CHAPTER 2 INTRODUCTION TO COMMERCIAL BANK AND NON-BANK INSTITUTIONAL FINANCING IN THE MINERALS INDUSTRY

• Jurisdiction: United States

Mineral Financing
(Nov 1982)
CHAPTER 2
INTRODUCTION TO COMMERCIAL BANK AND NON-BANK INSTITUTIONAL FINANCING IN THE MINERALS INDUSTRY
C. Stephen Christian
Security Pacific National Bank
Denver, Colorado

I. OVERVIEW OF CAPITAL DEMANDS

The petroleum and the mining industries have traditionally been the most capital intensive of all industries, with the exception of the high-technology and chemical industries, in which expenditures are primarily related to research and development of new products. The following table shows the very high dedication of total earnings to capital expenditures for the petroleum and mining industries projected for the calendar year 1982. For comparative purposes, dedication rates for the auto and steel industries, also highly capital intensive, are included:¹

Industry	Capital Expenditures as a Percentage of Sales
Petroleum	10%
Non-ferrous Metals	10%
Coal	14%
Steel	6%
Autos	6%

Based upon the optimistic assumption that 1981 earnings margins for both the petroleum and mining industries hold constant in 1982 (1.9 percent for mining, 4.8 percent for petroleum² ), a substantial portion of planned expenditures must be funded from outside sources.

In terms of aggregate capital demands, the petroleum industry alone is expected to show a 16.6 percent annual increase in expenditures through 1990. Total capital requirements for the decade are expected to be more than $3.3 trillion, with over 26 percent to be funded from sources other than internally generated cash flow.³

Expressed in current dollars, the following table exhibits anticipated sources of capital for the period 1980-1990:

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Source	Amount ($ Billion)	Percent
Internal Cash Flow	2,429	73.1
Credit Markets	710	21.4
Other*	185	5.5
3,324	100.0

As the above table illustrates, debt capital represents the primary outside source of capital for petroleum companies. Over the last few years, the capital demands of the energy industry have represented approximately 20 percent of new corporate bond offerings in the public markets. Morgan Stanley & Co. estimates that the energy sector will represent nearly one-third of new offerings in 1982⁴ . Similarly, major commercial banks active in lending to the energy sector have devoted 20 to 30 percent of their loan portfolios to the energy industry. As a result of significant increases in debt-capital demands from the energy sector, especially from the independent oil and gas industry over the last 25 years, the commercial banking industry has established sophisticated lending practices for the oil and gas industry. Of nearly 15,000 commercial banks in the United States, approximately 300 do some type of energy financing, and nearly 100 of these have extensive departments. Whereas the public debt markets continue to be a viable source of funds for major and large independent oil and gas companies, commercial banks continue to represent the primary source of long-term debt capital for small- and medium-sized independents.

The inability of the smaller independents to tap the public debt market is primarily the result of the market's balance-sheet orientation with respect to financial analysis. Because the stated book value of oil and gas properties significantly understates their economic value, additions to debt cause relatively high debt-to-equity ratios, a key component of financial ratings. Commercial banks, on the other hand, are primarily cash flow lenders and therefore concentrate more on future ability to repay than on current liquidation value, as represented by the borrower's balance sheet.

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II. COMPARATIVE INTRODUCTION

A. Bank Financing. Bank financing is by far the most common type of debt financing in the minerals industry. A commercial bank will evaluate the following factors in analyzing a potential loan.

1) Purpose of Credit Facility. Not unlike an equity investor, a commercial bank extends credit to finance investments in assets which can be expected to generate a sufficient rate of return. In the case of the commercial bank, the rate of return is sufficient if it is enough to meet minimum debt-service requirements. Investments for the purpose of obtaining assets which are not expected to generate immediate cash flow sustainable over the life of the credit facility are not deemed appropriate for debt financing, unless secondary sources of repayment are available. In addition to purely economic considerations as to the purpose of a credit facility, legal constraints (e.g., Regulation U, which limits the amount of credit that can be extended for purchasing or carrying margin stock) and policy considerations (e.g., possible conflicts with existing customers) are also evaluated.

