Pub CH Oil and Gas
Pub CH Oil and Gas
Pub CH Oil and Gas
Office of the
Comptroller of the Currency
Washington, DC 20219
Version 2.1
Contents
Introduction ..............................................................................................................................1
Overview ....................................................................................................................... 1
Business Description............................................................................................... 1
Petroleum Reserves ................................................................................................. 5
E&P Funding Sources ........................................................................................... 10
Authority and Limits ............................................................................................. 13
Risks Associated With O&G E&P Lending ............................................................... 14
Credit Risk ............................................................................................................ 14
Interest Rate Risk .................................................................................................. 16
Liquidity Risk ....................................................................................................... 16
Operational Risk ................................................................................................... 16
Compliance Risk ................................................................................................... 17
Strategic Risk ........................................................................................................ 17
Reputation Risk..................................................................................................... 17
Risk Management ....................................................................................................... 18
Loan Policy and Governance ................................................................................ 18
Staffing.................................................................................................................. 19
Underwriting Standards and Practices .................................................................. 20
Credit Administration ........................................................................................... 28
Risk Rating E&P Borrowers ................................................................................. 32
Appendixes..............................................................................................................................66
Appendix A: Quantity of Credit Risk Indicators ....................................................... 66
Appendix B: Quality of Credit Risk Management Indicators ................................... 68
Appendix C: Recoverable Resources Classes............................................................ 71
Appendix D: Glossary................................................................................................ 75
Appendix E: Abbreviations........................................................................................ 82
References ...............................................................................................................................84
Introduction
The Office of the Comptroller of the Currency’s (OCC) Comptroller’s Handbook booklet,
“Oil and Gas Exploration and Production Lending,” is prepared for use by OCC examiners in
connection with their examination and supervision of national banks and federal savings
associations (collectively, banks). Each bank is different and may present specific issues.
Accordingly, examiners should apply the information in this booklet consistent with each
bank’s individual circumstances. When it is necessary to distinguish between them, national
banks and federal savings associations (FSA) are referred to separately.
The “Oil and Gas Exploration and Production Lending” booklet is one of several specialized
lending booklets and augments guidance contained in the “Loan Portfolio Management,”
“Large Bank Supervision,” and “Community Bank Supervision” booklets of the
Comptroller’s Handbook. The “Oil and Gas Exploration and Production Lending” booklet
addresses the risks associated with lending to upstream oil and gas (O&G) exploration and
production (E&P) companies and provides examiner guidance on prudent risk management
of this lending activity. The booklet also includes expanded examination procedures for
examiners to use when warranted by the risks associated with this type of lending activity.
Overview
Business Description
The O&G industry is cyclical, mature, and vital to the proper functioning of a modern
economy. The industry provides the fuels needed for transportation and heating as well as the
key raw materials used in construction, paving, and manufacturing chemicals. It is a global
industry, although the natural gas segment is regional because natural gas transportation and
distribution to customers is largely dependent on pipelines. Natural gas can be liquefied and
transported longer distances. Such transportation, however, requires specialized port facilities
and higher cost to the producer.
The O&G industry is highly regulated because of its economic importance, significance to
national security, and potential for environmental concerns. In numerous countries, the
government owns O&G mineral rights exclusively through national oil companies and
government-sponsored enterprises. The location and state of industry infrastructure and
changing technology sometimes have a significant impact on regulation, production costs,
commodity prices, and industry profitability.
commodities market prices. This price risk can cause volatility in company cash flow and
the value of O&G reserves.
Upstream companies make up-front investments to obtain and develop reserves from
which they expect to generate satisfactory investment returns based on their expectations
for production costs, production volumes, and future market prices. Once production
begins, the existing O&G reserves start to deplete. Therefore, upstream companies
require high levels of ongoing capital expenditures (capex) to maintain or increase
reserves to offset depletion. Sustained periods of capital investment can reduce the
amount of cash flow available for debt service or distributions. Upstream companies are
typically C corporations and are taxed separately from their owners.
• Midstream companies gather, process, store, and transport crude oil, raw natural gas,
NGLs, and refined petroleum products and chemicals. The midstream business model is
similar to a toll road that charges fees for the movement or intermediate processing of
O&G. Midstream companies require large up-front investments in long-lived
infrastructure and then generate medium to low profit margins by collecting fees for
services. These companies frequently are structured as master limited partnerships, which
are not subject to income tax. The master limited partnerships typically distribute a large
portion of income to unit holders, with distributed income taxed at the unit holder’s
personal income tax rate.
Integrated O&G companies, also known as majors, are involved in almost every aspect of the
O&G business: upstream, midstream, and downstream. This structure may better enable such
companies to successfully manage business cycle risks and price risks. Most of these
companies also manufacture and sell petrochemicals. International integrated O&G
companies conduct their operations worldwide and are among the largest and most
recognized companies in the world. The largest such companies are referred to as the super
majors.
Smaller E&P companies, referred to as independents, are not directly associated with any of
the major O&G companies. Some independent E&P companies have evolved from spin-offs
of larger corporations, such as railroads, integrated O&G companies, pipeline companies, or
utilities. A number of companies began with a single O&G field and grew by acquiring
smaller competitors or individual properties from larger competitors. Compared with majors
and super majors, smaller upstream companies have less diversification and may exhibit
greater vulnerability to commodity price volatility, cost overruns, production delays,
disruptions, and economic cycles.
This booklet addresses only E&P lending to upstream companies because their financing
structures are more specialized than financing structures used by midstream, downstream,
and service companies. Loan policies and underwriting standards applied to midstream,
downstream, and service companies are similar to traditional commercial and industrial
loans.
Price Considerations
Commodity prices can be highly volatile and cause upstream borrower profitability and
liquidity to change rapidly, in contrast with midstream and downstream businesses. Although
well-managed and conservatively underwritten E&P transactions have historically
experienced low losses compared with other sectors, given commodity volatility and other
specialized risks, lending to the industry can pose higher credit risk without strong expertise
and risk management practices.
Global events and new technologies dramatically affect O&G price volatility (short term) and
trends (long term). Volatility comes from shorter-term or one-time incidents, such as
geopolitical events (for example, circumstances in the Middle East or other large O&G-
producing regions that threaten to disrupt supply) and supply disruptions from major weather
events, or sharp recessions in major economies that temporarily reduce demand.
Over the long term, rising industrial production and larger automotive fleets in emerging
economies support increased demand prospects, while increased production from horizontal
drilling combined with hydraulic fracturing (known as fracking) in North America and
elsewhere has increased supply. Supply increases and economic slowdown of major world
economies can lead to rapid and significant price declines.
Because natural gas is difficult and costly to transport and export without dedicated pipelines,
natural gas markets are regional, meaning price volatility within each geographic market
reflects events within that region. The crude oil market, on the other hand, is global, and oil
price volatility reflects global events. Geopolitical risks in any of the top oil-producing and
- exporting countries can have a greater potential effect on companies with drilling and
extraction operations in unstable regions. Multinational oil companies, with overseas
operations, have greater exposure to global risks than non-multinational oil companies do.
Independents are key players in North American natural gas and oil. Independents tend to be
more geographically concentrated than majors and also have more flexibility in making
strategic decisions. This flexibility sometimes gives independents the ability to produce O&G
at a lower cost than larger competitors. North American natural gas is a commodity, and
independent E&P companies have historically been cost-competitive because of lack of
competition from low-cost imports.
Reserve Depletion
O&G assets deplete as E&P operators extract the oil and natural gas from their reserves.
Operators need to replace reserves and economically produce those reserves to maintain
future revenue, grow in size, and remain a going concern. To sustain profitable production,
E&P companies need to replace reserves at a reasonable cost. As a result of this dynamic,
E&P costs are a large portion of an E&P company’s expenditures. Exploration, however,
does not always result in successful replacement. Because of the high cost and elevated risk
of exploration, some E&P companies supplement internal development with acquisitions to
replace reserves. Alternatively, start-up E&P companies have very high operating costs
because of significant investment in projects that often have long lead times before becoming
productive.
There are differences between crude oil and natural gas that significantly affect the markets
for each. Crude oil, which is refined to produce transportation fuels and fuel oils, is a
globally traded commodity, and there are many different grades. The most commonly
referenced grades of crude oil are West Texas Intermediate (WTI), which is the primary U.S.
oil price benchmark against which other grades of crude are priced, and Brent, which is used
as a more global oil price benchmark. While WTI and Brent prices have diverged at times,
they have exhibited nearly perfect correlation over the last 30 years. Both WTI and Brent are
“light, sweet” grade crude oils, indicating low density and low sulfur content. This
consistency allows oil refineries to convert a higher percentage of the oil into fuel than
“heavy, sour” grade crude oils. Sweet crude tends to trade at a premium over heavy crude.
Within broad markets, there are submarkets for oil that do not perfectly correlate to changes
in the broader market, because of the differences in costs to transport the oil to refineries and
eventually fuel to the retail market.
The primary uses of natural gas are electricity production; home and building heating; and as
a base ingredient for industrial products, such as plastics, fertilizers, and chemicals. The price
of natural gas does not perfectly correlate to oil. Natural gas markets are regional and are
subject to regional supply and demand because transportation and distribution to customers is
largely dependent on pipelines. Natural gas also can take liquid form. Conversion of natural
gas to liquefied natural gas (LNG) has increased rapidly in recent years. Producers of LNG
hope to sell their product overseas in areas where natural gas production is not readily
available. Both the conversion process and specialized transport equipment, however, are
costly relative to the amount of energy produced, which diminishes international trading of
LNG.
Petroleum Reserves
The primary assets of E&P companies are their reserves. 1 Reserves are quantities of
petroleum 2 that E&P companies anticipate they will recover from known accumulations from
a given date forward. All reserve estimates involve some degree of uncertainty. The
uncertainty depends chiefly on the amount of reliable geologic and engineering data available
at the time of the estimate and the interpretation of the data. The relative degree of
uncertainty results in placing reserves into one of two principal classifications, either proved
or unproved. The recovery of unproved reserves is less certain than proved reserves and may
be further subcategorized as probable and possible reserves to denote progressively
increasing uncertainty of their recoverability. Similarly, proved reserves are further
subcategorized based on the status of well development and production.
Reserves derived under these definitions rely on the integrity, skill, and judgment of the
evaluator; the effects of geological complexity, stage of development, and degree of
depletion of the reservoirs; and the amount of available data. These definitions enhance the
distinction among the various classifications and help provide consistent reserve reporting.
Identifying reserves as proved, probable, and possible has been the most frequently used
classification method and indicates the probability of recovery.
There are two basic methods of reserve estimations. One method, called deterministic, is a
single best estimate of reserves made based on known geological, engineering, and economic
data. The second method, called probabilistic, is used when the known geological,
engineering, and economic data generate a range of estimates and their associated
probabilities. Reserve estimates are revised as additional geologic or engineering data
become available or as economic conditions change. Reserve estimates do not include
quantities of petroleum being held in inventory and may be reduced for usage or processing
losses if required for financial reporting.
1
This booklet uses commonly accepted definitions and terminology used in the O&G E&P industry and by
banks engaging in related lending activities. Examiners should be familiar with these definitions and terms,
many of which are defined by, set by, or adapted from definitions of the Society of Petroleum Engineers (SPE),
the World Petroleum Council (WPC), the American Association of Petroleum Geologists (AAPG), or the
Society of Petroleum Evaluation Engineers (SPEE) in the SPE/WPC/AAPG/SPEE Petroleum Resources
Management System and the WPC’s Petroleum Resources Classification System and Definitions. The use of
these definitions and terminology does not imply endorsement of this booklet by the SPE, the WPC, the AAPG,
or SPEE. Refer to appendix C of this booklet for an expanded discussion of recoverable resource classes.
2
Petroleum consists of hydrocarbons in the gaseous, liquid, or solid phase, including crude oil and natural gas.
O&G
reserves
Proved Unproved
Developed Undeveloped
(PUD) Probable Possible
Producing Nonproducing
(PDP) (PDNP)
Behind the
Shut-in
pipe
(PDSI)
(PDBP)
Source: OCC
Note: PUD means proved undeveloped. PDP means proved developed reserves subcategorized as producing. PDNP means
proved developed reserves subcategorized as nonproducing. PDSI means proved developed shut-in. PDBP means proved
developed behind the pipe.
The company’s undeveloped reserves should be economically and technically viable. When
estimating the amount of O&G that is recoverable from a particular reservoir, a company can
make three types of estimates:
Proved Reserves
Proved O&G reserves are quantities of petroleum that, by analyzing geological and
engineering data, are reasonably certain to be commercially recoverable from a given date
forward from known reservoirs and under current economic conditions, operating methods,
and government regulations. If the deterministic method is used, the term “reasonably
certain” expresses a high degree of confidence that the quantities are recoverable. If the
probabilistic method is used, there should be at least a 90 percent probability that the
quantities actually recovered will equal or exceed the estimate.
Establishing current economic conditions should include relevant historical petroleum prices
and associated costs and may involve an averaging period that is consistent with the purpose
of the reserve estimate, appropriate contract obligations, corporate procedures, and
government regulations involved in reporting the reserves.
Proved reserves also should have operational facilities to process and transport those reserves
to market at the time of the estimate or a reasonable expectation of installing such facilities in
the near term. Proved reserves are either proved developed or proved undeveloped.
• Proved developed: E&P companies expect to recover developed reserves from existing
wells including reserves behind the pipe. Improved recovery reserves are considered
developed only after the necessary equipment has been installed or when the costs to do
so are relatively minor. There are two subcategories of developed reserves: producing
reserves and nonproducing reserves.
– Proved developed producing (PDP): E&P companies expect to recover reserves
subcategorized as producing from completion intervals, which are open and
producing at the time of the estimate. Improved recovery reserves are considered
producing only after the improved recovery project is in operation. Loan underwriting
should be predicated primarily on PDP reserves.
– Proved developed nonproducing (PDNP): Reserves subcategorized as
nonproducing include proved developed shut-in (PDSI) and proved developed behind
the pipe (PDBP) reserves. E&P companies expect to recover PDSI reserves from
(1) completion intervals that are open at the time of the estimate but have not started
producing, (2) wells that were shut-in for market conditions or pipeline connections,
or (3) wells not capable of production for mechanical reasons. E&P companies expect
to recover PDBP reserves from zones in existing wells that require additional
completion work or future recompletion before the start of production.
