ALGIERS AUSTIN DALLAS FORT WORTH HOUSTON MONTERREY PARIS RIO DE JANEIRO The American Experience in...

ALGIERS AUSTIN DALLAS FORT WORTH HOUSTON MONTERREY PARIS RIO DE JANEIRO

The American Experience in The American Experience in Oil and Gas FinancingOil and Gas Financing

Rio de Janeiro Rio de Janeiro – 9– 9 June 2004 June 2004

Presented ByPresented By

John W. RainJohn W. RainThompson & Knight LLPThompson & Knight LLP

1700 Pacific, Dallas TX 752011700 Pacific, Dallas TX 75201214.969.1644214.969.1644

[email protected]@tklaw.com

NOT AN OFFICIAL UNCTAD RECORDNOT AN OFFICIAL UNCTAD RECORD


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“The two contracts that are basic with the American oil and gas producer are the oil and gas lease and the promissory note, and practically all of the contracts that are peculiar to the oil industry are variations, refinements, elaborations and extensions of one or the other of these basic contracts.”

“The oil and gas lease affords the oil producer something to work on, and the promissory note affords him something to work with.”

Thomas A. Knight, Esq. circa 1945.


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U.S. Oil and Gas ProductionU.S. Oil and Gas Production

Production began 150 years ago, mostly onshore.Production began 150 years ago, mostly onshore.

Relevant laws and financing practices developed in Relevant laws and financing practices developed in relation to onshore production.relation to onshore production.

Current law and financing practices stem from these Current law and financing practices stem from these origins and apply to both onshore and offshore origins and apply to both onshore and offshore production.production.


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U.S. Oil and Gas RightsU.S. Oil and Gas Rights

(“Something to Work On”)(“Something to Work On”)

Rights to license exploration and production typically Rights to license exploration and production typically belong to individual landowners, not to the Nation.belong to individual landowners, not to the Nation.

Diverse ownership by private farmers and ranchers Diverse ownership by private farmers and ranchers means many small entrepreneurs can buy or lease means many small entrepreneurs can buy or lease rights to drill and produce.rights to drill and produce.


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Finance CapitalFinance Capital(“Something to Work With”)(“Something to Work With”)

The independent producers needed capital.The independent producers needed capital.

Banks and private investors responded to this need.Banks and private investors responded to this need.

Over time, some oil companies grew quite large and Over time, some oil companies grew quite large and developed additional capital sources. But the larger developed additional capital sources. But the larger companies never crowded out the smaller companies never crowded out the smaller independent producers who own and operate many independent producers who own and operate many oil and gas properties today – both onshore and oil and gas properties today – both onshore and offshore – and who continue to need capital.offshore – and who continue to need capital.


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Historical Reserve-Based LendingHistorical Reserve-Based Lending

Banks developed “reserve-based lending.”Banks developed “reserve-based lending.”

! One of the very first was Republic National Bank of One of the very first was Republic National Bank of Dallas, represented by Thompson & Knight.Dallas, represented by Thompson & Knight.

Based on the idea that oil and gas reserves have a Based on the idea that oil and gas reserves have a “loan value.”“loan value.”

! Usually 50% - 65% of Usually 50% - 65% of

! the present value (at 10% discount rate) of the present value (at 10% discount rate) of

! future sales of oil and gas from proved, developed future sales of oil and gas from proved, developed producing reserves.producing reserves.

35% - 50% discount is Bank’s safety factor.35% - 50% discount is Bank’s safety factor.


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Historical Reserve-Based Lending Historical Reserve-Based Lending (cont’d.)(cont’d.)

Each bank develops its own “price deck” to use in Each bank develops its own “price deck” to use in calculating future sales proceeds.calculating future sales proceeds.

! Based on experience as well as economic forecasts.Based on experience as well as economic forecasts.

! Less volatile than the futures markets.Less volatile than the futures markets.

Estimates of future production are made by reserve Estimates of future production are made by reserve engineers.engineers.

