As The Energy World Turns: Bankruptcy Is A Constant
“The latest Haynes and Boone statistics provided the context for our discussion with leading lawyers at the firm about trends and issues impacting the energy sector. Get ready for complex issues to roil the energy market.”
The latest bankruptcy figures for October have been released by law firm Haynes and Boone. The show that filings by oil and gas producers and oil services companies continue. The October figures for E&P companies might suggest a respite – only three entered bankruptcy proceedings. Nine oil services companies filed, however. These bankruptcies added $138 million in additional debt to the year-to-date total for E&P companies in 2020, and boosted the oil services’ total by $3.9 billion.
Exhibit 1. Oil Services Bankruptcies Setting New Records SOURCE: Haynes and Boone, PPHB
Exhibit 2. E&P Bankruptcies Continue Increasing Slowly SOURCE: Haynes and Boone, PPHB
Through the first 10 months of 2020, E&P company debt is trailing the record bankruptcy year of 2015 by $3 billion from 43 filers, compared to 70 in the earlier period. The oil services sector has passed its record year of 2017 by one company (53 vs. 52), and by 10% in total debt involved ($38.95 vs. $35.25 billion.) These stats signify how damaging the industry’s debt has been in a Covid-19 and oil price crash environment. Debt is one thing, but the jobs lost and lives disrupted are the saddest aspects of this correction.
We caught up with Buddy Clark, co-head of Haynes and Boone’s energy practice and Charles Beckham, Jr., the head of the energy bankruptcy efforts last Friday morning. While our conversation was held before the final October bankruptcy data was released, we talked briefly about the market trends reflective in the energy bankruptcy filings. Since their firm began tracking and publishing industry bankruptcy data in 2015, there have been over 250 filings total in each industry sector – 251 E&P producers and 254 oil services companies. The E&P sector total includes a couple of reruns, or Chapter 22 filings, when a company goes through bankruptcy a second time.
Given the relatively few filings last month, we wondered if the bankruptcy tsunami had run its course. Mr. Beckham noted that the timing of filings is dictated by liquidity and/or debt maturity events for companies, and not the calendar. While always wondering if the pipeline of bankruptcy candidates will run dry, especially with over 500 filings over the past five years, Mr. Beckham said he was not concerned about the lack of bankruptcy candidates in the foreseeable future. He began his energy bankruptcy practice in the 1980s in Midland, Texas, when the last major industry bust was underway. His career is a testament to the inability of some energy executives, even in boom times, to properly managing their company’s financial affairs.
According to Mr. Beckham, 2020 has seen more liquidity-driven filings than debt maturity ones, which may be a commentary on the impact of low oil and gas prices and the inability to cut costs fast enough to keep from sinking under debt loads. This trend is likely to continue during 2021 as producers see their production hedges burning off, meaning that revenues may take a hit, putting increased pressure on expense management.
As the energy industry moves through this period of restructuring, there are several developments that bear watching. In the last 90 days, these two lawyers are noticing greater financial restructurings underway among energy companies backed by private equity (PE) funds. PE funds traditionally utilize large amounts of debt in order to help boost investor returns. These financially over-leveraged companies are struggling in a low-oil price environment, forcing their PE sponsors to merge, sell or shut them down, but usually without going through the traditional bankruptcy process. A complicating consideration pointed out by Mr. Clark, is that there are often plugging and abandoning liabilities associated with the wells and leases, making it a less clean open-or-shut decision, especially if these firms are partners in E&P projects. The emergence of PE-backed companies as the next area of bankruptcy concern reflects the active involvement of these firms during the oil and gas boom years of 2010-2014. This is a dynamic making this industry downturn different from previous cycles in which few PE funds were involved. In the earlier cycles, debt financing came from more traditional sources such as banks, insurance companies and public markets.
The most intriguing development impacting the industry’s future we discussed with Messrs. Beckham and Clark are the battles between E&P companies and their midstream gathering and transmission vendors. Midstream companies negotiated contracts with producers to install pipelines in fields to collect the produced oil and gas and move it to market based on the belief that these contracts created a covenant that ran with the land and could not be rejected by a debtor during bankruptcy. These sacrosanct contracts provided the security allowing the midstream companies to borrow the funds to construct these pipeline networks. In a 2016 bankruptcy case, In re Sabine Oil and Gas Corp., a New York bankruptcy court, interpreting Texas law, held that midstream gas gathering agreements did not create covenants with the land and could therefore be rejected by the debtor during its bankruptcy. Different conclusions were reached in other cases: in Badlands, a Colorado bankruptcy court, applying Utah law, found such a gathering agreement did create real property covenants that could not be rejected; while in Alta Mesa, a Texas bankruptcy court, applying Oklahoma law, found certain gathering agreements also created real property agreements that could not be rejected.
In a world where cost pressures are intense on E&P companies, the issue of gathering contracts creating covenants that run with the land and cannot be rejected in bankruptcy is becoming the next major battleground. This is because E&P producers, having fixed their balance sheets via bankruptcy, are now addressing fixing their income statements, as commodity prices remain low. The battle involves the role of bankruptcy courts interpreting various state property laws, and reaching decisions that put the entire midstream industry at risk for raising financing for new pipeline networks, but more importantly in servicing its debt if its revenue stream is damaged.
Reading commentary by law firms about these cases and the issue, we have reached one conclusion. That is: writing future agreements between E&P producers and midstream companies will be challenging. Actually, the proper description is more like pretzel-making. A recent presentation on the issue by Haynes and Boone energy lawyers highlighted text from a recent decision relieving Chesapeake Energy Corp. from its midstream contracts under an interpretation of Texas property law. The citation stated:
“It does not stretch the imagination to envision a contract that both contains a covenant that runs with the land and is executory. In such a circumstance, the appropriate analysis is what benefit was previously bestowed by the debtor on the non-rejecting party that remains post-rejection and what future performance by the debtor is excused by rejection. Depending on the particular language of the subject agreement, a plethora of outcomes are possible”
Welcome to Pretzel Land!
While we have much to learn about this complex legal issue, we raised the question with the Haynes and Boone lawyers as to whether this could lead to massive restructuring of the midstream industry, much like resolving take-or-pay gas supply contracts did for the interstate natural gas pipeline industry in the 1990s. There are significant differences between the two business, not only in where they operate, but who their regulators are and the laws that govern the companies. However, at a very high level, we need to approach this industry uncertainty within the context of the degree of business risk producers and midstream companies are willing to assume. As an example of how traditional energy industry structures are being upset, think about the challenges commodity prices have caused for utilities. Low natural gas prices have impacted the economics of their long-term coal and nuclear power contracts. These issues are part of the “unintended consequences” of the oil and gas downturn, combined with the energy transition underway.
While the law is often thought of as being dry and dull, when it is caught up in the maelstrom of an industry restructuring, such as energy is undergoing, this could be an exciting period. While the lawyers wrestle with state property laws, contract law, energy law, and bankruptcy law, the economics of the industry are in turmoil, hampered by uncertainty about the future of the energy world dealing with Covid-19, collapsed energy demand, altered business and lifestyles, and the global push for a carbonless energy system. Stay tuned, as we monitor: “How the Energy World Turns.”