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BOARD OF GOVERNORS

OF THE

FEDERAL RESERVE SYSTEM

WASHINGTON, D.C. 20551

DIVISION OF BANKING

SUPERVISION AND REGULATION

SR 16-17

December 1, 2016

TO THE OFFICER IN CHARGE OF SUPERVISION

AT EACH FEDERAL RESERVE BANK

SUBJECT:Supervisory Expectations for Risk Management of Reserve-Based Energy 

Lending Risk

Applicability: This guidance applies to state member banks, U.S. branches and agencies of 

foreign banking organizations, and depository institution holding companies and nonbank 

subsidiaries of such holding companies involved in energy lending, regardless of the asset size of 

the supervised institution.

The purpose of this letter is to enhance existing energy lending guidance1 and to update 

financial institutions and supervisory staff about key risks and risk management factors for 

reserve-based lending activities.

Reserve-based lending is a type of financing where a loan is secured by the reserves of oil 

and gas of a borrower and repaid primarily using the proceeds from the future sale of 

encumbered oil or gas reserves. The amount of a reserve-based loan is determined based on the 

borrower’s “proved reserves” borrowing base, adjusted for certain risk factors. Categories of 

proved reserves include proved-developed-producing,

2 proved-developed-nonproducing,3 and 

proved-undeveloped reserves.

4 While this guidance is being issued largely in response to recent 

 1 See Energy Lending—Production Loans, Commercial Bank Examination Manual, Section 2150.1.

2 Proved-developed-producing reserves are those quantities of petroleum which, by analysis of geological and 

engineering data, can be estimated with reasonable certainty (90%) to be commercially recoverable, from a given 

date forward, from known reservoirs and under current economic conditions, operating methods, and government 

regulations. Reserves subcategorized as producing are expected to be recovered from completion intervals which 

are open and producing at the time of the estimate. “Petroleum Reserves Definitions,” Society of Petroleum 

Engineers, last modified March 1997, www.spe.org/industry/petroleum-reserves-definitions.php.

3 Proved-developed-nonproducing reserves include shut-in (open but not producing, waiting on market/pipeline 

connections, or mechanical problems) and behind pipe (requires additional completion or future recompletion) 

reserves. Ibid.

4 Proved-undeveloped reserves are reserves to be recovered from additional drilling, deepening existing wells to a 

different reservoir, or where a relatively large expenditure is required to complete an existing well or install 

production or transportation facilities. Ibid.
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oil and gas industry developments, the risk-management principles are broadly applicable 

irrespective of market conditions.

Market Issues and Risk Ramifications

A financial institution engaging in reserve-based lending should maintain a robust risk 

management program to manage and control the level of risk in and concentration of its reservebased lending portfolio. The program should include timely market condition analysis that 

supports sound credit risk management and underwriting practices. The range and extent of 

market analysis may vary depending on the composition of the institution’s energy-related loan 

portfolio and overall risk exposure to the energy industry. The analysis should provide an 

institution’s management and its board of directors with sufficient information on market 

conditions to make informed decisions regarding both loan and portfolio risk changes. 

Prolonged declines in crude oil prices often result in substantial declines in crude oil and 

natural gas reserve collateral values and associated cash flows, challenging the loan repayment 

ability of oil and gas exploration and production borrowers. Highly leveraged borrowers and

those that are in weakened financial condition are most vulnerable to these market conditions.

Financial institutions should monitor market factors to better manage and control the risk of their 

reserve-based lending portfolios and to determine the repayment ability of their borrowers. 

These factors include:

• Oil and gas commodity prices. Commodities are particularly susceptible to price 

volatility. Global supply and demand imbalances can affect commodity prices and the 

cost of production. For example, weather events, economic conditions, and numerous 

other factors can alter global supply as well as demand and place downward pressure 

on exploration and production company performance. Financial institutions should 

take market developments and price volatility into consideration when critically 

reviewing collateral valuation assumptions and managing their reserve-based lending

exposure.

