Why banks make deathbed loans to oil drillers
How lenders make money from fossil fuel firms on the cusp of bankruptcy
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Another one bites the dust. On Sunday, Chesapeake Energy, once the second-biggest producer of natural gas in the United States, filed for bankruptcy, crippled by the free-fall in energy prices.
It’s a story that’s become all too familiar for investors in the US shale revolution, the glory days of which are today a distant memory. Year-to-date, more than 400 oil and gas companies have collapsed.
The immediate culprit is the coronavirus crisis, which has bruised global energy demand. But the current tumult augurs ill for ailing drillers faced with a worldwide transition away from oil and gas — and the banks that finance them.
Chesapeake’s collapse stands out, as it is a particularly big beast. The Oklahoma-based exploration and production firm is a regular near the top of the S&P Global Platts global energy company rankings for the Americas. As of end-2019, it owned 13,500 oil and natural gas wells and had estimated proved reserves — its best guess of its available hydrocarbon assets — of 1.6 billion barrels of oil equivalent (BOE), with a present fair value of $9 billion.
Yet like many pioneering drillers, it also had the burden of a huge debt pile. At the turn of the year, Chesapeake had $2.10 of long-term borrowings outstanding for every $1 of equity, and net debt outstanding of $9.1 billion.
This made it vulnerable to the ravages of the coronavirus crisis. When energy prices went into a tailspin, oil which the company had been selling for an average of $59.16 a barrel last year started to fetch 21% less, strangling operating cashflows. Worse, the collapse forced the firm to write down the present value of its unexploited reserves, contributing to an impairment charge of $8.5 billion — an amount on a par with its revenues for the whole of 2019.
Starved of cash, earlier this month Chesapeake skipped payments of $13.5 million on two high-yielding senior notes, putting it on the path to default. The firm chose to get ahead of the curve and voluntarily file for Chapter 11 bankruptcy protection rather than wait for the clock to run out.
Squeezing ‘em dry
Chesapeake will now be reorganised in the best interest of its creditors — putting a cadre of banks that extended loans to the troubled driller in the spotlight. Data from S&P Capital IQ shows that the firm had bank loans outstanding of $3.4 billion as of end-March. A year ago, there was less than half this amount due.
What blew up Chesapeake’s loan balance? The answer is its activation of a revolving credit facility (RCF), a kind of loan that typically only gets used when a firm runs into trouble, and can end up costing them a bomb.
An RCF is like a credit card for corporates, allowing firms to draw cash from a series of banks, repay them, and tap them again as needed. They are typically collateralised, with the credit limit capped at a proportion of the value of pledged assets — known as the “borrowing base”.
Banks demand fees to set up and maintain RCFs, and a variable interest rate is charged on outstanding balances, which typically ratchets up as a borrower nears its credit limit. This makes RCFs highly lucrative, especially when firms are forced to max out their borrowing base.
At end-2019, Chesapeake had a $3 billion RCF, committed by 15 lenders including household names Wells Fargo, JP Morgan, Bank of America, Goldman Sachs and Morgan Stanley.
When it was last amended in September 2018, the banks secured the loan against the company’s assets, including mortgages on 85% of its oil and gas reserves, and charged Libor (the interbank funding rate) plus 1.5% to 3% on any draws.
Pretty soon after it was set up, Chesapeake began to run its balance up — and lordy did the interest build. In Q3 2018, the first three months of the amended RCF’s operation, Chesapeake paid $11 million on $645 million of outstanding borrowings. A year later, in Q1 2019, it was paying $29 million on $1.5 billion. Over 2019 as a whole, the average interest rate charged was 4.8%. The average one-month dollar Libor rate, meanwhile, was 2.2%. Now that’s an attractive margin.
Source: Chesapeake Energy 10-Q and 10-K filings
A risky borrower like Chesapeake, which had a junk credit rating at the time the amended RCF was struck, was always a likely bankruptcy candidate. But even though it was on death row, the banks still decided to extend the loan — and got to pocket a combined $137 million in interest for their pains.
Still, with Chesapeake now bankrupt, the lenders have $1.9 billion in principal payments outstanding. If lost, this would wipe out any interest gains from the RCF’s activation. Why take the risk?
First, remember the banks have recourse to Chesapeake’s hydrocarbon reserves. Though these, too, have fallen in value because of the coronavirus crisis, the banks could seize them to make good their losses. Fossil fuel lenders including Bank of America, JP Morgan and Wells Fargo are even considering setting up their own oil companies to exploit the oil and gas reserves they acquire from delinquent borrowers.
Second, the RCF lenders are now partly in charge of the bankrupt Chesapeake’s business plan going forward. The banks all signed off on a Restructuring Support Agreement (RSA) and lent an additional $925 million to the company, meaning it can keep drilling for and make the revenues needed to pay them all back — with interest.
Similar RCF agreements can be found all across the US oil patch. Whiting Oil and Gas, which filed for bankruptcy in April, had an RCF with a borrowing base of $2.05 billion on which it paid $15 million of interest in 2019. Diamond Offshore Drilling, which also capsized in April, had a $950 million facility, from which it borrowed $436 million in March as it teetered on the brink of bankruptcy. The weighted average interest rate on this loan was 5.3%.
Clearly, banks believe RCFs are a good bet — even though principal balances could be locked up in bankrupt entities, and potentially never repaid. The interest that can be earned, and choice collateral pledged, compensate handsomely.
Still, deathbed loans to drillers make less sense in a post-Covid world — and zero sense as the world transitions away from fossil fuels — because the hydrocarbon assets used to secure them are hemorrhaging value.
Take Chesapeake’s facility. When amended in 2018, its borrowing base was $3 billion. In June, this was revised down to $2.3 billion, reflecting the diminished market price of the oil and gas collateral, and uncertainty as to whether the firm could exploit these reserves without incurring debilitating losses.
Put simply, banks are lending high-interest loans, to oil firms already on their way to the boneyard, against collateral that can lose tremendous amounts of value in a matter of months. If it doesn’t sound like a sustainable business, that’s because it isn’t. Still, like with other ailing industries — such as newspapers — there are still profits to be wrung out of the walking dead.
And banks could keep the oil drills spinning for years to come. Though several Wall Street giants booked large loan-loss provisions in the first quarter, in part because they anticipated oil clients would go belly-up, risky RCFs aren’t a large enough part of their portfolios to cause them real trouble.
What could make a difference, though, is their capital treatment. Assigning a weighty equity charge to “brown” RCFs could put the boosters on banks’ plans to get out of shale financing and make the prospect of inheriting hydrocarbon reserves unattractive from a return on capital perspective.
Applying such a charge, however, requires regulatory and political will — both in short supply under the current administration.
But absent bold action banks will continue to squeeze oil firms dry — and underwrite their drilling into bankruptcy and beyond.
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