Risk Factors in Oil and Gas Lending-New Financing Alternatives
Authors: David Amiel , Kipp James M. 
Published: December 2007

Summary
With the increasing internationalization of the petroleum industry, lendersto the industry must understand and overcome several new credit risk factors. As a result, new financial products are now available to reserve-basedborrowers. Traditional project financing now also may include futures hedging, swaps, and collar elements.

Introduction
Financings secured by oil and gas reserves expose the lender to numerousrisks. It is beneficial for a prospective borrower to know and understand therisk factors the lender must analyze in considering credit requests. Theability of the borrower to reduce the risk exposure of the lender enhances thelikelihood of successfully arranging a reserve-based credit facility. A numberof financial products developed in recent years facilitate the transfer of riskto third patties. These risk-transfer products and techniques can proveinstrumental in determining the feasibility of a financing request. This paperdiscusses the various risks a lender must consider in financing oil and gasreserves and several financial products and techniques available to reduce therisk exposure of both borrower and lender. The final part of this paperpresents a brief example showing how these products can be used effectively toreduce risks.

Reserve-Based Loans
The typical financing request received by commercial banks from small- tomedium-sized energy companies is a loan secured by reserves. Reserve-basedloans are credit extensions that are collateralized by oil, gas, and/or otherhydrocarbons to be produced in the future with a reasonable degree ofcertainty. The collateral requirements are very similar to requirements fornonenergy loans; the lending institution uses collateral to enhance thefinancial integrity of the borrower. Cash flow from the property is used toservice the debt and to fund the cost of continuing operations. The differencebetween conventional and energy loans is the ability to determine the certaintyof the collateral value and the cash flow that it will generate. Obviously, there are significant differences between determining the value of hydrocarbonreserves and determining the value of other types of collateral. Withreserve-based credits, the borrower represents and warrants to the bank thecondition of the collateral it wishes to pledge. This representation includesthe following.
List and description of all wells, both producing and nonproducing.producing and nonproducing. Ownership interest in the wells or units, including working interest, net revenue interest, and royalties. Productionhistory for oil, gas, and water. Historical revenue and operating expensedata. Prices received for all products sold. Any special agreements, contracts, or arrangements that affect the price, production, or ownership ofthe reserves. production, or ownership of the reserves. Technical documentsthat will verity or support the determination of reserve value. These mayinclude geological maps and analysis, seismic interpretation, logs, core data, PVT information, pressure history, and any other information that can be usedto determine the extent of the reservoir. Reserve reports prepared by anindependent engineering firm.
(Most companies engage a third-party engineeringfirm to provide independent verification of reserve values.) The informationprovided to the bank is used to determine the value of the collateral underseveral scenarios. Many large banks specializing in reserve-based lending havea staff of petroleum engineers who support the lending staff in determiningloan values and in structuring credits. A survey conducted in June 1990 foundthat there were about 180 in-house bank engineers. This survey indicated thatthe staffing levels ranged from 1 to more than 10 engineers. Many banks do notemploy in-house engineers but retain engineering consultants to assist themwith interpreting reports provided by the borrower. Additionally, some bankshave lending staffs with engineering backgrounds who provide technical support.provide technical support. An integral part of the engineer's analysis is todetermine the risks associated with the various reserve categories. Becausemost banks are risk-averse, those lending on oil and gas properties typicallydo not assign value to reserve categories other than the proved categories. Many of these banks proved categories. Many of these banks will not assignvalue to proved undeveloped (PUD) reserves. The reason for this limitation istwo-fold.
JPT
P. 1490