Oil & Gas Asset-Backed Securitizations: An Alternative Avenue for Financing

Introduction

The oil and gas industry has traditionally relied on reserve-based lending (RBL) and high-yield debt to finance operations. But with capital markets constrained by economic uncertainty, commodity price volatility, and shifting environmental, social, and governance policies, these conventional financing methods have become increasingly difficult for independent producers to access. In particular, commercial bank lenders have reduced their exposure to the upstream oil and gas sector due to sustainability concerns, and investors have cooled on high-yield bonds amid fears of stranded asset risk. To maintain liquidity and fund their operations, independent oil and gas producers are turning to alternative sources of capital—including asset-backed securitization (ABS).

Securitization, while historically rare in the oil and gas sector, is gaining traction as companies seek innovative financing options. This approach allows producers to transfer revenue-generating assets to a special purpose entity (SPE), which issues debt securities backed by those assets’ cash flows. Unlike traditional financing, which is vulnerable to market fluctuations and lender sentiment, ABS offers a structured solution with enhanced creditworthiness, attracting a new class of investors.

Understanding Securitization

Securitization is a structured financial transaction in which an owner of cash flow-producing assets pools and then transfers those assets to a newly created, bankruptcy-remote SPE. This entity issues securities to investors, secured by the cash flows of the transferred assets. The sponsor company then uses the proceeds from the note issuance in exchange for the transferred assets. Unlike conventional loans, the SPE operates independently, ensuring that the transferred assets remain separate from the sponsor company’s balance sheet—and the potential risk of the sponsor’s bankruptcy.

Securitization is a well-established financing mechanism in sectors such as mortgage lending, auto loans, and credit card receivables, all of which involve contractually based, relatively stable and predictable cash flows. In the oil and gas industry, few ABS transactions had been executed before 2019. As traditional capital sources have tightened, however, the appeal of securitization has grown. Securitized oil and gas cash flows are also attractive to investors because, unlike contractually based cash flows, they are unaffected by movements in prevailing interest rates — making them a “non-correlated” asset class. Companies such as Raisa Energy, Maverick Resources, and Diversified Gas & Oil have successfully conducted such transactions, demonstrating ABS’s viability as an alternative financing method.

Key Parties Involved in Oil and Gas Securitizations

Several entities play a crucial role in structuring and executing an oil and gas securitization:

• Sponsor Company: The oil and gas producer initiating the securitization and transferring assets to the SPE
• Special Purpose Entity: The bankruptcy-remote entity that issues the securities and holds the transferred assets
• Investors: Institutional investors such as pension funds, insurance companies, and asset managers who purchase the securitized notes
• Credit Rating Agencies: Independent agencies that assess the risk and creditworthiness of the securitization structure
• Hedge Providers: Financial institutions that enter into commodity hedging agreements to stabilize cash flows
• Trustees and Servicers: Entities responsible for overseeing the SPE, managing cash flows, and ensuring compliance with transaction agreements
• Legal and Financial Advisors: Experts who assist in structuring the transaction, drafting legal documents, and securing regulatory approvals

Types of Assets Suitable for Securitization

For a securitization to be effective, the underlying oil and gas assets must provide stable, predictable cash flows. The most commonly securitized assets include:

• Proved Developed Producing (PDP) Reserves: These assets have long production histories, low decline rates, and require minimal capital expenditure.
• Operating and Non-Operating Working Interests: The degree of operational control determines the obligations and revenues associated with these interests.
• Royalty and Overriding Royalty Interests: These generate passive revenue streams without requiring operational involvement.
• Volumetric Production Payments: These entitle the holder to a set volume of production over a specified period.
• Net Profits Interests: These provide revenue after deducting operating expenses.

Diversification of Asset Pool

A key factor in the success of oil and gas securitizations is the diversification of the asset pool. A well-diversified portfolio of oil and gas assets improves the stability of cash flows and reduces overall risk exposure. Diversification can take several forms:

• Geographic Diversification: Assets located across multiple basins and states help mitigate the impact of localized economic, regulatory, or environmental risks.
• Operator Diversification: Bundling assets operated by multiple companies reduces reliance on the performance of a single producer.
• Reserve Type Diversification: A mix of PDP reserves, royalty interests, and volumetric production payments can create a more stable cash flow profile.

For example, Raisa Energy’s securitization included more than 3,000 wellbores across multiple states, operated by various producers. This diversification contributed to the transaction’s achieving an investment-grade rating, making it more attractive to institutional investors.