Bank uses this loan value to establish a “Borrowing Bank uses this loan value to establish a “Borrowing Base,” which is Borrower’s line of credit with Bank.Base,” which is Borrower’s line of credit with Bank.


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Historical Reserve-Based Lending Historical Reserve-Based Lending (cont’d.)(cont’d.)

A new reserve report is received every six months A new reserve report is received every six months and Bank redetermines the Borrowing Base.and Bank redetermines the Borrowing Base.

Bank has discretion to consider other factors in Bank has discretion to consider other factors in setting the Borrowing Base. setting the Borrowing Base.

! Some future sales prices might be based on Borrower’s Some future sales prices might be based on Borrower’s hedges, rather than on Bank’s price deck.hedges, rather than on Bank’s price deck.

! PUD reserves might get partial value.PUD reserves might get partial value.

! Special credit problems might reduce Borrowing Base.Special credit problems might reduce Borrowing Base.

Bank almost always receives a mortgage covering Bank almost always receives a mortgage covering Borrower’s proved, developed producing reserves.Borrower’s proved, developed producing reserves.


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What Happens When a Loan is in Default?What Happens When a Loan is in Default?

If Borrowing Base is redetermined and falls short of If Borrowing Base is redetermined and falls short of the outstanding loan balance, Borrower is in default the outstanding loan balance, Borrower is in default unless it quickly pays back the shortfall.unless it quickly pays back the shortfall.

Loan documents also contain other defaults Loan documents also contain other defaults customary for bank loans.customary for bank loans.

If a default occurs, Bank and Borrower typically If a default occurs, Bank and Borrower typically engage in “workout” negotiations:engage in “workout” negotiations:

! Bank gives Borrower more time to pay.Bank gives Borrower more time to pay.

! Borrower agrees to raise the money to repay by cutting Borrower agrees to raise the money to repay by cutting costs or selling assets.costs or selling assets.


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What Happens When a Loan is in Default?What Happens When a Loan is in Default?(cont’d.)(cont’d.)

If Borrower is unable to cure the default within a If Borrower is unable to cure the default within a reasonable time, Bank will attempt to foreclose its reasonable time, Bank will attempt to foreclose its mortgage.mortgage.

Borrower will either allow foreclosure or commence a Borrower will either allow foreclosure or commence a bankruptcy case.bankruptcy case.

If Bank forecloses, U.S. law allows it to own the reserves If Bank forecloses, U.S. law allows it to own the reserves for up to 5 years while it seeks a buyer.for up to 5 years while it seeks a buyer.

In a bankruptcy, Borrower will have more time to put its In a bankruptcy, Borrower will have more time to put its affairs in order. But ultimately, it must either repay Bank, affairs in order. But ultimately, it must either repay Bank, or refinance, or sell its properties.or refinance, or sell its properties.


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Key “Infrastructure” for Reserve-Based Key “Infrastructure” for Reserve-Based FinanceFinance

Borrower owning proved, developed producing reserves.Borrower owning proved, developed producing reserves.

Professional reserve engineers who estimate future Professional reserve engineers who estimate future production.production.

An established market to sell this production.An established market to sell this production.

An enforceable mortgage from Borrower to Bank.An enforceable mortgage from Borrower to Bank.

An insolvency system that allows Bank’s mortgage to An insolvency system that allows Bank’s mortgage to give it priority over most other creditors, especially other give it priority over most other creditors, especially other lenders.lenders.

Reserve-based lending is based on:Reserve-based lending is based on:


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Who Provides Oil and Gas Financing Who Provides Oil and Gas Financing in the U.S. Today?in the U.S. Today?