• Proved undeveloped reserves (PUD): E&P companies expect to recover undeveloped
reserves (1) from new wells on undrilled acreage; (2) from deepening existing wells to a
different reservoir; or (3) where a relatively large expenditure is required to
(a) recomplete an existing well or (b) install production or transportation facilities for
primary or improved recovery projects. Up-front capex, mainly drilling and completion
costs, are required to develop the reserves to a producing state. The advent of horizontal
drilling techniques has increased the success of drilling undeveloped reserves, reducing
“dry hole” risk, though often at higher development costs.
• the locations are directly offset to wells that have indicated commercial production in the
objective formation.
• it is reasonably certain that such locations are within the known proved productive limits
of the objective formation.
• the locations conform to existing well spacing regulations when applicable.
• it is reasonably certain that the locations will be developed.
Reserves from other locations are categorized as PUD only where interpretations of
geological and engineering data from wells indicate with reasonable certainty that the
formation is laterally continuous and contains commercially recoverable petroleum at
locations beyond direct offsets.
Unproved Reserves
Unproved reserves are based on geologic or engineering data similar to that used in estimates
of proved reserves, but technical, contractual, economic, or regulatory uncertainties preclude
categorizing such reserves as proved. There are two subcategories for unproved reserves:
probable reserves and possible reserves.
Unproved reserves may be estimated assuming future economic conditions different from
those prevailing at the time of the estimate. The effect of possible future improvements in
economic conditions and technological developments can be expressed by allocating
appropriate quantities of reserves to the probable and possible classifications.
Probable Reserves
Probable reserves are unproved reserves that are expected to be produced based on
geological or seismic data from planned wells in areas anticipated to be economically viable
(for example, with a 50 percent certainty of recovery). In general, probable reserves may
include
Possible Reserves
Possible reserves are unproved reserves inferred from geological and seismic information
that have a chance of being developed under favorable circumstances but are less likely to be
recoverable than probable reserves (for example, possible reserves that have a 10 percent
certainty of recovery). In general, possible reserves may include
• reserves that, based on geological interpretations, could possibly exist beyond areas
classified as probable.
• reserves in formations that appear to be petroleum bearing based on log and core analysis
but may not be productive at commercial rates.
• incremental reserves attributed to infill drilling that are subject to technical uncertainty.
• reserves attributed to improved recovery methods when (1) a project or pilot is planned
but not in operation and (2) rock, fluid, and reservoir characteristics are such that a
reasonable doubt exists that the project will be commercial.
• reserves in an area of the formation that appears to be separated from the proved area by
faulting, and geological interpretation indicates the subject area is structurally lower than
the proved area.
E&P lending involves understanding the allocation of the borrower’s property interests,
reserves, and cash flow within the capital and ownership structure. Each interest is subject to
encumbrance, and the borrower may have numerous entities that hold different interests and
have different encumbrances. Conversely, the borrower may subject all interests to a single
encumbrance. Properties may be located in various jurisdictions, including different states
and countries, but mortgaged under a single loan transaction. The following is a partial list of
types of ownership interests:
Accounting approaches differ significantly among E&P companies. A company may use two
methods of accounting for drilling costs: full cost and successful efforts. The choice greatly
affects a company’s income statement. A full-cost company capitalizes all of its acquisition,
exploration, and development costs and does not differentiate between successful and
unsuccessful projects. A successful-efforts company only capitalizes costs pertaining to
successful projects and acquisitions, amortized over the production life of the projects. If the
efforts are unsuccessful, the company expenses the costs. The result is that the full-cost
companies typically report higher earnings and equity initially, with higher depreciation,
depletion, and amortization charges in future periods. Comparatively, successful-efforts
companies tend to have lower earnings and equity in the early stages, with lower
depreciation, depletion, and amortization charges in future periods.
The reliability of reserve disclosures sometimes varies among companies. Lenders prefer
reserve reports prepared by an independent, third-party engineer. Lenders may use company-
prepared reports, however, if reviewed by third-party engineers. E&P companies’ annual
reserve disclosures can have a material impact on stated earnings. Companies that book
reserves liberally may be required to make substantial revisions to their financial statements.
E&P companies that hold derivatives that do not qualify for hedge accounting report their
gains and losses on each income statement. Unrealized gains and losses that relate to future
production can distort current cash flow analysis and make O&G performance comparisons
difficult.
O&G reserve disclosures usually adhere to the definitions set by the Society of Petroleum
Engineers (SPE), World Petroleum Council (WPC), American Association of Petroleum
Geologists (AAPG), or Society of Petroleum Evaluation Engineers (SPEE) in the
SPE/WPC/AAPG/SPEE Petroleum Resources Management System for classifying and
reporting reserves. Additionally, the U.S. Securities and Exchange Commission has
established a reporting and disclosure rule 3 for O&G public companies.
There are several loan structures used by E&P companies to finance their businesses. Most
independent, non-integrated E&P companies obtain financing through a reserve-based loan
(RBL). The RBL typically is a revolving facility secured by lower-risk proved reserves and
governed by a borrowing base determined by a valuation of those reserves.
Most RBLs have a term of three to five years. The RBL’s purpose is primarily to fund
acquisition and development costs for new reserves, which, if successful, increase the reserve
valuations and provide increasing cash flow for debt service and profits for the company’s
shareholders and investors. Other senior notes, bonds, or other forms of debt are normally
subordinate to the RBL in collateral position, but in certain cases, second-lien loans are pari
passu with the RBL in right of contractual payment streams.
RBLs are subject to periodic evaluation of the borrower’s O&G reserves to redetermine the
borrowing base commitment. Redeterminations typically occur semiannually, but lenders and
borrowers normally have the right to additional redeterminations once or twice during a year,
as defined by the credit agreement.
3
Refer to the U.S. Securities and Exchange Commission’s final rule, “Modernization of Oil and Gas
Reporting.”
Typical financial covenants included in the RBL credit agreement include cash flow
leverage, interest coverage, and current ratio covenants:
• The cash flow leverage ratio is typically defined as senior funded debt or total debt over
trailing 12 months (TTM) EBITDAX. 4 This covenant is the most critical of the three
main RBL covenants because it may provide the least amount of headroom while also
controlling the amount of additional borrower debt. The total debt to EBITDAX covenant
is frequently set at 3.5x and normally does not exceed 4.0x, unless the covenant is
increased to account for an acquisition with step-downs to more reasonable leverage.
• A standard definition for interest coverage is TTM EBITDAX divided by TTM interest
expense. Interest coverage covenants for RBLs may require 2.5x to 3.0x EBITDAX
coverage of TTM interest expense.
• A standard definition of the current ratio is current assets divided by current liabilities
less current maturities, requiring at least 1.0x to 1.25x coverage. Some transactions,
however, may define the current ratio covenant as current assets plus unfunded RBL
availability divided by current liabilities less current RBL maturities.
Declining commodity prices and a corresponding drop in revenues can stress these measures
and limit production growth, which can lead to reduced RBL borrowing bases during
redeterminations. Lenders work with borrowers to formulate plans and implement short-term
solutions. Without a significant rebound in prices, however, borrowers may need to negotiate
covenant waivers or longer-term loan amendments, with lenders allowing borrowers to
develop a combination of short-term liquidity and long-term capital structure solutions.
These solutions can include obtaining a term loan secured by a junior lien on the O&G
reserves or sale of reserve assets.
Although less common in the United States, another credit structure that E&P companies use
is a reducing revolver, which is a combination of a revolving loan and a term loan. The
revolver can increase to a maximum commitment level and then step down at regular
principal payment dates.
Lenders may also make term loans for project financing, acquisition of O&G properties, or
acquisition of other fixed assets secured by a first lien on the company’s reserves. For term
loans, banks determine the lendable amount based on engineering reports and make a one-
time advance for the acquisition. This type of financing amortizes over the loan term or the
principal balance is paid at maturity. The term of loans typically varies from five to 10 years,
but the term of these loans should always be tied to the economic life of the underlying asset.
Although banks have historically been the primary financial provider of RBLs, other market
participants are active in providing additional sources of capital to the industry. Examples of
other forms of capital extended to the sector include the following:
4
EBITDAX is earnings before interest, taxes, depreciation, and amortization (EBITDA) with depletion,
exploration, and abandonment expense added back. These expenses are add backs because they are often
considered discretionary, while also providing consistent application of the covenant regardless of whether the
company uses the full cost accrual or successful efforts accounting method. EBITDAX, rather than EBITDA,
appears almost universally in O&G financings.
• Second-lien debt: In E&P lending, second-lien senior term loans may rank pari passu in
right of payment with first-lien debt, including RBLs. Second-lien loans carry higher
interest rates than the senior RBLs because of the additional risk to repayment but remain
in a secured position ahead of unsecured debtors, such as bondholders. Second-lien loans
often are structured with five-year maturities with interest-only payment requirements.
• Mezzanine debt: Mezzanine loans are subordinated to senior loans and are used to
leverage acquisition or development activities, particularly when companies do not have
sufficient producing reserves to support borrowing under an RBL. These loans may have
tight covenants and extensive controls on funding and are generally unsecured and not
subject to a borrowing base; rather, these loans are based on collateral coverage or cash
flow ratios.
• Bonds: High-yield bond offerings and securitizations have played an important role in
E&P financing by providing affordable access to capital markets. Longer-term bond
offerings with 10-year maturities and interest-only payments have been common sources
of funding for E&P companies.
• Equity: The role of equity investors in the E&P industry has increased significantly as
new E&P ownership and financing structures have evolved. The increasingly complex
corporate structure of E&P companies also requires that E&P lenders have more
specialized expertise and monitoring systems. For example, the equity structure can be a
traditional (operating) equity investment in the operating company or a nonoperating
investment in an affiliate when the operating company has limited liability exchanged for
the capital investment. An example of the latter is a volumetric production payment
(VPP) arrangement, an increasingly popular financing structure.
Under a VPP financing transaction structure, the bank provides financing to an O&G
producer and receives a limited overriding royalty interest in the producer’s lease of
specifically identified reserves. A VPP arrangement is a method to monetize future O&G
production. Instead of cash payments, the VPP interest entitles the bank to receive a
dedicated share of the hydrocarbons produced over a stated term. Additionally, the bank
enters into a forward sale agreement to presell the hydrocarbons at a set price (spot price)
based on the forward prices for the commodity at the time of the transaction. On the day of
settlement, the producer, through the bank, transfers the title to the hydrocarbons to the
purchaser of the forward contract. As either an alternative or supplement to selling the
forward contract, the bank may mitigate the hydrocarbon price risk using other derivative
transactions to hedge the risks, such as commodity swaps. Banks should contact their
supervisory offices before engaging in such transactions to assess whether the activities can
be conducted in a safe and sound manner and in accordance with applicable law. With
respect to national banks, refer to 12 USC 29, “Power to Hold Real Property,” and OCC
Interpretive Letter 1117 for details on the permissibility of VPP financing transactions.
From the bank’s risk perspective, the VPP interest is free and clear of all operating costs,
capex, and taxes. The O&G producer (borrower) retains all of the operational and
environmental risks. Commodity price risk is negligible if appropriate hedging techniques are
used. The VPP, however, has recourse only to the production from the specified reserve and
not the producer’s other assets. Although the bank has first right to the production up to the
specified amount, there is no right to additional production unless the reserves under-
produced in a previous period. Therefore, excess production cannot be captured unless there
has already been a shortfall. As a result, the bank has production risk if the underproduction
is permanent or otherwise not replaced by overproduction later.
A national bank’s E&P lending exposure is not specifically limited other than limitations
provided by 12 USC 84, provided the volume and nature of the lending do not pose
unwarranted risk to the bank’s financial condition. Certain types of E&P lending may require
consideration of the requirements of 12 USC 29. (Refer to OCC Interpretive Letter 1117.)
5
Refer to 12 USC 1464(c)(2)(A). Small business loans include any loan to a small business (defined in
13 CFR 121) and any loan that does not exceed $2 million and is for commercial, corporate, business, or
agricultural purposes. Refer to the definitions of “small business loans and loans to small businesses” and
“small business” in 12 CFR 160.3.
6
12 CFR 160.31(a) states that if a loan is authorized under more than one section of the Home Owners’ Loan
Act, an FSA may designate under which section the loan has been made. Such a loan may be apportioned
among appropriate categories.
7
12 USC 1464(c)(2)(B) generally limits nonresidential real property loans to 400 percent of the FSA’s capital.
The risks associated with O&G E&P lending are credit, interest rate, liquidity, operational,
compliance, strategic, and reputation.
Credit Risk
Credit risk to banks that finance E&P companies arises from the ability or inability of the
E&P borrower to repay debt with operating cash flow generated from the production and sale
of oil and natural gas. The repayment capacity of an E&P borrower highly depends on the
company’s ability to economically and successfully acquire, develop, and produce O&G
reserves on an ongoing basis. Additionally, an E&P company’s repayment capacity is
vulnerable to market volatility, government policies, and legal risk, which may not be under
the borrower’s control. Borrowers can mitigate many of these risks by using geographic and
product diversification strategies, obtaining insurance coverage, integrating operations,
employing hedging and structured finance strategies, and taking ownership of service
companies or equipment.
Market Volatility
Volatile market prices for O&G present the primary repayment risk for the E&P borrower.
Large price fluctuations can occur because of weather, changes in supply and demand, and
geopolitical events. Because crude oil usually trades in U.S. dollars, changes in the value of
the dollar also may affect oil prices. Producers have the ability to hedge their production to
alleviate large price variations; hedges, however, tend to be short term with three-year
maturities or less, and may prove costly if the commodity price already is depressed.
Commodity swaps, call options, put options, futures contracts, and forward contracts are the
most common derivatives used. Call options (ceilings) and put options (floors) can be
arranged to form collars. Some collars, known as participating collars, have provisions that
8
Financial condition includes impacts from diminished capital and liquidity. Capital in this context includes
potential impacts from losses, reduced earnings, and market value of equity.
9
Resilience recognizes the bank’s ability to withstand periods of stress.
allow the producer to participate in a portion of the upside (that is, when the market price
moves above the ceiling). Others may have disappearing ceilings, known as knockouts.
