Oil and gas energy Bankruptcy and Chapter 11
Oil and Gas Bankruptcy Issues facing Texas
Bankruptcy filings come as U.S. oil producers are expected to feel financial pressure on two fronts, as oil prices have fallen to less than half their peak 2014 prices and U.S. oil companies have racked up half a trillion dollars in risky corporate bonds and leveraged loans, according to Deutsche Bank’s head of U.S. credit strategy.
“Overextended producers will either be filing for bankruptcy or be swallowed up by larger producers,” said Austin Morris, managing partner at SunGard Financial Systems in Houston. “Smaller producers are probably more at risk.”
That’s because a lot of small U.S. producers generally don’t hedge their production well enough – a task that has gotten harder to do after big banks have exited the physical commodities trading business, Morris said. Among the smaller producers with fewer hedging contracts that lock in oil prices, “I think you’ll see some rapid defaults,” he said.
High-yield bonds tied to U.S. shale energy companies have plunged in price as oil has fallen, according to Barclays. WBH Energy’s bankruptcy proceedings come a few days after another small oil explorer, Colorado-based American Eagle Energy, said it would stop drilling for oil until petroleum prices rose back up again.
Oil and gas energy Basics
A commercial oil deposit requires the presence of a porous, permeable rock formation containing oil of a marketable A.P.I. gravity and of producible viscosity. Three fundamental properties of petroleum (for oil and gas production): 1. state (gaseous, liquid or solid) 2. specific gravity or density = the ratio between the weights of equal volumes of water and another substance measured at a standard temperature. The specific gravity of oil is expressed as A.P.I degrees, oil with the least specific gravity has the highest A.P.I. gravity (inverse relationship) 3. Viscosity = inverse measure of the ability of a liquid to flow (the less viscous the fluid the greater its mobility). Nearly all commercial oil and gas production is from some form of sedimentary rock due to the porosity and permeability of such rocks.
Rule of Capture
The Rule of Capture: one who captures the resource has ownership and therefore there is no liability for capturing oil and gas that drains from another’s lands. Under the classic rule of capture, a landowner has only one option when someone is draining oil and gas from beneath his property: drill his own offset well to intercept the flow. In Texas and other states, production may be restricted by state regulatory agencies. In Ohio, the courts have rejected the rule of capture and replaced it with a rule that includes the correlative rights of the owners over the common source of supply.
Type of Interests
In general, the types of interest that the landowner may create by grant or reservation in oil, gas and other minerals are leasehold interests, mineral interests, and royalty interests: Leasehold interest: (oil and gas lease) the lessees under this instrument are given the exclusive authorization to go upon the land for the purpose of prospecting for oil and gas, has the right to work on the leased property to search, develop and produce oil and gas. Mineral Interest: the owner of the full mineral interest in a particular premises has the right to go upon the premises for the purpose of prospecting for, severing and removing therefrom all minerals. Royalty interest: the owner is not authorized to go upon the premises to prospect for or remove minerals. The owner is entitled to share in such minerals as are severed or the proceeds thereof.
Specific Lease Considerations
Specific lease clauses that can have effects on the outcome include habendum clause (length of lease including primary and secondary terms); delay rental clauses (payments to extend necessity for drilling during primary term); well commencement clauses (primary term extension without payment of delay rentals); and the dry hole clause (prevents implication of condemnation or abandonment of a lease from the drilling of an unproductive well on the leased premises); continuous operations clause (extends primary term if drilling operations are in progress); shut-in gas royalty clause (a substitute for production under the habendum clause.) Except in a few states, actual production (marketing) is required to extend an oil and gas lease to the secondary term. (unless some other provision dictates otherwise). A literal construction of “production” in the habendum clause of an oil and gas lease would mean that small amounts of production would suffice to extend the lease indefinitely. With a few exceptions, however, the courts that have considered the issue have concluded that production must be “in paying quantities to the lessor.” The reason is that if you don’t have production in paying quantities (though able to) you are holding the lease for speculative purposes (hope price will go up) and the lease is executed for productive purposes.
Division and Transfer Orders
Division order: provide a procedure for distributing the proceeds — a statement executed by all parties who claim an interest stipulating how proceeds of production are to be distributed (purpose is protect the distributor of such funds against liability for improper payment).
Transfer order: a direction and authorization to change the distribution provided for in a division order
A mineral acre is the full mineral interest under one acre of land. Sometimes conveyances are made by reference to “mineral acres” or “royalty acres.” This can create problems of interpretation. The following case refers to “royalty acres” which are generally defined as the full lease royalty (whatever percentage may be specified in present or future leases) under one acre of land.
The phrase “top lease” is used in the oil and gas business to refer to the circumstance in which a lease is executed covering land upon which a current lease already exists. As commonly spoken, the phrase is often used as a verb, as in “we’re top leasing in that area”. It’s meant to illustrate that a lease is taken on “top” of another preexisting lease, with the top lease becoming effective only after the termination of the first lease. Top leases and top leasing usually occur in areas of significant competition among oil and gas companies. As a mineral owner, consider it a vote of confidence if someone wants to top lease your property.
Pooling and Unitization
Proration/allowable order: the formula that sets out how much you can produce (usually based 50/50 on the number of wells/acreage). Spacing order: have to have so much land to drill or have drill a certain footage away from property lines (but can get exception or have forced pooling) Pooling order: pools the land for the purpose of efficiently developing common formation States regulate the rate and volume of production for two reasons: (1) prevention of waste and (2) protection of correlative rights.
Oil and gas energy Bankruptcy Issues:
Common issues in oil and gas energy bankruptcies include:
- Are oil and gas interests property of the estate?
- Are conveyances of certain oil and gas interests unexpired leases or executory contracts?
- Are certain production payments treated as grants of property or disguised financings?
- What is the status of an unrecorded interest owner in the bankruptcy of the interest owner’s assignor/operator?
- Does Section 365 of the code mean that the trustee is free to accept or reject an oil, gas, and mineral lease?
- Whether an MMS/OCS lease is an executory contract or unexpired lease within the meaning of Sec. 365 of the Bankruptcy Code?
- What implications flow from the lease being governed by Sec. 365 of the Bankruptcy Code
- Can an OCS bonding company cancel the Debtor’s bond and thus destroy its right to operate in the gulf because it is no longer qualified with MMS?
- May the operator withhold proceeds attributable to the interest of a bankrupt non-operator who has failed to pay his share of operating expenses?
- Whether and what type of constructive notice will defeat the trustee’s avoiding powers?
- What type of recording of an interest in leases will be sufficient to defeat the trustee’s avoiding powers?
- Are unpaid royalty owners unsecured creditors?
- Where to file a mineral contractor’s or subcontractor’s lien against an OCS lease?
- How to foreclose a mineral contractor’s and subcontractor’s lien?
- Whether it is necessary to file suit post-petition to avoid the lien being lost?
- Use of the mineral contractor’s lien rights as a defense to a preference action.
Factors to Consider in oil and gas energy bankruptcies
Factors and challenges to consider with oil and gas bankruptcy filings include:
- Oil and gas production depletes the asset, thus cutting investment spending does not work as along term strategy.
- Failure to explore can cost an oil and gas energy company valuable assets by forfeiture of rights accompanying the delay
- Oil and gas energy companies may be unable to control costs or production levels on their oil and gas properties
- Oil and gas energy companies often have significant high-yield debt.
- Oil and gas energy companies often have limited liquidity on their books.
For more information, please contact us:
Dallas: Richard G. Grant, Practice Chair | Direct: 214-210-2929
New York: Robert W. Dremluk | Direct: 516-883-2759