Novel asset-backed bonds lure shale sector away from bank loans
(Bloomberg) — As big banks pull back on lending to oil and gas drillers, some U.S. energy companies are relying on a novel kind of bond to get the financing they need.
The bonds are backed by the companies’ oil and gas reserves, meaning producers are essentially pledging income from their wells in exchange for up-front cash. The debt known as “proved developing producing” securitizations can allow shale drillers to pay less to borrow, in exchange for giving up some of their possible gains if energy prices rise.
Companies this year have sold, or are in the middle of selling, $4 billion of PDP securitizations. That’s up from just $1.4 billion total over the previous three years, according to data from Fitch Ratings. The first such bond was sold in 2019.
Energy companies are broadly cutting back on borrowing now because they are awash in cash. New loans to oil and gas firms fell more than 30% from 2018 to 2021 and are on track to fall again this year, according to data compiled by Bloomberg. Banks have also been under pressure from regulators and investors to cut back on lending to an industry that is notorious for overspending during booms that get followed by busts.
But many energy companies still need financing. Colorado-based Jonah Energy sold a $750 million PDP securitization this month, backed by the rights to proceeds from about 2,400 oil and gas wells -- virtually all the wells it owns. The driller will pay a yield of about 8% for its PDP securitization with an average life of three years.
In contrast, UK-based oil and gas driller EnQuest Plc this month sold unsecured five-year bonds at a yield of 12%.
By selling a PDP securitization, Jonah managed to garner substantial savings, all the more impressive because just a few years ago the company couldn’t pay its obligations. In 2020, during the early stage of the pandemic, the company restructured its balance sheet to cut its debt, raise equity and hand over a majority of the company to some former noteholders.
The securitizations offer other advantages as well, most notably when energy prices drop. A common alternative form of financing, known as reserve-based loans, is also secured by a company’s wells. With these loans, every six months, banks estimate the value of the oil and gas wells backing the loan.
If the assets have declined in value, companies have to cut their borrowings or offer more collateral. And even in good times, when prices are rising, drillers may not see their borrowing bases rise, meaning the corporations may not be entitled to borrow more. According to a survey of borrowers and lenders in the reserve-based loan market from Haynes and Boone, a law firm, strong oil and gas prices haven’t been resulting in borrowing base increases recently.
With PDP securitizations, collateral doesn’t get re-valued.
“This is a more permanent source of capital,” said Greg Kabance, a managing director at Fitch.
Jonah is using the proceeds from its securitized deal to refinance its existing reserve-based loan, according to a statement from Tom Hart, Jonah’s president and CEO. The deal “positions us with a strong balance sheet to pursue the significant drilling opportunities that we have on our acreage and strategic opportunities that may come our way,” he said.
But there are downsides to these deals too. To protect investors in PDP securitizations, companies selling these bonds usually enter derivatives transactions that effectively give them steady income from the assets over the life of the bonds, and reduce their potential gains from energy price increases. The banks that sell these derivatives bear the risk of oil and gas prices falling and reap the benefits of prices rising. The Wall Street firms can hedge their exposure using options and other instruments.
These derivatives are one reason why big, integrated oil and gas firms like Exxon Mobil Corp. have avoided selling PDP securities: they don’t want to give up their potential gains. So far, the space has been dominated mostly by smaller, private firms, some of which have done multiple securitizations. They include Wyoming-focused gas producer PureWest Energy and Denver-based Raisa Energy, which owns and leases oil assets across North America. Diversified Energy, the owner of a vast empire of wells in Appalachia, has completed six.
In addition to pressure from regulators, banks have faced pressure from investors to cut exposure to businesses that are seen as risky from an environmental, social or governance perspective.
“Fewer banks these days are willing to lend into the upstream oil and gas industry, in part of because of ESG and other concerns,” said Michael O’Leary, a partner at law firm Hunton Andrews Kurth, who has written about PDP securitizations.