By Chris Harris (Partner) and Ky Kvisle (Associate) of Blake, Cassels & Graydon LLP

Oil and gas producers are in the midst of the worst downturn in a generation. While producers are accustomed to the cyclical nature of the industry, amendments the Alberta Energy Regulator (AER) made to the Licensee Liability Rating Program (LLR) in 2013 (the "2013 Amendments") have created additional challenges in this downturn for producers with limited liquidity. On June 20, 2016 the AER released Bulletin 2016-16 outlining a new policy with regards to how the AER will administer the LLR program which will have a major impact on the financial viability and strategic options of many producers. 

Bulletin 2016-16 was issued in response to the Redwater Energy Corporation (Re)(Redwater)decision from the Alberta Court of Queen’s Bench, which determined that receivers and trustees of insolvent producers are able to sell off valuable assets without having their disclaimed assets included in the LMR calculation used by the AER to determine whether to approve the transfers (as further described below), leaving the abandonment and reclamation obligations associated with the disclaimed assets to the Orphan Well Association (OWA). The AER and the OWA are in the process of appealing the Redwater decision.

Overview of LLR Program and Bulletin 2016-16

The LLR program, and associated programs, require licensees, both upstream and midstream, to post security deposits with the AER if their Deemed Liabilities exceed their Deemed Assets(i.e. if the cash flow associated with oil and gas production or midstream operations in Alberta is less than the costs to reclaim and abandon their wells and facilities licenced by the AER). This ratio of Deemed Assets over Deemed Liabilities is called the Liability Management Ratio (LMR). Licensees are required to maintain an LMR greater than 1.0 and to post security with the AER if their LMR falls below 1.0.

Another significant facet of the LLR program are the requirements for the transfer of AER licences. The transferor and transferee were previously required to have an LMR of 1.0 or greater for a licence transfer to be approved by the AER. Bulletin 2016-16 has increased the required LMR threshold for transferees to 2.0.Given that a number of licensees maintain an LMR below 2.0, this will have significant implications for the energy industry in Alberta. In addition, the AER has retained the discretion to refuse any proposed licence transfer even if the specified requirements have been met, and has also reserved the right to revisit any previously approved licence transfer where the transfer has not yet occurred.

The 2013 Amendments resulted in significant uptick in security deposits payable to the AER as well as increased difficulty in transferring licences and completing assets sales. Bulletin 2016-16 is going to amplify this difficulty, making it impossible for some previously negotiated transactions to close in their current form, and substantially diminishing the prospect of future asset sales for many producers.

Debt Covenants and the LLR

Many in the industry have been facing increased pressure from their lenders as poor market conditions have resulted in many producers being in default of certain covenants under their credit facilities.  In some cases this has happened gradually as, for example, financial covenants such as a requirement to maintain a specified debt/EBITDA ratio are breached.  In other cases it has happened literally overnight as lenders complete their semi-annual borrowing base recalculations under reserved-based lending facilities, where the amount available to borrow is based on the value of a producer’s reserves. In some cases the recalculations have decreased the borrowing base to less than the amount already drawn on the credit facility, resulting in immediate liquidity issues and ultimately, an event of default.  Lenders have shown a willingness to work with producers so far, pushing only a select few of the defaulting producers into insolvency proceedings, and working with most to help them regain their financial footing.

The LLR requirements have added to the challenges facing defaulting producers (or those on the verge of default) as they work with their lenders to renegotiate their credit facilities, look to sell assets or raise equity to shore up their balance sheet. As producers were largely unsuccessful earlier in the downturn of selling non-core assets to ease their liquidity concerns, lenders have now been forced to pressure producers into marketing core assets. These core assets typically carry a better LMR.  However, in some cases producers have been prevented by the AER directives governing transfers from selling these assets as it would have resulted in the producer subsequently having a LMR of less than 1.0 and therefore being required to post security in order to fully consummate the transaction. This is something that a capital-constrained producer is often unable to do.  With the new 2.0 LMR policy requirement, there will be a more limited number of credible buyers and fewer available avenues for distressed producers to sell assets.

The AER may inadvertently cause an increase in the number of wells being disclaimed to the OWA as lenders may decide to push more producers into insolvency as it may be the only way the lenders will be able to monetize assets of a defaulting producer. Furthermore, some producers may view an insolvency filing as the sole way to continue as a going concern (albeit through consolidation) as they will only then be able to disclaim lower value/higher obligation assets.

To be sure, there have been and will most likely be further insolvencies created in part by the LMR program. After Bulletin 2016-16 it is possible that several more producers will be pushed into insolvency as a growing number of producers will have no ability to buy or sell assets in efforts to remain solvent.

