When worlds collide: Alberta’s oil & gas industry navigates the insolvency space
June 2017 | EXPERT BRIEFING | SECTOR ANALYSIS
It has been almost three years since oil prices plummeted from a high of US$112 per barrel in June 2014, and Alberta has seen its share of oil & gas sector insolvencies in the rocky months that have followed. The economic circumstances have forced consideration of novel issues by the oil & gas industry and insolvency professionals, as well as by the courts. Reactive shifts in the regulatory environment have produced corresponding changes in the transactional realm.
The insolvency proceeding which served as the spark to a powder keg of regulatory change was the receivership of a junior oil & gas producer in May 2015. At the commencement of the receivership proceedings, Redwater Energy Corp. had 19 producing wells and associated facilities and pipelines (the producing assets) and 72 non-producing wells and associated facilities and pipelines (the non-producing assets). Due to the restrictions on licence transfers imposed under the Alberta Energy Regulator’s (AER) licensee liability rating programme, it was clear from the outset that this would be a challenging receivership.
The AER’s licensee liability rating programme has been in place in Alberta since 2000. Its stated purpose is to reduce the risks of underfunded abandonment and reclamation liability by requiring payment of a security deposit if a particular ratio is not maintained by the licensee of oil & gas assets. The liability management rating (LMR) of each and every licensee is calculated and publically posted by the AER on a monthly basis, using a ratio of deemed asset value to deemed asset liabilities. Based on this ratio, Redwater had an LMR below 1.0 which meant on any sale, the AER would require payment of a security deposit before approving a transfer of the licensed assets.
Faced with a handful of good, saleable assets among a lot of liabilities, the court-appointed receiver of Redwater, Grant Thornton Limited, opted for a strategy not tested in case law. Relying on a provision of the Bankruptcy and Insolvency Act (BIA), which shields a receiver from environmental liability for assets, the receiver renounced any interest in the non-producing assets. This ‘cherry-picking’ approach resulted in the non-producing assets falling into Alberta’s orphan well fund, which is used to cover the costs of abandonment and reclamation of assets without a legally responsible or financially capable owner. The coffers of the orphan well fund are filled by an industry levy. If the fund is overburdened, financial responsibility for orphan wells may ultimately fall on the Alberta public.
Under Alberta oil & gas law, a receiver falls within the definition of ‘licensee’. Accordingly, the AER objected to the receiver’s renouncement of the non-producing assets on the grounds that a receiver must comply with the licensee obligations under the Oil and Gas Conservation Act (OGCA), the Pipeline Act, the Environmental Protection and Enhancement Act, and all associated regulations. A licensee is not permitted to disclaim its assets under the legislation. The rationale behind this is simple – a licensee has an obligation to abandon and reclaim its assets at the end of their economic life. If a licensee were permitted to simply walk away from those obligations it would allow them to reap the benefits of the assets during its productive life and leave all of the liabilities to the orphan well fund. The dispute was the subject of a two-day hearing before Chief Justice Wittmann of the Alberta Court of Queen’s Bench.
The court determined that, as a result of the doctrine of federal paramountcy, the receiver had the right to renounce its interest in the non-producing assets. Federal paramountcy is a Canadian constitutional law principle governing the intersection of federal and provincial legislation—rendering provincial laws inoperative to the extent of the conflict. The provision of the BIA, which is federal legislation in Canada, was paramount to the regulatory orders issued by the AER under Alberta law.
The court also held that the AER could not require the receiver to pay a security deposit as a condition of approving a transfer of producing assets to a purchaser. As a result, the AER was only entitled to consider the LMR of the producing assets in deciding whether to transfer the associated licences to a purchaser.
Shortly following release of the court decision, the AER rattled the industry by doubling the required LMR ratio for purchasers of licensed assets going forward. The result is that in order for a licence transfer to be approved, the transferee must have an LMR of 2.0 or higher following the transfer or payment of an equivalent security deposit. Whereas previously, licensees were expected to have asset values matching their liabilities, purchasers will now require an asset value double that of their liabilities.
