February 26, 2009
Paul S. Pilecki, Esq.
Winston & Strawn
1700 K Street, N.W.
Washington, D.C. 20006-3817
Re: Financing Oil and Gas Production Payments
Dear Mr. Pilecki:
This letter is written in response to two letters you submitted on behalf of your client, [---] (the “Bank”) inquiring about the permissibility, under New York Banking Law (“NYBL”), of certain financing transactions with respect to oil and gas production payments in which the New York Branch of the Bank (the “Branch”) seeks to engage.
We understand that the proposed transactions would take the following form:
A trust or special purpose vehicle (“SPV”) would purchase a non-operating interest in an oil or gas property from an oil or gas producer.1 The interest might be in the form of a volumetric production payment (“VPP”), a limited term royalty interest in oil and gas reserves that entitles the purchaser to receive scheduled production volumes from specific lease interests. The SPV would obtain financing from the Branch – usually a 5 to 7 year loan -- to support the purchase price of the non-operating interest. Repayment of the loan would be non-recourse to the SPV, and would depend solely on the cash flow from the production that the SPV is entitled to receive.2 To secure the loan the lender would hold a security interest in the SPV or the VPP, as well as in the cash proceeds from sales of the oil or gas. For Branch-affiliated SPVs, the SPV’s purchase of the production interest or VPP will be booked in the Branch and will be categorized as a loan.
At the time the producer delivers oil or gas to the SPV, the SPV would sell the production at current market prices to a purchaser. In order to hedge against changes in the price of oil and gas between the time it purchases the VPP and the time it makes sales to purchasers, the SPV would use hedging devices.3 When the producer has delivered the scheduled production from the oil or gas property, the SPV’s interest in the oil or gas property would revert to the producer.
The Branch seeks to serve not only in the capacity of lender but also as an arranger of such transactions. As arranger, the Branch would negotiate the terms of a transaction with the producer, conduct due diligence on the properties involved and form the SPV. As lender or arranger, the Branch might also hold any senior or subordinated piece of the loan transaction.
According to the Branch’s counsel, the SPV (and the Branch, as lender) bears the risk of (1) the property achieving the expected production levels, and (2) commodity price risk between the time the VPP is valued and the time the SPV fixes a sale price with the purchasers.
The Branch’s submission indicates that the VPP structure provides the owner/operator of oil or gas production access to financing on attractive terms, without giving up control of the oil and gas assets. The production payment obligation may be booked by the company as deferred revenue or as a capitalized operating expense. The seller retains the tax shield of both the production costs and the depreciation of the properties. The resulting tax benefit is likely to be more favorable economically than that for the interest expense on a comparable debt financing. As a result, incentives for exploration and production are increased with the consequent benefit of less dependence on foreign energy sources and possibly less rapid increases in prices for hydrocarbon products.
The legal issues presented by the Bank’s proposal are: 1) whether the above-described transactions are authorized as a permissible and/or incidental banking activity, and 2) whether the Branch’s non-operating interest, held through the SPV, in oil and gas property, constitutes an impermissible investment in real property.
The VPP financing transactions described above are, in substance, loans, and therefore permissible under a bank’s lending authority (see, NYBL §§96, 200). Under the proposed transactions as structured, the Branch is entitled only to repayment of its loans with interest, and the SPV’s use of a price hedge would convert the Branch’s return into a fixed return, or at least minimize the effect of commodity price fluctuations. For Branch-affiliated SPVs, the SPV’s hedging activities in this context consisting of forward trading on the underlying commodities would be permissible “incidental” activities to the financing transactions.
We note that the Office of the Comptroller of the Currency (“OCC”) has approved similar transactions in which the investing bank-owned entity obtained a working interest in oil and gas properties. For example, in a November 4, 1994 letter, the OCC confirmed that a national bank could extend credit to owners of gas or oil properties through a trust arrangement in which the funds advanced by the bank were repaid through the sale of gas produced from the reserves in which the trust acquired a working interest.
