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Credit Crunch Ahead for Gas Drillers?

Because of the timing of the decrease in natural gas prices, and a "timely hedge book," exploration and production (E&P) companies mostly have "coasted" through 1Q2012's borrowing base season, but there may come a point when commercial banks may not continue to use a lending gas price deck well above strip prices, the energy team at Raymond James & Associates Inc. said last week.

"On the whole, we are expecting our predominantly gas-weighted producers to realize 5-15% borrowing base declines in the fall borrowing base redetermination season, as banks adjust to lower gas price decks and apply a layer of conservatism to their lending practices," wrote Kevin Smith, John Freeman and Justin Albert in a note to clients.

"Ultimately, we believe this will result in a more active acquisition and divestiture (A&D) market with operators that have access to capital becoming the financers of choice for more debt-ridden gas-weighted E&P companies."

The industry already knows that earnings season won't turn out well for the gas bears, the analysts said (see related stories). The "semi-annual borrowing base redetermination season" could turn out to be just as impactful, they said. For most private, small, and mid-cap E&P companies, borrowing bases are the primary way to access debt markets because these secured credit facilities are backed by liens on the oil and gas properties.

"This is the semi-annual (spring and fall) time of the year when banks receive a reserve report from E&P companies and calculate how much credit they are willing to provide ('conforming borrow base') based on the new reserve report and an updated commodity price deck," noted Smith and his colleagues.

"So why is this year going to be important? The weakness in natural gas prices (down over 40% since the start of the year) will eventually cause banks to dramatically reduce the gas price deck against which they are willing to lend. Most companies are getting a hall pass for the spring borrowing base season thanks to stubbornly high bank price decks, legacy natural gas hedges and historically a lack of understanding about how bad it was going to get in the natural gas market.

"In our view, hall passes for small cap gas-weighted companies will become incrementally harder to acquire over the next six-to-12 months."

Every commercial lender has a different process to calculate a borrowing base, but the Raymond James analysts said a typical bank process is to use a company's reserves report, layer in a bank's price deck and then discount that cash flow back at 9-10%. Banks separately go through the same process with proved developed producing (PDP), proved developed nonproducing, and proved undeveloped reserves (PUD). After calculating present values, the banks usually will lend 60-70% against the PDP volumes, cap out any PUD value component to 10% of the total borrowing base and only lend 60% against PUDs until it "hits the ceiling."

Since the bases are looked at semiannually lenders "conservatively roll off the first six months of cash flow, essentially assuming that cash flow generated over this time frame won't be available to repay the loan. Thus, keep in mind that if production starts to decline following a cut in capital spending, so too will the borrowing base commitment amount."

Commercial banks tend to be accommodating to existing clients -- and no banker wants to have a bad loan on its books, the analysts noted.

"Our best guess is that banks will likely continue to lend at or near gas strip pricing while hair cutting oil prices," which could lead to producers having "no economic incentive, unless they are gas bears, to add new gas hedges," they wrote. "However, we will likely continue to see producers aggressively hedge oil prices in order to capture that 20% portion of the futures curve their lenders are not giving them credit for. The end result is that unless gas prices move materially over $4.00/MMBtu, look for gas hedging percentages to decline over time."

The borrowing issues are "clearly" a gas-dominated concern" and "for gas-weighted producers that are outspending their cash flow to grow production and financing this cash burn through debt, credit is likely going to contract due to the run-off of hedges and the reduction in the lending price deck.

"Also, while we are by no means calling for the credit crunch of 2008/2009, this is more a call that senior debt lenders will navigate back to old historical ways and cut down on commodity price exposure by conservatively lending against a discount-to-strip pricing. If true, this will ultimately lead to a contraction in lending capacity."

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