Oil and gas price volatility has always been an inescapable element of the energy business. That said, the current confluence of events is unprecedented and would have been hard to predict. On March 6, 2020 when the COVID-19 crisis was slowly making its way into the domestic news cycle, a long simmering conflict between Saudi Arabia and Russia over production levels came to a head with Russia’s refusal to continue abiding with OPEC guidance for agreed production level reductions. Saudi Arabia’s subsequent decisions to dramatically increase production levels and discount oil pricing were met with tit-for-tat responses by Russia and other market participants over the next 2 days, sparking sharp increases in supply and reductions in market prices of as much as 30% on March 8. Then the true magnitude of the COVID-19 pandemic and its impact on the world economy and energy demand came to the fore. Subsequently, oil prices plummeted with WTI dipping into negative values in late April. As of this writing, prices have improved somewhat; however, IEA guidance sees global oil demand in a freefall due to the government actions to combat the COVID-19 contagion.
Demand and price disruptions could have long-term consequences that will likely suppress product prices for months or years. The impact to US domestic producers and service providers will likely be serious. This is particularly true since the conflict between Saudi Arabia and Russia has its genesis in a shared desire to hamper the competitiveness of US shale oil producers. Consequently, while we may see seasonal relief from the COVID-19 in the relatively near term, there is no assurance that the Saudi-Russian market disruption will abate before substantial damage is done to the U.S. oil industry due to distortion of demand and the resultant impacts on pricing.
Pricing impacts the finances of the entire energy industry at all levels. While the industry has improved efficiencies and reduced F&D costs substantially over the course of recent years, the improvements can’t keep up with disruptions of the magnitude we are currently seeing. And the impacts will not end with producers. Service providers, suppliers and midmarket companies will all feel the sting. Insolvencies, business failures and bankruptcies are inevitable in this environment; and when they occur, there are ripple effects in all aspects of the industry. Though industry participants cannot change the price of oil, they can protect their interests in other ways. In times like this, fortune favors the prepared.
Mitigation and Preparation
Proactive/Preparatory Measures: Hoping for the Best but Planning for the Worst
There are relatively obvious, but often overlooked measures that can be taken to prepare for economic uncertainty and incipient insolvency.
Of critical importance are maintaining close controls on receivables and payables. Account management and practical issues aside, maintaining accounts in a relatively current status will make a difference in how they will be treated in litigation and bankruptcy. Payments made in the ordinary course of business are going to receive different treatment than payments made on account of a delinquent or “antecedent debt.” That issue could come to have outsized ramifications in the event of bankruptcy as will be discussed further below.
Proactive contract review of substantial contracts is also very helpful in planning in uncertain economic times. Many contracts contain “safe harbor” provisions for early termination or reductions in performance obligations if notice is given timely. For example, it is not uncommon to see provisions for early termination of a contract at will provided notice is timely given in writing. Irrespective of whether such a provision works to your benefit or may be used against you, advance review and understanding of the implications of such a provision allows for advance planning for negotiation or resolutions of problems. Similarly, force majeure provisions are common in oil and gas agreements. Understanding which of your agreements have force majeure provisions and what constitutes a force majeure event and what kinds of activities may be affected by the event is critical to understanding what flexibility you may have in dealing with economic upset.
Early engagement in negotiations to address anticipated problems is key to effective management. Whether the counter-party is a vendor, bank, landowner or regulator, early affirmative engagement puts a company in some control of the process. Rather than being driven by events the negotiator has the opportunity to shape the narrative and the solution. Regulators are often willing to work with companies that are actively addressing issues, even if compliance takes time. Financiers will often enter into agreements for forbearance or suspension of performance if its perceived that the procedure may improve the potential for future performance. Those opportunities may be lost if negotiations only begin in the face of a liquidated demand, threat of enforcement action or litigation.
In particular, communication and negotiations with lenders and capital providers are of critical importance once the possibility of violations of loan covenants or default become likely. This can even be the case if restructuring (through bankruptcy or otherwise) is seen as a significant likelihood. Recent downturns have seen substantial increases in the number of pre-planned bankruptcy cases filed with post-petition financing and reorganization plans negotiated in advance of filing. Both in terms of controlling expense and maintaining predictable outcomes, understanding rights and planning for the most favorable outcomes, forethought and engagement provide significant advantages.
All of the analysis and preparation in the world will not eliminate the possibility of having to deal with bankruptcy in some form. In a recent interview, Daniel Yergin Pulitzer prize winning historian, when confronted with a prediction that as many as 70% of current shale producers may be bankrupted by the current downturn, noted “[c]ompanies go bankrupt, but rocks don’t go bankrupt. When this all shakes out, there will be other people to develop shale.” Certainly true, but cold comfort if you’re one of those companies or are in business with one of those companies. Many analysts predict that like prior downturns, this one will end with a strong recovery with the industry including fewer but stronger companies that are more efficient and cost competitive. Recognizing that there will be a future, but that the present will almost certainly involve dealing with insolvency and bankruptcy, the issue becomes how to deal with the present to enjoy that future.
When bankruptcy laws are implicated, an entirely new structure is imposed. Bankruptcy effectively creates a new entity as of the time the petition is filed – the bankruptcy estate. The bankruptcy filing freezes the debtor’s estate — it sets the board for the rest of the game. Bankruptcy rules create priorities for the division of the limited resources of the bankruptcy estate. While the rules are complex, in general they strongly favor parties – debtors and creditors — who take the necessary steps to protect and perfect their interests prior to the time bankruptcy is filed. Conversely, they severely penalize the complacent.