LMR Calculation

Another challenge that may arise in the coming months could come from how the LMR is calculated. The Deemed Liabilities portion of the calculation, which looks to the costs of abandoning and reclaiming wells and facilities, is a relatively fixed variable set by the AER and based on estimated costs for various regions in the province. The Deemed Assets portion of the calculation, which for producers is calculated using the three-year average industry netback multiplied by production volume, is inherently much more volatile. The AER has been providing some relief on this calculation as it has not recalculated the three-year average industry netback since March 2015, with the value currently set at just over $37/bbl oil. This value is a significant premium to what most unhedged producers have been realizing of late. A recalculation of this value using a more realistic netback would push many producers into negative LMR territory,thereby requiring the posting of substantial security. Just as it is unclear how long lenders will continue to show restraint against technically defaulting producers, it is similarly unclear how long the AER will continue to provide this relief.

While the AER has provided relief on the pricing portion of the Deemed Asset calculation, producers who have been unable to drill due to a lack of available capital will see pressure on their LMR rating on a different front as they face declining production. The LMR calculation for many producers will decrease for this reason if not on account of a revised deemed netback value.

Unintended Consequences

The LLR program may inadvertently lead to an increase in defunct licences by causing more producers to be caught in the LLR trap resulting in more insolvencies due to insufficient liquidity. Given Bulletin 2016-16and the Redwater decision, managements, boards of directors and lenders may be incentivized to push more producers into insolvency as their only means of extracting value from a producer’s good assets,resulting in increased levels of wells renounced to the OWA.  As the oil and gas industry funds all of the costs incurred by the OWA through a biannual levy, the costs are apportioned to all producers in Alberta – the more orphan wells in the OWA, the higher the levy on industry.

In addition, the LLR program may have the effect of reducing total recoverable reserves. Marginal companies that cannot afford to post security for negative LMR assets will be forced to either sell those negative LMR assets, for which there is a limited market for, or pre-maturely shut-in and abandon those assets. Pre-maturely abandoning assets result in a loss in the total recovery of the original oil/gas in place, which results in reduced recoverable reserves, not to mention a corresponding decrease in the borrowing base for producers with reserves-based loans.

Policy Considerations

Environmental stewardship is one of the most important business and moral imperatives in the contemporary energy industry, and no one in industry has argued that producers should not be liable for the full cycle of wells from drilling to abandonment. However, Alberta’s two tiered system, the LLR, its associated programs, and the OWA, may not be the most effective system for preventing the Crown from assuming liability for abandonment and reclamation costs.

There are a wide variety of systems in place to address abandonment and reclamation costs. Many jurisdictions in the US, such as Texas, make use of a model requiring security to be posted prior to drilling a well. The posted security is independent of commodity price and is either a flat rate per well or per well depth. Producers are therefore not exposed to the volatilities associated with production volumes or commodity pricing with respect to security posting requirements. Mature wells also do not potentially face premature abandonment as they do in the LLR program. There have been recent calls for the AER to implement such a system. However, this flat rate security model is also under scrutiny and it may not be as effective at reducing orphan wells as an LLR type program. In Texas alone there are nearly 10,000 orphan wells which will require an estimated $165 million to plug and reclaim. Texas regulators now want taxpayers to supplement industry for reclamation costs of orphan wells as the initial flat rate security posted is insufficient to cover the costs of abandonment and reclamation.

Opportunities and Novel Deal Structures

Every challenge creates opportunities. Given Redwater, there may be increased opportunities to purchase cheap assets with a positive LMR through insolvency scenarios (and the amount of such assets on the market may increase substantially as a result of Bulletin 2016-16).Environmental specialists may be able to purchase assets for little or nothing more than the cost of posting security and thereafter abandon and reclaim those assets for less than the amount of posted security or the residual value associated with those assets, thereby capitalizing on the difference.  There may also be an increase in entities looking to use alternative deal structures, including by purchasing the debt of a target entity and pushing such entity into insolvency as a means to obtaining control of its assets, or alternatively by using partnerships or joint ventures to acquire control of and/or develop assets that continue to be held by the same entity rather than utilizing standard purchase and sale agreements.

The higher LMR requirement may also provide an incentive for producers to increase their oilsands exposure as insitu oilsands assets tend to have high LMRs due to their lowvalue of abandonment liabilities.

For better or worse, the LLR program will undoubtedly impact the decisions that producers, mid-streamers and energy investors and lenders will be making in the months to come.  Tensions between managements, boards and lenders and the AER are sure to increase and the industry will be awaiting resolution of the Redwater appeal and the new regulations to be rolled out by the AER.

The authors acknowledge the contribution of Jack Whelan (Summer Law Student).