Valuing E&P Company Proved Reserves as Cost Curves Decline – Insolvency in Mirror May Be Closer Than It Appears

This article can also be found at my LinkedIn page, and will soon be published in a forthcoming Permian Basin Landmen’s Association newsletter.

In the past year, there has been ample discussion about the role of asset-based lending redeterminations as they pertain to the availability – or unavailability – of funding on the capital markets through existing credit revolvers[1] for many oil and gas companies. The borrowing bases utilized in these funding structures are typically calculated through lender price decks that consider both the amount of proved reserves a company has at a given time, as well as the going price for the reserves themselves on the open market. In good times, capital is plentiful and an oil and gas company’s borrowing base burgeons under reasonable valuations as determined by commodity values. In these times of distress in the oil and gas markets, though, capital has largely dried up and the valuation of a company’s reserves is becoming critically important, as that valuation directly affects their borrowing bases under the credit revolver.

Valuation of Proved and Unproved Reserves

Unproved reserves are easier to classify, as they include the remainder of the reserves that cannot be classified as proved reserves – they are more speculative in nature, and are not given great weight in the valuation process.[2] Proved reserves are generally separated into three categories.[3] First, proved developed producing (“PDP”) reserves are those currently generating cash flow from production. Second, proved developed nonproducing reserves (“PDNP”) are those that require some sort of further work or action before being productive; one might think of a shut-in well as a prime example. Lastly, proved undeveloped reserves (“PUD”) are those expected to be recoverable but at a future time, after new wells are drilled on undeveloped acreage or existing wells are brought up to full operability. With regard to PUD reserves, they are generally not included in the valuation of proved reserves unless a pertinent well will soon be brought up to operating standards and production will subsequently be achieved.

Both proved and unproved reserves in the abstract are not a controversial notion – a company owns certain properties, petroleum geologists and engineers ascertain how rich with hydrocarbons these properties are, it is determined how feasible acquisition of the hydrocarbons would be, and the numbers are crunched. However, the more critical variable in the valuation formula is the price of the asset or commodity upon which the valuation is ultimately derived. These valuations can vary greatly – consider two companies operating in two different hypothetical pricing environments, but with exactly the same proved reserves. In hypothetical pricing environment “A,” the company’s proved oil reserves (which will be discussed infra) are viewed in the lens of $30/bbl oil (as is currently the case); by comparison, pricing environment “B” features those same proved reserves but instead in an $80/bbl oil environment. The consequence of this is that the company’s reserves in the latter pricing environment effectively have over double the valuation. In and of itself this is not a groundbreaking concept, but companies seem to be getting more adept at massaging this variable in an attempt to appear more financially robust and perhaps even artificially prop up their valuation for the purpose of preventing reduction of lent capital under existing revolving credit facilities when commodity prices begin to decrease.

Fall 2015 Borrowing Base Redeterminations – Dodging a Bullet

As 2015 progressed into spring and summer, it became clear that oil prices would continue to languish. This posed a challenge for highly levered E&P companies, whose borrowing bases could potentially have been greatly constricted by their lenders as a result of the pricing slide. As consensus built around the likelihood of forced M&A and bankruptcy filings as a result of decreases in these borrowing bases, the industry was somewhat chagrined when the redetermination process came and went with far fewer borrowing cuts than expected.[4] Those waiting for the financial pressure to build won’t have long to do so, as the next wave of redeterminations will take place this coming spring (in April for most borrowers). The current sustained period of crude oil in the $30s will pull down many lending price decks and summarily should result in more year-over-year reductions in borrowing bases.[5]

Ultimately, the wait for deal flow to begin in earnest has become more protracted than originally expected; the proverbial axe has not come down upon the number of companies that some had expected that it would, and more companies are eking their way through this current period in pure survival mode. Those companies precariously dangling over the abyss of insolvency are generally widely known in our industry, and potential buyers of assets – or the distressed companies outright – seem content to wait for alternative options to acquire assets on a much cheaper basis, such as through §363 sales under Chapter 11 of the Bankruptcy Code.

— — —

[1] Credit revolvers “allow the borrower to buy goods or secure loans on a continuing basis as long as the outstanding balance does not exceed a specified limit.” Black’s Law Dictionary 424 (9th ed. 2009).

[2] Unproved reserves can be further bifurcated into “probable” reserves (those approximately 50% likely to be recoverable), and “possible” reserves (those approximately 10% likely to be recoverable). Reserve Based Loans: Issues and Considerations, Practical Law, http://us.practicallaw.com/4-618-2271?source=relatedcontent#a000014 (last visited Feb. 22, 2016).

[3] Alex W. Howard, and Alan B. Harp, Jr., Oil and Gas Company Valuations, 28 Bus. Valuation Rev. 30, 31 (2009), available at http://www.srr.com/assets/pdf/oil-and-gas-company-valuations-business-valuation-review.pdf.

[4] In a Thompson Reuters review of 61 credit revolvers whose borrowing bases were criticized by lenders in Fall 2015, almost half were reduced; however, one-third of them were reaffirmed, and the remaining 18% were actually increased. Of the 30 that were reduced, 11 were reduced by 20% or greater. See Reserve Based Lending: How Bad Were the Fall 2015 Borrowing Base Redeterminations, Practical Law, http://us.practicallaw.com/w-000-7741 (last visited Feb. 22, 2016).

[5] A recent study by Haynes and Boone LLP analyzed what various lenders and borrowers predicted for the Fall 2015 and Spring 2016 redetermination periods – those lenders and borrowers surveyed forecast approximately 68% of current oil and gas related borrowing bases would be decreased in Spring 2016, and that these decreases would average about a 26% reduction as juxtaposed against Fall 2015 bases. See Presentation, Haynes and Boone, LLP – Borrowing Base Redeterminations Survey: Spring 2016, (Jan. 19, 2016), http://www.haynesboone.com/~/media/files/attorney%20publications/2016/bbsurvey.ashx.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s