Oil price movement through 2014 and into 2015 is a consequence of market fundamentals. Europe’s continued economic woes, paired with the slowdown in China’s economy, have led to a fall in demand for oil.
At the same time, the growing U.S. shale-oil boom (over which OPEC has no control) and the pick-up in drilling in Libya have led to an excess of supply. However, in the past few months the issue has switched from how quickly oil prices have fallen, to how much further they have to fall.
Price movements suggest that the relatively stable (and high) prices of the last few years have given way to a new era of volatility, where comparatively small changes in market fundamentals will lead to significant price swings.
The commodities markets thrive on volatility, as this is where opportunity lies. Oil, more than most commodities, is price inelastic. Significant investment in the oil market from hedge funds and commodity-index funds is also thought to have contributed to market volatility. But by its very nature, oil trading is rife with uncertainty: most of the world’s oil reserves are located in geopolitically sensitive regions. Predicting future demand would need a crystal ball to foretell global economic performance. The opportunities this ‘new normal’ situation presents are complex and multifarious, as are the risks.
It is simplistic, however, to see low oil prices in exclusively negative terms. Lower oil prices will affect market participants differently, depending on their function and position in the market. Integrated businesses may face risks and opportunities simultaneously in different parts of their business. Lower prices may also stimulate demand among consumers and businesses with a high dependency on energy, and so will be seen as a positive development. Refiners, depending on their contractual positions, may also benefit from the low price of crude product and a lag in the price reduction for refined products. For crude producers, however, low prices mean reduced revenue and pressure on profitability, especially for those with higher extraction and capital costs.
Insolvency and Restructuring Some producers facing lower cash flows with no reduction in debt expenses and operating costs are likely to succumb and seek bankruptcy protection. Others may be better able to restructure their debt outside a formal insolvency process. Moreover, those service providers whose businesses rely on a more sustainable price for oil or gas will be in belt-tightening mode over the next year. While acquisitive businesses with strong balance sheets may see these challenges as opportunities.
Markets are increasingly global and ‘borderless’, and the energy sector is no different. In the United States, expect to see an increase in filings in New York, Delaware and Houston, as well as in Pennsylvania, Ohio and West Virginia, and anywhere there is a concentration of oil and gas businesses. The UK and Singapore are also likely to see an increase in insolvencies and arbitration proceedings, as well as Hong Kong for shipping cases.
Bankruptcy and restructuring in a regulated industry, as parts of the energy industry are, coupled with legal complexities such as the U.S. Bankruptcy Code’s “safe-harbor” provisions, can create their own challenges. In this environment, although it is important to know your contract terms and legal rights, it is equally vital to recognise that the issues affecting a contract and the outcome may depend significantly on where the bankruptcy is filed.
Although any number of questions may arise in a given bankruptcy case, we have identified 12 priority issues that companies in the oil and gas sector are likely to face in the coming year. These ‘top 12’ focus on U.S. bankruptcies, but the same issues are equally relevant to proceedings in other jurisdictions around the world, even if the terminology may differ.
Top 12 Considerations for Oil and Gas Companies
- “First day” issues: terminating contracts; preventing the assignment of assets; cessation of performance; using collateral to reduce exposure; reporting terminations to regulators and mitigating loss.
- Application of “safe harbors”: application to contracts or netting agreements of the “safe harbor” provisions of the U.S. Bankruptcy Code; impediments to exercising early termination rights; valuing provisions if terminating contracts; assessing whether it is necessary to conduct an auction or to obtain price quotes; possible qualification of contracts for the special protections of the Bankruptcy Code for forward contract merchants and swap participants; preparing for the possibility of negotiating and litigating termination issues and values with the debtor.
- Cash flows, balance sheets, offshore assets: assessing the current value of oil and gas reserves and the cash flows that can be obtained from them; considering how a particular entity’s balance sheet can be fairly represented; ascertaining whether there are offshore assets outside the jurisdiction of the bankruptcy court and determining how far the bankruptcy court’s jurisdiction reaches.
- Deliveries to the debtor: can anything be done about deliveries made to the debtor in the month before the bankruptcy filing, or will the creditor only get pennies on the dollar? If product is in transit to the debtor, can the seller have it returned before it gets there? What entities have superior rights over product in transit?
