RESERVE-BASED LENDING

• Jurisdiction: Derecho Internacional

International Mining and Oil & Gas Law, Development, and Investment
(Apr 2013)
CHAPTER 23B
RESERVE-BASED LENDING¹
Lynn P. Hendrix
Partner, Bryan Cave LLP
Denver, Colorado
Hendrix@BryanCave.com

LYNN P. HENDRIX is a partner in the law firm of Bryan Cave HRO, and was formerly with the Denver-based law firm of Holme Roberts & Owen LLP until it combined with Bryan Cave in 2012. His practice emphasizes energy and natural resource law and intellectual property law. Lynn graduated from the University of Nebraska in 1973 with a Bachelor of Science Degree in Electrical Engineering, and graduated with distinction from the University of Nebraska College of Law in 1978. During law school he served first as Executive Editor and later as Editor-in-Chief of the Nebraska Law Review. Lynn is a former President of the Rocky Mountain Mineral Law Foundation (RMMLF) and is a member of several RMMLF committees. Lynn has authored or co-authored four papers presented at RMMLF Annual Institutes, and over 12 papers presented at RMMLF Special Institutes. Lynn served as Program Chair of RMMLF's 45th Annual Institute, and Landmen's Chair of the RMMLF's 43rd Annual Institute. Lynn has also presented to the Annual Institute on Oil and Gas Law and Taxation and the Annual Institute on Intellectual Property Law, both sponsored by the Center for American and International Law, and the Eugene Kuntz Conference on Natural Resources Law & Policy sponsored by the University of Oklahoma College of Law. Lynn is past Chair of the Natural Resources and Energy Law Section of the Colorado Bar Association, and served as Chair of the Oil and Natural Gas Exploration and Production Committee of the American Bar Association. Lynn has been listed in Best Lawyers in America for over 12 years, with such listing in various years including the areas of Energy Law, Natural Resources Law, Oil & Gas Law, Native American Law, Intellectual Property Law and Information Technology Law. He is also listed in Colorado Super Lawyers, and was named by Lawdragon as one of the 500 Best Lawyers in America. Lynn is licensed in Colorado, Montana, Nebraska, New York and Wyoming and with the U.S. Supreme Court, and is a registered patent attorney with the United States Patent and Trademark Office. He is a member of the American, Colorado, Montana, Nebraska, New York and Wyoming Bar Associations. He is also a member of the American Association of Professional Landmen and the Denver Association of Petroleum Landmen.

I. INTRODUCTION

This paper discusses what has become known as "reserve based lending." Reserve based lending is a type of asset based lending used primarily in the oil and gas industry² where the amount available to be advanced under the credit facility³ is determined by the value of the oil and gas reserves, and the collateral securing the credit facility is the oil and gas reserves. Oil and gas reserves are the oil and gas in the ground before they have been produced or extracted.⁴ While the concepts of reserve based lending can be applied to term loans, reserve based lending is generally reserved for revolving credit facilities. Reserve based lending is also used primarily in connection with producing (as opposed to non-producing) oil and gas properties.

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The unique nature of oil and gas reserves makes reserve based lending quite different from typical asset based lending in many respects, and adds numerous nuances not encountered in typical asset based lending. Oil and gas is a depleting resource, but additional reserves can be identified and developed. In addition, each property (well) can have significantly different characteristics. Oil and gas is also subject to extreme price fluctuations and, even more than other assets, is affected by matters beyond the control of either the lender or the borrower; such as, political and geopolitical factors, governmental regulation, market and transportation factors, in addition to normal supply and demand. Additionally, while typical asset based lending involves a limited number of properties, because oil and gas companies typically have a large number of wells, and several properties (oil and gas leases) can contribute to each well, reserve based lending often involves hundreds, if not thousands, of properties, often in distant proximity.