2) Primary Source of Repayment. The structure of bank credit facilities relies upon specifically identified sources of repayment. Obviously, the most common is net cash flow generated by producing oil and gas or mineral properties. Because of sophisticated petroleum engineering techniques and fairly reliable price forecasting methods, producing oil and gas properties represent one of the most reliable sources of repayment in bank portfolios. Assuming there are no other demands placed upon the cash flow generated by seasoned producing properties, banks are generally willing to lend up to

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75 percent of the estimated value of such assets. Other categories of oil and gas assets, which represent less reliable sources of repayment and are thus capable of supporting less leverage, include developed properties not yet producing, proved properties not yet developed, and unproved acreage. Typically, these asset categories are heavily discounted to account for the risk of cash flows being less, or later, than anticipated. Alternatively, these assets may support specific-purpose, short-term credit facilities which rely upon potential liquidation value rather than cash flow as the primary source of repayment. More typically, however, these less-developed properties significantly increase in value as development proceeds, because of improved reliability of cash flow estimates, which then serve to increase the maximum permitted debt supported by the entire asset package.

3) Security. The general concept governing a bank's decision to secure or not to secure its credit facilities with appropriate mortgage documentation relates to the borrower's overall financial strength. The worst-case scenario is evaluated in terms of the ability of the cash flow generated by the borrower's assets to continue to service debt and to meet other demands. In the case of an oil and gas producer, diversity considerations are very important, including the extent to which production is concentrated geographically and the extent to which production is concentrated in any one product category. Examples of material adverse changes resulting from such concentrations include the impact of one gas purchaser significantly reducing its takes or of material price declines in either oil or gas (or in one of the many categories of gas) upon the total cash flow.

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4) Summary of Documentation. All credit facilities, secured or unsecured, are governed by some type of credit agreement negotiated between the borrower and the bank and a promissory note. The purpose of the credit agreement is to establish the terms and conditions under which the credit facility will operate, including:

a) specific definitions of important terms;

b) amount and terms of the loan;

c) identification of documentation to be submitted in connection with the loan;

d) the borrower's representations and warranties;

e) the borrower's affirmative covenants;

f) the borrower's negative covenants; and

g) events of default.

In the event two or more banks participate in the credit facility a section is included in the credit agreement or a separate participation agreement is executed defining the rights and obligations of each bank, especially as they relate to the obligations of the lead bank in connection with the ongoing management of the facility.

In cases where the facility is to be secured by assets of the borrower, the various mortgage documents are required to provide the bank a valid first lien enforceable in accordance with stated terms and conditions. The bank requires a security opinion from outside counsel as to its security position, including all material title defects.

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As a matter of policy, most banks require the entire documentation package to be reviewed by bank counsel (outside or in-house) for the purpose of determining completeness and appropriateness.

B. Institutional Financing. Over the last five years, non-bank financial institutions have captured a significant share of the total debt and equity market. Other than the pure equity financing underwritten by investment banking institutions, the bulk of institutional financing recently has represented a sophisticated mixture of debt and equity financing. These financing arrangements have been provided by organizations such as bank holding company subsidiaries, insurance companies, and independent lease financing companies. These institutions have essentially created their own market by providing a financing service that accepts a higher degree of risk, yet does not require the ownership yield demanded by pure equity investors. This is made possible by combining the minerals industry expertise of the institutions with the voracious appetite for capital of small, independent oil and gas companies.

1) Purpose of Credit Facility. Typically, institutional financing is structured to finance the development of a specific property. However, in many cases, the loan is used to increase working capital, but is based upon the ability of a specific asset or group of assets to provide the source of repayment. In any case, the purpose of the facility is to provide a very short-term source of...