Q: Reserves are the common stock of the oil and gas business. The value of that stock rises and falls with commodity prices, and crucially, directly affects reserves-based borrowing determinations. What do you see ahead for reserves-based lending (RBL) as fall redeterminations approach? How could the dynamics shift should prices continue to edge upward?

MORRIS: Unless oil prices increase considerably more over the next three-four months, more decreases of borrowing bases seem likely in the fall redetermination season despite the oil price recovery since April. While I do not expect significant changes or new developments in bank RBL methodologies for the upcoming redetermination season, I anticipate at least four key themes.

First, many oil and gas companies curtailed or suspended drilling and completion activity in the first and second quarters. As a result of this lower activity, coupled with the natural production decline of producing wells, proved developed producing (PDP) reserves, which receive the highest advance rates or lowest risking in the sizing of an oil and gas RBL, will decrease compared with the just-concluded spring redeterminations. Whether higher oil and gas prices will be enough to offset the present-value impact of lower PDP reserve volumes remains to be seen.

"Unless oil prices increase considerably more over the next three-four months, more decreases of borrowing bases seem likely in the fall redetermination season despite the oil price recovery since April."

Second, existing and newly booked proved undeveloped (PUD) locations in mid-year reserve reports will face increased scrutiny by banks. Which PUD locations are projected to generate rates of return in excess of the lenders’ hurdle rate thresholds? Are the projected well costs, operating expenses, and production volumes reasonable and supported by historical data? These are only a few of the questions that bank engineers and credit professionals will be considering as they evaluate midyear reserve reports.

Third, banks will carefully evaluate each borrower’s liquidity, expected cash flow, leverage and commodity hedge protection. Does the borrower have enough liquidity to justify borrowing base credit for its PUD reserves?

Finally, some companies may have to trade borrowing base reductions for financial covenant relief from their bank groups, while other less-challenged companies may face pressure from retrenching banks to decrease their borrowing bases. Banks will be especially motivated to reduce exposure to RBLs of companies that are anticipating high leverage (greater than 3.5 times) in 2021.

Q: With operators continuing to face a high degree of business risk, many companies are highly leveraged and would be vulnerable should prices come under renewed pressure. How would you describe the general sentiment among banks with exposure to oil and gas? Could today’s market environment permanently alter the risk/reward metrics for bank RBL programs?

MORRIS: The capital markets have very little appetite for oil and gas equity and debt exposure, and the U.S. market for oil and gas properties remains exceptionally weak. In addition to an oversupply of oil in the first half of 2020, the industry still is suffering from COVID-19-related demand destruction. Many “oily” independent companies had very little of their 2020-21 production hedged prior to the price rout. For these and other reasons, I think the sentiment is negative among the banks engaging in oil and gas RBL. Many may be wondering what OPEC and Russia will do when global demand eventually recovers.

"Banks will be especially motivated to reduce exposure to RBLs of companies that are anticipating high leverage (greater than 3.5 times) in 2021."

If oil prices increase significantly in the near future and oil production ramps up again in the Permian Basin, will natural gas benchmark prices or basis differentials suffer due to the resulting increase in associated natural gas production? Are there gas-focused companies that are vulnerable to this potential shift?

I am not bold enough to predict permanent changes in the oil and gas business, particularly the financing of it. Eventually, bankers will retire, institutional memories will fade, and oil and gas prices will increase enough to embolden banks and other investors to become more aggressive. However, in the foreseeable future, I would not be surprised to see banks re-evaluate their guidelines for assigning loss given default (LGD) percentages to oil and gas RBL and conclude that LGDs should be higher. Typically, loans with higher LGDs have higher interest rate margins. Indeed, we already have seen loan pricing increases in conjunction with spring redeterminations.