Factors Influencing Oil and Gas Industry Lending Decisions

By Nichols, Linda | Journal of Commercial Lending, January 1992 | Go to article overview

Factors Influencing Oil and Gas Industry Lending Decisions


Nichols, Linda, Journal of Commercial Lending


Managers of oil and gas companies disagree with the way bankers make decisions about loans to the oil and gas industry. Oil and gas company managers believe that bankers are much more concerned than they will admit with financial statement appearances. The study discussed in this article was undertaken to reveal which factors are actually important to bankers making oil and gas industry lending decisions.

THE OIL AND GAS ACCOUNTING ENVIRONMENT

There are currently two generally accepted methods of accounting for preproduction, exploration, and development costs in the oil and gas industry: the full-cost and successful-efforts methods. The full-cost method of accounting capitalizes all preproduction exploration, acquisition, and development costs regardless of whether the activities result in a discovery of oil or gas reserves in economic quantities--in other words, when the present value of net revenue is greater than the net future costs, such as lifting costs.

The successful-efforts, method, on the other hand, capitalizes these costs only when there is a direct relationship between costs incurred and specific oil and gas reserves discovered.

A major difference between these two methods becomes obvious when examining how dry hole costs are recorded. The successful-efforts method expenses exploratory dry hole costs, while the full-cost method capitalizes these costs and charges them against future production.

Debate over a Uniform Method

The need for a uniform method of accounting for preproduction, exploration, and development costs in the oil and gas industry has been periodically debated for more than a decade. The most recent debate occurred in 1986. Clarence Sampson, then chief accountant of the Securities and Exchange Commission (SEC), wanted to abolish the full-cost method of accounting.

Independent producers using the full-cost method lobbied hard against such a change. They warned that a mandated change to the successful-efforts method of accounting would cause many companies to go into technical default on their lending agreements. Even Congress, prompted by oil industry lobbyists, asked the SEC not to eliminate full-cost accounting. (1)

Many independent producers using the full-cost method want to maintain use of that method to stay within the ratio provisions of their debt covenants. However, informal talks with several senior lenders in Louisiana and Texas revealed some interesting aspects of their concerns regarding oil and gas loans.

Financial Ratios' Importance

Most notably, while financial ratios (primarily those dealing with capital structure and net worth) are used in oil and gas loan covenants, they are not as important to bankers as such ratios are in other industries.

In dealing with the oil and gas industry, bankers' primary concern is the amount of proven, developed, producing reserves. Provisions concerning these reserves are included in loan covenants. The covenants normally do not require that particular accounting methods be used and do allow firms to change methods, as long as the methods used are in accordance with generally accepted accounting principles (GAAP). Bankers do not view changing methods as a problem, since their main concern is with the amount of proven, developed, producing reserves.

THE STUDY

The study was conducted using a questionnaire that was sent to bank loan officers. The questionnaire comprised a set of financial statements for a fictitious oil and gas company, Oil-finders Exploration Company. The bankers were asked to make a lending decision for this company.

Comparative financial statements of Oilfinders Exploration for the years ending June 30, 1989, and June 30, 1988, were provided. Also included in the questionnaires were:

* Notes to the financial statements.

* A description of the company, which was the same for all eight sets of financial statements. …

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