- Storage at the debtor: recovering product stored at the debtor’s facilities and the exercise of contractual or proprietary rights to collect it; where there is a particular through-put agreement, where does a debtor entity’s interest in product begin and end?
- Cross-affiliate set-off and netting: where there are contracts with the debtor and its affiliates, can a creditor net or set-off amounts between or among them?
- Secured creditor rights: as a secured creditor, protecting and preserving rights of lien; assessing rights under an inter-creditor agreement as a secured creditor and hedge provider to the debtor having a lien shared with the debtor’s lenders; obtaining a share of the collateral; protecting against the debtor using the same collateral for debtor-in-possession (DIP) financing; securing “adequate protection”.
- Critical vendor programmes: considering whether to participate in the debtor’s critical vendor programme; considering whether it is possible to enter into new transactions under an existing master agreement; objecting to the debtor’s proposed programme where a creditor is not designated as a “critical vendor”.
- Claims process and timing of distributions: the possibility of specialised claims filing and claims resolution protocols; the timetable for any recoveries on claims from the debtor; the time available to the debtor to assume or reject a contract; the time for which the debtor will be able to maintain bankruptcy protection; when should a creditor consider selling its claim?
- Preference claims and fraudulent transfer actions: assessing vulnerability to preference claims and fraudulent conveyance actions arising from transfers made by an insolvent counterparty on the eve of a bankruptcy filing; formulating defences.
- Doing business with the debtors: considering whether court approval is needed to enter into contracts with the debtor or modify contracts that are in place, or else whether these are “ordinary course transactions”; protecting lien rights under an operating agreement; considering whether a creditor can purchase assets from the debtor directly or whether there must be a special bankruptcy process, such as a court-supervised auction; what due diligence and access to the assets can be expected before a sale; are there any particular considerations for purchasing upstream, midstream and downstream oil and gas assets through a bankruptcy case?
- DIP financing: can a particular creditor provide DIP financing and if so, what are the requirements and risks?
It is critical to coordinate your positions and properly identify claims and risks when the family of debtor entities is dispersed around the globe.
The interplay between the core insolvency issues and labyrinthine intricacies of the U.S. Bankruptcy Code, the peculiarities of the regulated energy markets, and the potential cross-border exposure and conflicts of laws are likely to create headaches for many in the coming year. But for those who can navigate these issues with proactive understanding, pre-emptive action and sufficient liquidity, there is not only the opportunity to minimise risk, but also to maximise reward when energy prices rebound.
Default Management and Litigation When a client is faced with a potential default against an open contract, an experienced commodities lawyer will normally ask: “where is the market price relative to the contract price?”
An adverse price differential will often drive a counterparty to look for a way out of a contract, lawfully or otherwise. Beyond that, the price differential will very often be the most appropriate starting point for assessing damages for breach of contract.
Producers, refiners and pure traders face the increased risk of price-led default. Naturally, price is not the only possible cause of a default. For instance, sellers and buyers alike may find themselves in difficulty if related contracts fall into default or if credit lines are constricted or withdrawn. But by taking action early, the prospects for dispute avoidance, mitigation or successful litigation can be significantly improved.
All parties to open contracts should assess their position and follow best practice, including:
- An urgent review of contract terms: this allows you to identify potential threats or gaps early, so that steps can be taken to avoid or mitigate problems. Early, proactive reviews make more sense than a reactive response to a problem that has already arisen.
- Adhere to contract terms: a purchaser looking for the exit will seize on any opportunity, especially a breach.
- Respect the technicalities of any notice provisions under the contract: these are not confined to matters that might amount to a breach. For example, a put option might be invalidly exercised and so lost if the requirements for giving notice are not met in time. Similarly for a buyer, the opportunity to prevent an automatic contract renewal might be missed for want of proper notice.
- Prevention/impediment: if it is necessary to give notice of an event that might impede or prevent performance, such as under a force majeure clause, ensure the terms of the clause are respected.
- New contracts: be alive to the above issues when agreeing fresh terms.
If a default is in prospect or has occurred, it is important that the situation be properly managed. At a minimum, this will entail:
- Paying close attention when preparing correspondence: it is crucial to manoeuvre yourself into the strongest position possible, as early as possible.