Paired with low commodity prices pushing down asset values, the effect of the AER’s actions exponentially increased the amount of required security deposits and decreased the pool of qualified purchasers. The new requirements chilled transactional activity as the industry attempted to grasp the consequences and the path forward. Perhaps in recognition of the unintended impacts of its decision, the AER later announced that it would consider approving licence transfers on a case-by-case basis for purchasers with an LMR between 1.0 and 2.0.
The stated purpose for this enhanced LMR requirement was to ensure that the purchasers of the assets were financially sound and would not later find themselves unable to fulfil their regulatory obligations. However, many in the industry do not consider the LMR of a company to be an accurate predictor of financial health.
An LMR is attributed to the licensee of the assets on a 100 percent basis, regardless of the percentage working interest that the licensee actually holds in any assets. As a result, the assets and liabilities, and hence the LMR, of a licensee can be artificially inflated or deflated. The LMR also does not consider factors such as assets in other jurisdictions, reliance on credit facilities, disputes about the borrowing base within banking syndicates, disgruntled bondholders or shareholder activists, all of which can substantially impact the long-term or short-term viability of a company.
As expected, the Orphan Well Association and the AER appealed the court’s Redwater decision. The Alberta Court of Appeal recently released its judgment, upholding the lower court ruling in a 2-1 split with a strong dissent. Particularly given the split decision, the AER has indicated it will be seeking leave to appeal to the Supreme Court of Canada.
In light of the appeal en route to the Supreme Court of Canada, the uncertainty surrounding the ability of a receiver to renounce assets, as well as the significant change in transfer requirements, has produced some interesting developments in insolvency proceedings. We have seen the strategic appointments of receivers over only the non-operated assets of a debtor company in order to steer clear of regulatory hurdles. Another approach, utilised in two separate receivership proceedings, involved secured creditors appointing receivers solely over a limited number of higher-value assets located in jurisdictions outside of Alberta where the debtor companies were not off-side the provincial equivalent of the LMR programme. While beneficial for the secured creditors, without possession and control of their high-value assets the debtor companies no longer had the ability to service and maintain their Alberta assets and, in some cases, simply shut-in those assets and essentially handed the keys to the AER and the Orphan Well Association – an action not permitted under the OGCA or the Pipeline Act.
Redwater and the associated regulatory environment has resulted in LMR becoming a driving factor in deal negotiation. Payment of security deposits by the party owing had previously been a fairly standard covenant; however, payment of LMR deposit funds has now become a negotiable business term. Depending on the package of assets being sold and the purchaser’s existing assets, the security deposit requirement could range from tens of thousands to millions of dollars. We have seen distressed deals where the purchaser agreeing to foot the entire deposit means the purchase price drops to $1. In other agreements, parties’ concerns regarding LMR requirements have resulted in a substantial holdback of the purchase price, releasable only on confirmation of licence transfers.
The unfortunate alignment of an economic downturn with an increasingly stringent regulatory environment has produced myriad interesting and complex challenges for the energy industry, as well as for insolvency practitioners. The circumstances have been exacerbated for the large number of junior oil & gas companies that call Alberta home. Conversely, some major industry players have capitalised on the opportunity to purchase valuable assets at a discount. Throughout this period, the AER’s administration of the regulatory backdrop has played a significant role in shaping the energy insolvency landscape. As a hub of energy activity, with a highly developed regulatory framework, other jurisdictions have and will look to Alberta’s lead when facing similar challenges. In light of the forthcoming Redwater AER application to the Supreme
Court of Canada, this will be an area to keep tabs on going forward.
Carole Hunter is of counsel at DLA Piper. She can be contacted on +1 (403) 698 8782 or by email: email@example.com. Natasha Wood is an associate at Burnet, Duckworth & Palmer, LLP. She can be contacted on +1 (403) 260 0159 or by email: firstname.lastname@example.org.
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