan agreements do not themselves typically have a force majeure clause as such. However, almost every RBL will have an event of default based on the occurrence of a “material adverse effect”, or “material adverse change” (MAC). The purpose of the MAC clause is to cause an immediate event of default to arise where something more serious may occur at a later date, or to cover a risk has not specifically been envisaged and made subject to an individual undertakings or event of default. While the actual wording of the clause will vary in each case, almost all will include reference to there being an adverse effect on borrower’s ability to meet debt repayments, and many will include reference to a more general concept of there being an adverse effect on the overall financial condition of the borrower or its group. In addition, some MAC clauses allow the lenders to take the view as to whether a MAC has occurred and others leave it to be a wholly objective test. However, a number of factors mean that it is perhaps unlikely that lenders will, in the immediate future, start to use MAC clauses to seek early repayment. First there is very little clarity from any case law on what will constitute a MAC, and as a result it’s extremely rare for a lender to rely on an MAC clause alone to accelerate debt. It’s also risky, since if the lenders get it wrong, they and not the borrower, will be in breach of contract. Secondly, the oil price shock (at least at current levels) may well be short term. And thirdly, the existence of the fixed price commodity hedging arrangements that we refer to above, means that the lowering of the oil price should not in itself result in the reduction of cashflow available for debt service.
- Borrowing base amount. It may be more likely that lenders take action by requiring an unscheduled borrowing base redetermination. Borrowing base redeterminations usually take place every 6 months and will, on a rolling basis, reset the amount of the “borrowing base” (in short the projected value of the oil & gas revenues from the projects), which in turn determines how much can be borrowed. Lenders can seek an unscheduled redetermination on certain grounds, often including where they consider that an MAC has occurred or if they think the borrowing base amount has materially reduced. They may therefore seek to use a redetermination to bring forward a reduction in the amount borrowed. For the reasons mentioned, in particular the hedging arrangements being in place, it may be that there is no material reduction in the borrowing base. However, in cases involving producers with useful cash reserves, lenders may look to take that chance, especially where, as is often the case, they ultimately control the technical assumptions that are used to calculate the relevant amount.
We are still at an early stage in this unfolding crisis. The oil price collapse may not last, at least at current levels. If US shale producers start to fall, tightening supply may lead to upward price pressure. However, views are mixed as to how material this factor is in the context of what is likely to be a sustained period of lower demand worldwide. There may still be oversupply absent a more comprehensive agreement between Russia and Saudi. While that agreement might be more likely after a few US producers have gone bust, there is no certainty as to where these factors would leave the commodity price.
For current purposes, this may simply mean that lenders are nervous. They may not be nervous enough to look to enforce – there is always the question of who would give them sufficient value, as a distressed buyer, for that to make sense. And there may still be government support/incentives that would be designed to prevent energy companies from becoming insolvent. But with cash reserves sitting in project accounts that may otherwise be used to fund returns to shareholders, there may be pressure on lenders to seek to materially reduce their credit exposure.
What steps should borrowers be taking now?
It is crucial that borrowers engage with their lenders at this time, to keep them fully informed as to how the crisis is impacting their businesses, and where possible to provide the reassurance on matters such as the continuing viability of the supply chain, continued availability of all key advisor reporting, and cash available to service debt. If borrowers do consider that defaults may arise from the current crisis, consideration should be given to looking at appropriate waivers, and approaching lenders at any early stage for discussions around those, in a structure and orderly manner.
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