The Examiners: Oil Field Servicers and Shale Producers May Be Hardes...

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?

Common wisdom is that the decline in oil prices to multi-year lows, driven by a steep increase in U.S. production and no let-up in foreign production, will lead to even greater distress in the oil and gas industry. I don’t disagree, but just as an earthquake can level one building and leave its neighbor weakened but standing, some sectors of the exploration and production industry will withstand this latest economic storm better than others.

In the near term, there may be even more industry fallout because we still may not have seen the bottom of the oil price trough. Further downward pressure on oil prices will only exacerbate the existing liquidity crises throughout the industry. Further, most producers are facing near-term redeterminations of their borrowing bases, which is typically done twice a year on a reserve basis. Though producers may find that their assets are worth far less at the end of the spring resets, banks likely will provide some borrowing base flexibility giving those producers some breathing room until the fall. In order to avoid the impact of price redeterminations and avoid the need for balance sheet restructurings, borrowers may sell assets or try to issue more debt with a fixed loan amount (e.g., high-yield bonds) to buy more time.

Unfortunately, oil field servicers, which provide equipment and personnel to support exploration and production, may not be so fortunate. These businesses typically have far fewer hard assets and their revenues depend on new production (not price level), which producers may be reluctant to engage in while oil prices are so low. Accordingly, we can expect to see the most significant and immediate distress—and need for traditional restructurings—in the oil field service sector.

In addition, shale producers may find themselves with insufficient liquidity to ride out the pricing storm. Generally, shale producers must continually drill to retain their rights, because if fields are left undeveloped or don’t produce for a relatively short period, the lessee will forfeit its rights. Given that the cost of shale production can exceed traditional drilling costs (and be uneconomic in today’s pricing regime), shale producers will be left with very poor choices. They may not be forced to go through traditional bankruptcies, but we may see consolidation among smaller players in order to stay in the game.

Practitioners hesitate to classify any workout in any industry as a typical “restructuring.” Every business and balance sheet has its own unique challenges. Even so, oil and gas restructurings may have even more pitfalls. For example, it’s not so easy to walk away from under-performing assets in an oil and gas bankruptcy. Environmental plugging and abandonment liabilities with respect to abandoned wells can give rise to large administrative claims. Additionally, exploration and production companies may have significant royalty liabilities, and “production payments” (i.e., royalties) are generally excluded from property of the debtor’s estate in bankruptcy and cannot be rejected. Also, regulatory agencies continue to exert significant influence on an exploration and production debtor’s prospects, as the debtor must remain in compliance with the regulations of each state in which it operates—often at great cost.

In sum, it won’t be an easy year for these players. For those without sufficient liquidity to bide time until prices inevitably rise, survival will likely depend on the ability to sell non-core assets (without the mounting attendant liabilities of shut downs), attract suitors for mergers or find non-reserve based sources of capital.

Shaunna D. Jones is a partner at Willkie Farr & Gallagher’s business reorganization and restructuring practice. She is based in New York.