In addition to internal cash flow from operations and In addition to internal cash flow from operations and reserve-based lending, capital comes from:reserve-based lending, capital comes from:

! Equity investors, including mutual funds, hedge funds, Equity investors, including mutual funds, hedge funds, and endowmentsand endowments

! Corporate lenders (generally to investment grade Corporate lenders (generally to investment grade companies)companies)

! Project partnersProject partners

! Proceeds from asset salesProceeds from asset sales


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What Do All Investors Require in Order What Do All Investors Require in Order to Provide Financing?to Provide Financing?

Satisfactory projected returnsSatisfactory projected returns

Satisfactory probability of achieving projected returnsSatisfactory probability of achieving projected returns

LiquidityLiquidity

Legal certainty about rights and remedies in case of Legal certainty about rights and remedies in case of defaultdefault


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Why Does Finance Still Matter to the Why Does Finance Still Matter to the Oil and Gas Industry?Oil and Gas Industry?

Multiple financing sources provide multiple ways for Multiple financing sources provide multiple ways for more individuals and organizations to acquire and more individuals and organizations to acquire and operate oil and gas reserves. operate oil and gas reserves.

When there are more potential owners, there is a When there are more potential owners, there is a greater probability that the best owner for the greater probability that the best owner for the properties will become the actual owner. properties will become the actual owner.


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Who is the “Best Owner” for a Who is the “Best Owner” for a Particular Property?Particular Property?

Oil and gas properties have a life cycle:Oil and gas properties have a life cycle:

! Geological conceptGeological concept

! Exploration projectExploration project

! Development projectDevelopment project

! Operating assetOperating asset

! Mature field to be nurturedMature field to be nurtured


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Who is the “Best Owner” for a Who is the “Best Owner” for a Particular Property? Particular Property? (cont’d.)(cont’d.)

The “best owner” for a property is the owner who can The “best owner” for a property is the owner who can maximize its value. Different owners can:maximize its value. Different owners can:

! Manage each stage of the life cycle better than others.Manage each stage of the life cycle better than others.

! Manage each stage more economically than others.Manage each stage more economically than others.

! Find new applications for technology to specific basins and Find new applications for technology to specific basins and fields.fields.

! Keep fields producing longer than others.Keep fields producing longer than others.

Shared, partial ownership of properties diversifies risks Shared, partial ownership of properties diversifies risks and encourages investment.and encourages investment.


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Why Does Transferability of Oil and Gas Why Does Transferability of Oil and Gas Assets Facilitate Financing?Assets Facilitate Financing?

Transfers of properties to the “best owners” maximize Transfers of properties to the “best owners” maximize the value of the properties.the value of the properties.

! When a property matures and the present owner can no When a property matures and the present owner can no longer maximize its value, it is time to sell to a new longer maximize its value, it is time to sell to a new owner who can maximize value.owner who can maximize value.

! When a property’s probability of success becomes When a property’s probability of success becomes better known, it is time to find lower cost financing.better known, it is time to find lower cost financing.


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Why Does Transferability of Oil and Gas Why Does Transferability of Oil and Gas Assets Facilitate Financing? Assets Facilitate Financing? (cont’d.)(cont’d.)

Transferability of properties provides liquidity for Transferability of properties provides liquidity for investors, and liquid investments are safer. investors, and liquid investments are safer.

! If a borrower can sell a property to pay its lenders, the If a borrower can sell a property to pay its lenders, the lenders are more willing to lend.lenders are more willing to lend.

! If a lender can foreclose its mortgage in an emergency, If a lender can foreclose its mortgage in an emergency, the lender is more willing to risk an emergency.the lender is more willing to risk an emergency.

! If a project equity investor knows the project can be If a project equity investor knows the project can be sold once it is fully developed, the investor is more sold once it is fully developed, the investor is more willing to make a medium term investment at a lower willing to make a medium term investment at a lower rate of return.rate of return.