Most frequently, E&P companies use simple commodity swaps, in which the borrower swaps
a floating market price (usually New York Mercantile Exchange, or NYMEX) for a fixed
price (the strike price) on a given volume of the commodity (the notional amount). E&P
companies also use future and forward contracts to lock in O&G at a future sell price. The
bank’s written E&P lending policy should address the use of commodity derivatives. The
policy should include a discussion of counterparty risk, operational risk, the maximum O&G
production volume that can be hedged, and the tenor of hedges.
O&G E&P is highly regulated in the United States, and changes in government policies can
affect the industry. Regulations may differ among states or even counties. Private landowners
often own mineral rights in the United States, but public entities often own mineral rights
abroad, causing ownership, environmental liability, and business risks to vary depending on
where the operation is located.
E&P companies need large areas of land to develop and operate wells. O&G E&P carries
environmental risks, and there is extensive state and federal regulation of access and
environmental remediation. Additionally, government restrictions can affect the type of
drilling technology used to extract O&G. New technologies, such as fracking, are particularly
susceptible to regulatory restrictions. In such cases, the industry may rapidly adopt new
technology, but final health, safety, and environmental regulations may follow a significant
time lag. If the regulations involve production restraints or even cessation, banks that have
made loans based on the technology and communities that have built up around the
technology may experience significant harm.
O&G drilling-related equipment collateral may have few or no alternative uses to support
value under depressed market conditions. Mineral interests can be bought and sold, however,
through a secondary market. In the case of O&G equipment, auction companies can dispose
of bank collateral on an as-needed basis. Demand for specialized O&G equipment, however,
closely correlates with O&G commodity prices. When O&G prices fall, equipment values
usually fall as well. Additionally, during periods of severe price declines, banks may have
difficulty liquidating equipment at a reasonable price.
Liquidity Risk
The nature of E&P lending can result in higher liquidity risk at some banks, especially
smaller banks in areas where changes in O&G supply and demand strongly affect the local
economy. High levels of correlated credit concentrations may be evident under those
circumstances, and a bank’s liquidity can become strained if unfavorable market conditions
result in borrowers having difficulty making loan payments or in reduced public and private
deposits. Longer-term liquidity pressure may arise at some banks because of capped or
abandoned wells, reduced exploration, and population migration due to high local
unemployment. A bank’s inability to liquidate or sell E&P loans at a reasonable price during
sustained downturns in the O&G market also may cause liquidity risk.
Operational Risk
E&P lending carries an elevated level of operational risk because of the complexity of the
industry and E&P borrowers as well as the corresponding need to maintain effective
monitoring and control systems. A lack of understanding of operational risks, or failure to
monitor and control them, may lead to serious credit weaknesses, including ultimate
collection problems. E&P operational risks are affected by the following:
Compliance Risk
E&P lending is subject to the same regulatory and compliance issues as other types of
commercial lending. Given the numerous restrictions governing O&G E&P activities, E&P
lending can be vulnerable to specific types of compliance risk, such as potential
environmental liability, should the bank repossess contaminated collateral. Some banking
regulations discussed in this booklet govern an institution’s risk management.
Strategic Risk
A sound E&P lending program should include management and staff that have the
knowledge and experience required to recognize, assess, mitigate, and monitor the risks that
are unique to E&P. Prudent E&P lending requires specialized expertise. Failure to invest in
sufficient staff and infrastructure, or to provide effective oversight of E&P lending, can
significantly increase the bank’s strategic risk profile while also affecting other interrelated
risks such as credit and reputation.
Reputation Risk
Over the years, the O&G industry has achieved high technical and safety standards. When
accidents occur, however, the loss of life, property, and damage to the environment attracts
wide media coverage and results in significant reputation risks.
Some E&P transactions are syndicated throughout the institutional market because of their
size and risk characteristics. A bank’s failure to meet its legal or fiduciary responsibilities in
sourcing and syndicating E&P loans can damage its reputation and impair its ability to
compete successfully in this line of business.
As previously discussed, some E&P loans are only a part of complex structured finance
arrangements. These arrangements involve the structuring of cash flows and the allocation of
risk among borrowers and investors to meet specific customer objectives more efficiently.
The transactions involve professionals with specialized expertise and may involve creation of
special purpose entities. Although the majority of transactions serve legitimate business
purposes, banks may expose themselves to significant reputation and legal (compliance) risks
if they enter into transactions without appropriate due diligence, oversight, and internal
controls. Further guidance pertaining to structured finance is contained in OCC Bulletin
2007-1, “Complex Structured Finance Transactions: Notice of Final Interagency Statement.”
Risk Management
Each bank should identify, measure, monitor, and control risk by implementing an effective
risk management system appropriate for the size and complexity of its operations. When
examiners assess the effectiveness of a bank’s risk management system, they consider the
bank’s policies, processes, personnel, and control systems. Refer to the “Bank Supervision
Process” and “Loan Portfolio Management” booklets of the Comptroller’s Handbook and
section 201 of the Office of Thrift Supervision Examination Handbook for expanded
discussions of risk management.
As discussed in the “Overview” section, this booklet addresses only the more specialized
E&P segment of the O&G industry. Because a variety of companies engage in E&P, the
booklet includes some discussion of equipment lending and other considerations that may be
applicable to midstream or upstream companies.
• E&P lending objectives and risk appetite, including acceptable types of E&P loans,
portfolio distribution (concentrations of credit), lending market or territory, risk limits
measured as a percentage of capital, and correlation risk to other industries in the bank’s
loan portfolio.
• Comprehensive, written O&G engineering policy that provides specific guidelines for
engineers and is reviewed and approved at least annually by an appropriate governing
body. The policy should provide for the following:
– O&G engineering function is independent of line of business, credit approval, credit
administration, and financial functions.
– Someone who does not have credit approval authority performs the annual
performance evaluations of engineers.
– Compensation program for engineers does not include incentives for loan volume
generated by the O&G lending department.
– Depth of experience among the engineering staff enables succession and continuation
of quality work during times of change or adversity.
– Sufficient resources allocated to talent development and continuing education of staff
is a high priority.
– Reasonable price decks are used and adjusted semiannually or on an as-needed basis.
• Requirements for the structure, reporting lines, and oversight of the E&P lending
department and independent engineering department.
• Underwriting standards and approval requirements that are specific to lending to the E&P
industry and provide appropriate lender controls, including measurement of O&G reserve
and production history; financial analysis expectations; realistic repayment terms
consistent with the use of proceeds; advance rates and risk adjustments on various reserve
types; pricing parameters; stress or sensitivity analysis of cash flow; covenant and
structure expectations; approval authority; and policy exception authority.
Senior management should ensure risk management systems are in place to monitor
compliance with established E&P lending policies. Bank management should provide the
board of directors with an analysis of the risk posed by E&P lending activities as well as
risks correlated to the E&P industry and their potential effect on the bank’s asset quality,
earnings, capital, and liquidity. Management should consider the potential impact on earnings
and capital and on the bank’s operating strategy of E&P lending under stressed market
conditions and economic downturns, as well as normal market conditions.
The board of directors should consider whether the bank maintains adequate capital relative
to concentration risks, including concentrations pertaining to E&P lending. Examiners should
refer to the “Concentrations of Credit” booklet of the Comptroller’s Handbook for more
details pertaining to concentration risk. There may be cases in which the potential risk to
capital is so significant that reduction of the concentration or suspension of E&P loan
originations may be the most effective risk mitigation action.
Staffing
E&P lending involves unique, and sometimes complex, risks that require specialized
knowledge and controls. The E&P lending staff should possess sufficient technical expertise
for the volume and complexity of E&P lending performed and monitored. Given that E&P
lending decisions rely on quality engineering reports, the technical expertise of the
engineering staff is critical. The board should assess whether the size of the engineering staff
is sufficient to enable timely completion of work so all borrowing base redeterminations can
be promptly completed. The depth within the engineering staff should enable succession and
continuation of quality work during times of change or adversity. Additionally, sufficient
resources should be allocated to staff development and continuing education.
The board should have systems in place to ensure that the O&G engineering function is
independent of the E&P loan production and credit approval functions. Although engineers
may have communication with and input from loan production personnel to facilitate credit
analysis, the reporting line for the engineering function should be separate from the
production line. Someone independent of the credit approval process should perform
performance reviews and approve the list of acceptable third-party engineers. The bank’s
engineering department may have input into credit decisions, for example, veto power, but
should not have loan approval authority. The engineer’s compensation program should not
include incentives for E&P loan production volume.
• Receipt and analysis of the borrower’s business plan, including well-supported financial
projections and a detailed capex program.
• Assessment of the borrower’s RBL and total debt repayment capacity based on base case
cash flow projections. 10 Projections should include one or more realistic downside
scenarios or sensitivity analysis that estimate the impact that sustained changes in market
conditions would have on the borrower’s repayment capacity.
• Loan structures appropriate for the type of borrowing and primary source of repayment,
including maximum loan terms.
• Loan agreement covenants.
• Assessment of the borrower’s history of meeting projections and managing debt
repayment.
• Ongoing monitoring of the borrower’s O&G exploration, development, and production
activities, including in-depth financial analysis of the borrower and any guarantors, and
comparison with the borrower’s financial plan.
• Repayment criteria, if the borrowing base declines below the outstanding balance.
• Fully supported risk adjustment factors applied to proved nonproducing O&G reserves.
• Fully supported cash flow discount rates used in reserve valuation that reflect an
appropriate risk premium over the risk-free rate of return.
• Timely preparation of in-house engineering reports or reviews of external reports to
support timely semiannual borrowing base redeterminations.
• Assessment of the impact of hedging and hedge expiration.
• Independent collateral evaluations, including bank-reviewed semiannual engineering
reports, borrowing base redeterminations, and updated bank O&G price deck.
• Limits on concentration of production (by well or field), inclusion of nonproducing
reserves in the borrowing base.
• Minimum number of producing wells, and minimum levels of property and liability
insurance.
• Acceptable status with state-specific governing authority.
10
In general, the base case cash flow projection is the borrower or deal sponsor’s expected estimate of financial
performance using the assumptions that are deemed most likely to occur. The financial results for the base case
should be better than those for the conservative case but worse than those for the aggressive or upside case. The
bank may adjust the base case financial projections, if necessary.
Hedging
Commodity hedging, as a risk management tool, is used to help ensure stable and predictable
cash flow, maintain liquidity, and manage credit risk. If used incorrectly, derivative strategies
can multiply losses, particularly in the case of underperforming reservoir-related production.
The use of derivative strategies should involve clear understanding of the interaction between
the derivative product and the production, timing, and fiscal risks of the underlying reserves.
Factors contributing to derivatives hedging risk include the nature of underlying reserves; the
size, scale, maturity, and sophistication of the company’s operations; the petroleum
economics of the underlying asset(s); and the fiscal context of the country of operations.
Additionally, monetizing hedges or selling hedges that are “in the money” may have the
effect of improving liquidity, but to the detriment of future cash flow. Examiners should
review financial statements, financial projections, and engineering and bank approval memos
to determine the borrower’s cash flow reliance on hedge revenue.
Engineering Function
engineering data that depict the value of the future cash flow stream is critical to the initial
lending decision and equally important to an examiner assessing credit quality.
Estimating O&G reserves is difficult and not always precise. The reliability of reserve
estimates can be inconsistent depending on the assumptions used by engineers. Because
O&G prices and production are subject to significant risks that are volatile and difficult to
predict or control, reserve development and extraction operations are sometimes delayed,
suspended, or even stopped.
The bank’s engineer reviews the reserve report for estimates of operating costs and expected
ultimate recovery of reserves, production rates, and capex needed to convert reserves into the
PDP category. The bank’s engineer makes technical adjustments based on his or her
professional judgment. Examiners should assess whether adjustments are well supported and
documented. The bank engineer provides adjusted engineering valuations based on the
bank’s price deck and that conform to the bank’s energy lending policy with respect to
risking, concentration and reserve limitations, and discount rates.
Pricing: O&G prices should be realistic and fully supported. Banks and independent
engineers use a price deck to determine the assumed future price of O&G production. The
price deck is used in calculations, modeling, predictions, underwriting, and ongoing
monitoring. Price decks should be updated at least semiannually (or more frequently during
periods of high commodity price volatility). The bank’s price deck should indicate
consideration for potential price deflation and cost inflation over time.
Banks commonly construct their commodity price deck at a discount to the current NYMEX
futures curve and consider industry price deck surveys. Individual borrower pricing used in
the engineering analysis is adjusted up or down from the base price deck by oil and natural
gas price differentials, which represent the borrower’s historical sales price in comparison
with the market benchmark crude prices (WTI for U.S. oil and Henry Hub for natural gas).
The price a borrower receives in the market can be more or less than the spot prices for these
indices, as determined by the quality of the commodity and transportation costs specific to
the borrower’s reserves. Price differentials should be documented and supported by review of
the borrower’s historical LOS.
11
For guidance pertaining to use of third parties, refer to OCC Bulletin 2013-29, “Third-Party Relationships:
Risk Management Guidance.”
Costs: Cost assumptions also should be realistic and fully supported. Costs affect the
economic life of reserves primarily in two ways: development costs and production costs.
Production costs are a key focus in underwriting because the borrowing base is based
primarily on PDP reserves. Production costs include lifting costs or lease operating expenses,
which include operating and maintenance expenditures for materials, supplies, fuel,
insurance, maintenance, and repairs. Additional production costs include property and
severance taxes. If there are plans for further development, engineering reports may include
development costs, or capex, for PDNP and PUD properties as well. Capex may include
roads, utilities, drilling pads, site facilities, development wells, wellheads, well casing, and
pipe and well equipment. To a lesser extent, capex may include workover costs for PDP
wells.
Discount rate: The discount rate depends on current market factors that consider the
required market rate of return on future cash flows given the relative risks involved.
Assumptions used to determine the discount rate should be fully supported.
Timing: The annual and interim engineering reports should be based on data that are no
more than six months old. Recent significant price fluctuations or changes in interest rates
may require bank management to adjust the evaluation of the reserves to reflect current
conditions. The “as of” date of the evaluation is typically dated forward to the next
redetermination date, often six months, to ensure the amount outstanding does not breach the
borrowing base evaluation at the next redetermination date because of reserve depletion. This
is referred to as a “roll forward” evaluation.
When engineering reports do not address one or more of these four critical concerns, the
examiner should challenge management to provide support for the evaluation assumptions,
and may need to evaluate other bank methodologies, for example, recent cash flow histories,
to determine the current collateral value. In addition, appropriate comments should be
included in the report of examination and recommendations or matters requiring attention
made to bank management for improving its engineering reporting and requirements.
