This note is a sequel to the blog I posted in April 2015 that examined the connection between Federal Reserve policy and the collapse of the oil price. The conclusion in that blog post was that the policy of Quantitative Easing indirectly and unintentionally contributed to the oil price slide by funneling bond investments into more drilling and therefore unwittingly increased U.S. production. The blog ended by posing a rhetorical question: “How will production from shale wells be sustained if the money becomes much more expensive or non-existent?”
The answer to the question is now emerging from an unlikely place — the U.S. Federal Bankruptcy Courts. Despite cost cutting measures and the application of money saving technologies, Shale Operators are deeply in the red at average prices around $42/bbl. A recent Wall Street Journal survey indicated that break-even oil prices from shale needed to be between $46 to $70, depending on specific asset size and company characteristics.¹ Even the most optimistic company surveyed stated that it needed $50 oil to survive.² As a result, the prolonged price slump is now causing industry fallout in terms of a major reduction of drilling, declining production, and an increase in bankruptcy fillings.³ This trend raises new questions about how these shale assets, from a comparatively new technology, will be treated in the bankruptcy system?
Before addressing the specific question, it will be helpful to summarize for non-lawyer readers what happens to companies in bankruptcy.
Bankruptcy is controlled by Federal Law (Title 11 of the U.S. Code) and administered by special, Federal Bankruptcy Courts. The Code provides for five separate types of bankruptcy,⁴ only one of which be discussed here, Chapter 11 Reorganization. Reorganizations are generally used by business entities (corporations, partnerships, sole proprietorship) gain time to continue doing business free of pressure from creditors. When a Bankruptcy petition is filed, an automatic stay or standstill order goes into effect during which all judgments, collection activities, lawsuits, foreclosures, and repossessions are suspended for any debt that arose prior to filing the petition.⁵ The filing also starts the clock during which the debtor business has an exclusive right to file a plan of reorganization within 120 days.⁶ Once the exclusivity period ends, other interested parties, usually the creditors acting through a committee, can file their own reorganization plans. In a complex reorganization, the various parties consider the plan or plans, meet among themselves and at court scheduled hearings, file adversary proceedings and decide whether they want to urge the Court to either dismiss the petition or convert the Chapter 11 proceedings to a Chapter 7… more akin to a liquidation.
In the end, the Court hears all interested parties both objecting to and supporting a plan of reorganization. In deciding whether to accept the plan the Court is guided by general language in the Bankruptcy Code and must make fact findings that:
- The plan is feasible;
- The plan is proposed in Good Faith; and
- The plan complies with and addresses other requirements found elsewhere in the Code.⁷
When a plan is approved by the Court, pre-bankruptcy debt, obligations, and contracts are superseded and replaced by new obligations in accordance with the plan.⁸
Turning to the specific case of companies holding unconventional oil and gas assets filing for Chapter 11 protection from creditors, it can be seen from the brief description of the process, above, that plan “feasibility” is a key requirement and is largely a function of reworking the balance sheet. Simply put: Is there enough value to service the anticipated debt? A more difficult question is: How can the future value a commodity such as oil be determined given the technical uncertainties of unconventional drilling and the geopolitical uncertainties of the global marketplace?
A typical oil exploration company debtor will be required to identify in any plan, the following assets:
- Lease or Host Government Contract holdings;
- Reserves, usually through an expert report and “risked” according to the usual classifications (proved, probable, possible);
- Future cash flow using different combinations of discount rates and price assumptions.⁹
- For any given company, the “break-even” price for the purposes of the plan.
The first two items are usually quantifiable. The third item has been lately subject to speculation by many crystal ball gazers across the industry. The fourth item depends on the size and circumstances of the corporate debtor. Many different, per barrel oil prices have been published as being the “floor” which can sustain the U.S. industry.¹⁰ No doubt, expert testimony will need to be offered on these two last points to support any plan in Chapter 11 filings.
A more troubling question, raised in my earlier blog post in relation to companies heavily invested in unconventional assets, is whether a Chapter 11 plan can be devised to take into account the need for continuous drilling to sustain deliverability? In some cases, it is the characteristic of unconventional resource recovery which has created a high appetite for more debt in the first place.
In summary, unconventional resource companies pose new questions for the Bankruptcy Court in formulation of Reorganization Plans. Any operations that include fracking, horizontal drilling, and lower deliverability are higher cost than their conventional counterparts. Since the oil costs more to recover, are the assets in the ground, to be valued at less than the market for conventional resources? At the same time, valuation questions that hinge on unknowable, future political events pose a challenge to the adoption of a commercially feasible plan of reorganization.
¹ WSJ November 21-22, 2015, page 2 graphics.
² Id. (Referring to EOG.)
³ WSJ November 20, 20125 (Where it was stated that 37 North American producers had file Chapter 11 Bankruptcy cases in 2015 to the date of the article.)
⁴ The five types are named according to their Chapter headings in the Bankruptcy Code: Chapter 7 – Cancellation of unsecured debt; Chapter 9 – Reorganization of Municipalities; Chapter 11 – Reorganization of Debt; Chapter 12 – Restructuring and Chapter 13 – 3-5 year repayment plans.
⁵ 11 USC 362 (a)
⁶ 11 USC 1121 (b). The “exclusivity period” can be extended by the court but not for more than 18 months.
⁷ 11 USC 1129.
⁸ 11 USC 1141 (d) (1)
⁹ See, Campbell and Hancock, Litigating Value in Oil & Gas Bankruptcy Cases, Journal of Corporate Renewal July/August 2012.
¹⁰ See WSJ Nov 21-22, 2015 page 1 et seq.