Non-E&P Assets: The New Belle of the Ball

12/02/2015

As we continue our series of articles relating to distressed commodity prices in the oil and gas market, we expound on the option to monetize assets that are not included in the calculation of your borrowing base. This topic was briefly discussed in our article, “A Dozen Ways to Stretch Your Borrowing Base.”

Under reserve based loans (“RBLs”), producing reserves have always been what one may call the “belle of the ball.” However, in this current commodity price environment producers may be looking to new belles to step onto the dance floor and help them through this ‘lower-for-longer’ dance marathon. A producer’s borrowing base is tied solely to the future value of its proved reserves. No direct credit is given to any other assets owned by the producer. The monetization of non-reserve assets may give companies creative ways to fill the funding gap by providing additional cash flow or serving as collateral for additional loans. Below is a list of five non-E&P assets you may consider monetizing:

1. Linefill can be Monetized through Borrowing Base Credit or Title-Based Ownership

Linefill” consists of the hydrocarbons in a pipeline that are rendered to the transporter for the purpose of maintaining a minimum level of pipeline pressure. Typically, companies are required to provide a certain volume of Linefill for the pipelines they utilize to assist in maintaining that minimum level of pipeline pressure. Yet, while Linefill is required to operate a pipeline, financiers give no value to Linefill for purposes of a traditional reserve-based borrowing base facility. Similar to Linefill, “Tank Bottoms” are also not credited borrowing base value in a typical reserve-based credit facility. Tank Bottoms are a mixture of water, hydrocarbons and sediment accumulated in the bottom of a storage tank. Companies can typically borrow against 40 to 60 percent of the value of the hydrocarbons in Tank Bottoms in a downstream borrowing base structure.

For near full value, consider working with a financing entity to monetize Linefill. This can provide an immediate injection of cash to the owner of the Linefill, while providing the financing party with security on or title based ownership over the Linefill, depending upon how the transaction is structured. Regulatory considerations specific to the individual pipeline (e.g., interstate pipeline regulations and limitations) must be considered, but the intent of the financing party is to provide an alternative means of financing, not to undertake capacity on the pipeline.

2. Equipment can be Monetized through a Sale and Leaseback

Many E&P companies own production associated facilities, equipment and other similar assets that are not given borrowing base credit under their credit facility. Such assets include salt water disposal wells and related facilities, storage tanks, compressors, gas gathering and processing facilities and other associated equipment. Haynes and Boone worked this year on more than $200 million in development financing for a number of salt water disposal facilities in Texas and Oklahoma.

Our firm also worked with Ultra Petroleum (“Ultra”) to monetize its liquids gathering system (“LGS”) in a sale to a real estate investment trust in December 2012, in which Ultra retained operational control over its asset under a 15-year triple-net lease. Mark Smith, Ultra’s Chief Financial Officer at the time, said “The [structure] satisfies strategic objectives for Ultra Petroleum. We maintain operational control over the LGS, while freeing up internal capital for growth which will in turn create additional value for our shareholders.” The real estate investment fund paid $205 million in cash and approximately $24 million in certain other equity securities for the purchase of the LGS from Ultra. From the producer’s perspective, the key to this transaction is maintaining control of the asset without interruption of ongoing operations. For example, a producer can sell its storage tanks and then enter into a long-term leaseback of those same storage tanks to maintain the guaranteed use of those tanks.

Note that some credit facilities prohibit the disposition of assets whether or not borrowing base credit is specifically tied to such assets. This means underlying loan documents need to be reviewed to determine if consent is required from lenders. To the extent the producer’s existing lender has an affiliated equipment-leasing finance company to use in this structure consent may be more readily granted. In order to offset the cost of such transactions, the value of the assets would likely need to meet a point of critical mass.

3. Midstream Assets (including Midstream Equipment) can be Monetized through an Initial Public Offering (“IPO”), Equity Sale, Asset Sale or Sale and Leaseback

Much like the production equipment of an E&P company, midstream assets are also not generally given borrowing base credit. Yet many E&P companies find themselves heavily invested in midstream assets, such as pipelines, gathering systems and processing facilities. As a recent example, this past September Sanchez Energy Corp. performed a $345 million drop down of its Eagle Ford gathering, pipeline, and compression assets to its MLP Sanchez Production Partners LP. Matador Resources Co. also recently monetized its Delaware Basin gathering and processing assets but instead of an IPO, it sold those assets outright to EnLink Midstream Partners LP for $143 million.

The typical IPO setup involves moving the midstream assets of an E&P down into a newly formed partnership entity that then raises capital through a public offering. The cash generated from the IPO is paid to the E&P company in return for the contribution of the midstream assets. The E&P company typically becomes the controlling or parent entity of the newly created midstream company, thereby maintaining control of and access to the assets. During the heyday of midstream IPOs in 2014, Rice Energy spun off its midstream assets under a January IPO that raised $924 million, followed by Eclipse Resources Corp.’s June IPO that raised $818 million. A number of midstream IPOs were issued in the first half of 2015; however, in the second half of 2015, the long-term dip in commodity prices may be decreasing the market’s appetite for these offerings.

IPOs involve considerable upfront transaction costs so an E&P company that is contemplating an IPO should have a substantial amount of assets to spin off. A private equity sale, asset sale or sale and leaseback may be a better option for a price-conscious E&P company with a smaller amount of midstream assets. Finally, akin to the monetization of equipment, the key to this transaction is maintaining control of the assets.

4. Proven Undeveloped (“PUDs”) Non-Borrowing Base Reserves can be Farmed Out or Dedicated to a DrillCo JV to Convert Reserves into Cash or Borrowing Base Properties

Non-Borrowing Base Reserves are the reserves of a company which are given little to no borrowing base credit. These reserves usually consist of PUDs or contingent reserves.

Companies can monetize or develop these non-producing properties through a farm-out structure. In this structure, a capital provider forms a special purpose entity (“Drillco”) that finances the development of wells on leases owned and drilled by the E&P company pursuant to a joint development agreement (or participation agreement). In exchange, Drillco is assigned a majority of the E&P’s working interest in the wells drilled until payout defined as a certain return on investment or other financial hurdle is met. After payout, Drillco’s interest is reduced and reverts to the E&P company. This structure typically requires consents from lenders or other lienholders over the leases and assets and resolution of any preferential right issues.

By using this structure, an E&P company brings in the working capital it needs to drill up its PUDs, which will result in the creation of cash flow through newly drilled producing properties and the reclassification of these assets as proved developed producing reserves. The assets, though temporarily assigned to Drillco, revert to the E&P company upon payout and can then increase a company’s borrowing base with the additional proved up reserves.

Conclusion

The industry recognizes that proven oil and gas reserves will always be the true belle of the ball. However, they have temporarily stepped off the dance floor and non-E&P assets have stepped in. Utilizing any of the options described above may unveil the unrealized value of the new belle — your non-E&P assets. During this turbulent time in the oil and gas market, Haynes and Boone is actively working with E&P companies to facilitate the transactions described to monetize their non-E&P assets.

If you have any questions, please contact one of the attorneys listed below.

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