The borrowing base for E&P loans represents the lending commitment established from the
engineering valuation of the borrower’s proved O&G reserves, subject to limitations and
adjustments. The borrowing base is determined by analyzing previous production reports and
independent engineering evaluations.
The borrowing base, as established in the loan agreement, governs the maximum amount of
availability under the RBL at any one time. The commodity prices, risk adjustment factors,
and cash flow discount rate used to determine reserve values and the borrowing base should
be fully supported in the lender’s underwriting documentation. The RBL is normally secured
by a first lien on the borrower’s O&G reserves, the cash flow from which is the loan’s
primary source of repayment. Banks typically perfect liens on reserve interests that produce
75 percent to 90 percent of the economic value of the borrowing base.
The value of the reserves helps determine the loan amount and dictates the availability of
funds. Normally, the borrower has unrestricted draws on the RBL up to the available
borrowing base or commitment amount. The outstanding balance of the loan fluctuates with
the operating needs of the borrower, subject to the availability constraints of the borrowing
base. Credit availability increases when principal is repaid or collateral value increases
through acquisition or development of new reserve assets.
Lenders usually require that collateral reserves have diversification in the geographic
location of fields or reservoirs where the reserves are situated. At a minimum, limits should
be set on the lowest number of producing wells needed to establish an acceptable borrowing
base and concentration limits on the maximum value contribution from any single well or
field.
Lenders typically attempt to limit well concentration in the construction of the borrowing
base so that the loss of one well or a number of wells will not excessively jeopardize the
repayment source. The borrowing base may also require the inclusion of wells from more
than one field. A single well is usually limited to no more than 15 percent to 20 percent of the
borrowing base.
Lenders generally use risk adjustment factors to lower the value of unseasoned (less than six
months of production) producing and nonproducing reserves before applying advance rates.
Frequently used risk adjustment factors are 100 percent of seasoned PDP, 90 percent to
95 percent of unseasoned PDP, 65 percent to 75 percent of PDNP, and 25 percent to
50 percent of PUD reserves. The risk adjustment factors are applied to the net present value
(NPV) of the reserve estimate. Some lenders may use a more conservative approach by
applying the risk adjustment factors to the projected O&G production volume (volumetric
adjustments) rather than the NPV.
Banks using risk adjustment factors typically apply a single advance rate to the total risk-
adjusted proved reserves to determine the borrowing base commitment. The maximum
advance rates against the total risk-adjusted NPV of the proved reserves typically range
between 50 percent and 65 percent. Other lenders may not apply risk adjustment factors
directly but instead use separate advance rates for each reserve category based on the relative
reserve risk. For instance, the net advance rate may range from 50 percent to 65 percent of
the NPV of PDP, up to 50 percent of unrisked NPV of PDNP, and up to 35 percent of
unrisked NPV of PUD reserves.
Regardless of the method used, there should be a limit established for the contribution of
nonproducing reserves (for example, PDNP and PUD) to the borrowing base. This is
commonly set at no more than 25 percent to 35 percent of the valuation. Unproved (probable
and possible) reserves are typically not included in the collateral pool or used in determining
the borrowing base of a RBL, given the level of uncertainty involved in the development of
these assets.
The borrowing base is normally reset every six months. The bank reviews the most recent
engineering reserve report and determines the revised borrowing base commitment by
applying the bank’s borrowing base methodology to the reserve report valuation. Engineering
and approval memos should address the reasons for any changes in borrowing base amounts
(for example, new production, acquisitions, reserve depletion, commodity price volatility,
shut-in wells, weather, or environmental issues). Per the credit agreement, borrowers should
be required to cure any over-advance within 30 days with either cash payment or pledge of
additional collateral. If the over-advance is not cured within 30 days, the bank may require
the borrower to repay the over-advance evenly over six months. At the next redetermination
date, the loan should comply with no over-advance, subject to revaluation of the reserves. An
over-advance does not automatically result in an adverse risk rating. Examiners must assess
the borrower’s ability to repay the total debt, including over-advances.
A “stretch” occurs when the bank agrees to provide the borrower with an RBL commitment
that materially exceeds the lendable amount as determined by the bank’s underwriting
criteria and loan policy. In a syndication, each participant calculates the RBL lendable
amount separately. The calculated lendable amount may vary by bank, and some banks may
agree to “stretch” to meet the higher borrowing base amount agreed upon by the syndication
group. Bank approval of the stretch should be supported by documented risk mitigants. The
approval of a stretched borrowing base should not be used to avoid borrower repayment
requirements caused by an over-advance. If the stretch is not well supported, the advance
should be considered in the risk rating assessment. Examples of lender actions to stretch the
borrowing base include the following:
• Providing higher advance rates (for example, over 65 percent), allowing less conservative
risk factors, and increasing the value attributable to PDNP and PUDs. These actions may
be supported by a variety of reasons, including borrowers backed by substantial private
equity sponsors.
• Allowing “leasehold” value when the borrower’s acreage position is located in a
particularly competitive area.
• Lending beyond 100 percent of PDPs on a temporary basis, with interest rates and fees
that reflect the increased risk.
• Giving value for the next six months’ production, which is usually omitted from the
borrowing base (with a monthly reduction feature).
• Lowering the discount rate for determining the NPV of reserves, thereby increasing the
total present value.
• Restructuring borrowing base loans into conforming and nonconforming stretch tranches
with higher fees and rates on the stretch loans.
The primary repayment source for most RBLs and other types of debt issued by an E&P
company is cash flow from operations. Therefore, a borrower’s future cash flow should
demonstrate the ability to cover projected expenses and repay total debt within a reasonable
time.
Prudent E&P loan underwriting requires that lenders have a thorough understanding of the
borrower’s operating environment and future cash flow capability. E&P company cash flow
is vulnerable to a wide range of risks, and lenders should have a comprehensive
understanding of the company’s financial operations, funding needs, and cash flow volatility.
O&G reserves are the most significant asset on an E&P company’s balance sheet and are
subject to both price volatility and depletion. An E&P borrower’s operating leverage,
liquidity, and access to capital are important factors to understand when determining the
borrower’s ability to withstand adverse conditions.
Royalties and ground lease costs for E&P companies also are significant. Royalty and ground
lease rates vary extensively depending on location, timing, tax rates, and contract structure. A
major risk facing E&P companies is overpayment for royalty and ground leases. This risk is
especially relevant if the company is a latecomer to a recently discovered field, where high
demand and a “boom” mentality pushes up lease rates. Lease overpayment can quickly erode
returns, especially if the field does not produce as expected. Additionally, leases may expire
at the end of the term unless the company has started drilling or producing O&G, which can
adversely influence the timing of drilling plans and capex in a company’s effort to retain
leases.
As part of the underwriting process, lenders normally prepare base case and sensitivity case
repayment analyses. Banks use repayment tests to determine whether future cash flow—
using revenue and expense projections from the engineering report less estimated general and
administrative (G&A) expense, production, and ad valorem taxes, capex, required principal
and interest payments, and required distributions—is sufficient to repay the existing
borrowing base commitment within a reasonable time. 12 A reasonable repayment period for
an RBL is normally within 60 percent of the economic life of the proved reserves
(alternatively, 120 percent of the economic half-life), and within 75 percent of the economic
life for total secured debt, in the base scenario. Refer to table 1 in this booklet for a sample
repayment test.
A base case analysis should use prevailing market prices, such as NYMEX futures prices, as
opposed to the bank’s commodity price deck used for borrowing base determination. The
repayment test should be based on repayment capacity from unrisked and undiscounted
revenues from the borrower’s total proved reserves. Proved reserve life is the estimated
productive life of a proved reservoir based on the economic limit of producing the reserves
assuming certain price and cost parameters. The economic half-life of the proved reserves
12
Repayment tests should use a fully funded borrowing base commitment, rather than the current outstanding
balance; it is reasonable, however, to assume excess availability under the RBL incrementally funds projected
capex.
represents the point in time when the borrower will have generated half of the estimated
future net revenue (FNR). 13 The reserve life and economic half-life of the reserves can be
stated in months or years or as a percentage of the total FNR.
The amount of the aggregate FNR remaining at the time of projected repayment, expressed
as a percentage of the total FNR, is called the “reserve tail.” A reasonable reserve tail
provides the lender with sufficient cushion against risks such as declining O&G prices, rising
borrower operating costs, or unsuccessful development. Sensitivity and total debt repayment
tests allow for longer repayment, that is, smaller reserve tails.
In addition, a sensitivity case analysis subjects the O&G reserves to adverse external factors,
such as stressed market prices or higher operating expenses, to determine the vulnerability of
the borrower’s repayment capacity to adverse economic conditions. When determining total
debt repayment capacity, banks should use sensitivity analysis in the underwriting process to
estimate the impact that sustained changes in commodity prices, E&P costs, and other market
conditions would have on a company’s repayment ability.
The analysis and risk assessment also should consider any necessary adjustments pertaining
to accounting, nonrecurring gains and losses, acquisitions or company restructure, and
hedging, all of which are common in the industry at certain stages of the E&P business cycle.
E&P companies capitalize exploration and development costs in different ways whether they
select the “successful efforts” method or the “full cost” method under generally accepted
accounting principles. Additionally, the E&P business is highly capital-intensive because of
the need for ongoing reserve replacement. As a result, liquidity analysis should determine
whether cash and RBL availability are sufficient to meet the borrower’s “capital plan,” an
industry term for projected acquisition and development capex.
As with other types of lending, when a bank relies on a guaranty to support approval of the
loan, a guarantor global financial condition (GFC) analysis should accompany the initial
underwriting and approval. The guarantor should be financially responsible, meaning the
guarantor has the capacity and willingness to support the loan. Determination of capacity
should include a current and comprehensive analysis of the guarantor’s GFC, including legal
structure, asset evaluations, liquidity, sources and amounts of recurring cash flow, actual and
contingent liabilities, and any other relevant factors necessary to demonstrate capacity to
support the loan. This analysis should consider the total number and amount of guarantees
currently extended by a guarantor and the effect such guarantees have on the guarantor’s cash
flow. Cash flow analysis should always be part of the GFC analysis. Subsequent to loan
approval and funding, a periodic financial analysis of a guarantor is appropriate and prudent
for most lending relationships. If the guarantor’s financial condition is complex or indicates
significant risk, a periodic guarantor GFC analysis should be performed to monitor other
projects and the guarantor’s financial capacity.
13
The FNR attributable to a company’s reserves typically does not include estimated interest costs or general
and corporate administrative costs, but is net of estimated royalties, production costs, development costs,
production and ad valorem taxes, and other income, as well as future capex and well abandonment costs related
to existing developed and undeveloped reserves.
E&P borrowers may have equity sponsors that fund a portion of ongoing exploratory capex
through equity injections, provided the company successfully meets projections. While the
presence of an equity sponsor alone does not enhance the credit risk rating of a borrower with
well-defined weaknesses, examiners should consider the strength of the sponsor and the
record of equity support when assessing the borrower’s liquidity and ability to meet its
projected capital plan. The greatest degree of consideration should go to borrowers with
formal equity commitment letters that include specific terms of equity support and a history
of sponsor injections.
Equipment
Many O&G equipment loans approved for acquisition or development are made separately
from E&P loans because some or all of the equipment does not remain at the drilling site. In
some cases, the equipment and working capital loans are combined. Banks also sometimes
cross-collateralize and cross-default loans to one borrower across multiple loans. Given the
limited use of some O&G equipment, banks may attempt to sell the company as a whole
rather than repossess limited-use collateral when an O&G company is under financial duress.
Credit Administration
Ongoing Monitoring
Ongoing monitoring is critical to prudent E&P lending. Ongoing monitoring entails not only
remaining well informed of the borrower’s operations but also independently keeping up
with market events that may affect the borrower. Banks should update their price decks at
least semiannually or more frequently as market conditions warrant. Banks should regularly
monitor O&G production output and compare it with assumptions provided in the
engineering report by obtaining periodic LOS from the borrower. When there is significant
deviation, a new or updated engineering analysis should be considered. Banks should assess
current market prices and the cash flow discount rate in comparison with previous
assumptions. The updated lender analysis should be documented and should consider
whether the borrower’s ability to repay committed debt remains within the bank’s
underwriting standards.
The quality of financial information and subsequent analysis is an integral part of any O&G
credit. This analysis should include an assessment of the following:
Subsequent updates to the base case and sensitivity case analyses should occur at least
annually or more frequently as changes warrant. Loan repayment sensitivity analysis should
fall within the standards set by the bank’s policy.
Collateral Documentation
E&P lending involves unique documentation and perfection of security interests in collateral.
The ownership of O&G is real property while it is still in the ground, but it changes to
personal property when it is extracted from the well. Following is a short synopsis of the
documentation that banks should use for E&P lending:
• Deed of trust or real estate mortgage: The deed of trust or real estate mortgage
(depending on the state in which the property is located) should provide for the
assignment of O&G proceeds, which allows the bank to request that payments from the
reserve purchaser be distributed directly to the bank. A bank may or may not perfect its
assignment of the lease proceeds, but this clause in the document is necessary if the bank
ever desires to do so.
• Title opinions: The bank should obtain a title opinion on loans secured primarily by
O&G reserves. A competent O&G attorney should prepare this opinion, and bank counsel
or the board of directors should approve it. This opinion is especially important when
there is a collateral concentration, a new borrower, or properties that are new to the
borrower.
• UCC-1: The bank should properly file a Uniform Commercial Code (UCC) UCC-1 form
to perfect the bank’s security interest in all equipment on the lease as well as the proceeds
from the lease. A UCC filing also should be made when the operator of the lease is a
significant working-interest owner. In most states, a UCC filing must be recorded with
the Secretary of State and, in some circumstances, in the county (or parish if in
Louisiana) where the O&G lease is located.
• Lien search: The bank should perform a lien search to determine the existence of any
previous liens before funding the loan and should document the lien search in the loan
file. This search normally is completed in conjunction with the title opinion. In the rare
case that a title opinion is not obtained, a lien search should be done as a minimum
precaution.