- Undertaking immediate and properly informed analysis of the problem: this allows you to assess the options early, including termination and mitigation.
- In case of a default or serious breach, limiting correspondence and communication with the breaching party until you have fully assessed the situation: this reduces the risk of a compromising statement being made. Special care is needed with apparently routine operational messages.
- Keeping careful records of all communications: this includes notes of telephone conversations or recordings if permissible, and gathering all relevant documents. You should avoid creating prejudicial documents that might be discloseable later.
- Checking any applicable time-bars or notification requirements, to ensure the right to make a claim is not lost: these should be met even if a settlement might be achieved. Take care to respect any requirement for “friendly negotiation” before starting proceedings.
- Considering the mitigation options: ensure that reasonable steps to avoid or reduce loss are properly considered and taken. That could mean entering a new contract with the defaulting party.
- Investigating the options for a commercial settlement: this can offer a saving in costs and preserve commercial relations for the future.
Regulatory Enforcement Apart from the impact of increased international regulation on trading activities generally, governments and regulators across the world have made clear their increased supervision of market players, both upstream and downstream.
It is likely that enforcement action and investigations will continue, as increased price volatility provides fertile ground for potentially manipulative trading practices. Enforcement is, and will continue to be, big business for major international regulators. Hence, low oil prices should not prompt companies to scale back their investment in internal compliance education and monitoring, rather it should mean an increased internal vigilance.
Employment / Contractor Services A considerable slow-down in the offshore service sector is already in progress, with some businesses needing to reduce staff costs dramatically.
The same is true in producing, refining and, in some cases, trading businesses. Some commentators predict a reduction in shale exploitation until prices rebound to support the expense of such operations. The impact of this would be felt across a range of support industries, not only in the energy sector.
The proper management of employment issues and contractors can throw up specific demands and risks, depending on the jurisdiction(s) in question. These should be assessed at the planning stage before action is taken.
In addition, at a time when many market players are shedding staff, it is worth being mindful when negotiating exit terms that ex-employees may turn out to be crucial witnesses whose future cooperation you may need.
Storage Low prices offer an opportunity for those who can store product until prices recover. The commercial risks are obvious, not least the difficulty of knowing when that recovery will begin. But the potential gains are significant.
Storage facilities will be keen to capitalise on their ability to offer services to those wanting to sit on stocks, but tanking and pipeline capacity is finite, and in some regions it is already stretched.
One solution is floating storage, and the present climate provides openings for those with suitable units or tank vessels. Storage facilities may seek to enlarge their capacity, and those able to acquire and expand existing facilities can capitalise on the low price environment.
Recent experience suggests that care is needed in preparing and managing storage contracts, as some facilities seek to balance the needs of their customers with their own desire to turn increased profits from throughput and storage.
Furthermore, the present situation should reinforce the importance of corporate emergency response planning and preparedness. Accidents and physical emergencies, such as explosions and pollution events, can occur at any time. But they are more likely to occur at times of corporate stress, with issues such as spending cuts and loss or demotivation of staff often contributory factors. Similarly, the expansion of temporary or converted storage carries special risks, not least potential liabilities for pollution.
Conclusions If your business operates in the market for crude oil and its products, evaluating your contractual and commercial positions early will improve your chances of avoiding or reducing difficulties and for exploiting opportunities.
In addition, remember that the adverse impact of mishandled emergencies may not be just physical: it could be financial, regulatory, reputational, or a combination of these. To minimise these risks, you need to be thoroughly prepared to deal swiftly and effectively with the fallout from emergencies that affect others, such as the sudden collapse of major counterparties.
As the low oil price continues, there is much for businesses in the sector to consider. You can stay up to date with these vital issues in future alerts, which will focus on particular areas in more detail.
Reed Smith is pleased to announce… the appointment of Matthew Gorman as a partner in its Singapore office. Matt joins the firm from Stephenson Harwood’s Singapore office, where he was head of the firm’s South East Asia corporate practice, to launch Reed Smith’s corporate practice in South East Asia. Matt provides strategic advice across sectors spanning energy and natural resources, TMT, real estate and financial services to both private and public companies on joint ventures, corporate restructurings, mergers and acquisitions, private equity, venture capital and initial public offerings (IPOs). Click here to read more.
Client Alert 2015-012