The following are a few basic rules unique to the bankruptcy game.
The filing of a bankruptcy petition automatically “stays” actions against the debtor, the property of the debtor, or the property of the estate. 11 U.S.C. §362. The stay bars virtually all creditor activity against the debtor, including obtaining, perfecting or enforcing liens. It generally applies until the bankruptcy case terminates. With limited exceptions, actions that violate the automatic stay are voidable and may subject the violator to actual and punitive damages.
Preferential and Fraudulent Transfer Avoidance
A trustee in bankruptcy has power to undo actions taken before the filing of the bankruptcy petition including preferential or fraudulent transfers. If you have received money or property under circumstances that constitute a preference or fraudulent transfer, you may be required to pay that money back to the bankruptcy estate. Preferential transfers include certain payments or transfers of property to creditors, while fraudulent transfers are those transfers made with the intent to hide assets or for less than fair market value.
A transfer is preferential if it is (i) to or for the benefit of a creditor; (ii) on account of an antecedent debt; (iii) made while the debtor is insolvent; (iv) made on or within ninety days of the petition date or within one year if the creditor at the time of the transfer was an insider; and (v) allows the creditor to receive more than the creditor would receive in liquidation.
Fraudulent transfers include those that are actually fraudulent — made with “actual intent to hinder, delay or defraud” creditors and in some cases those that are constructively fraudulent—if the debtor received less than “reasonably equivalent value” in exchange and was either actually insolvent on the date that such transfer was made or became insolvent as a result of such transfer. The trustee may avoid fraudulent transfers occurring up to two years prior to the filing of bankruptcy. The trustee can also apply State law, such as the Uniform Fraudulent Transfers Act or the Uniform Fraudulent Conveyances Act, to avoid certain transfers occurring even earlier.
Executory contracts — those requiring continuing performance such as JOA’s and Joint Development Agreements — can be assumed or rejected by a bankruptcy trustee. Effectively, the debtor is allowed to reject burdensome executory contracts and assume those that are to its benefit. Further, an executory contract is not enforceable against a debtor prior to its assumption, but is enforceable by the debtor. If a debtor elects to assume the benefits of an executory contract, however, it is required to perform all of its obligations — including remedying any unfulfilled obligations.
Winning Game Strategy
Record & Perfect Liens Early
Properly perfecting security interests should be a top priority since a secured creditor collects payment before unsecured creditors. Proper perfection of a security interest depends on state law and the type of lien and property. In most jurisdictions this includes recording an executed and acknowledged memorandum of the interest in the public records of the county where the property is located and filing a properly completed financing statement with the appropriate U.C.C. filing office. Failure to strictly follow the applicable perfection requirements may result in loss of the creditor’s secured status. Once a petition in bankruptcy is filed, the automatic stay applies to prevent perfection. A party should not wait until the eve of bankruptcy to perfect its security interest, however, since the date of a transfer for purposes of preferential avoidance will be the date of perfection.
Be Aware of Preference Periods
As simple as this sounds, stay current in accounts when dealing with a party in the zone of insolvency. As an account becomes non-current (antecedent), payments made within the preference period become subject to avoidance. Current accounts generally do not.
Setoff Early and Consider Recoupment
The right of setoff (also called “offset”) allows entities that owe each other money to apply their mutual debts against each other — avoiding “the absurdity of making A pay B when B owes A.” For setoff to be available, the debts must be “mutual” (between the same parties, standing in the same capacity) and must have arisen prior to the commencement of the bankruptcy case. Setoff rights are not unlimited. If a party chooses to offset within ninety days before the date of the petition the offset may be subject to avoidance in part. And once a bankruptcy petition is filed, the automatic stay prevents a counter party from off-setting without court permission. While setoff may be unavailable post-petition, when the debts arise out of the same agreement, a counter party may be able to equitably recoup its debt. The right of recoupment is narrower than setoff rights and will depend on the facts of the case.
Withhold to Protect Against Lien Exposure
Laborers or vendors involved in the drilling, operation, or maintenance of a well generally have statutory or constitutional lien protection for the services and goods they furnish. The lien attaches to the property involved. Though a non-operator does not have a contractual relationship with a service provider or a vendor, Texas law may allow service providers, as subcontractors, to attach a mineral lien against the non-operator’s leasehold interest. However, a non-operator’s liability to the laborer is limited to the amount that the non-operators owe the operator when the notice is received. Consequently, when a non-operator receives notice of vendor or subcontractor claims, the non-operator should consider withholding payment to the Operator “in the amount claimed until the debt on which the lien is based is settled or determined to be not owed.”
Remove Operator/Take-over Operations
If an operator is approaching insolvency, the non-operators may desire to step in to continue to preserve production and avoid adverse consequences. Most JOAs provide for situations, such as an operator’s inability to continue operations, under which parties to a JOA can elect a replacement. Since a JOA is an executory contract, effecting removal pre-petition will avoid significant complication in bankruptcy.
Forethought and preparation are key to successful outcomes in bankruptcy. The time to prepare for bankruptcy is before it becomes an inevitability.