Appeal of Shared National Credit (SNC) (Third Quarter 2015)
An agent bank appealed the substandard rating assigned to a revolving credit during the 2015 Shared National Credit (SNC) examination.
The appeal asserted that a pass rating for the reserve based loan (RBL) was appropriate because, consistent with the “Oil and Gas Exploration and Production Lending” booklet of the Comptroller’s Handbook, dated March 2016 (OCC booklet), the bank views RBLs as a form of asset-based lending (ABL) rather than an enterprise value cash flow lending.
The appeal acknowledged the decline in the company’s financial performance but noted that the OCC booklet defines a substandard asset as one that is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged. The OCC booklet further explains that substandard assets must have well defined weaknesses that jeopardize the liquidation of the debt. The appeal asserted that the borrower’s liquidity was adequate to meet its projected cash flow deficit for the remainder of 2015 as well as 2016. Furthermore, the appeal asserted that although not considered in its rating decision, the nationally recognized statistical rating organizations rated the borrower’s first lien debt B2 and B+.
An interagency 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 RBLs 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 ABL. For an ABL, however, the primary source of repayment is the conversion of working capital assets to cash, whereas for RBL, 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 which 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. RBL often share 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 that the company had seen large swings in revenues as the use of hedges was limited to relatively short terms (3–6 months). Use of this short-term hedging strategy resulted in revenues declining rapidly and sharply as commodity prices deteriorated. Given the lack of hedges and price declines, revenues were expected to drop significantly in 2015 with a small increase in 2016. The decline in commodity prices also resulted in a large non-cash write-down of oil and gas properties. The company experienced large net losses before taxes in recent years.
The appeals panel concluded based on the company’s 2015 projections, leverage would increase in 2015 due to declining earnings before interest, taxes, depreciation, and amortization (EBITDA). Furthermore, company projections showed an insufficient fixed charge coverage ratio (FCCR) well below 1.0 times.
The appeals panel concluded that EBITDA plus exploration expense was projected to decline significantly due to the decline in commodity prices and the company’s use of short-term hedges. FCCR was projected to decline below 1.0 at fiscal year-end (FYE) 2015 and 2016, respectively. Interest coverage was projected to remain positive; however, EBITDA was projected to be insufficient to support capital expenditures and interest. EBITDA is also insufficient to repay senior debt or total debt within seven years. Total leverage was expected to increase based on the company’s 2015 forecast, which reflects declines in EBITDA and an increased usage of the revolver.
The appeals panel concluded that liquidity is marginal and consists largely of the remaining availability on the revolving credit. The company’s cash flow projections indicate declining liquidity.