• Production costs and capital expenditure. Production costs are also known as 

“lifting costs.” These costs are incurred in the operation and maintenance of wells,

related equipment, and facilities, and can affect sustained production. Financial 

institutions should critically review production costs and capital expenditures when 

determining borrower repayment capacity, financial viability, and liquidity.

Additionally, production costs can vary significantly between wells and fields. 

Financial institutions should use location-specific production cost and capital 

expenditure estimates instead of general assumptions, particularly for those reservebased lending portfolios containing wells in different oil fields.

New technological drilling and completion improvements, such as horizontal wells 

with multistage hydraulic fracturing completions, have significantly increased the upfront capital needs for exploration and production borrowers. Financial institutions

engaging in exploration and production lending should understand the capital needs 

of these borrowers, including the use of new technologies, when determining 

borrower repayment ability. As reserves are depleted, additional capital spending is

required to bring additional reserves into production and maintain productivity levels.
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• Lease provision and maintenance. Oil and gas leases generally include a “continuous 

drilling” or “continuous operations” clause to prevent the lease from expiring at the 

end of the primary term while drilling operations are in progress. It gives the lessee 

the right to continue drilling any well that was begun before the lease expired and to 

begin drilling more wells. Maintaining production in order to exercise these lease 

maintenance clauses can potentially cause financial challenges to a borrower, 

particularly during weak market condition. Financial institutions should understand 

the scope of lease maintenance clauses in place and assess the borrower’s ability to 

remain in compliance during stressed time periods. 

Supervisory Expectations for Credit Risk Management and Underwriting Practices

Financial institutions should have in place appropriate risk management programs and 

prudent underwriting standards for reserve-based lending. A risk management program should 

cover concentration limits and market condition analysis, as well as expectations to identify, 

measure, monitor and control concentration risks associated with reserve-based lending. 

Moreover, an institution’s risk management program for reserve-based lending should be 

effectively integrated into its capital planning practices. A financial institution should regularly 

review its policies and practices for reserve-based lending, including any relevant contingency 

plans in the event of market changes, and should maintain capital levels commensurate with the 

level and nature of its reserve-based lending exposure. 

At a minimum, an institution with significant reserve-based lending exposure should have 

established risk management practices that address the following:

Individual Reserve-Based Lending Credit Monitoring

• Assessment of a Borrower’s Creditworthiness. An institution should conduct a thorough 

analysis of a borrower’s past and prospective creditworthiness, including:

o projected income and expenses compared to actual results, as well as the results 

of peer oil and gas producers in the region, 

o working capital adequacy, 

o capital expense analysis, 

o cash flow analysis, and 

o price sensitivity analysis.

Current borrower financial information is essential to the institution’s ability to 

evaluate the borrower’s creditworthiness, leverage, and liquidity. A creditworthy

exploration and production business should exhibit strong repayment ability, risk 

analysis, liquidity, solvency, reserve valuation, credit management, profitability, and 

management performance.

• Assessment of a Borrower’s Cash Flow. In volatile markets, a highly leveraged 

borrower may not have the necessary cash flow to properly service its debt according to 

the loan terms. By reviewing borrower-prepared cash flow statements, an institution 

should be able to identify potential repayment ability problems, calculate key cash flow 

ratios, and assess the ability of the business to handle risk and uncertainty. 
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Risk and uncertainty due to market factors, commodity prices, and production levels 

are prevalent characteristics of most exploration and production operations and should 

be reflected in the cash flow projections. A sensitivity analysis that determines an 

exploration and production operator’s ability to withstand fluctuations in commodity

prices and uncertainty in production levels is critical in analyzing cash flow projections. 

