RJR management was concerned about the large debt incurred with Burmah and turned to a financing mechanism commonly used in the oil patch, a production payment loan.
For collateral, this loan carved out a specified amount of the oil reserves that would be sold each year and dedicated those revenues to pay the debt. With a production payment loan, RJR had no obligation to pay more than the amount that the reserves would generate. The lender’s oil and gas specialists independently valued the oil reserves to assure that they had enough collateral. However, the loan still carried risk; the value of the reserves would decline if the price of oil dropped. For this reason, the lender charged a higher rate of interest.
Being cautious, RJR opted for the conservative financing to protect its credit rating and conservative balance sheet. Aware that we were paying a premium interest rate, I asked the RJR Treasurer if we would default on the loan should the production not be enough to cover it. His answer was, “Of course not. We need to maintain an AA rating on our debt, and we would honor our commitment, regardless.“ This raised the question – Why pay a premium interest rate if we never intended to use the advantage it provided us?
A year later, with its tobacco cash flow, RJR repaid much of that debt and refinanced the remainder at a lower rate.