• Transfer or division orders: The bank should obtain copies of transfer or division
orders from the reserve purchaser. Transfer or division orders usually are not available
until at least 60 days after a loan is made if the loan is for the acquisition of such
property. Most title opinions verify the existence of a proper payee on division orders to
assist in the determination of ownership (division order title opinion) when title is being
transferred from a seller to the buyer. New division orders are issued to the new owner
from a certified copy of a filed assignment or deed of trust.
• Appraisal/evaluation: Documentation of the value of the O&G-related collateral should
be an integral part of the file. Whether the loan is for equipment or O&G production, an
evaluation of that collateral is necessary.
• Leases and operating agreements: If applicable, the file should contain copies of all
agreements that the debtor has entered into with others that involve the O&G property
pledged as collateral.
• Equipment lists and valuation: If possible, a complete listing of all equipment found on
an O&G lease, including models and serial numbers, should be in the file. Since many
leases contain hundreds of wells, it may not be practical to obtain such information. At a
minimum, collateral supporting term debt should be inspected and valued on a periodic
basis. Collateral condition and marketability assessments should be included in the
documentation.
• Conveyance documents: The bank should obtain all conveyance documents related to
an O&G transaction, particularly when a title opinion is not obtained or the bank is
financing the purchase of the producing collateral. Normal conveyance documents would
include assignments as well as purchase agreements.
• Certificate of insurance: The bank should obtain documentation showing that payment
of insurance premiums are up-to-date and that collateral is appropriately covered against
potential perils.
• Phase I environmental report: This document should be required for acquisition
financing.
Similar to other types of lending, management should have a continuous process to identify,
approve, document, and monitor loan policy and underwriting exceptions. To gain the
maximum benefit from such a process, management information systems (MIS) should
provide data not only on individual exceptions but also on the aggregate level of policy
exceptions. Such aggregated data can provide a more complete picture of risk in the portfolio
and reveal weaknesses in the underwriting process or in the policy itself.
Concentrations
Excessive and poorly managed O&G loan concentrations can lead to significant losses during
financial stress periods and adversely affect a bank’s earnings and capital position. Banks
with geographic concentrations in areas that are heavily dependent on the O&G economy can
be affected beyond their direct E&P lending activities. For example, during periods of either
slowing demand or oversupply, O&G companies can slow drilling and exploration or even
shut down unprofitable wells. Ancillary O&G businesses, such as O&G service companies,
water haulers, and O&G construction companies, may lay off employees or move operations
to a more profitable area. Banks that finance local hotels, housing projects, restaurants,
convenience stores, etc., in the area are likely to be sensitive to the O&G industry. Bank
management may face other correlated risks due to funding concentrations, deposit declines
Environmental Issues
Significant environmental risks can affect O&G borrowers. Some environmental issues, such
as large oil spills and the safety of fracking techniques, have been widely publicized in recent
years. Environmental problems can cause project delays, terminate drilling, increase costs,
impair cash flow, and reduce collateral values. In some instances, environmental problems
can cause significant losses. If banks become responsible for repossessed property, they may
be held financially accountable for environmental remediation under the Comprehensive
Environmental Response, Compensation, and Liability Act.
Significant environmental disasters can severely increase reputation risks for responsible
parties. Potential liabilities can greatly exceed the amount of the original loan. Banks should
perform appropriate due diligence, including obtaining independent environmental
engineering reports when appropriate, to understand any existing environmental issues and
potential environmental risks. Banks should consider both the borrower’s operations and the
collateral in this analysis.
Banks should segment O&G loans in their allowance for loan and lease losses (ALLL)
analyses when the exposure represents a meaningful level of risk (for example, a
concentration) because of the unique risks that affect borrower performance. Banks also
should consider the extent of exposure to oil production versus natural gas production, risk
within particular geographies, and other risk factors to determine if further segmentation is
necessary. When changes or other significant events pose additional risks, banks should
consider adjusting their historical loss rates to ensure an adequate ALLL is estimated and
reported.
An E&P loan should be considered impaired when, based on current information and events,
it is probable the bank will be unable to collect all amounts due (including interest and
principal) according to the contractual terms of the loan agreement. For regulatory reporting
purposes, an impaired collateral-dependent loan should be measured for impairment based on
the fair value of the collateral (less estimated costs to sell, if appropriate) regardless of
whether foreclosure is probable.
Generally, the fair value of O&G reserves should be based on the risk-adjusted NPV of total
proved reserves, unless more appropriate and supportable comparable sales information is
available. The evaluation of the discounted and risk-adjusted NPV should be based on
historical production and cost data (decline curve analysis engineering), using current market
pricing, market-supported cash flow discount rates, and supportable adjustments that account
for the inherent production, operating, development, and market risk of the reserve
categories, particularly for unseasoned proved producing, proved nonproducing, and PUD
reserves. Adjustments should be well supported and reflect current market conditions.
The “Allowance for Loan and Lease Losses” booklet of the Comptroller’s Handbook
contains further guidance.
Although RBLs have some similarities to traditional working capital asset-based lending
(ABL) facilities, there are notable differences that warrant different risk rating
considerations. Traditional ABLs are committed lines of credit subject to a borrowing base
that can be drawn and repaid as needed, secured by a first-priority lien against a borrower’s
relatively liquid assets (that is, assets that can be converted to cash quickly at a relatively
stable value). In most ABL transactions, this collateral consists of short-term working capital
assets, such as accounts receivable and inventory. The borrowing base of an ABL facility
fluctuates depending on the amount of underlying assets available to secure the facility and is
re-determined monthly, if not more frequently.
RBL collateral is significantly more volatile given historical changes in the commodity
prices, has a longer cash conversion cycle (RBL cash conversion can take several years as
opposed to days or months for working capital collateral found in other borrowing base
loans), and requires experienced operators to continue extraction and production.
Furthermore, unlike traditional ABL facilities, a decline in the borrowing base of an RBL
does not necessarily coincide with reduced funding needs of the borrower. The RBL
borrowing base tends to decline because of a drop in the underlying commodity prices at a
time when the company may be experiencing a decline in operating cash flow and liquidity.
Borrowers may find the RBL over-advanced in these scenarios, triggering principal payment
or other actions to return the line to a conforming status.
Liquidity Considerations
E&P companies are highly capital intensive because of the need for almost constant reserve
replacement. Liquidity analysis is therefore a critical part of the financial analysis. Liquidity
should be evaluated when the lender is considering the likelihood of the borrower being able
to meet its development plan and production estimates. This evaluation includes assessing
the borrower’s planned capex and sources of funds to meet the cash demands.
A sudden and significant reduction in operating cash flow and liquidity can force a company
to reduce capex that support drilling programs, incur higher borrowing costs, issue equity at
unattractive prices, monetize hedges to improve short-term liquidity (at the expense of future
revenues), or sell assets. For a company already in a weak financial position, this reduction
could lead to payment default and cause the borrower to file for bankruptcy. In addition to a
decline in commodity prices, other circumstances can lead to a sudden reduction in the RBL
borrowing base. These include a sudden rise in the company’s costs associated with drilling
and production, delays in the expected production schedule, a reserve write-down or other
decline in reserves, and tightened underwriting standards by lenders.
The level of projected capex in the engineering report represents the estimated capex needed
to develop the PUD reserves (drilling and completion of the wells) and, to a lesser extent,
completion of PDNP wells or workovers of PDP wells. Projected capex in the engineering
report may differ from the borrower’s budgeted “Capital Plan,” which describes the
company’s forecasted capex, including potential acquisitions. If the borrower is unable to
meet projected capex because of limited or no liquidity sources, the borrower may be unable
to fully realize the cash flows projected in the engineering report from PDNP and PUD wells,
which may affect the reserve valuation. Repayment analysis of borrowers with limited to no
liquidity should give more consideration to scenarios that focus on cash flows from PDP
reserves (currently producing).
While capex may be discretionary, liquidity analysis is particularly important for borrowers
with significant “nonoperated” reserves, as the projected capex associated with these reserves
may not be discretionary. Nonoperated lessees are normally required to pay the operating
lessee the pro rata share of the incremental capex as incurred in order to maintain the
nonoperated lessees’ interest in the reserves.
The “Interagency Guidance on Leveraged Lending” issued by the OCC, the Board of
Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation on
March 22, 2013, applies to E&P borrowers meeting an institution’s definition of leveraged
lending. The “Risk Rating Leveraged Loans” section of the leveraged lending guidance states
that risk rating for leveraged loans involves the use of realistic repayment assumptions to
determine a borrower’s ability to de-lever to a sustainable level within a reasonable period.
The leveraged lending guidance also states that supervisors commonly assume that the ability
to fully amortize senior secured debt or repay at least 50 percent of total debt over a five- to
seven-year period provides evidence of adequate repayment capacity. Regarding loans to
E&P borrowers, the borrower’s ability to repay the RBL and total debt are assessed relative
to the economic life of the borrower’s O&G reserves, rather than the five- to seven-year
period discussed in the leveraged lending guidance.
Table 1 provides a sample repayment test to determine whether the borrower has the capacity
to repay total secured debt from excess cash flow within a reasonable time. Cash flow
available for debt repayment is equal to projected FNR less G&A and interest expense on
total debt (column J). The beginning borrowing base commitment (column K) is reduced by
the incremental cash flow available for debt repayment from each period until payout and
then applied to junior lien secured debt (column N). At payout, the FNR remaining (column
Q) divided by the aggregate FNR represents the reserve tail (column R). Said differently, the
inverse represents the percent of economic life used to repay total debt (column U). The
example shows the borrower can repay the RBL well within 60 percent of the economic life
(actual payout at 40 percent of the economic life) and repay total debt within 75 percent of
the economic life (actual payout at 59 percent of the economic life).
Examiners should evaluate the borrower’s ability to repay total secured debt, including a
fully funded RBL and interest expense on all debt. When it is unlikely that the borrower will
use the full RBL commitment to fund projected capex or deficit cash flow, however,
examiners may also run scenarios of the borrower’s repayment capacity reflecting actual or
anticipated usage on the RBL. The ability of the borrower to repay or refinance unsecured
debt should consider the maturity structure and any contractual repayment obligations of the
unsecured debt relative to the repayment capacity of the total secured debt.
C G J
A B =A+B D E F =C–D–E–F H I =G–H–I
Total
Oil, gas, Hedging Total lease Production/ Interest Cash flow
and NGL revenues Total operating ad valorem expense (all available for
Year ending revenues (losses) revenues expense (LOE) taxes Capex FNR G&A debt) debt repayment
Year 1 48,892 8,699 57,591 6,623 733 6,917 43,318 2,512 8,500 32,306
Year 2 53,401 7,783 61,184 7,036 801 34,601 18,746 2,667 7,369 8,709
Year 3 45,003 3,919 48,922 5,626 675 3,412 39,209 2,131 7,064 30,013
Year 4 42,486 42,486 4,886 637 36,963 1,848 6,014 29,101
Year 5 37,965 37,965 4,366 569 33,030 1,651 4,987 26,391
Year 6 36,455 36,455 4,192 547 31,716 1,586 2,348 27,782
Year 7 28,068 28,068 3,228 421 24,419 1,221 23,198
Year 8 26,094 26,094 3,001 391 22,702 1,135 21,567
Year 9 21,075 21,075 2,424 316 18,335 917 17,418
Year 10 16,860 16,860 1,939 253 14,668 733 13,935
Remainder 67,750 67,750 7,791 1,016 58,943 3,092 55,851
Total 424,049 20,401 444,450 51,112 6,359 44,930 342,049 19,493 36,282 286,274
L M O P Q R
K =J =K–L N =J–L =N–O = total FNR – G = Q ÷ total FNR
Beginning RBL Ending RBL Beginning junior Ending junior Year-end FNR FNR remaining
Year ending (total committed) Cash repayment balance secured debt Cash repayment secured debt remaining percent
Year 1 100,000 32,306 67,694 50,000 50,000 298,730 87%
Year 2 67,694 8,709 58,985 50,000 50,000 279,984 82%
Year 3 58,985 30,013 28,971 50,000 50,000 240,775 70%
Year 4 28,971 28,971 0 50,000 129 49,871 203,812 60%
Year 5 49,871 26,391 23,480 170,783 50%
Year 6 23,480 23,480 0 139,067 41%
T U
= R at payout =1–T
FNR remaining at payout Economic life at payout
RBL payout 60% 40%
Total debt payout 41% 59%
Source: OCC.
Examiners should consider the following factors and borrower characteristics when
determining the regulatory rating for E&P loans. These factors and characteristics are not all
inclusive, nor are they meant to be “bright lines” for rating purposes, because other factors or
characteristics may be present that influence the analysis and rating decision. When using
these factors or characteristics, a borrower or credit might meet one or any combination of
them when assigned to a particular rating. Examiners must use judgment and reasonableness
when making final regulatory rating decisions; each borrower is unique. Further guidance on
regulatory loan rating processes is in the “Rating Credit Risk” booklet of the Comptroller’s
Handbook.
• The borrower has potential weaknesses that deserve management’s close attention. If left
uncorrected, these potential weaknesses may result in well-defined weaknesses and
deterioration of repayment capacity.
• Cash flow from operations is declining, total debt repayment capacity under the “base
case” forecast is marginal, or financial performance to plan has not been achieved.
• Bank projections indicate the borrower’s future cash flows repay the borrowing base
commitment under the RBL within 60 percent to 75 percent of the total proved reserve’s
economic life or repay total secured debt within 75 percent to 90 percent of the total
proved reserve’s economic life. When either case is true, the borrower’s repayment
capacity may be marginal.
• The loan structure possesses inadequate bank monitoring and lender control (for example,
no or not meaningful covenants, excessive headroom, or too few covenants).
• Borrower is approaching covenant limits or has experienced recent covenant waivers or
resets.
• Advance rates and the mix of reserve categories used to determine the borrowing base
exceed the bank’s limits or industry standards.
• Engineering evaluations may be outdated, be incomplete, or use assumptions that are
inconsistent with the current market environment or the borrower’s current financial
plans.
• Liquidity and cash flow are diminished and marginally sufficient to fund operations and
meet the borrower’s projected operating and capital plan. The borrower has a history of
over-advances and demonstrates marginal capacity to cure such over-advances.
• Borrower’s equity capital has declined in response to the company’s deteriorating
financial condition. Leverage metrics have increased or exceed industry norms.
– Total funded debt ÷ EBITDAX is generally greater than 3.5x.
– Total funded debt ÷ the sum of total funded debt + equity capital is generally greater
than 50 percent.
