In 2015, the energy sector accounted for more than one-half of all public company bankruptcy filings, including eight of the 10 largest filings. Current oil prices and bond values indicate that 2016 will be another active year. As of late January 2016, crude oil prices hovered around $30 per barrel. These low prices are reflected in the bond market, where in December 2015, approximately $80 billion in non-defaulted oil and gas debt was trading below 50 cents on the dollar.
To account for anticipated energy sector losses, many lenders have already increased loan loss reserves. These anticipated losses, while not crippling, are significant nonetheless, because the energy sector accounts for between 1 and 4 percent of outstanding loans issued by medium and large banks. Further, lenders are expected to significantly reduce borrowing bases during the upcoming reviews in April and October. The 2015 reviews did not produce drastic cuts to borrowing bases because lenders anticipated that oil prices would increase. Lenders may not be as sanguine in 2016.
Against this backdrop, issues specific to oil and gas bankruptcies will continue to play an important role in 2016.
One of the many issues unique to oil and gas bankruptcies involves one of the interests typically available for purchase in oil- and gas-producing properties. The Bankruptcy Code excludes from the bankruptcy estate many of these interests. In particular, the Bankruptcy Code creates a Non-Operator Interest Exclusion, which excludes an interest in production payments transferred by the debtor to a party that does not “participate in the operation of” the property.
The Bankruptcy Code defines a “production payment” as a term overriding royalty satisfiable in cash or in kind: (1) contingent on the production of a liquid or gaseous hydrocarbon from particular real property; and (2) from a specified volume, or a specified value, from the liquid or gaseous hydrocarbon produced from such property, and determined without regard to production costs.
An overriding royalty interest (ORRI) is an interest in a production payment, and is commonly expected to qualify as a Non-Operator Interest Exclusion. However, applicable state law may characterize an agreement that purports to be an ORRI as a disguised debt instrument. This can have a profound effect. If the agreement does not fall under the Non-Operator Interest Exclusion, the would-be ORRI holder is transformed into a creditor, its interest is subject to the automatic stay, and it may face clawback actions with regard to payments it received.
The ATP Oil & Gas bankruptcy proceedings in the Southern District of Texas have repeatedly confronted the ORRI-characterization issue over the last two years. In this case, the debtor entered into several agreements with various counterparties that were formally characterized as ORRIs. However, in a number of adversary proceedings, the debtor-in-possession or its successor sought to recharacterize the ORRIs as debt instruments under applicable Louisiana law, based on, among other arguments, the assertion that, in economic substance, the transactions were loans rather than agreements to make production payments. The bankruptcy court, in multiple instances, declined to rule at the motion-to-dismiss or summary-judgment stage that these agreements are ORRIs. This protracted litigation exposed the ORRI holders to significant costs, including legal fees, delays in realizing their investments, and potential preference liability. Ultimately, each ORRI-characterization issue was resolved before the court could rule on the merits, leaving the question open for the industry to navigate without clear guidance.
ATP Oil & Gas highlights the need for oil and gas companies, and lenders to and other stakeholders of those companies, to take a close look at the operators’ agreements to analyze the potential effect of a bankruptcy filing. Regardless of the ultimate outcome in ATP Oil & Gas, one lesson from the case is that a pre-bankruptcy business understanding of an agreement between parties in the oil and gas sector may bear little resemblance to how a bankruptcy court interprets that same agreement. As a result, oil and gas industry participants who are confronted with financial distress, whether those participants are operators, or counterparties or creditors of those operators, should consult with experienced restructuring and insolvency counsel early in the process. Experienced counsel could help an oil and gas company or its lenders avoid some of the pitfalls seen in ATP Oil & Gas by, for instance, examining an ostensible ORRI agreement to determine whether a change in the choice of law or other modification should be considered and is feasible in the context of a forbearance.
To read the previous installment in this series, please see “R&I Update: Hot Topics in Oil and Gas Restructurings, Volume 1” and “R&I Update: Hot Topics in Oil and Gas Restructurings, Volume 2, R&I Update: Hot Topics in Oil and Gas Restructurings, Volume 3, and R&I Update: Hot Topics in Oil and Gas Restructurings, Volume 4.”
McGuireWoods’ Restructuring and Insolvency Department has 36 lawyers working from most of the firm’s 21 offices, including in New York, Texas, and London. They have significant experience in energy insolvencies.