While eight and nine figure deals in the oil and gas industry are frequently publicized, the less high profile deals have significant impact on a community and create opportunities for community banks to profit from our state’s natural resources. Community banks assist purchasers in the acquisition of property, operating assets and working capital and can be an important wealth management resource for sellers of oil and gas interests. This article analyzes the potential borrower, collateral package, required due diligence, and lien attachment and perfection in this transaction. It also addresses lending to the secondary and tertiary businesses that depend on the oil and gas industry’s revenue stream.
As an initial matter, the bank must determine the nature of the borrower’s interest in the business. Is the borrower a royalty owner (owner of a fractional interest of the revenues that typically has no operational interest in the wells, but benefits from the revenue stream)? Is the borrower a working interest holder (owns the right to extract oil and gas and sell it)? A working interest holder can pledge its entire working interest under its oil and gas leases and its interest under any pooling agreement, as well as proceeds to be paid to it under sales contracts. Is the borrower the owner of an operational interest (has no ownership in the oil and gas, but collects a portion of the proceeds for operating the well, which can be pledged as collateral)? The answers to these questions will allow the bank to begin underwriting and determine what collateral may be available.
One very important role that community banks fill is providing funding to secondary and tertiary business in the oil and gas industry. The accompanying diagram illustrates only a few of the businesses in the oil and gas development supply chain. Over 400 people and 150 different suppliers are required for the development of just one Marcellus shale well. Considering the rural nature of many areas where oil and gas development are occurring, this supply chain and infrastructure is in the developmental phase, providing opportunities for community banks to lend to more traditional clientele.
Collateral for primary oil and gas industry lending can range from oil and gas leases, working interests, fee interests, gas wells, pipelines, tanks, production, proceeds, royalties, drill sites, personal property, collateral assignment of production and/or transfer orders, gas contracts, gas systems, hydrocarbons, coal, oil and gas leases, and operating equipment. If an oil and gas lease is offered as collateral, is important to note the terms of such lease. Typically the royalty owner only grants the right to develop the oil and gas for a stated number of years “and as long thereafter as the property is operated for oil and gas purposes” or “as long as oil and gas is produced in paying quantities.” A lender must ensure that the borrower will have a continued legal interest in the lease for the lending term.
As with any financing, it is important to do the necessary due diligence to ensure repayment. One unique consideration is the necessity of monitoring payments and lease statuses. If an operator does not make royalty payments or does not drill a well during the primary lease term, a lease may be cancelled. If a sale or transportation contract is terminated, the product may not be able to get to market and the revenue stream will be halted. Special monitoring covenants should be added to the loan agreement based upon a review of all leases, permits, bonds and contracts.
Revenue calculations for oil and gas production can be complex, but numerous West Virginia accountants specialize in oil and gas financial analysis and offer assistance to lenders. The following figures and documents are important to review during underwriting: valuation of properties, cash flow from properties, production decline curves, oil and gas reserve reports, costs of properties and Authorization for Expenditures (AFE’s); related party transactions and operating agreements, delay between production and revenue receipt, taxes, and environmental compliance.
After identifying the collateral, it is important to ensure that the documentation properly attaches and perfects the security interest. It is best to avoid lien perfection issues by using documents that will cover the collateral regardless of whether it is considered real property or personal property, including deeds of trust, security agreements and assignments, as well as a mineral filings, fixture filings and UCC financing statements. A deed of trust will likely include a grant of gas contracts, gas systems, hydrocarbons, oil and gas leases, operating equipment and production sale contracts, and include fixture and as-extracted mineral filing language. A security document should grant all oil, gas, and other minerals before extraction; all oil, gas, and other minerals constituting as-extracted collateral, all pipelines, contract rights, wells, leases, leasehold estates, and bonds related to the production of oil, gas and other minerals.
The description of the collateral is important and will vary depending on what the collateral consists of. If leases are taken as collateral, the security document should contain the lessor name, lessee name, date of lease, any assignment thereof, recording information (if recorded), acreage covered, district, county, well names, well numbers, and API numbers.
The nature of the collateral determines the method of perfection of the security interest. A lessee’s interest under a gas lease is real in nature and a security interest is perfected by recordation of a deed of trust. A borrower’s interest under an operating agreement is personal property perfected through an assignment of the operating agreement and filing of a UCC financing statement. Drilling equipment and wellhead fixtures and real and personal property and should be perfected by filing a financing statement and a fixture filing. A stream of funds under contracts would be perfected by the filing of a financing statement.
Community banks can make wise and profitable lending choices to the oil and gas industry with an understanding of potential borrowers, industry asset valuation, revenue streams, and lien perfection techniques.