The Examiners: Industry Presents Opportunities for Investors, If Hom...

How much stress can we expect to see for oil and gas producers and related companies as a result of the current low prices? And what special issues does this industry face when it’s time to restructure or file for bankruptcy?

Absent a sustained increase in energy prices, there will continue to be a material and increasing number of energy-related companies—including producers and oil field services companies—under substantial stress. Some will be able to ride out the cycle by raising incremental (especially second-lien) financing; Others will fail and restructure in chapter 11 or otherwise, especially as hedges start to run off.

There are several unique attributes of the capital structures of many of these companies as well as the underlying state and federal hydrocarbon law that must be understood to properly manage risk and make prudent additional investments in this sector.

As a general rule, the most senior portion of the capital structure for exploration and production companies is a reserve-based revolving loan (RBL).  These loans are characterized by tight covenant packages that necessitate lender consent for material transactions. However, non-core and/or non-proved assets for which a borrower is not receiving RBL borrowing base credit could serve as the collateral for any incremental financing. Moreover, many indentures in this industry have a significant amount of flexibility for incurring additional secured financing. As long as the RBL lenders can be satisfied—often through significant commitment and borrowing base reductions (reducing their exposure during this volatile period)—material secured debt can be put in place.

Given the amount of capital that distressed funds have recently raised to invest in this sector, there likely will be many recapitalization and refinancing transactions in the coming months. New money investors may be in an enviable position: If borrowers weather the commodity cycle, these investors earn an attractive return on investment. If the company fails at a low point in the commodity cycle, these investors may be in a position to convert their debt into the equity of a reorganized company with a healthy balance sheet and the potential for high-equity returns when the cycle eventually turns.

That said, new money investors need to have their eyes wide open to the complexities of oil and gas bankruptcies. The bankruptcy code contains special provisions applicable to the oil- and gas-space, and the interaction between the bankruptcy code and state law gives multiple parties far stronger rights than they would normally have.

More than in almost any other industry, a deep knowledge and diligence of specific facts regarding the assets, financings and other transactions relevant to the debtor—in combination with the choice of law that a bankruptcy court is likely to apply—is necessary to understand a new money investor’s likely recovery in a downside scenario.

•  Does an investor’s secured claim trump the statutory liens for oil producers, contractors and materialmen?
•  Will the debtor lose its interest in its mineral leases if it does not timely perform its obligations?
•  Are those leases subject to assumption and rejection under the bankruptcy code, or are they property rights under (some) state law?
•  Will the debtor’s conveyance of revenue streams through overriding royalty interests and farmouts ride through the bankruptcy unimpaired or be recharacterized as financing arrangements or as fraudulent transfers?
•  Will royalty interests constitute secured or unsecured claims?

These are but a few of the complex questions that will turn on the application of specific facts, the bankruptcy code and disparate state law, and could significantly drive recoveries for classes of creditors. Careful planning and structuring of any transaction and sound advice will be critical to successfully navigating these turbulent waters.

Marshall Huebner is a partner with Davis Polk & Wardwell LLP in New York and is co-head of the firm’s insolvency and restructuring group.