Some key elements of sound financial analysis that an institution should conduct 

include:

o Reviewing the reasonableness of underlying assumptions and projections for 

production, pricing, and price differentials;

o Comparing these projections with historical production and performance results; 

o Analyzing hedges in place as of collateral valuation date;

o Assessing the impact of changes in capital expenditures on production levels; and 

o Evaluating a borrower’s ability to timely service total debt and significant 

changes in its balance sheet structure.

• Reliable Collateral Evaluations. Valuation of oil and gas reserves demands expertise 

and industry experience. The interconnected nature of the energy industry is complex 

and demands breadth and depth of understanding across all business sectors which 

include upstream, midstream, and downstream segments. Specialized contracts with 

energy services providers, such as transportation to market or delivery point, should be 

carefully reviewed as part of risk management practices for reliable collateral valuation.

A typical reserve-based lending credit facility requires a borrower to deliver an updated 

reserve engineering report twice a year to the lender. A financial institution should 

identify additional costs and value adjustments not included in the engineering report, 

such as information on land mortgage restrictions and lease assignments, and use this 

information to understand the scope and limitation of the collateral securing the 

reserve-based lending. An institution should assess the assumptions contained in the 

reserve report, as this information forms the basis for its analysis of the reserve 

valuation.

A financial institution should have a well-defined and consistently applied process, 

including minimum frequency, for obtaining independent reserve engineering reports. 

These reports require significant industry expertise and should include a complete 

analysis of the wells and production requirements from current production and over the 

life of a well.

A financial institution should periodically conduct independent assessments of reserve 

valuation. Depending on the level and complexity of reserve-based lending in its 

portfolio, an institution should utilize its own independent staff engineers (if available) 

or retain independent petroleum engineers to conduct a comprehensive assessment of 

reserve valuation. This assessment should consider such factors as the relevant 

production volumes, expected ultimate recovery of reserves, and capital expenditures 

needed to convert reserves into production. An institution should also have processes in 

place to monitor periodically (at minimum, twice a year) the value of collateral pledged 

in order to manage repayment risk over the life of the loan. An institution’s processes, 

risk adjustment factors, and discount rates for reserve analyses should be well defined 
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in policy and consistently applied. Additionally, evidence of collateral lien perfection 

and collateral inspections should be documented in loan files.

• Loan structure. The structure of a reserve-based loan should depend on the nature of a

borrower’s business. To properly structure a borrowing relationship, a financial 

institution should be able to:

o Project how the borrower will perform in the future, including likely primary and 

secondary repayment sources from producing and developing assets. There should 

be limits to the portion of repayment capacity derived from developing assets.

o Anticipate challenges and problems that the borrower may encounter, such as 

commodity price volatility, operational risks, and lease maintenance 

requirements.

o Match the type and terms of the loan to both the loan purpose and the likely 

repayment sources. This includes ensuring the loan is supported by sufficient cash 

flow from the expected repayment source, particularly when a reserve-based

loan’s collateral includes undeveloped fields (that is, proved-developednonproducing reserves and proved-undeveloped reserves) or fields that do not 

have a continuous production history as collateral. The primary source of 

repayment is typically proved producing reserves.

o Develop loan agreement covenants that protect the financial institution, including 

provisions for monitoring the borrower’s expenditures for the term of the loan. 

For example, a forward-looking liquidity test should provide an institution with 

visibility to the future consolidated liquidity position of the borrower and all

guarantors to the loan. In addition, covenants should require the borrower to 

obtain the financial institution’s approval prior to lifting any hedges upon which 

the institution is relying to mitigate collateral market value fluctuation. 

o Secure the credit facility with collateral and consider requiring the borrower to 

provide loan support such as guarantees and hedges for commodity price 

volatility. Any guarantor should be included in the loan agreement. A financial 

institution should have processes and procedures in place to limit a borrower’s 

commodity price hedging to its total production and thereby avoid over-hedging.

