Jason Kathman, Partner, Pronske Goolsby Kathman, P.C.
Doug McCullough, Partner, McCullough Sudan, PLLC
April 22, 2016
Also published on B&V Capital Advisors “Capital Talk”.
You don’t have to be J.R. Ewing to know what has happened to oil prices in the last two years. In June of 2014, West Texas Intermediate Crude (the benchmark for domestic oil prices) was trading at $105/bbl. By December 2015, WTI had dropped to $34.55/bbl, and as recently as February 2016, the price had dropped as low as $26.19/bbl. That’s a 75% decline in 19 months. At the time of this writing, WTI has partially rebounded to $43.70, despite the failure of OPEC to agree to a production freeze in the recent Doha talks. Sure, anyone who has been remotely involved in oil & gas knows that it’s a boom and bust industry, but what makes this bust a little more problematic is the incredible over-leveraging of debt that occurred in this most previous boom cycle. A January 2015 Wall Street Journal explained that between 2010 and 2014, aggregate debt for U.S. Companies focused on producing oil and gas increased approximately 55% from $128 Billion in 2010 to $199 Billion in the fourth quarter of 2014. As oil prices continue to lag, that debt is not going anywhere. With multiple financial institutions warning that oil prices are not going to dramatically rise anytime in the near future, oil and gas companies face a number of operational and financial obstacles.
Early in the downturn, there were many rosy predictions of a quick rebound. However, the current wisdom in the industry is that prices will be “lower longer.” Hope for a quick turnaround combined with uncertainty about where the market would bottom out has kept deal activity sluggish for months. Now that prices are slowly inching up, we may see many more assets changing hands in a combination of sale of non-core assets, distressed asset deals, and bankruptcy proceedings.
SALE OF NON-CORE ASSETS PRE-INSOLVENCY
Liquidity is the key to surviving the downturn. E&P and oilfield service companies that have made it this far have likely gone through a series of cost cutting measures including eliminating independent contractors, announcing mass layoffs, renegotiating contracts with vendors, and eliminating new exploration activities. If these measures are insufficient, struggling companies will need to consider the sale of “non-core” assets.
In tough times, determining what a core asset is may be a bit surprising. Exploration and Production (E&P) companies are eliminating the exploration for new fields, but are continuing to operate producing fields. “Non-core” is in the eye of the beholder. Depending on the company, non-core assets might include idle rigs, proved non-producing fields, or a parking lot of frac trucks.
Identifying non-core assets isn’t the problem. Would-be sellers would be happy to unload assets and reduce operating costs and debt burdens. However, finding willing buyers has been a problem since the inception of the downturn. Energy mergers and acquisitions have been sluggish since the inception of the downturn because of the valuation gap between buyers and sellers and the general economic uncertainty about the industry. But, if oil prices continue to inch upward, opportunistic buyers may finally risk capital on acquiring companies and producing fields.
The sale of a non-core business could involve the sale of stock of a subsidiary. However, in most instances, the sale of the non-core business will involve the sale of assets. In an asset purchase, the buyer is not obligated to acquire all assets or assume all liabilities. A sale outside of a bankruptcy proceeding will not extinguish any debt. Any debt obligations to be assumed by the buyer should be explicitly listed as an assumed liability.
A sale of non-core assets pre-insolvency would be negotiated by the parties and not supervised by a court. However, as a company approaches the zone of insolvency, the likelihood increases that there could be a derivative suit against the company or a suit against the board of directors and officers for a breach of fiduciary by disgruntled shareholders. To ensure that they have acted within their fiduciary duties to the company and shareholders, the board and officers should consider seeking independent legal advice about the legality of the proposed transaction and obtaining a fairness opinion from an investment banker or business appraiser.
WORKOUTS: RENEGOTIATING REVOLVING BASE LINES OF CREDIT
As oil prices decline, upstream companies begin to rely more heavily on their debt to pay operating expenses. Many upstream companies have a line of credit whose borrowing base is tied to the value of its oil and gas reserves. Thus, when the company needs its line of credit the most, is when the line of credit is most likely to be reduced. When determining the borrowing base, each bank will generally make its own calculation of the collateral value by assigning a value to each reserve category (PDP, PDNP and PUD). A recent survey of oil and gas lenders and borrowers found that 79% of respondents expected borrowing bases to drop this Spring. Further, those same respondents expect that on average borrowing bases will be reduced by approximately 38% from the amount determined in the Fall of 2015. As borrowers begin to realize that their borrowing base may likely be cut, it is worth exploring a number of different options with the bank to prolong the use of the levered cash.
