As the oil market reels from shocks on both the demand and supply side, exploration and production (E&P) companies are reviewing and restructuring loan agreements in a bid to free up capital and ensure long-term security.

Last month, Saudi Arabia flooded the oil market after Russia refused to decrease its production, resulting in a global oversupply of oil. Meanwhile the spread of Covid-19 caused a crash in demand as transport networks have come to a grinding halt.

“We have seen somewhat of a double blow to the oil market. We have an oversupply of oil as a result of the Russia and Saudi war, combined with the reduction in demand because of Covid-19,” Sonya Boodoo, vice-president of upstream research at energy consultancy firm Rystad Energy, tells GTR. “As a result of both events, oil prices have plummeted.”

To mitigate the risks arising from the pricing war and Covid-19, E&P companies are looking to preserve and secure capital to ensure their long-term value, doing so by revaluating loan agreements and slashing operations.

US E&P companies California Resources and Gulfport Energy have both hired Perella Weinberg, a financial services group, to help restructure their debt, reports the Financial Times. “We’re sitting on a precipice of a lot of E&P restructuring right now. Bankruptcy is increasingly on the table,” said Ryan Bouley, partner in the restructuring group at Opportune, a US consultancy, in the report.

A common form of financing that E&P companies use is reserve-based lending (RBL), a type of financing that allows the loan to be agreed against an asset’s (gas or oil field) future revenue based on certain assumptions, including oil price and estimated reserves. RBLs are typically recalculated every six months.

E&P companies with RBLs are looking into loan documentation which might mitigate or relieve their obligations, and whether or not Covid-19 and the price plunge might constitute a default on grounds that a ‘material adverse change’ has occurred, says a blog from law firm Bracewell. A material adverse change is a change in circumstances that significantly reduces the value of an asset.

It adds that “borrowers have been seeking advice on force majeure, and borrowers and lenders have been considering the ambit of facility provisions that relate to material adverse change”.

“One of the key assumptions in RBL is the oil price, so you would imagine that not only has Covid-19 been a major issue for E&P companies, the collapse that is happening almost independently from the supply side has also been a big problem as well,”  Olivia Caddy, partner at Bracewell, tells GTR.

Andy Hartree, senior advisor at energy consultancy firm Gneiss Energy and former head of commodity markets solutions at Lloyds Bank, tells GTR: “While banks take security over assets, the basis of their lending decisions is always the ability of the assets to generate the necessary cash to repay the loan. But they are also making an investment at a fixed return, regardless of what the market does. Their valuation premises are therefore all conservative, including a view of oil or gas prices that mean they get paid out even in the worst-case scenario. It is also why the banks require hedging to protect the uncertainty in getting their fixed return.”

Hedging involves locking in a future price to buy or sell a commodity. Players in commodity markets, which often see price fluctuations, may hedge to offset the risk of any adverse price movements.

Bracewell’s Caddy explains that hedging may or may not be mandatory when doing an RBL. “It’s actually more common not to be compulsory for a company, however because companies are usually well managed and it is prudent, most of the E&P firms will be hedged,” she says.

However, E&P companies are taking different steps to ensure their security in the long term. “What we’ve seen in recent weeks is a question mark as to whether companies who have hedges in place should be closing out those hedges either because we have reached the end of the oil cycle or because it will help them manage liquidity,” says Caddy. “While others want to hedge as a form of investment in security.”

She adds: “Because a lot of companies are well hedged and because they have this ability to recall the debts, E&P companies with an RBL can communicate with their banks and have a conversation to try and best manage the impacts of Covid-19 and oil prices generally.”