Financing Undeveloped Secondary Recovery Acquisitions
Authors: Jackson E.G. 
Published: December 2007

Introduction

Although commercial banks have been making loans secured by producing oil and gas properties for more than 35 years, it has been only since the close of World War II, and more notably since the middle 1950's, that real growth in this type of credit has taken place. This growth reflects the great increase in property acquisitions during recent years and is a product of a number of changes in our economic conditions, both on a national and an industry level.

Federal income taxes, of little importance prior to World War II, have become a dominant factor in evaluating capital investments. Substantially increased tax rates fostered the development of new financing techniques to maximize rate of return on invested capital. Production payment financing, particularly the ABC-type of transaction, is an outgrowth of the impact of higher postwar tax rates. Commercial banks, which have had a long and successful history of conventional oil lending, are now competing vigorously for this type of credit.

The availability of production payment financing, coupled with the relatively depressed state of the domestic oil producing industry, induced the so-called "sellout trend". The volume of sales has been maintained, and perhaps even further accelerated, by other factors including [1] the increasing level of prices paid for desirable oil and gas properties, [2]the increasing costs associated with exploration for new oil and gas reserves, [3] the threat of changes in existing tax provisions, and [4] the industry's inherent "herd instinct".

The experience of most commercial banks in the financing of oil and gas property acquisitions has been very satisfactory, provided reasonable precautions have been taken in evaluating the collateral and in preparing for contingencies. Banks have a duty to protect the funds owned by their depositors; however, they also have a duty to design each loan in the best interests of the borrower. Lending limits and repayment schedules should be tailored within the bounds imposed by the value of the collateral and the expected rate of cash flow. Adequate coverage should be provided in setting such limits to take into account contingencies resulting from:evaluation errors [on the high side],reduced oil and gas prices,reduced allowables,increased operating costs,unforeseen capital expenditures,inefficient operations, andmechanical difficulties.

UNDEVELOPED SECONDARY RECOVERY ACQUISITIONS

In spite-of their long experience in oil and gas lending, it has been only within the last five years' that banks have assigned significant collateral value to undeveloped primary or undeveloped secondary reserves.[The term "secondary reserves", as used in this paper, refers to increases in ultimate recovery anticipated from any process which involves fluid injection, and includes the so-called"tertiary reserves".] Previously, such reserves were considered to be too speculative for collateral purposes. Properties with substantial undeveloped secondary reserves were considered even less attractive as security than undeveloped primary properties, since the former usually were subject to wider variations in engineering appraisals and their development often was subject to prolonged delays. This placed undeveloped secondary reserves in the same category as the salvage value of equipment-a "plus" that hopefully would not be required to pay out the loan.