• Risk rating credit facilities. A financial institution should have in place a robust process 

to risk rate reserve-based loans. Risk rating for reserve-based loans should be based on 

realistic repayment assumptions for a borrower’s ability to de-lever and repay the 

reserve-based loan and its total debt relative to the economic life of the borrower’s oil 

and gas reserves. Financial support or credit enhancement from a sponsor (such as the 

borrower’s parent company) should be demonstrated and documented for rating 

conclusions.

• Timing of collateral impairment testing and impairment indicators. Generally, reservebased loan terms require a borrower to prepare a reserve impairment assessment at least 

annually, and more frequently depending on events or changes in circumstances. A 

financial institution should review the reserve impairment assessment report and

associated recoverability test of pledged assets’ value whenever events or changes in 

circumstances indicate that a pledged asset’s carrying amount may not be recoverable.
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Reserve-Based Lending Portfolio Monitoring

• Underwriting standards. An institution should periodically review its underwriting 

standards to ensure its reserve-based lending policies do not become outdated,

ineffective, or unaligned with its stated risk appetite. The frequency and depth of the 

review will depend on circumstances specific to the institution, such as growth 

expectations, competitive factors, economic conditions, and overall financial condition. 

An institution’s management should review and modify, as appropriate, reserve-based 

lending policies based on any planned changes to its reserve-based lending function or 

business plan. An institution should also address significant criticisms and 

recommendations about its underwriting standards that have been identified in recent 

audits and examinations.

• Concentration limits. In general, a financial institution should monitor and manage its

aggregate energy lending portfolio to avoid concentration risk. The institution should 

set risk limits for reserve-based energy lending that are consistent with the risk appetite 

approved by the board of directors. In addition, an institution should monitor and 

manage its production and regional concentration risk for exploration and production

borrowers to avoid any single well or field accounting for a high percentage of its 

energy-related loan portfolio.

5

• Credit administration and controls. An institution should have appropriate policies and 

controls to monitor and separately manage troubled reserve-based loans for which a

borrower is unable to generate sufficient cash flow from oil and/or gas production to 

repay the loan (sometimes called “stretched” reserve-based loans). A stretched reservebased loan reflects a borrower with credit or liquidity weaknesses, and an institution 

should understand the fundamental causes of those weaknesses. An institution may still 

work with a troubled borrower to continue to service existing loans. An institution 

should confirm the reasons for the borrower’s cash flow problems (for example, 

weaknesses in a borrower’s financial condition or operations, or poor market 

conditions). An institution’s credit administration process should appropriately monitor 

exposure to the borrower and adjust the credit facility rating to reflect the borrower’s 

credit condition, as well as the viability of the borrower’s operation, so that the 

institution can make an informed decision as to whether advancing additional funds is 

appropriate. Any additional funds advanced should be for the purpose of improving the 

borrower’s financial condition.

Expectations for the level of sophistication of risk management systems will vary based 

on the specific risk characteristics, complexity, and size of an institution’s reserve-based lending

exposure. In general, there are higher expectations around risk management for financial 

institutions with significant reserve-based lending exposures in concentrated geographic 

locations and market segments. An institution should assess the effect, if any, of its reservebased lending activities on the institution’s overall financial condition, including capital, the 

allowance for loan and lease losses, and liquidity.

 5 For more information, see 17 CFR 210.4-10, “Financial accounting and reporting for oil and gas producing 

activities pursuant to the Federal securities laws and the Energy Policy and Conservation Act of 1975.”
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Contacts 

Reserve Banks are asked to distribute this letter to supervised organizations in their 

districts and to appropriate supervisory staff. Questions regarding this letter should be directed to 

Peter Clifford, Manager, Risk Policy, at (202) 785-6057; or Lesley Chao, Senior Supervisory 

Financial Analyst, Risk Policy, at (202) 974-7063. In addition, questions may be sent via the 

Board’s public website.6

Michael S. Gibson

Director

 6 See: http://www.federalreserve.gov/apps/contactus/feedback.aspx.