Similarly, in Corporate Decision #98-17 (May 1998), the OCC approved a request from a national bank that its operating subsidiary be permitted to obtain a working interest in certain oil and gas leases held by a limited liability company to which the bank had extended credit. The operating subsidiary sought to obtain the working interest in order to obtain certain tax credits that would be applied to reduce the balance on the bank’s loan. The OCC held that this arrangement was within the definition of a “loan or extension of credit” set forth in 12 CFR § 5.34(d)(1), and approved the transaction. Further, the OCC has held that a working interest in these circumstances did not run afoul of the strict limitations imposed by 12 USC § 29 with respect to real property ownership on the part of national banks.4
We note that 12 USC § 29 is very similar to the NYBL § 98 (generally prohibiting bank investments in real property with certain exceptions), and that these provisions have been interpreted similarly. We believe that the fact that the Branch would incidentally hold a non-operating interest in the oil and gas property does not convert the substance of the described transactions from permissible financing transactions to prohibited investments in real property.5
In summary, we believe that the VPP transactions described in your letters are legally permissible under the NYBL for New York State-chartered commercial banks, as well as for foreign bank branches and agencies. The Department’s opinion is limited to the facts described in your letters, and different facts could result in a different conclusion.
In its submissions, including various responses to Department follow-up inquiries, the Bank also provided detailed information concerning, among other things, its risk management practices, policies and procedures and internal controls that would be adhered to in carrying out the proposed financing activities. The Department’s non-objection to the Branch’s commencement of the described activities is based on the Bank’s satisfactory response to the Department’s inquiries in this regard. Please be advised that the next safety and soundness examination of the Branch will include a review of the described VPP activities and associated policies and procedures, risk management practices and internal controls.
I trust that the foregoing is helpful.
cc: David Fredsall
1 The SPV might be an affiliate of the Branch or it might be unaffiliated with the Branch. The purchase price for this interest would be based on the SPV’s estimate of the price of oil or gas at the time of expected delivery, discounted to the date of the closing of the purchase, after subtracting certain costs of the transaction and a profit margin.
2 In order to mitigate the risk that the production of the oil or gas the SPV is entitled to receive will be insufficient to repay the loan, the Bank undertakes due diligence concerning the production history and reserve analysis of the property in question and incorporates production-related terms into the deal structure. A customary part of the Bank’s diligence is to concentrate its purchases predominantly on properties that are among the most reliable properties the producer has to offer, also known as “proved developed producing or PDP” properties. These properties are required to have well understood geology, predictable production characteristics, and minimal future development costs to produce the volume necessary to satisfy the volumetric production payment transaction. This may include review of the reserve data and production forecasts by an independent reserve engineer. In addition, a haircut is applied to the forecast of production volume to ensure that sufficient quantities may be delivered. In addition, estimates of hydrocarbon reserves also are required to exceed the total delivery obligation under the VPP, i.e. minimum reserve coverage. The reserve coverage factor depends on the characteristics of the underlying wells, the percentage of PDP properties involved and the diversification of the wells, among other factors, but is determined so that the debts associated with a VPP transaction can be serviced even under various downside scenarios projected by the Bank.
3 In order to hedge the risk that market prices could fluctuate from the time of sale to the time of delivery, the Branch will enter into offsetting forward transactions. The Bank states that the hedging devices will be accounted for as derivatives, according to FASB No. 133 (“Accounting for Derivative Instruments and Hedging Activities”), which requires all derivatives to be recognized on the balance sheet either as assets or liabilities at their fair value. The Branch will report these transactions on Schedule L of FFIEC 002, line item 9.b, column D.
4 An analysis of similar transactions provided in a Federal Reserve Board letter dated May 15, 2006 from Scott Alvarez, Esq., to Elizabeth Davy, Esq. noted that, although an interest in the production rights of a commodity is, under most state law, a real property interest, the so-called owner is not entitled to all of the rights typically associated with ownership. For example, the SPV would have no right to control the operation of the gas or oil property.5 The permissible powers and activities of New York state-licensed foreign branches and agencies are generally determined with reference to New York state commercial bank powers (See Article III of the NYBL, §90 et. seq.).