Importance of Long-Term Hedging Contracts in Securitization

Long-term or long-dated hedging contracts (for three to seven years post-securitization) mitigate the inherent risks associated with commodity price volatility. Given that oil and gas prices are subject to fluctuations driven by geopolitical events, macroeconomic trends, supply-demand imbalances, and regulatory changes, ensuring predictable cash flows is essential for the success of asset-backed securitizations.

Hedging contracts, entered into with hedge providers and primarily in the form of futures, swaps, and options, allow producers to lock in future prices for a significant portion of their projected production. This price certainty enhances the stability of cash flows, making the securitization structure more attractive to investors. Institutional investors, such as pension funds and insurance companies, typically favor investment vehicles with stable, predictable returns. By reducing exposure to price volatility, hedging contracts help achieve credit ratings that enhance the marketability of securitized notes.

Achieving an investment-grade rating is a key consideration in structuring oil and gas securitizations. Credit rating agencies evaluate various factors, including asset diversification, historical production stability, and risk mitigation strategies such as hedging. Transactions with robust hedging structures are more likely to receive higher ratings, as they demonstrate reduced exposure to downside price risk. Higher-rated securitizations attract a broader investor base and can secure lower financing costs.

While hedging enhances predictability, it also limits potential upside gains in a rising commodity price environment. As a result, structuring an effective hedging strategy involves balancing the need for cash flow stability with the desire to retain some exposure to favorable price movements. Many securitization transactions require a substantial portion of production to be hedged, typically from 50% to 80% of expected future output. Building flexibility into the structure allows sponsors to retain some unhedged volumes to benefit from market price appreciation.

Advantages of Securitization

Securitization offers several benefits compared to traditional financing options:

1. Access to a New Investor Base: Unlike high-yield debt, which has made investors cautious about oil and gas investments, ABS attracts pension funds, insurance companies, and institutional investors seeking structured finance products with stable returns.
2. Bankruptcy Remoteness: Proper structuring ensures that the SPE’s assets remain separate from the sponsor’s estate, reducing the risk of creditors making claims against these assets in bankruptcy proceedings.
3. Credit Enhancement and Ratings Requirements: By isolating high-quality PDP assets, securitized notes can achieve investment-grade ratings, making them more attractive to conservative investors. The rating process involves evaluating the production risk, diversification of assets, and the financial structure of the ABS transaction.
4. Predictable Financing Terms: Unlike traditional RBLs, which are subject to periodic borrowing base redeterminations, securitizations lock in financing terms at the outset, avoiding exposure to commodity price fluctuations.
5. Flexible Capital Structure: Securitization can complement or replace other financing sources, providing an avenue to refinance RBL borrowings or supplement capital expenditures.
6. Advance Rate: The advance rate in an ABS transaction is typically between 55% and 75% of the present value (PV-10) of the underlying reserves. This is significantly higher than the advance rates typically available in RBLs, making securitization a more attractive financing option for many producers.
7. Commodity Price Risk Management: Many ABS transactions require hedging a substantial portion of expected production, ensuring a level of cash flow stability that benefits both sponsors and investors. This requirement makes ABS structures more appealing to conservative investors, as it mitigates cash flow uncertainties. 

Disadvantages of Securitization

While securitization provides multiple benefits, there are challenges to consider:

• High Transaction Costs: The process of structuring a securitization deal involves significant legal, administrative, and credit rating fees.
• Loss of Borrowing Base: Because assets are transferred to an SPE, producers may see a reduction in the collateral available for other financing sources like RBLs.
• Hedging Requirements: Many ABS structures require a significant portion of production to be hedged, limiting potential upside from commodity price increases.
• Prepayment Restrictions: Many securitization structures include no-call provisions, making early refinancing costly or prohibitive.
• Complexity and Structuring Challenges: ABS transactions require detailed asset evaluation, legal structuring, operational considerations, and compliance with securities regulations, leading to extended timelines for execution and increased transaction costs.

Despite these complexities, once an ABS structure is established, subsequent securitizations can be executed more efficiently, as companies gain familiarity with the process and refine their financial models.

Conclusion

As traditional financing options become more constrained, oil and gas asset-backed securitizations are emerging as an attractive alternative. Despite their complexity and higher upfront costs, ABS transactions offer substantial advantages, including access to new investors, improved credit profiles, and long-term stability. With further refinements and growing adoption, securitization may become a mainstream financing tool for independent oil and gas producers navigating capital market challenges.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. David Aaronson, an O’Melveny partner licensed to practice law in Texas contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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