Oil and gas producers in Canada have historically relied predominately on reserve based lending arrangements from institutional credit providers for production and operating liquidity. Prolonged economic uncertainty, commodity price volatility and institutional lender hesitancy resulting from environmental, social and governance considerations have made it difficult for some Canadian upstream oil and gas companies to secure financing in the current environment. Those with continued access to customary capital are navigating the impact of a reduced borrowing base, substantially higher costs of borrowing given the current higher interest rate environment, and credit provider requirements to de-lever the balance sheet by paying down debt.
South of the border, investment grade rated securitizations backed by proved developed producing (PDP) oil and gas assets have gained traction as an alternative means of sourcing new capital for oil and gas producers able to leverage mature, steadily producing assets. The first such securitization completed in the United States in 2019. Notwithstanding the products' short lifespan, approximately US$1 billion in notes have been issued in PDP asset backed securitizations (PDP ABS financings) in the United States to a wide variety of investors, including pension funds, large asset managers and insurance companies. Given the intrinsic advantages of PDP ABS financings for oil and gas producers, it is only a matter of time before the product is deployed in the Canadian market.
While possessing idiosyncratic complexities, PDP ABS financings have the same basic structure as other ABS securitized financings. Customarily securitizations are structured such that an entity (the sponsor) pools financial assets that generate revenue, such as mortgages, auto loans and leases, student loans, equipment and aircraft leases, and credit card receivables. The pooled assets are then conveyed to a bankruptcy-remote special purpose vehicle (SPV) in a true sale transaction. The SPV finances the purchase price of the conveyed assets through the issuance of debt instruments to investors of notes or bonds collateralized by the revenue generated by the asset pool. If the notes are rated, the credit rating is based primarily on the underlying assets and not on the sponsor's credit quality. The resulting debt is non-recourse to the sponsor, except to the extent of retained equity interests and customary indemnities.
In a PDP ABS financing, income-producing oil and gas assets, including wellbores, associated leasehold interests and the related personal property used in development processes are securitized. PDP assets generate future cash flow from a receivable once hydrocarbons are extracted and sold by the sponsor as servicer on behalf of the SPV. The PDP assets most appropriate for securitization have proven historical production records; the majority of the capital expenditure costs have already been incurred and these assets have relatively predictable cash flows. The repayment of issued notes in a PDP ABS arrangement is however potentially impacted by fluctuating payments for the produced asset. The implementation of hedging arrangements and backup servicer agreements are common elements in PDP ABS financing transactions as a means employed by the SPV issuer to mitigate future cash flow receivable risks as well as the performance risk of the sponsor as servicer, contributing to the SPV issuer's ability to garner an investment grade rating for the notes. An investment grade rating translates into a debt raise for the SPV issuer with lower funding costs; often the interest rate associated with PDP ABS financing transactions is two to three percentage points lower than the interest rates usually associated with traditional high yield bond issuances.
PDP ABS financing offers producers the opportunity to tailor the securitization arrangement to its present circumstances and business goals:
Given its unique features and complexities, PDP ABS financing requires dedicated financial services, securitization and energy legal expertise to effectively implement, in particular in instances where the sponsor has secured debt arrangements already in place. To discuss PDP ABS financing opportunities in Canada, please contact one of the authors; we would be pleased to discuss the product with you in greater detail.