First, a borrower should consider reaching out to its lender (early) and attempt to negotiate a freeze of the borrowing base amount and an extension of the maturity date with temporary concessions related to compliance with financial covenants. Banks are generally not in the business of owning and operating oil and gas wells. If prices bounce back faster than expected, the short extension benefits both the borrower and the lender. The extension allows the borrower a little time to allow prices to increase, allowing them to again operate profitably and provide the necessary coverage ratios for the lender. Likewise, the extension allows the lender a short reprieve from classifying the loan as “non-performing.”
Another method to attempt in an out-of-court workout is to request a change in how the bank calculates the borrowing base amount. As briefly described above, banks look at a borrower’s reserve report and attribute value to each of the reserve categories based upon a net present value calculation. While SEC guidelines dictate using a PV10 discount rate, other non-public lenders are already using PV9 and PV8 to calculate the borrowing base. Decreasing the discount rate has the effect of giving a higher value to the cash flow stream. Alternatively, a change in the discount rate percentage can provide a higher value and thus lead to a higher borrowing base amount.
As noted above, each individual loan is different and each loan and factual situation will provide different opportunities and incentives for the parties to reconsider the parties’ option before a bankruptcy is filed.
While the entire Chapter 11 process is beyond the scope of this article, below are a couple of tools an oil and gas company may consider when making the decision of whether to file for bankruptcy. Section 365 of the Bankruptcy Code allows a debtor to reject “executory contracts.” Executory contracts are contracts in which performance is still due on both sides. As such, where a company is unable to renegotiate burdensome contracts with vendors outside of bankruptcy, the Bankruptcy Code allows a debtor to renegotiate or reject those contracts altogether. For the reasons described above, lowering costs and eliminating burdensome contracts is critical to a company’s turnaround and often survival. One example of the broad power behind this tool was recently litigated and is the source of much concern amongst midstream companies. In the recent bankruptcy case of Sabine Oil & Gas, the United States Bankruptcy Court for the Southern District of Texas ruled that a debtor could use the authority and power of Section 365 of Bankruptcy Code to reject “gathering agreements” entered into with midstream companies. Based upon this ruling, E&P Companies may now leverage the threat of bankruptcy and rejection of the gathering agreements to obtain concessions or renegotiate those agreements with their midstream partners.
Another key tool afforded to debtors in bankruptcy are the so-called “avoidance powers”, which provide a debtor with authority to avoid certain preferential and fraudulent transfers. Perhaps more than the power to reject burdensome contracts, the avoidance powers are broad and far reaching. Pursuant to its avoidance powers, a debtor may be able to claw-back dividends made prior to the bankruptcy. The avoidance powers also allow a debtor to avoid unperfected liens in oil and gas assets. The ability to avoid unperfected liens can prove crucial to a debtor’s reorganization efforts as it may create unencumbered property (available to offer to the debtor’s secured creditors and perhaps increase the borrowing base) from property that was previously encumbered.
Finally, the cram-down provisions of Section 1129 of the Bankruptcy Code allow a debtor, under certain circumstances, to alter and modify the terms of its loans with its lenders. Where the debtor may have sought consensual modifications in a pre-bankruptcy workout, those modifications may be cram-downed on a lender through a debtor’s plan of reorganization. The threat and ability of the debtor to cram-down the lender is often a strong bargaining tool when the debtor finds itself negotiating a workout with a lender pre-bankruptcy.
SALE OF ASSETS IN BANKRUPTCY
Another unique tool provided to a debtor in bankruptcy is the ability to sell its assets free and clear of liens. This added protection, and a court order confirming the same, adds an extra layer of marketability to the sale of assets in bankruptcy that does not exist outside of bankruptcy. One advantage to selling assets via a motion is the speed in which those sales can occur. Where a debtor has marketed its assets pre-bankruptcy, the sale of assets can occur rather quickly (30 days or less). If, on the other hand the assets have not been marketed pre-bankruptcy, a procedure for allowing for due diligence and bidding can be established with a sale to follow at the conclusion. Depending on the extent of the assets and the due diligence necessary, such a process can take anywhere from 90 – 180 days.
Despite its current troubles, the industry isn’t going anywhere. The industry as a whole will survive. But we believe many assets will be changing hands in a great reshuffling.
 Erin Ailworth, Russel Gold & Timothy Puko, Deep Debt Keeps Oil Firms Pumping, Wall St. J., Jan. 6, 2015.
 Haynes and Boone, LLP Borrowing Based Redeterminations Survey: Spring 2016, Jan. 19, 2016, available at http://www.haynesboone.com/~/media/files/attorney%20publications/2016/bbsurvey.ashx
 In re Sabine Oil & Gas Corp., Case No. 15-11835, 2016 WL 890299 (Bankr. S.D.N.Y. March 8, 2016)