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Transferability of Oil and Gas Rights Transferability of Oil and Gas Rights in the U.S. Todayin the U.S. Today

Allows capital for new projects to be generated by Allows capital for new projects to be generated by sales of older projectssales of older projects

Encourages equity investors who have medium-term Encourages equity investors who have medium-term horizonshorizons

Allows secured lending for higher risk companiesAllows secured lending for higher risk companies

Allows companies to find project partners both before Allows companies to find project partners both before and after a project has begunand after a project has begun


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Should Governmental Authorities Outside the Should Governmental Authorities Outside the U.S. Consider Allowing Concessions to be U.S. Consider Allowing Concessions to be

More Easily Transferred?More Easily Transferred?

There are many kinds of qualified operators, including:There are many kinds of qualified operators, including:

! Huge companies with the capital to finance exploration and Huge companies with the capital to finance exploration and development.development.

! Smaller companies with operating expertise who need access to Smaller companies with operating expertise who need access to capital from lenders and investors.capital from lenders and investors.

! Service companies who operate for hire.Service companies who operate for hire.

! Start-up companies formed by the individuals who previously worked Start-up companies formed by the individuals who previously worked for the huge companies, the small companies or the service for the huge companies, the small companies or the service companies.companies.

All of these can be competent, responsible operators, regardless All of these can be competent, responsible operators, regardless of whether their capital is generated internally or comes from of whether their capital is generated internally or comes from lenders.lenders.


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Proposals to Encourage Oil and Gas Financing Proposals to Encourage Oil and Gas Financing for Medium and Smaller Companiesfor Medium and Smaller Companies

Develop an official list of qualified concession Develop an official list of qualified concession holders.holders.

! Include all companies with adequate operating Include all companies with adequate operating experience, both large and small.experience, both large and small.

! Include service companies willing to act as contract Include service companies willing to act as contract operators for lenders, investors, and others.operators for lenders, investors, and others.


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Proposals to Encourage Oil and Gas Financing Proposals to Encourage Oil and Gas Financing for Medium and Smaller Companies for Medium and Smaller Companies (cont’d.)(cont’d.)

Allow free transferability of concessions among Allow free transferability of concessions among qualified concession holders.qualified concession holders.

! Allow investors and lenders to take mortgages on Allow investors and lenders to take mortgages on concessions and to foreclose and own the concessions for a concessions and to foreclose and own the concessions for a limited number of years.limited number of years.

! Make Agency approvals of assignments as fast and easy as Make Agency approvals of assignments as fast and easy as possible, so lenders know they will be able to resell possible, so lenders know they will be able to resell foreclosed properties and investors know the concessions foreclosed properties and investors know the concessions are liquid investments.are liquid investments.

! Do not provide for concessions to terminate upon Do not provide for concessions to terminate upon foreclosure or “change of control.”foreclosure or “change of control.”


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SummarySummary

Banks and investors have learned how to evaluate the Banks and investors have learned how to evaluate the risks of investing in oil and gas reserves.risks of investing in oil and gas reserves.

These risks are reduced as oil and gas concessions These risks are reduced as oil and gas concessions become more and more liquid.become more and more liquid.

! Property values increase when concessions are Property values increase when concessions are transferred to new “best owners.”transferred to new “best owners.”

! Investors provide more capital for liquid investments Investors provide more capital for liquid investments and will spend more for concessions if the concessions and will spend more for concessions if the concessions are liquid.are liquid.

! Banks lend more capital when they receive mortgages.Banks lend more capital when they receive mortgages.


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John W. RainJohn W. Rain

Thompson & Knight LLPThompson & Knight LLP1700 Pacific, Dallas TX 752011700 Pacific, Dallas TX 75201

Tel:Tel: 214-969-1644214-969-1644Fax:Fax: 214-969-1751214-969-1751Email:Email: [email protected]@tklaw.com

John W. RainJohn W. Rain

Thompson & Knight LLPThompson & Knight LLP1700 Pacific, Dallas TX 752011700 Pacific, Dallas TX 75201

Tel:Tel: 214-969-1644214-969-1644Fax:Fax: 214-969-1751214-969-1751Email:Email: [email protected]@tklaw.com

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