Covenants and Investment
Covenants and Investment Productivity Christopher Michael Rigsby This dissertation explores the interaction of debt covenants and firms' investment behaviors, especially the association between debt covenants and project-level operations. Although previous research has examined the association between contractual terms or gross measures of investment and covenants, there is little known about the ways that covenants influence the choice and operation of projects. The main contribution of this
... tribution of this study is to fill this gap. Using the oil and gas industry as a natural setting for project-level data and the borrowing-base covenant as a feasible connection to the operation of oil wells, I show that covenants can be associated with investment productivity and efficiency. The first chapter provides an overview of lending in the oil and gas industry with a particular focus on revolving credit facilities. In this industry, a borrowing-base covenant uses the expected cash flows from the quantities of subsurface oil and gas to set the firm's credit limit, collateralizes the loan with these quantities, and allows lenders to review the collateral typically twice per year. One of the primary drivers of fluctuating expected cash flows from reserves is the volatility of oil and gas prices; 4 however, because firms can potentially control the productivity of their wells, firms can influence the expected cash flows by drilling high-quality wells. During the semi-annual review process, lenders weight reserves from currently producing wells more heavily, further incentivizing borrowing-base firms to operate more productive wells than those operated by non-borrowing-base firms. The second chapter explores the association between borrowing-base covenants and project-level operations. I show that firms with borrowing-base covenants have higher five-year cumulative oil production, have greater maximum production rates, produce oil more efficiently relative to maximum production rates, and more quickly replace subsurface oil compared to firms without such covenants. The empirical findings suggest that this covenant relies on an investment feedback mechanism: it encourages firms to drill high-quality wells by offering investment funding for productivity and by magnifying the opportunity costs of failing to drill productive wells.