Here's what producers, service companies, and lenders here in the US should do

John Melko, Gardere Wynne Sewell LLP, Houston

In April 2008, with WTI above $100 per barrel, soaring toward its peak in the $140s, I began cautioning participants in the oil and gas business to check up on paperwork to ensure that their mineral interests were recorded, liens were filed, and that they knew who they were dealing with.

I did not have a crystal ball and had no way to predict the rapidly plummeting prices that would occur just a few months later. But I had noticed a rash of small oil and gas bankruptcies, a cooling US economy, and rumblings out of OPEC about maintaining its level of production. The article I wrote at the time was titled "An Ounce of Prevention is Worth a BBL of Cure" (see April 2008 issue of OGFJ). Just a few months later, the market crashed, plummeting from $145 in July 2008 to $36.51 in January 2009.

We are now at a new inflection point. The price of a barrel of WTI has dropped more than 50% and is currently in the high $40s. Gas is below $3, and Saudi Arabia is again steadfastly maintaining its market share in hopes of driving prices low and higher-cost producers out of the market. We are in the midst of year-end audits, which means that "earnings season" will soon be here, along with the required new reservoir reserve reports. Those reports will cause many borrowers with reserve-based loans to be in default of loan covenants. Even the better capitalized producers will be staring at capital budgets which have not changed in costs, but which will bring in lower revenues because of price drops, and thus drilling projects will be deferred. Because of the cancellation or deferral of those projects, oilfield service companies have already cut back staff, meaning that many experienced and previously high earning workers are newly unemployed.

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The initial euphoria over the resulting low gasoline prices, and schadenfreude in certain political circles, has begun to subside against the realization that lower revenues mean, well, lower revenues. State and federal coffers will go begging for tens of millions of dollars in oil and gas severance and income taxes. Lower energy prices will result in higher manufacturing profits, if we assume that the economic malaise and deflation threatening Europe and Asia suddenly subsides and the manufacturers have someone to sell to.

Macroeconomics aside, what should producers, service companies, and lenders here in the US do? The advice is the same now as it was then, just more urgent.

PRODUCERS - OPERATING AND NON-OPERATING ALIKE

Focus just on the financial and legal issues and leave the operations to the engineers. Start with giving early warnings to your reserve-based lenders. Internally, you probably know, more or less, what your new reserve report will say and how it will compare to your required borrowing base. If you can bring in new capital, great, but it may be expensive. If not, remember that bankers hate surprises. Begin early discussions about covenant waivers or moratoriums. And you may need to start looking for a new lender. There is a lot of private equity money sloshing around, but these funds are distressed debt buyers. Be prepared. They will seek discounts from your lenders, various fees and expense reimbursement, and very likely some sort of "equity kicker" from the borrowers, either in the form of overriding royalty interests or ownership in the company.

Keep an eye on your contractors. The major oilfield service providers are well capitalized and will ride out the current market dislocation. But the smaller companies, even if you have paid them in full, may be cash strapped and pressed to defer payments to their subcontractors. This can result in mineral liens or privileges (in Louisiana) being filed against your properties by subcontractors, some of which you may not even have been aware of. Be sure that payments to contractors are conditioned on getting releases from the contractor and subcontractors for the invoices being paid.

Operators also need to look to the Joint Operating Agreement to exercise their rights if any non-operating working interest owners fail to pay their share of joint interest billings (JIBs). Likewise, the non-operating interest owners need to ensure that the operator is collecting the JIBs and making timely payments to those vendors supplying goods, services, and labor to the leases. Owners of any form of mineral interest need to be sure that their interests are filed of record. Many passive or non-operating owners look at their purchase of an overriding royalty interest or non-operating working interest as a passive investment and that their direct involvement ends once they write a check. However, most states treat those interests as something which must be recorded in real property records - very similar to the deed for a house. The operator or promoter may have undertaken to record them for you, but either way, you should have a file stamped recorded document in your file. If you haven't recorded your interest, and the operator or promoter files bankruptcy, or a lien holder files against the property, you may be left holding nothing more than an unsecured claim.

OILFIELD SERVICE PROVIDERS

Oilfield service providers as a group are pretty savvy about filing liens to secure overdue invoices. But given the (until recently) frenetic pace of drilling, it has been all that many of these providers could do to get the work done and the bills out the door. The world has changed. It is now time to take a look at your accounts receivable. There are different requirements for mineral or mechanics' liens depending on the state in which the work was performed. Generally, all require copies of invoices supported by an affidavit from the service provider and served with proof of delivery to the customer. If the requisite time has passed without payment, the next step is to file in the real property records.

Service providers can be contracted directly by an operator which also owns an interest in the lease or well on which work is being performed. A provider with a direct contract with the mineral owner is a mineral contractor, and as such would file a mineral contractor's lien. However, in many instances there will be other, non-operating working interest owners. As to those parties, the service provider is a sub-contractor. To assert and perfect liens on those parties' interests, the filing requirements generally include an additional step, and the lien filing that the service provider makes will be as mineral sub-contractor, at least under Texas law. Because notice is always a requirement, oilfield service providers need to know who the mineral owners are. Engaging the services of a good landman to check real property records and make a list of owners of record may be a worthwhile investment.

LENDERS AND INVESTORS

As discussed previously, dropping prices will likely result in borrowing base covenant violations. More obviously, operators and owners who bought in late in the game likely have overpaid for their properties, and quite apart from covenant breaches, they may be hard pressed to keep the wells pumping, let alone make debt service.

Keeping in mind the familiar (if inaccurate) adage that the Chinese character for "crisis" is formed by combing the characters for "danger" and "opportunity," lenders have an array of options available to them. On the low impact side, lenders may modify, renew, or extend existing loans, generally with a "modification" or "renewal" fee paid by the borrower to the lenders. The other end of the spectrum includes exercising stock or membership pledge rights to take over the borrower or its parent company, or attempting to foreclose mortgages or deeds of trust on the mineral interests, and exercising "letters of direction" to have first purchasers of production remit proceeds to the lenders (assuming properly documented and perfected liens). In between, and assuming the borrower doesn't elect to file bankruptcy, are many alternatives. These may include mergers of the borrower with other entities (frequently favored by hedge or PE fund sponsors), sales of properties, debt to equity conversions, or additions of mezzanine financing.

Traditional bank lenders are frequently constrained by regulations from agreeing to less standard approaches. In these circumstances, there are almost always private funds willing to step in to acquire the bank debt, but at a discount. Banks wishing to avoid protracted negotiations with borrowers or potential bankruptcy filings very often are willing to sell their positions. Sales of debt are generally marked to an approximation of current collateral value and guarantee value. The buyers will close at this level if they believe the market will move up or if they can improve operations within their acceptable time frames. Those horizons are generally longer for private equity investors than hedge funds. Because of the inherent risk, the reward or discount to par value of the loans will be significant. However, for devalued assets and impatient or constrained lenders, such an arrangement can be the best, if not the only, option available short of a Chapter 11 filing.

CONCLUSION

We are in for a wild ride. But it is nothing that the oilfield hasn't seen before. Keeping in mind previous lessons learned and taking advantage of the increased participation and flexibility of non-traditional lenders and investors should provide for softer landings than in previous price pull-backs.

About the author

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John Melko [jmelko@gardere.com] is a partner at Gardere Wynne Sewell LLP and chair of the firm's Financial Restructuring and Reorganization Practice Group. Melko focuses his practice on assisting oil and gas, energy, electric and maritime clients with complex financial and business restructurings.

Time to take our medicine

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