Breaking Point

Junior oil producers have managed to hang on by cutting expenses to the bone, but as prices retreat once again, a spike in bankruptcies late this year could be inevitable

CHIP JOHNSTON CALLS it sinking below “the frost line.” It’s that point where many oil and gas companies their fortunes pulled down by two years of depressed commodity prices — look at their balance sheets and realize they are close to capsizing. Johnston, a veteran Calgary energy lawyer and partner in Stikeman Elliott LLP’s corporate group, has been, like other energy-focused lawyers, busy advising clients on how to best survive the repercussions of this downturn.

Energy company insolvencies in the Western Canadian oil patch are actually down compared to 2015’s carnage. But with oil again retreating to around $40 at the time of writing, a spike in insolvencies and bankruptcies could well happen in the latter half of the year.

Downturns bring with them a whole range of financial issues, and stemming from those, legal issues. They’re concerns that, just three years ago when times were good, energy company boards and executives perhaps ignored. The fine print in loans and other debt facilities and other questions not talked about then “get a lot more attention now,” says Johnston. “I think in bear markets people are more concerned, more thorough, more serious. The [legal] paper gets pulled out; people are looking at what the indemnity agreement says.”

There are options to consider — legal life rafts a floundering company can reach for as their ship sinks. Canadian banks, for instance, may be staunchly conservative. But Johnston says they also have a reputation for being patient investors who care about their reputation in the energy sector. They’re often prepared to do “work-offs” — finding a way to rewrite loan terms and credit facilities to give a company some relief in hard times when it appears it could be about to break loan terms or debt covenants.

That kind of lender patience is not always the case, though, for companies with what’s known as mezzanine debt or second-lien debt, notes Frank Turner, Calgary-based co-chair of Osler, Hoskin & Harcourt LLP’s corporate group. Such debt often changes hands and can end up in the talons of vulture funds; funds that look to make money over much shorter time frames or that hope to leverage the debt a company owes them into an ownership position. Then they can sell off their stake or the assets of a company for a profit. With these kinds of impatient creditors, says Turner, “it’s a different conversation” than with big banks. “It can turn adversarial for sure.”

FORGET HUNKERING DOWN

It used to be, says Turner, that a prime strategy for hurting energy companies was to “wait it out and hunker down.” Not this time. “In the past,” he recalls, “prices have declined precipitously for a period of time, then rebounded sharply.” Hunkering could work.

But “this is a more profound downturn than we have experienced in the last ten years,” says Turner. Sensing in 2014 where things might be headed, Osler began preparing for the kind of work they expected this bust would bring. “We thought, what would be the response of our clients? Typically what happens in this situation is, you attempt to cut your expenditures to the bone. And if that is not sufficient then you need to raise additional capital, and you do that by monetizing your assets.”

That, indeed, was the first-wave response to the price crisis in the patch. Wobbly companies began selling off royalties on assets, or the assets themselves. “As we got deeper in the cycle,” continues Turner, “we formed the view we were going to see more insolvency and restructuring work. And that too came to pass, though I think in some respects, not as much as people thought.”

Now, Turner points out, with more clarity out there about the likely go-forward oil and gas prices in the current slump, he’s seeing a third wave: opportunistic M&A as the “strategics” begin pouncing on good value-buying opportunities. Canadian Natural Resources Ltd., for instance, has in the past two years snapped up some 12,000 gas wells in a buying spree that’s seen it eclipse Encana Corp. as Canada’s largest gas producer. Private equity, pension funds and foreign buyers — largely Asian state-owned enterprises as well as private Asian companies — are also sniffing out potential acquisitions in the Canadian oil patch.

Yet that option for distressed companies — selling assets to survive — now has a strong whiff of uncertainty. As of June 20, as a result of an Alberta Court of Queen’s Bench decision May 19 regarding Redwater Energy Corp., the Alberta Energy Regulator (AER) changed its rules regarding the transfer of licences companies need to operate wells in the province.

Essentially, in Redwater, the court ruled that when a receiver or trustee attempts to sell the assets of an insolvent oil or gas company, it can legally avoid and renounce liability and costs of well abandonment, remediation and reclamation. That means clean-up for such abandoned wells would now fall on the industry-funded Orphan Well Association. (The AER’s and Orphan Well Association’s appeal of the Redwater decision is expected to be heard in October.)