– Total committed debt is between 65 percent and 75 percent of the total unrisked and
undiscounted proved reserves.
• A substandard RBL is inadequately protected by the current sound worth and paying
capacity of the borrower. Borrowers have well-defined weaknesses generally
characterized by current or expected unprofitable operations, inadequate repayment
capacity, inadequate liquidity, or marginal capitalization. There is higher probability of
payment default, and repayment may depend on collateral or other secondary sources of
repayment.
• Cash flow from operations has significantly deteriorated, and total debt repayment
capacity under the “base case” forecast is insufficient.
• Lender financial projections indicate the borrower’s future cash flows either repay the
borrowing base commitment under the RBL, or some other RBL amount as determined
by the examiner as described in the Repayment Test Example, beyond 75 percent of the
reserve’s economic life, or repay total secured debt beyond 90 percent of the reserve’s
economic life.
• Borrower breached covenant limits or needs covenant waivers.
• Liquidity and cash flow are insufficient to fund operations and meet projected capex. The
company may need to sell assets or operations due to weak or distressed financial
condition. The borrower has a history of over-advances and cannot cure existing over-
advances within six months.
• Borrower’s equity capital has declined in response to the company’s deteriorating
financial condition. Leverage metrics have materially increased or exceed industry
norms.
– Total funded debt ÷ EBITDAX is generally over 4.0x.
– Total funded debt ÷ the sum of total funded debt + equity capital is generally over 60
percent.
– Total committed debt is greater than 75 percent of the total unrisked and
undiscounted proved reserves.
• In combination with other substandard risk characteristics,
– loan structure weaknesses provide for inadequate bank monitoring and lender control
(for example, no or not meaningful covenants, excessive headroom, or too few
covenants).
– advance rates and the mix of reserve categories used to determine the borrowing base
exceed the bank’s limits or industry standards.
– engineering evaluations are outdated, incomplete, or use assumptions that are not
consistent with the current market environment or the borrower’s current financial
plans.
When well-defined weaknesses exist, the following criteria should be applied to determine
the appropriate regulatory rating classification.
Substandard
The portion of the loan commitment(s) secured by the NPV of total risk-adjusted proved
reserves should be classified substandard. The evaluation of the risk-adjusted NPV should be
based on historical production and cost data (decline curve analysis engineering), using
current market pricing, market supported cash flow discount rates, and supportable
adjustments that account for the inherent production, operating, development, and market
risk of the reserve categories, particularly for unseasoned proved producing, proved
nonproducing, and PUD reserves.
Adjustments should be well supported and reflect current market conditions. For example,
property that is shut in because of a shortage of pipeline or other disruptions in transportation
to market presents different risk characteristics than a property that is shut in because of
lingering price pressures affecting the commodity. Furthermore, differing market and interest
rate environments may influence changes in capitalization rates for discounted cash flows.
While banks appropriately limit the contribution of PDNP and PUD in determining the
borrowing base, the collateral evaluation for regulatory classification purposes should
include all proved reserves that serve as collateral, subject to market and production risk
adjustments. Similarly, while many banks exclude the first six months of production in the
borrowing base determination, the collateral evaluation for classification purposes should be
as of the same date of the evaluation. The evaluation should include hedge positions, but it
should not include probable or possible reserves.
Doubtful
The remaining balance secured by the NPV of unrisked proved reserves should be classified
doubtful when the potential for full loss may be mitigated by the outcome of certain pending
events, or when loss is expected but the amount of the loss cannot be reasonably determined.
The combined substandard and doubtful portions should not exceed 100 percent of the
unrisked NPV of proved reserves.
Loss
The portion of the loan balance that exceeds 100 percent of the unrisked NPV of proved
reserves and is clearly uncollectible should be classified loss.
Banks should follow the Federal Financial Institutions Examination Council’s “Instructions
for Preparation of Consolidated Reports of Condition and Income” (call report instructions)
when determining the accrual status for oil and gas loans. As a general rule, banks shall not
accrue interest, amortize deferred net loan fees or costs, or accrete discount on any asset if
• the asset is maintained on a cash basis because of deterioration in the financial condition
of the borrower,
• payment in full of principal or interest is not expected, or
• principal or interest has been in default for a period of 90 days or more unless the asset is
both well secured and in the process of collection. 14
The call report instructions provide one exception to the general rule for commercial loans: 15
Purchased credit-impaired loans need not be placed in nonaccrual status when the
criteria for accrual of income under the interest method are met, regardless of whether
the loans had been maintained in nonaccrual status by the seller. 16
• none of its principal and interest is due and unpaid and the bank expects repayment of the
remaining contractual principal and interest, or
• it otherwise becomes well secured and is in the process of collection.
The OCC’s Bank Accounting Advisory Series and the “Rating Credit Risk” booklet provide
more information for the recognition of nonaccrual loans, including the appropriate treatment
of cash payments for loans on nonaccrual.
14
An asset is “well secured” if it is secured (1) by collateral in the form of liens on or pledges of real or
personal property, including securities, that have a realizable value sufficient to discharge the debt (including
accrued interest) in full, or (2) by the guarantee of a financially responsible party. An asset is “in the process of
collection” if collection of the asset is proceeding in due course either (1) through legal action, including
judgment enforcement procedures, or, (2) in appropriate circumstances, through collection efforts not involving
legal action which are reasonably expected to result in repayment of the debt or in its restoration to a current
status in the near future.
15
For more information, refer to the “Nonaccrual Status” entry in the “Glossary” section of the call report
instructions. This entry describes the general rule for the accrual of interest, as well as the exception for
commercial loans. The entry also describes criteria for returning a nonaccrual loan to accrual status.
16
For more information, refer to the call report instructions’ “Glossary” section, entry “Purchased Credit-
Impaired Loans and Debt Securities.”
Table 2 illustrates an example of the rating methodology for a classified borrower. Actual
pricing, discount rates, and risk adjustment factors may vary according to current market
conditions and the nature of the reserves. Examiners should closely review the key
assumptions made by the bank in arriving at the current collateral valuation.
Note: The $25 million of doubtful represents the difference between the unrisked NPV and the risked NPV. If the borrower's
prospects for further developing PDNP and PUD reserves to producing status is unlikely or not supported by a pending event,
this amount should be reflected as loss.
Examination Procedures
This booklet contains expanded procedures for examining specialized activities or specific
products or services that warrant extra attention beyond the core assessment contained in the
“Community Bank Supervision,” “Large Bank Supervision,” and “Federal Branches and
Agencies Supervision” booklets of the Comptroller’s Handbook. Examiners determine which
expanded procedures to use, if any, during examination planning or after drawing
preliminary conclusions during the core assessment.
Scope
These procedures are designed to help examiners tailor the examination to each bank and
determine the scope of the E&P lending examination. This determination should consider
work performed by internal and external auditors and other independent risk control
functions and by other examiners on related areas. Examiners need to perform only those
objectives and steps that are relevant to the scope of the examination as determined by the
following objective. Seldom will every objective or step of the expanded procedures be
necessary.
Objective: To determine the scope of the examination of E&P lending and identify examination
objectives and activities necessary to meet the needs of the supervisory strategy for the bank.
1. Review the following sources of information and note any previously identified problems
related to E&P lending that require follow-up:
• Supervisory strategy
• Examiner-in-charge’s (EIC) scope memorandum
• OCC’s information system
• Previous reports of examination and work papers
• Internal and external audit reports and work papers
• Bank management’s responses to previous reports of examination and audit reports
• Bank correspondence pertaining to E&P lending
• Customer complaints and litigation
2. Obtain the results of such reports as the Uniform Bank Performance Reports and Canary.
Identify any concerns, trends, or changes involving E&P lending since the last
examination. Examiners should be alert to growth rates, changes in portfolio
composition, loan yields, and other factors that may affect credit risk.
3. Obtain and review policies, procedures, and reports that bank management uses to
supervise E&P lending, including internal risk assessments. Consider
4. In discussions with bank management, determine if there have been any significant
changes (for example, in policies, processes, personnel, control systems, third-party
relationships, products, services, delivery channels, volumes, markets, geographies, etc.)
since the previous examination of E&P lending. Discussions should address
5. Based on an analysis of information obtained in the previous steps, as well as input from
the EIC, determine the scope and objectives of the E&P lending examination. Consider
6. For FSAs, determine if O&G loans are approaching the limits described in
12 USC 1464(c) and 12 CFR 160.30. O&G loans typically are classified as commercial
loans, which, under 12 USC 1464(c)(2)(A), cannot exceed 20 percent of total assets,
provided that commercial loans in excess of 10 percent of assets must be small business
loans. Small business loans include any loan to a small business (defined in 13 CFR 121)
and any loan that does not exceed $2 million and is for commercial, corporate, business,
or agricultural purposes. An FSA, however, may make O&G loans under other authority,
depending on the circumstances. For example, to the extent an O&G loan is secured by
nonresidential real property, an FSA may make the loan under its nonresidential loan
authority. Under this authority, an FSA generally may make loans secured by
nonresidential real property up to 400 percent of capital.
Quantity of Risk
Credit Risk
Objective: To determine the quantity of credit risk associated with E&P lending. Consider the
product mix, markets, geographies, technologies, volumes, size of the exposures, quality
metrics, concentrations, etc.
1. Analyze the composition and changes to the O&G portfolio, including off-balance-sheet
exposure, since the previous examination. Determine the implications for the quantity of
risk of the following:
2. Assess the effect of external factors, including economic, industry, competitive, and
market conditions.
• concentration reports.
• portfolio stress testing reports.
5. Obtain and review credit files for all borrowers in the sample and prepare line sheets for
the sampled credits. Line sheets should contain sufficient analysis to determine the credit
rating; support any criticisms of underwriting, servicing, or credit administration
practices; and document any violations of law. In particular, examiners should
6. Review the completed line sheets and summarize the loan sample results. The examiner
responsible for the E&P lending review should
• identify recommended loan risk rating downgrades and assess whether such decisions
are appropriately documented.
• maintain a list of structurally weak loans reviewed.
• complete the Credit Underwriting Assessment requirements to evaluate underwriting
practices since the previous supervisory activity and determine the appropriate
assessment rating.
• complete the Credit Underwriting Assessment requirement to determine the direction
of underwriting practices since the previous supervisory activity and draw a
conclusion on the appropriate assessment rating.
• maintain a list of loans for which examiners were unable to determine the risk rating
due to a lack of information.
• maintain a list of loans not supported by current and complete financial information
and engineering reports, and loans in which collateral documentation is deficient.
• summarize whether policy, underwriting, loan administration, or documentation
exceptions were appropriately identified and approved.
7. Analyze the level, composition, and trend of policy and underwriting exceptions, and
determine the impact on the quantity of risk. Consider the frequency of reporting, the
total dollar volume, and the percent of the portfolio that exceptions represent in
comparison with established limits. (Note: A bank’s lack of an internal tracking system
indicates a need to test for policy adherence.)
8. Evaluate the trend and level of concentrations as a percentage of total capital. Consider
exposure compared with policy limits for individual wells, fields, political or regulatory
jurisdictions, extraction technologies, etc.
9. Evaluate portfolio stress testing. Determine whether assumptions to develop base case
and downside cases are reasonable and whether key vulnerabilities have been considered.
10. Determine whether any previously charged-off O&G loans have been re-booked.
11. Using a list of nonaccruing loans, test loan accrual records to determine that interest
income is not being recorded.
12. Evaluate the adequacy of the ALLL for the O&G portfolio.
13. Consider the quantity of credit risk indicators in appendix A of this booklet, as
appropriate.
14. Discuss the results of the loan sample with the EIC or loan portfolio management
examiner and bank management.
Objective: To determine the quantity of other risks associated with E&P lending activities.
1. Assess the effect of E&P lending on the quantity of interest rate risk. Consider
• the effect of interest rate changes on both the borrowers and the bank.
• underwriting terms such as tenor and management’s pricing structure, for example,
fixed vs. variable interest rates and the potential exposure to different pricing indices.
• off-balance-sheet exposures.
• the quality and results of sensitivity analysis and portfolio stress testing.
2. Assess the effect of E&P lending on the quantity of liquidity risk. Consider
• the composition and trends of the E&P portfolio and the ability to convert the loans to
cash. Consider correlated concentrations of E&P loans that may be subject to similar
supply and demand volatility.
• current market conditions, including
− longer-term liquidity pressure due to capped or abandoned wells, reduced
exploration, and population migration.
− deposit trends in regions dependent on the O&G economy.
3. Assess the effect of E&P lending on the quantity of operational risk. Consider
4. Assess the effect of E&P lending on the quantity of compliance risk. Consider
5. Assess the effect of E&P lending on the quantity of strategic risk. Consider
• management’s strategy regarding E&P lending and the potential effect on risk
including those posed by concentrations.
• board oversight of strategic initiatives and stated risk appetite.
• the adequacy of the bank’s program for monitoring economic and market conditions.
Consider management’s assessment of O&G supply and demand, government
policies, and socioeconomic and demographic trends.
• the ability of the staff to implement E&P lending strategies without exposing the bank
to unwarranted risk.
6. Assess the effect of E&P lending on the quantity of reputation risk. Consider
• the bank’s effectiveness in meeting the E&P needs of the communities it serves,
including credit needs of small businesses that depend on the O&G industry.
• management’s oversight of environmental compliance and social responsibility
pertaining to E&P lending.
• the volume of syndicated E&P loans, and the bank’s ability to meet its legal or
fiduciary responsibilities in sourcing and syndicating E&P loans.
• management’s oversight of complex structured finance arrangements.
Policies
Policies are statements of actions adopted by a bank to pursue certain objectives. Policies
guide decisions, often set standards (on risk limits, for example), and should be consistent
with the bank’s underlying mission, risk appetite, and core values. Policies should be
reviewed periodically for effectiveness and approved by the board of directors or designated
board committee.
Objective: To determine the adequacy of the O&G loan policies and to reach a conclusion on
underwriting policies and standards for completing the Credit Underwriting Assessment.
1. Assess E&P lending objectives and risk appetite, including acceptable types of E&P
loans, portfolio distribution (concentrations of credit), lending market or territory, risk
limits measured as a percentage of capital, and correlation risk to other industries in the
bank’s loan portfolio.
