Energy investment strategies in a shifting economic landscape

Richard L. Burleson, Burleson Cooke LLP, Houston

Global economic conditions continue to change the landscape for energy investors. Credit markets, previously tight, have begun to thaw; however, lenders are being more selective, targeting experienced operators with good assets. Private equity has a reservoir of available capital, but is looking at distressed proved developed producing assets for acquisition at discounted prices. There's little interest in acquiring proved undeveloped reserves because capital requirements are significant and not much bank debt is available to develop them.

Additionally, borrowing bases are expected to decrease in the fall redetermination period, especially among companies with a high ratio of natural gas to oil. Also, companies that have natural gas hedges locked in at higher prices will have to confront the reality of lower prices once those contracts begin to roll off. Meanwhile, cash flows are stressed, balance sheets remain under pressure, capital expenditures are being scaled back, and the viability of new projects continues to be closely scrutinized.

What does all this mean?

• Secured debt represents a much greater proportion of value than it has in previous cycles.
• Second lien loans, themselves a significant contributor to the lack of liquidity for many overleveraged companies, are now a standard component of the debt market, and the presence of more second lien debt will have a dramatic effect on future restructurings.
• Borrowing base resets will cause new stress on borrower liquidity, and put more companies in a position to sell assets.
• As "in the money" natural gas hedges roll off, lower prices will create cash flow stress – and likely result in the sale of more assets.
• Weaker covenants that evolved in the bull market will provide less warning before distress and prevent lenders from taking control of situations early.
• Increased levels of secured debt will put secured lenders more in control of restructuring transactions than they have been.

For all of this change and uncertainty, however, one thing is becoming clear: We are likely entering into a period of unprecedented restructuring and distressed merger and acquisition activity. This translates to abundant opportunities for well-capitalized energy investors – opportunities that may have been overlooked during better economic times.

Purchase undercapitalized E&P

Shareholders of these companies are likely to be highly motivated, meaning that the price is right. However, investors will not be protected from liabilities that remain with the acquired company; and the ultimate financial impact may not be known, such as environmental or plugging and abandonment liabilities. It is also important to note that the price could be re-examined under fraudulent transfer laws to determine whether it was adequate, whether the sale was designed to hinder or delay creditors, or whether the transaction rendered the seller insolvent.

Purchase assets from undercapitalized E&P

The pros and cons of this approach are consistent with those referenced above except that potential liabilities can be more easily addressed. But investors should be aware that even in asset deals, certain liabilities can follow the assets.

Enter JV structured around specific assets

This approach is a means of investing in a quality company with good assets and a strong management team that may be experiencing a shortage of capital or other financial difficulties. This structure may solve a company's near-term capital issues and provide the investor with access to experienced management and proprietary technology. It is also less complex than a going private transaction, reverse merger, or bankruptcy proceeding, and generally minimizes risk to investors.

Buy oil, gas assets through foreclosure

Lenders are becoming much more proactive in negotiating with investors to sell defaulting borrowers' assets through structured foreclosures as a means of liquidating non-performing loans and assuring buyers that inferior claims against the assets have been effectively cut off. Purchasing assets through foreclosure is much less expensive and time consuming than Chapter 11 Bankruptcy. If these types of sales are properly noticed and regularly conducted, the price will likely be considered adequate and potential adverse claims of a former owner will be mitigated. However, if the IRS is not put on notice, it could have the right to redeem the acquired assets. However, the sale will not cut off "secret" superior liens such as ad valorem tax claims.

Purchase E&P company through bankruptcy

Typically, this involves the transfer of sales proceeds – after payment of secured liabilities, ad valorem tax claims, and closing costs – to a liquidating trust for distribution to creditors. Because this requires a court order approving the sale, it cuts off tail liabilities and claims of successor liability; eliminates the potential for fraudulent transfer claims; and, if the order contains a "good faith" finding, it ensures that the closing will pre-empt any appeal of the sale order. At the same time, the acquired company can shed burdensome executory contracts that impose performance requirements on both sides, such as an equipment lease, office lease, or drilling rig contract.

There are risks, however, and the process is expensive. If a creditors committee is appointed, for example, professional fees alone can double the cost of the case. Moreover, the total costs are often unknown at the time of filing simply because certain critical expenses cannot be determined, including whether there will be a creditors' committee, environmental reclamation claims, employee priority claims, etc.

Purchase oil and gas assets through bankruptcy

The benefits of purchasing oil and gas assets through bankruptcy mirror those of purchasing a company through bankruptcy. There is one additional upside: Claims of creditors, whether known or unknown, are attached to sale proceeds rather than to the assets themselves.

But the challenges are significant. Courts don't like cases in which assets are sold and the case itself lingers on with neither a plan nor a direction. As a result, they may require that a plan be filed as a precursor to the sale – or even condition the sale on the confirmation of a plan. They also sometimes disfavor a process in which the only party benefiting from the sale of the oil and gas assets is the secured creditor and no benefit flows to the bankruptcy estate beyond the payment of the secured claim. Additionally, an offer made for assets may be viewed as a market-maker and could be used as a stalking-horse bid for an auction of the assets; the only protection against this is a court-approved breakup fee.

In the end, we know at least two things: The energy market has changed dramatically in the past year, and it is impossible to predict when stability will return. Still, this may be an ideal time to seek out opportunities for investment. By identifying the right structure and carefully managing risk, prudent energy investors can profit during the uncertainty.

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