In response the AER hiked what is known as the liability-management ratio (LMR) from 1.0 to a minimum of 2.0. The LMR is a deemed asset-to-liability ratio meant to ensure a company has the financial ability to properly deal with the proper clean-up of any wells it owns or acquires from another company, should economic or other factors force it to shut down those wells. Purchasers that fail to meet the threshold are prohibited from buying AER-licensed wells. As of the AER’s last report in April, 311 licensees had LMRs below 2.0 versus 219 that had an LMR of 2.0 or more.

The new LMR requirement, says Kelly Bourassa, a partner and head of the restructuring and insolvency group with Blake, Cassels & Graydon LLP in Calgary, will likely limit the prospective pool of purchasers now looking to buy assets of distressed Alberta oil and gas companies. Bourassa says it’s “early days” and that, so far, the AER has shown some flexibility on existing LMRs lower than 2.0 for deals that were already underway. But, she notes, LMRs are based on the deemed value of a company’s assets based on the rolling three years’ prior netback (gross profit per barrel of oil or equivalent it produces). Should low oil prices continue as the high prices of three years ago roll off, that will dramatically affect future LMR calculations. Moreover, if prices go lower, otherwise viable wells may no longer be economic and thus be shut in until prices rise. That will only add to the liability side of a company’s LMR calculation should it wish to buy assets with wells that are or may be shut in at some point.

Companies with an LMR below 2.0 must post a security with the AER to cover any possible future abandonment and reclamation costs, if it wishes to make an asset acquisition. “So there is additional risk and cost to purchase a distressed asset that otherwise could be a great buy for a well-positioned company,” says Bourassa.

As oil prices declined some big law firms with a presence in Calgary began holding seminars with their client base on how to deal with fallout of distressed balance sheets. Osler’s, for instance, held seminars on how to do business with insolvent counter parties. “We also presented a series of seminars to the independent director community on the theory that they might be tested in the current commodity downturn in a way that hadn’t been in the past,” says Turner. With the hunker-down strategy seemingly no longer viable, he says, “boards are left with some very difficult problems.”

“Personal liability was a topic we got a lot of questions on,” says Turner. “There is concern for the things for which directors can be personally held liable for” when their companies face financial trouble. For instance, they may have exposure to environmental liabilities if their insolvent company doesn’t properly remediate abandoned well sites.

Randall Block, QC, is a Calgary-based partner with Borden Ladner Gervais LLP’s litigation and arbitration group who specializes in dispute resolutions in the oil and gas industry. He’s been through several boom-and-bust cycles in his 35-year career. One of the bigger problems he sees in this one may involve the way that investors with non-operating interests treat operating partners should those partners become insolvent. Most oil or gas operations involve partnerships and numerous suppliers and contractors, but with one company — the operator — managing the property and pumping the profits from a resource. When one partner in that line-up goes bankrupt or insolvent, it often impacts the others.

Protecting cash flow from working-interest partners that cannot pay their fair share of capital outlays and operating costs is critical, says Block. Most operator agreements, he explains, give an operator a breadth of remedies to inure itself from a non-operating partner that has become insolvent. Ultimately, the operator could seize the non-operating partner’s share in an asset and sell it. “The trickier issue,” says Block, “is for the non-operator” who is solvent, when the operator of a joint project suddenly is not.

But there are remedies when a non-operator is owed money by an operator. “Non-operators,” explains Block, can make a claim against owed revenues the insolvent operating partner has received, but not turned over. “You [the non-operator] are entitled, generally, under most operating agreements, to take the hydrocarbons at the well head in kind. … You actually obtain your hydrocarbons yourself and sell them. They never go through the account of the operator.” It’s known as a take-in-kind provision and has been common in oil and gas partnership agreements for decades. However, says Block, there is often confusion in the industry about how the provision works — and operators often feel they have the right to control sales of all hydrocarbons produced in joint operations.

These days Block sees far more take-in-kind provisions being triggered. And new laws and rulings stemming from the last bust cycle have clarified that revenues collected by an operator are technically held “in trust” for non-operators, giving the latter more legal leverage to gain access to that money.

For lawyers in the patch, says Chip Johnston, depressed oil prices mean they’ve had to find ways to “manage the process of using lawyers, so clients spend more time on business and ultimately consume less of their money on our fees. You can say that’s terrible for the legal business. But I take the contrary view.

“I think law has to look at itself in the same way as people who are drilling wells, hauling water and supplying frac fluids. We are all in this to have greater capital efficiency. And that does not have to destroy our margins. It just has to involve creativity as to how we deliver our services.”