2. Assess underwriting standards and approval requirements that are specific to lending to
the E&P industry and provide appropriate lender controls, including measurement of
O&G reserve and production history; financial analysis expectations; realistic repayment
terms consistent with the use of proceeds; advance rates and risk adjustments on various
reserve types; pricing parameters; stress or sensitivity analysis of cash flow; covenant and
structure expectations; approval authority; and policy exception authority.
4. Assess requirements for the structure, reporting lines, and oversight of the E&P lending
department and independent engineering department.
5. Evaluate lender controls, including measurement of O&G reserve and production history,
financial analysis expectations, stress or sensitivity analysis of cash flow, and approval
authorities.
6. Assess covenant and structure expectations and how borrowing bases are determined.
7. Assess maximum advance rates and risk adjustments for all categories of O&G reserves.
9. Assess how borrowing base deficiencies are cured and how long the bank gives the
borrower to cure them.
10. Determine the minimum percentage of production loan value attributable to PDP
reserves.
11. Determine whether risk adjustments are applied to nonproducing reserves to discount
values before applying advance rates to the borrowing base.
12. Assess maximum loan term and whether the term reflects the purpose and source of
repayment.
13. Determine if there is a periodic review and adjustment, if necessary, of the O&G pricing
policy (price deck) assumptions and escalation factors for base case and sensitivity case
analyses. Industry standard is to review the O&G pricing policy at least quarterly.
Reasoning for changes should be documented in writing. Consider
14. Assess hedging activities and strategies, including maximum percent of PDP reserves
hedged and maximum tenor of hedges.
16. Evaluate collateral documentation and title verification and whether policy specifies
percentage of O&G properties to be covered under mortgage.
17. Determine if there is a comprehensive engineering policy that provides guidelines for
engineers, including discount rates applied to future net income to arrive at the present
worth of future net income. Some banks maintain a separate engineering policy.
19. Determine if policy outlines collateral margins for specific types of O&G equipment
lending.
20. Determine if policy addresses how O&G loan policy exceptions are defined, identified,
monitored, and controlled, including expectations for the frequency of exception report
updates. Has the bank established a limit for the percentage of the portfolio with
exceptions and does it monitor its performance against this limit?
21. Determine how credit enhancements (personal guarantees, hedging, etc.) are used to
support credit underwriting.
22. Does the board review and approve the E&P lending policy annually?
• Does it evaluate existing policies to determine if they are compatible with market
conditions?
• Does it assess whether policies are consistent with the bank’s strategic direction and
risk appetite?
23. Reach and document conclusions and findings from the review of the bank’s commercial
lending policies. Examiner conclusions and findings of the bank’s commercial lending
policies can also support the “Commercial Credit––Underwriting Assessment” module
and the “Overall Credit—Underwriting Assessment” module in Examiner View.
Examiners may also add both these modules to the examination activity, if applicable.
Processes
Processes are the procedures, programs, and practices that impose order on a bank’s pursuit
of its objectives. Processes define how activities are carried out and help manage risk.
Effective processes are consistent with the underlying policies and are governed by
appropriate checks and balances (such as internal controls).
Objective: To determine the adequacy of the bank’s lending practices, procedures, and internal
controls regarding O&G loans.
1. Evaluate how policies, procedures, and plans affecting the O&G portfolio are
communicated. Consider whether
2. Assess the process to determine the accuracy and integrity of the O&G loan data.
3. Assess and reach a conclusion on underwriting practices for E&P lending and complete
the appropriate sections of the Credit Underwriting Assessment. Consider
4. Assess the process for approving policy exceptions. Consider the following:
• Is there a process to ensure exceptions are appropriately identified before loans are
approved?
• Does the process ensure identified exceptions must be authorized by appropriate
approval authority?
5. Evaluate the accuracy and integrity of the internal risk-rating processes. Consider
6. Determine whether there are processes to monitor strategic and business plans for the
O&G portfolio. Consider
• how the O&G portfolio business plans and strategies affect earnings and capital.
7. Review the process to assess compliance with applicable laws, rulings, regulations, and
environmental guidelines. Consider
• for E&P loans, if there is a process in place to ensure that preparation of in-house
engineering reports or review of external reports is consistently completed in a timely
manner so that semiannual borrowing base redeterminations are not delayed.
• for equipment loans, if values are updated periodically. Are values provided by
personnel or third parties with sufficient expertise when updating values for
specialized equipment (drilling equipment, fracking equipment, etc.)?
• whether the bank has adequate processes to monitor O&G prices.
• whether drilling rigs and other equipment are periodically inspected. Are inspections
performed by technically qualified and competent inspection personnel or third
parties?
• whether the bank has processes to ensure liens on O&G properties are filed and
perfected. Is outside counsel required to review documentation before loan closing?
• whether the bank has processes to monitor the adequacy of insurance coverage.
9. The examiner reviewing the E&P lending portfolio should review the loan portfolio
manager’s examination findings to determine whether additional analysis is required for
issues related to E&P lending pertaining to
10. Review the methodology for evaluating and maintaining ALLL. Consider whether
• the portfolio is analyzed as a separate pool or further segmented by loan type (oil
production, natural gas production, equipment, or service) or geographic area.
• the methodology is reasonable based on historical experience and current trends.
11. Verify that the bank has an effective process to periodically evaluate internal controls.
(Note: The lack of an effective process may require examiners to conduct additional
testing. Refer to the “Internal Control Questionnaire” section of this booklet for details on
additional testing.)
Personnel
Personnel are the bank staff and managers who execute or oversee processes. Personnel
should be qualified and competent, have clearly defined responsibilities, and be held
accountable for their actions. They should understand the bank’s mission, risk appetite, core
values, policies, and processes. Banks should design compensation programs to attract and
retain personnel, align with strategy, and appropriately balance risk-taking and reward.
Objective: To determine whether management, lending, and engineering personnel possess and
display acceptable knowledge and technical skills to manage and perform their duties, given
the bank’s size and complexity.
1. Evaluate the adequacy of the E&P lending staff in terms of the level of expertise and
number of assigned personnel. Consider
2. Assess the performance management and compensation programs for E&P lending
personnel. Consider whether these programs measure and reward behaviors that support
strategic and risk appetite objectives for the portfolio.
3. Evaluate the adequacy of the internal engineering staff in terms of the level of expertise
and number of assigned personnel. Consider
5. If the bank has third-party relationships that involve critical activities, determine whether
oversight is consistent with OCC Bulletin 2013-29, “Third-Party Relationships: Risk
Management Guidance.”
Control Systems
Control systems are the functions (such as internal and external audits and quality assurance)
and information systems that bank managers use to measure performance, make decisions
about risk, and assess the effectiveness of processes and personnel. Control functions should
have clear reporting lines, sufficient resources, and appropriate access and authority. MIS
should provide timely, accurate, and relevant feedback.
Objective: To determine whether the bank has systems in place to provide accurate and timely
assessments of the risks associated with E&P lending.
• segregation of duties.
• quality control testing and monitoring systems.
• data reconciliation.
• system access including logical access and physical access to negotiable items or
vaults.
4. Assess the scope, frequency, effectiveness, and independence of the internal and external
audits of the E&P lending function. Consider the qualifications of audit personnel and
evaluate accessibility to necessary information and board responses to audit findings.
5. Assess the effectiveness of loan review. Evaluate the scope, frequency, effectiveness, and
independence of loan review, as well as their ability to identify and report emerging risks.
Determine whether loan review reports address the
• quality of the E&P portfolio.
• trend in portfolio quality.
• effectiveness of the engineering function.
• reliability of price deck, price deck assumptions, and updates to the price deck.
• quality of individual loan and portfolio stress testing.
• quality of significant relationships.
• level and trend of policy, underwriting, and pricing exceptions.
Conclusions
1. Determine preliminary examination findings and conclusions and discuss with the EIC,
including
Interest rate
Liquidity
Operational
Compliance
Strategic
Reputation
2. If substantive safety and soundness concerns remain unresolved that may have a material
adverse effect on the bank, further expand the scope of the examination by completing
verification procedures.
4. Compose conclusion comments, highlighting any issues that should be included in the
report of examination. If necessary, compose a matters requiring attention comment.
5. Complete the Credit Underwriting Assessment for O&G production lending, if included
in the examination scope.
6. Update the OCC’s information system and any applicable report of examination
schedules or tables.
7. Write a memorandum specifically setting out what the OCC should do in the future to
effectively supervise E&P lending in the bank, including time periods, staffing, and
workdays required.
8. Update, organize, and reference work papers in accordance with OCC policy.
9. Assess whether any paper or electronic media that contain sensitive bank or customer
information are appropriately disposed of or secured.
Policies
1. Has the board of directors, consistent with its duties and responsibilities, adopted written
O&G loan policies that are consistent with safe and sound banking practices and
appropriate to the size of the bank and to the nature and scope of its operations? In
particular, do the bank’s policies
• identify the geographic areas where the bank will consider lending?
• establish a loan portfolio diversification policy and set limits as a percentage of total
capital for O&G loans by type and geographic market?
• establish policies for the identification, monitoring, and management of
concentrations?
• identify appropriate terms and conditions for lending on different types of reserves
and equipment based on risk?
• establish loan origination and approval procedures, both generally and by size and
type of loan?
• establish prudent underwriting standards that are clear and measurable, including
− the maximum loan amount by purpose and collateral?
− maximum loan maturities by purpose and collateral?
− amortization schedules?
− borrowing base determinations?
− collateral coverage?
2. Has the bank also established loan administration and documentation expectations for its
O&G portfolio that address
• foreclosure timing?
• extensions and other forms of forbearance?
• acceptance of deeds in lieu of foreclosure?
• claims processing (for example, seeking recovery on a defaulted loan covered by an
insurance program)?
• servicing and participation agreements?
3. Are procedures in effect to monitor compliance with the bank’s E&P lending policies?
4. Does the bank effectively monitor conditions in the O&G markets to ensure that the E&P
lending policies remain appropriate?
5. Does the bank have an internal review procedure to determine whether the engineer
consistently follows engineering policies and procedures and that documentation supports
those conclusions?
6. Are there policies and procedures to ensure that preparation of in-house engineering
reports, or review of external reports, is consistently completed in a timely manner so that
semiannual borrowing base redeterminations are not delayed?
8. Does the bank take steps to determine whether there are any environmental hazards
associated with the real estate proposed to be mortgaged?
9. When there is reason to believe that there may be serious environmental problems
associated with property that it holds as collateral, does the bank
• take steps to monitor the situation to minimize any potential liability on the part of the
bank?
• seek the advice of experts, particularly in situations in which the bank may be
considering foreclosure on the contaminated property?
O&G Underwriting
1. Does the bank require
2. Do E&P company budgets include all costs to bring the hydrocarbons to market both
initially and over the life of the loan (including maintenance expenses over that period)?
3. Does the bank require an estimated cost breakdown for each expense?
4. Does the bank require that independent engineers review the reasonableness of cost
estimates?
Disbursements
1. Are disbursements
2. Are there periodic reviews of undisbursed loan proceeds to determine their adequacy and
that they are reconciled to the budget?
Documentation
1. Does the bank require that documentation files include
• loan applications?
• financial statements for the
− borrower?
− guarantors?
• credit and trade checks on the
− borrower?
− guarantors?
• a copy of all O&G project budgets?
• the loan agreement?
• engineering and appraisal reports?
• title searches and other lien searches?
Conclusions
1. Is the foregoing information an adequate basis for evaluating internal controls in that
there are no significant additional internal auditing procedures, accounting controls,
administrative controls, or other circumstances that impair any controls or mitigate any
weaknesses indicated in this section (explain negative answers briefly and indicate
conclusions as to their effect on specific examination or verification procedures)?
2. Based on the answers to the foregoing questions, internal controls for E&P lending are
considered (strong, satisfactory, insufficient, weak).
Verification Procedures
Verification procedures are used to verify the existence of assets and liabilities, or test the
reliability of financial records. Examiners generally do not perform verification procedures as
part of a typical examination. Rather, verification procedures are performed when substantive
safety and soundness concerns are identified that are not mitigated by the bank’s risk
management systems and internal controls.
1. Reconcile the trial balance to the general ledger. Include loan commitments, overdrafts,
and other contingent liabilities in the testing.
2. Using an appropriate sampling technique, select loans from the trial balance and
• review procedures for accounting for accrued interest and handling of adjustments.
• scan accrued interest and income accounts for any unusual entries and follow up on
any unusual items by tracing to initial and supporting records.
4. Obtain or prepare a schedule showing the amount of monthly interest income and
balances at the end of each month since the last examination and
5. Using a list of nonaccruing loans, check loan accrual records to determine that interest
income is not being accrued and whether cash payments received are applied to principal
when collection is in doubt.
Appendixes
Appendix A: Quantity of Credit Risk Indicators
Examiners should consider the following indicators when assessing the quantity of credit risk
of E&P lending activities.
Class/
Subclass Definition Guidelines
Reserves Reserves are those Reserves must satisfy four criteria: They must be discovered,
quantities of recoverable, commercial, and remaining based on the
petroleum anticipated development project(s) applied. Reserves are further subdivided in
to be commercially accordance with the level of certainty associated with the
recoverable by estimates and may be sub classified based on project maturity or
application of characterized by their development and production status.
development projects
to known To be included in the reserves class, a project must be sufficiently
accumulations from a defined to establish its commercial viability. There must be a
given date forward reasonable expectation that all required internal and external
under defined approvals will be forthcoming, and there is evidence of firm
conditions. intention to proceed with development within a reasonable time.
Approved for All necessary At this point, it must be certain that the development project is
development approvals have been going ahead. The project must not be subject to any contingencies
obtained, capital such as outstanding regulatory approvals or sales contracts.
funds have been Forecast capex should be included in the reporting entity’s current
committed, and or following year’s approved budget. The project “decision gate” is
implementation of the the decision to start investing capital in the construction of
development project production facilities or drilling development wells.
is under way.
Class/
Subclass Definition Guidelines
Justified for Implementation of the To move to this level of project maturity, and have reserves
development development project associated with it, the development project must be commercially
is justified because of viable at the time of reporting, based on the reporting entity’s
reasonable forecast assumptions of future prices, costs, etc. (“forecast case”), and the
commercial specific circumstances of the project. Evidence of a firm intention
conditions at the time to proceed with development within a reasonable time will be
of reporting, and sufficient to demonstrate commerciality. There should be a
there are reasonable development plan in sufficient detail to support the assessment of
expectations that all commerciality and a reasonable expectation that any regulatory
necessary approvals approvals or sales contracts required before project
and contracts will be implementation will be forthcoming. Other than such approvals and
obtained. contracts, there should be no known contingencies that could
preclude the development from proceeding within a reasonable
time (refer to reserves class).