While the overall process is generally the same from facility to facility, the details vary from lender to lender and depend on the properties involved. Accordingly, of necessity, this paper will present reserve based lending as it is generally implemented (i.e., what one would "typically" encounter, but recognizing that nothing is "typical").⁵ The reader should understand that this paper is a generalization and there are a number of variables that may come into play in any particular reserve based facility.

Not unlike other asset based lending, large reserve based credit facilities typically have more than one lender. Financial institutions often have internal restrictions on the amount they can loan to any one borrower, and prefer to share the credit risk with other institutions. Accordingly, lenders often group together in a single facility. These so-called "syndications" are headed up by a lead lender typically referred to as the "arranger" and/or "administrative agent." The lead lender typically makes the initial commitment and agrees to bring other lenders into the credit facility. In syndications, the lead lender is authorized under the documentation to take certain action without obtaining the consent of the other lenders; other action by the lead lender may require the consent of a majority or supermajority of the lenders (by proportion of each lender's commitment); and yet even other action may require the unanimous consent of all the lenders. Because whether a reserved based credit facility is, or is not, syndicated does not affect the matters discussed in this paper, and because the differences between syndicated credit facilities and non-syndicated credit facilities are not really different between reserve based lending and typical asset based lending, for simplicity this paper will assume a single lender (the "Lender") and a single borrower (the "Borrower").

II. STANDARD/CONSISTENT PROVISIONS

Although reserve based credit facilities can vary significantly from facility to facility, there are certain concepts that are in virtually all reserve based facilities: First, the amount available to be advanced under the facility correlates to the value of the oil and gas reserves; second, the collateral securing the facility is primarily the oil and gas reserves; and third, the amount available to be advanced under the facility can fluctuate up or down depending on the value of the reserves from time-to-time.

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.A. Valuation

As with any asset based facility, the amount the Lender is willing to advance to the Borrower is dependant on the value of the Borrower's assets; in the case of a reserve based facility this is the value of the oil and gas reserves. This amount is referred to as the "Borrowing Base." To determine this value the lender obtains what is known as an engineering reserve report. These reserve reports are really an appraisal of the reserves and are prepared by petroleum reservoir engineers. Because of the characteristics of oil and gas in the ground, these reserve reports are really just estimates of the recoverable reserves; but nevertheless they are highly educated estimates. While how engineering reserve reports are prepared is beyond the scope of this paper,⁶ the procedure can be simplistically described as a comparison of the characteristics of the wells or properties being evaluated with those characteristics of similarly existing wells and properties. Factors taken into consideration include production history, geographic location and proximity to other similar wells, the formation or zone that is producing, completion methods, costs of operation, product prices, transportation and processing costs. In addition, because of the time value of money and that the production of reserves occurs over a period of time, the engineer applies a discount rate to arrive at a present value of the reserves.

There are many factors that go into the preparation of reserve reports, most of which depend on the sciences of petroleum engineering and geology. But there are three factors that do not depend on those sciences; that is, how the costs of producing the oil and gas will fluctuate, how the selling prices for the oil and gas will fluctuate, and the discount factor applied to determine the present value.⁷ These factors are often referred to as the "price deck." The engineer often has his/her own estimates of these factors, but typically the Lender has its own estimates and the engineer uses the Lender's estimates in preparing the reserve report for the Lender.

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It is interesting to note that when companies provide reserve reports for public reporting purposes, the SEC⁸ requires that costs and prices are held constant at current levels (based on twelve month average for prices) and that a discount factor of 10% is applied.⁹ While a Lender reviews the reserve reports prepared for public reporting purposes, it has its own parameters of how prices and costs will escalate (or deescalate) and what discount factor should be used. These parameters not only affect the estimate of the value of the reserves, but also the estimate of the total recoverable reserves. Because oil and gas are depleting resources, at some time in the life of a well the costs necessary to produce oil and gas will equal the value of production, and at that time the well has no value.¹⁰ This occurs before all the oil and gas has been removed from the ground - at some point it costs more to remove the oil and gas than the amount that can be received from the proceeds of production.

Engineering reserve reports group reserves into three categories...