LOW OIL PRICES PUT PRESSURE ON MINIMUM HEDGING REQUIREMENTS IN ALTERNATIVE FINANCINGS FOR E&P BORROWERS
HERSCHEL HAMNER AND ROBERT G. STEPHENS, SIDLEY AUSTIN LLP, HOUSTON
AS REPORTS OF INCREASED supply and reduced demand continue to emerge, analysts are predicting a prolonged period of low oil prices, forcing upstream oil and gas producers to focus on survival by cutting costs, focusing on their most profitable wells and, in many cases, raising additional capital to plug liquidity needs. Some producers already have filed for bankruptcy protection, and many market analysts are predicting a wave of additional filings if prices remain depressed. But the low prices are creating another immediate quandary for producers: Should they hedge their anticipated production in a low price environment?
So far in this market cycle, hedging has been a friend to many producers, providing a welcome cushion for falling oil prices. Many companies covered a sizable portion of their estimated 2015 production at earlier prices that reflected then-prevailing robust forecasts. For example, Pioneer Natural Resources Company (NYSE:PXD) entered into hedging arrangements covering approximately 90% of its estimated production of crude oil for 2015 at a weighted average price, with respect to swap contracts, of $71.18 per barrel. With the spot price of WTI crude oil hovering around $59 per barrel as of June 30, 2015, the relative price impact of these hedging arrangements reported by Pioneer for the three-month period ended June 30, 2015 amounted to $12.96 per barrel. (See Pioneer 10-Q, June 30, 2015, filed on Aug. 7, 2015.)
But the hedging arrangements of many companies cover only the succeeding 24 months or less. That means that many higher price hedges entered into before price declines in 2014 will begin rolling off in the near term, resulting in a much lower share of production being hedged at the higher price levels in 2016 and beyond. Taking the Pioneer example above, the company has shifted its focus of oil derivative contracts from swap contracts to collars, with swaps covering 82,000 bbls and collars covering 15,000 bbls in 2015, to swaps covering 0 bbls and collars covering 100,514 bbls in 2016. This shift evidences the increased difficulty of hedging to protect against price declines when prices are low, as pure swaps can be unattractive at lower price levels.
Management teams at upstream producers, traditionally bullish when it comes to oil prices, can be expected to resist locking in 2016 prices in the low to mid $40s, hoping for the WTI to bounce back to the $60s. Indeed, we have heard that many upstream producers failed to lock in prices when oil was in the $60s in June 2015. And if hedging is desired (or required, see below), simple fixed price swaps may be rejected in favor of hedges that create collars or floors, to preserve some pricing upside.
Hedging strategy is also driven by the requirements of lenders. As crude oil prices have declined and conforming borrowing bases under reserve-based lending facilities have been correspondingly trimmed, many oil and gas companies have turned to non-bank capital sources to provide additional liquidity, often in the form of higher yield, higher risk indebtedness such as second-lien term loans and "stretch" or "overadvance" tranches of revolving credit facilities that are not tied to conforming borrowing base criteria.
These lenders often require borrowers to enter into hedging programs covering certain minimum levels of estimated volumes to be produced in order to provide certainty that the borrowers will have a predictable revenue stream from sales of production to utilize for their debt service. From the borrower's perspective, the end result of this arrangement is short-term access to much needed capital coupled with mandated hedging requirements under which the borrower may sacrifice future gains were crude prices to rebound.
There are several recent examples of second-lien and "stretch" facilities that include minimum hedging requirements. For example, in June 2015, Alta Mesa Holdings LP entered into a second-lien term loan facility containing a requirement that Alta Mesa hedge 65% of its forecasted PDP production for a 36-month period following closing at prices reasonably acceptable to the second-lien facility agent. (See Alta Mesa Holdings 8-K filed June 30, 2015.)
Resolute Energy Corp. entered into a second-lien term loan facility in December 2014 with lenders requiring that the borrower certify, upon each delivery of a reserve report, that it has hedged at least 70% of its anticipated production from PDPs for a rolling 24-month period beginning on the date of each reserve report. (See Resolute Energy 8-K filed Dec. 31, 2014.) In some private transactions, the lenders' ability to force the borrower to hedge is triggered by an event such as a drop in the asset coverage ratio (PV-10 of proved reserves to total debt) below a certain threshold.
While these minimum hedging requirements may have been acceptable to many producers when prices were in the $50s or higher, a cash-strapped upstream producer that is uncertain if it can sustain itself with prices in the upper $30s may be hesitant to accept hedging program requirements that would force future hedging activity when prices are hovering in the low $40s, with an uncertain future direction. And if producers push back on minimum hedging requirements that would have been palatable to them several months ago, what options are available to second-lien lenders to protect their interests in ensuring stable cash flows to service their debt?
One possible option, that we have yet to see, is for second-lien and "stretch" lenders to link hedging program requirements to certain market conditions. By way of example, a lender could agree to provide financing today, but include a requirement that, if WTI oil prices exceed $50 per barrel for X number of days, then at the lenders' request, the borrower would hedge 50% to 70% of its anticipated 2016 and 2017 production from PDP reserves. If lenders could accept such hedging program requirements, upstream producers could receive much needed cash today without being bound to any long-term detrimental hedging arrangements. The lenders under such an arrangement would be able to ensure that a material price improvement would be captured by the borrower, and not lost to overly optimistic views of continued price increases.
To guard against the lenders' concern of further price declines from the current mid $40s, such an arrangement could be coupled with a requirement to enter into swaps or collars at closing covering a smaller portion of estimated production for a shorter time horizon than would be the case in a higher price environment, a requirement to obtain hedges at closing creating some lower level price floors (if the cost of such floors would not be too costly to the borrower), or a requirement that the borrower enter into hedges after closing if prices drop below a certain amount for a specified number of days. Alternatively, the risk of further price declines could be priced into the yield of the indebtedness. In light of the new environment of low to mid $40s crude prices, such adjusted hedging programs may provide more utility to lenders and borrowers than the more traditional minimum hedging requirements that made sense at higher price levels.
ABOUT THE AUTHORS
Herschel Hamner is a partner in the Houston office of the law firm Sidley Austin LLP where he is a member of the Energy and Global Finance groups. He has extensive experience representing agents, lenders, and borrowers in a variety of debt financings in the energy industry. He is a graduate of Harvard Law School.
Robert G. Stephens is a partner in the Houston office of the law firm Sidley Austin LLP where he is a member of the Energy and Global Finance groups. He represents financial institutions and energy companies in a variety of structured financing transactions, and is a recognized expert in commodity hedging transactions. He is a graduate of the University of Texas School of Law.
This article has been prepared for informational purposes only and does not constitute legal advice. This information is not intended to create, and the receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers. The content therein does not reflect the views of the firm.