Contingent Those quantities of Contingent resources may include, for example, projects for which
resources petroleum estimated, there are currently no viable markets; when commercial recovery is
as of a given date, to dependent on technology under development; or when evaluation
be potentially of the accumulation is insufficient to clearly assess commerciality.
recoverable from Contingent resources are further categorized in accordance with
known accumulations the level of certainty associated with the estimates and may be
by application of subclassified based on project maturity or characterized by their
development economic status.
projects, but which
are not currently
considered to be
commercially
recoverable because
of one or more
contingencies.
Development A discovered The project is seen to have reasonable potential for eventual
pending accumulation where commercial development, to the extent that further data acquisition
project activities are (e.g., drilling or seismic data) or evaluations are currently ongoing
ongoing to justify with a view to confirming that the project is commercially viable
commercial and providing the basis for selection of an appropriate
development in the development plan. The critical contingencies have been identified
foreseeable future. and are reasonably expected to be resolved within a reasonable
time. Note that disappointing appraisal and evaluation results could
lead to a reclassification of the project to “on hold” or “not viable”
status.
Class/
Subclass Definition Guidelines
Development A discovered The project is seen to have potential for eventual commercial
unclarified or accumulation where development, but further appraisal and evaluation activities are on
on hold project activities are hold pending the removal of significant contingencies external to
on hold or where the project, or substantial further appraisal and evaluation activities
justification as a are required to clarify the potential for eventual commercial
commercial development. Development may be subject to a significant time
development may be delay. Note that a change in circumstances, such that there is no
subject to significant longer a reasonable expectation that a critical contingency can be
delay. removed in the foreseeable future, for example, could lead to a re-
classification of the project to “not viable” status.
Lead A project associated Project activities are focused on acquiring additional data or
with a potential undertaking further evaluation designed to confirm whether the
accumulation that is lead can be matured into a prospect. Such evaluation includes the
currently poorly assessment of the chance of discovery and, assuming discovery,
defined and requires the range of potential recovery under feasible development
more data acquisition scenarios.
or evaluation to be
classified as a
prospect.
Class/
Subclass Definition Guidelines
Play A project associated Project activities are focused on acquiring additional data or
with a prospective undertaking further evaluation designed to define specific leads or
trend of potential prospects for more detailed analysis of their chance of discovery
prospects, but which and, assuming discovery, the range of potential recovery under
requires more data hypothetical development scenarios.
acquisition or
evaluation to define
specific leads or
prospects.
Appendix D: Glossary
Abandon: (1) The proper plugging and abandoning of a well in compliance with all
applicable regulations, and the cleaning up of the well site to the satisfaction of any
governmental body having jurisdiction with respect thereto and to the reasonable satisfaction
of the operator. (2) To cease completion of a well and salvage drilling or well material and
equipment.
Abatement: (1) The act or process of reducing the intensity of pollution. (2) The use of some
method of abating pollution.
American Petroleum Institute: The primary trade association representing the O&G
industry in the United States.
Annulus: The space between (1) the casing and the wall of the borehole, (2) two strings of
casing, and (3) tubing and casing.
Appraisal well: A well drilled as part of an appraisal drilling program that is carried out to
determine the physical extent, reserves, and likely production rate of a field.
Barrel (bbl): One barrel of oil (1 barrel = 42 U.S. gallons [approx.] or 35 imperial gallons
[approx.] or 159 liters [approx.]; 7.45 barrels = 1 ton [approx.]; 6.29 barrels = 1 cubic meter).
Bcf: Billion cubic feet (1 billion cubic feet of natural gas = 0.026 million metric tons or 0.18
million barrels of oil equivalent).
Blow-out: When well pressure exceeds the ability of the wellhead valves to control it. O&G
“blow wild” at the surface.
BOE: Barrel of oil equivalent. A unit of measure to equate O&G volumes. Each barrel of oil
equals 6,000 cubic feet (or 6 mcf) of natural gas. For example, if a company produces
1 million barrels of oil and 6 million mcf of gas, it has produced 2 million BOE.
Borrowing base: A collateral base agreed to by the borrower and lender that is used to limit
the amount of funds the lender advances the borrower. The borrowing base specifies the
maximum amount that can be borrowed in terms of collateral type, eligibility, and advance
rates.
Brownfield production: An existing field that is brought back into production because of
improved markets, technology, etc.
Casing: Pipe cemented in the well to seal off formation fluids or keep the hole from caving
in. Casing remains in the well as a permanent reinforcement after the drilling is complete.
Completion: The installation of permanent wellhead equipment for the production of O&G.
Condensate: Hydrocarbons that are in the gaseous state under reservoir conditions and
become liquid when temperature or pressure is reduced.
Contango: A circumstance in which the futures price of a commodity has risen above the
future expected spot price. A contango implies that investors are willing to pay a premium
for delivery of a commodity in the future rather than pay the carrying costs of buying the
commodity today and holding it.
Crude oil: Liquid petroleum as it comes out of the ground as distinguished from refined oils
manufactured out of it.
Day rate: The rate paid to a drilling contractor for each day’s work under a day work
contract, which stipulates that the contractor be paid based on time worked, not footage
drilled.
Derrick: The tower-like structure that houses most of the drilling controls.
Development: O&G well development occurs after exploration has located an economically
recoverable field. It involves the construction of one or more wells from the beginning
(called spudding) to either abandonment if no hydrocarbons are found or to well completion
if hydrocarbons are found in sufficient quantities.
Development well: Any well drilled in an area where oil or natural gas has previously been
found.
Drilling: The use of a rig and crew for the drilling, suspension, completion, production
testing, capping, plugging, and abandoning of a well or the converting of a well to a
producing well. Also includes any related environmental studies. Associated costs include
completion costs but do not include equipping costs.
Drilling rig: A drilling unit that is not permanently fixed to the seabed, for example, a drill
ship, a semisubmersible, or a jack-up unit. Also, a derrick and its associated machinery.
Dry hole: A well that contains no oil or natural gas, or too little of either to make production
economically viable.
Enhanced oil recovery: A process whereby oil is recovered other than by the natural
pressure in a reservoir. Examples include water flooding, use of surfactants, and in situ
combustion.
Exploration: Oil and natural gas exploration is the search by petroleum geologists and
geophysicists for formations containing deposits of oil and natural gas beneath Earth’s
surface. O&G exploration is grouped under the science of petroleum geology.
Exploration well: A deep hole drilled into the earth by an O&G company that is used to
identify new sources of oil and natural gas.
Farm in: When a company acquires an interest in an acreage by taking over all or part of the
financial commitment for drilling an exploration well.
Fishing: Retrieving objects from the borehole, such as a broken drill string or tools.
Frack boat: An offshore vessel used in offshore frack jobs. These vessels include various
tanks, storage compartments, engines, pumps, mixing blenders, etc., for such jobs and coiled
tubing that are lowered into the wellbore to put the frack fluid mix directly into the wellbore.
Future net revenue half-life: The remaining value of cash flow after the depletion of half of
the reserves.
Greenfield production: New producing wells operating in a field that has not been in
production for a long time.
Ground lease: A lease agreement that allows a tenant to develop the property for the lease
period but forfeits rights to the improvements to the property owner when the lease has
matured.
Hydrocarbon: A compound containing only the elements hydrogen and carbon. May exist
as a solid, a liquid, or a natural gas. The term is mainly used in a catchall sense for oil,
natural gas, and condensate.
Infill drilling: Drilling new wells between established producing wells within an existing
field lease to accelerate recovery or to test recovery methods.
Jack-up rig: A mobile offshore drilling rig with legs lowered to the ocean floor as an
anchor. Once the legs hit bottom, the body of the rig is “jacked up” above the surface of the
water. These rigs are used in shallower applications for drilling, workover, or completion.
Lifting costs: The cost of producing oil or natural gas from a well or lease.
Majors: A term referring to the largest multinational integrated oil companies. Super majors
refers to the largest of the majors.
Mcf: One thousand cubic feet. The standard measure of natural gas volume (1 mcf =
1 million BTU [British thermal unit] of energy at 1 atmosphere of pressure; 6 mcf = 1 BOE).
Offset well: A well drilled near other wells to assess the extent and characteristics of the
reservoir. In some cases, this type of well is used to drain hydrocarbons from an adjoining
lease or tract.
Operator: The company with the legal authority to drill wells and undertake the production
of hydrocarbons that are found. The operator is often part of a consortium and acts on behalf
of this consortium.
Permeability: The property of a rock formation that quantifies the flow of a fluid through
the pore spaces and into the wellbore. A tight rock formation has low permeability and lower
capacity to flow O&G. Wells in such formations typically require additional stimulation via
fracking or other techniques.
Petroleum gas mud: Sometimes referred to as drilling mud, it is a mixture of base substance
and additives used to lubricate the drill bit and counteract the natural pressure of the
formation.
Porosity: Refers to the pore space present in the underground formation that enables the
rocks composing the formation to hold fluids.
Price deck: Bank-approved commodity pricing forecast that is used in RBL underwriting
and the evaluation of reserve assets for RBL borrowers. Bank pricing is often based on but
more conservative than market pricing forecasts, such as NYMEX futures curves.
Primary recovery: Recovery of oil or gas from a reservoir purely by using the natural
pressure in the reservoir to force out the oil or gas.
Probable reserves: Unproved reserves that are estimated to have a better than 50 percent
chance of being technically and economically producible.
Production: O&G production is the process of extracting the reserves and separating the
mixture of liquid hydrocarbons, gas, water, and solids; removing the constituents that are
nonsalable; and selling the liquid hydrocarbons and gas. Production sites frequently handle
crude oil from more than one well. Oil is nearly always processed at a refinery, while natural
gas may be processed to remove impurities either in the field or at a natural gas processing
plant.
Proved field: An oil or gas field whose physical extent and estimated reserves have been
determined.
Proved reserves: Those reserves that on the available evidence are virtually certain to be
technically and economically producible (that is, have a better than 90 percent chance of
being produced).
Recoverable reserves: That proportion of the O&G in a reservoir that can be removed using
currently available techniques.
Reservoir: The underground formation where O&G has accumulated. It consists of a porous
rock to hold the oil or gas, and a cap rock that prevents its escape.
Rig count: A survey revealing the number of drilling rigs in use during a particular period of
time in a given market. Usually includes onshore and offshore rigs, unless specified
otherwise.
Rotary drilling: A drilling system in which a rotating bit connected to a hollow drill pipe
penetrates a rock formation. Fluid is pumped through the pipe so the rock cuttings can be
brought to the surface.
Roughneck: Drill crew members who work on the derrick floor, screwing together the
sections of drill pipe when running or pulling a drill string.
Roustabout: Drill crew members who handle the loading and unloading of equipment and
assist in general operations around the rig.
Royalty payment: The cash or kind paid to the landowner or holder of royalty rights for a
portion of the property’s gross production of O&G. Although lease terms vary, a fairly
standard royalty is one-eighth of production.
Semisubmersible rig: A mobile offshore drilling rig that floats partially submerged.
Shut-in well: A well that is capable of producing but is not presently operating. Reasons why
a well may be shut in include lack of equipment or market.
Stripper well: A well that makes a nominal volume of production each day, typically 10
barrels or less. Smaller independents sometimes acquire stripper wells and rework them to
enhance production.
Submersible rig: A mobile offshore drilling rig with compartments that are flooded to cause
the structure to submerge and rest on the seafloor; used in shallow water.
Turnkey contract: A drilling contract that calls for the completion of a well for a fixed
price. All costs, including those that are unexpected, must be borne by the drilling contractor.
Utilization rate: The proportion of the total available rig fleet that is active at a given time.
Computed by dividing the number of active rigs by the number of available rigs. Differences
of opinion regarding the classification of “active” and “available” rigs mean that utilization
rates reported by different sources may vary widely. In the marine industry, the percentage
use rate for oilfield-related vessels.
Well log: A record of geological formation penetrated during drilling, including technical
details of the operation.
Well spacing: The maximum area of the resource reservoir that can be efficiently and
economically produced by one well. The purposes of well spacing are to prevent waste, avoid
the drilling of unnecessary wells, and protect the rights of reserves owners. Statutory spacing
is the limit of wells per a defined area of land established by state law or regulation.
Wildcat well: A well drilled in an unproved area. Also called an “exploration well.”
Working interest: The term, also called an operating interest, used to describe the lease
owner’s interest in the well. Lease owners pay 100 percent of cost and receive all revenues
after taxes and royalties are paid.
Workover: Remedial work to the equipment within a well, to the well pipework, or relating
to attempts to increase the rate of flow of a well.
Appendix E: Abbreviations
1P proved reserves
EIC examiner-in-charge
References
Laws
12 USC 24, “Corporate Powers of Associations” (national banks)
12 USC 29, “Real Property” (national banks)
12 USC 84, “Lending Limits” (national banks and federal savings associations)
12 USC 371, “Real Estate Loans” (national banks)
12 USC 1464, “Federal Savings Associations” (federal savings associations)
Regulations
12 CFR 32, “Lending Limits” (national banks and federal savings associations)
12 CFR 34, subpart C, “Appraisals” (national banks and federal savings associations)
12 CFR 34, subpart D, “Real Estate Lending Standards” (national banks)
12 CFR 34, subpart E, “Other Real Estate Owned” (national banks)
12 CFR 160, “Lending and Investment” (federal savings associations)
13 CFR 121, “Small Business Size Regulations” (federal savings associations)
Comptroller’s Handbook
Examination Process
“Bank Supervision Process”
“Community Bank Supervision”
“Federal Branches and Agencies Supervision”
“Large Bank Supervision”
“Sampling Methodologies”
OCC Issuances
Interpretive Letter 1117 (May 19, 2009) (national banks)
OCC Bulletin 2007-1, “Complex Structured Finance Transactions: Notice of Final
Interagency Statement” (January 5, 2007) (national banks and federal savings
associations)
OCC Bulletin 2013-29, “Third-Party Relationships: Risk Management Guidance” (October
30, 2013) (national banks and federal savings associations)