How much stress can we expect to see for oil and gas producers and related companies as a result of the current low prices? And what special issues does this industry face when it’s time to restructure or file for bankruptcy?*
Declining oil prices
The sharp decline in oil prices from more than US$100 per barrel nine months ago to around US$50 per barrel today (with some projecting still lower prices) has raised significant concerns about a crash in the oil and gas industry and the economies that depend on it. This stems largely from the massive expansion in US oil production in the wake of increasing global energy costs and the drive toward energy independence. Since 2008, US oil production has increased by 3.6 million barrels per day. And production continues to increase, even with the “crisis” in the industry.
"Complications will also invariably arise with respect to the industry’s unique financing structures"This massive price decline has caused and will continue to create significant stress, but many players should be able to weather the economic storm, assuming some price stability. For those that cannot, the unique nature of the oil industry creates challenges in the restructuring environment for many, with opportunities created for others.
For example, much of the production increase in the US has come from capital-intensive shale production. With the break-even price of this production at or above the current price of oil, why has this economy not crumbled?
Many producers are sitting on ample liquidity that will afford them far more time to wait out the uncertainty. Like most businesses facing macroeconomic challenge, they have cut costs − new well permits have dropped 40 percent so far this year. In addition, lower-cost production techniques continue to be implemented, allowing for profitable production even as prices remain near US$50 per barrel. And, even for those producers facing imminent liquidity events, billions of dollars in private equity funds remain on the sidelines, looking for a friendly home.
Increase in chapter 11 filings
But this doesn’t mean that all producers − and those that support them − can sustain their operations in this environment. A recent wave of chapter 11 filings from industry players confirms this. Several factors will make these restructurings (and chapter 11, if that is the necessary path) particularly complex.
The nature of the interests created by oil and gas production varies by state law. Some states view these interests as property rights, while others view them as true leases, creating a contractual right. This distinction is critical in the ability of an oil and gas producer to reject or assign these interests.
Complications will also invariably arise with respect to the industry’s unique financing structures. As the Tenth Circuit Court of Appeals said more than 50 years ago, “oil and gas financing is a world of its own.” But while the varied and increasingly complex financing arrangements utilized in the oil and gas industry create enormous challenges to restructuring these businesses, as seen in recent headlines, they can also create substantial opportunity for new money to acquire secured debt at substantial discounts and credit bid this debt as part of a loan-to-own strategy.
Other issues that must be considered in the restructuring context include the effect of farmout agreements and the interplay with the safe harbor provisions of the bankruptcy code, the recording of liens and impact of unrecorded interests, and the use and protection from avoidance actions on oil and gas transaction.
While treatises have been written on these issues, it is critical to understand that with this latest crisis in the oil patch, the restructurings that will undoubtedly take place will require specialized knowledge and creativity for both the producer and the many stakeholders who will be at the table.
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*prices mentioned reflect the time of writing, April 2015