United States: Opportunities In Oil Financing And Investment: Meeting The Industry's Capital Needs In Challenging Times

Last Updated: February 11 2015
Article by Omar Samji

Reduced Liquidity—How Will Oil Companies Feel the Pinch?

With crude oil prices tumbling nearly 60 percent since June 2014 to near six-year lows, the decline in energy company stocks alone has erased more than $263 billion in market value.1 Oil companies and investors alike are scrambling to adjust to lower oil prices. Oil producers in particular are in need of sources of capital, while hedge funds and other alternative asset investors are searching for lucrative opportunities to put capital to work. An extended period of low oil prices will hit oil companies with a one-two punch, both reducing revenues and cutting off access to traditional bank and capital market financing. Oil companies are responding by downsizing or deferring capital projects, freezing wages, and scaling back or delaying drilling programs, bringing active rig counts to their lowest level since August 2010.2 

This spring brings two important hurdles for producers. At the end of March, companies with outstanding debt must certify compliance with financial covenants to their banks and bondholders. Some oil companies will not be able to comply with their financial covenants due to the follow-on effect on revenue declines. Lenders will be faced with the decision of whether to grant waivers or amendments for the failed covenants or else reduce unused credit lines and accelerate the maturity on outstanding debt. A second hurdle comes in April when lenders will re-value the oil reserves and other collateral securing credit facilities. The value of reserves for many oil companies will be significantly lower in April compared to the previous valuation. The result of the drop in collateral values will be reductions in the borrowing bases that underlie lines of credit. As traditional credit sources dry up, oil companies will increasingly look for hedge funds and other alternative asset investors to provide that financing. "There are a lot of people who borrowed a lot of money based on higher price levels," the Blackstone Group's chief executive officer said, "and they're going to need more capital."3 

How Do Low Oil Prices Create Opportunity for Investors?

Cash-strapped oil companies with geologically sound asset bases, but that are no longer able to draw on credit or access public equity markets to support capital programs, are an attractive target for alternative sources of finance. "The timing of having that capital available now really couldn't be better,"4 according to the Blackstone Group's chief executive officer, "It's going to be one of the best opportunities we've had in many, many years."5 A number of energy-focused funds are currently raising billions of dollars in new capital to target these sorts of opportunities. Buying debt facilities directly from banks at a discount is one avenue for hedge funds looking to invest in oil companies. Hedge funds can also issue new senior debt to cash out distressed bonds and potentially even acquire control of distressed oil companies. In addition, the unique characteristics of oil and gas assets offer additional, and potentially more advantageous, structures for investors to put capital to work in the oil field.

Sale of a Working Interest—Linn Energy / GSO Capital

GSO Capital Partners, LP, Blackstone's credit arm, pursued one such opportunity in a transaction recently announced with Linn Energy LLC. GSO has reportedly committed up to $500 million to fund 100 percent of the drilling costs of new Linn wells in exchange for an 85 percent nonoperating working interest (i.e., a property interest in the underlying mineral assets where the interest holder shares in the revenues and costs associated with exploration and production) in the wells, with Linn retaining a 15 percent carried working interest. Once GSO achieves a 15 percent annualized return, GSO's working interest would drop to 5 percent and Linn's would increase to 95 percent.6 This arrangement benefits the otherwise cash-strapped Linn by enabling it to develop prospective producing assets and add a new cash flow stream with no capital outlay of its own, while mitigating drilling risk and avoiding potential loss of mineral rights resulting from failing to meet development requirements under its leases.

Will Royalty Transactions Bridge the Liquidity Gap in 2015?

In addition to working interest transactions, which include an obligation to bear costs associated with exploration and production but could provide investors with certain operational rights, a long-standing tool used in oil and gas investments has been the sale ofroyalty interests, which are property interests in mineral assets where the interest-holder is entitled to a share of the revenue from production but does not bear any costs of exploration and production. 

A key characteristic of royalty interests (and a major reason for their relative popularity) is that they are considered real property interests, which means that once the investor acquires the royalty interest, it is generally deemed outside the bankruptcy estate of the granting company. This places the royalty investor in a superior position to other creditors of the granting company in the event of its bankruptcy. However, as further discussed below, this bankruptcy-protected status has recently been subject to challenge. 

There are several types of royalty-based transactions, including overriding royalty interests ("ORRIs"), volumetric production payments ("VPPs"), and monetary production payments ("MPPs").

ORRIs. An ORRI entitles the investor to a specified percentage of proceeds from the sale of oil produced from a lease or well for as long as the lease or well continues to produce. As a defined percentage of proceeds, the return on an ORRI will fluctuate based on the quantity of oil produced and the price of oil. 

Production Payments. A production payment can be structured either as a VPP, entitling the investor to proceeds from a specific volume of production, or as an MPP, entitling the investor to a fixed dollar amount generated from production. A key difference between an ORRI and a production payment is that production payments are more limited in duration as compared to an ORRI (which typically lasts throughout the productive life of the well or lease). A VPP will continue until the investor has received the sale proceeds from an agreed volume of production, and an MPP will continue until the investor has received an agreed dollar value or an agreed rate of return from production proceeds. Production payments are thus much more akin to financial investments in that the investor is entitled to certain benefits from oil produced by the assets it has invested in, denominated in dollars, rate of return, or volume. VPPs can also be used as a hedging instrument where a large consumer or distributor of oil, in exchange for an upfront payment, can obtain the rights to a specified volume of oil as it is produced from the well or lease.

How Can These Investments Help Oil Companies?

Oil companies in need of capital stand to benefit in several ways from these forms of alternative financing. Royalty-based investments can provide oil companies access to cash to continue drilling programs and develop assets with significantly less capital outlay. Continuing drilling programs can be critical, as oil leases often require a minimum number of wells be drilled to maintain the lease. Continued drilling also provides additional revenue streams and allows oil companies to attract and retain top talent, particularly for positions requiring specialized or institutional knowledge.

What Benefits and Risks Do Investors Face in Royalty Transactions?

Use of Proceeds and Other Safeguards. In negotiating any investment, whether a royalty, working interest, or other transaction, investors would be wise to build in certain safeguards around the use of the investment proceeds. For example, investors could require oversight of the drilling program in order to steer funds to a company's best drilling prospects, increasing the likelihood the investor will realize a return on its investment. Investors could also require safeguards dictating not only where companies drill, but how they drill, and the terms on which they contract with affiliated entities and third parties. Investors should also ensure that funds are used to fully satisfy amounts owed to service company expenses to avoid materialmen's liens being placed on the assets. 

Investors should note that royalty interests entitle the interest holder only to a share of proceeds from production. Unless established by contract, royalty interests do not give the interest holder recourse against or control of the oil company that owns or operates the wells.

Structural Risk. As with other alternative investment structures, there is a risk that the transaction could be challenged, particularly in the event of bankruptcy. As noted above, royalty interests are considered real property interests, and thus outside the bankruptcy estate of the company that sold the royalty interest. However, as we noted in previous Jones Day Commentaries,7 any investor considering a royalty-based investment structure should become familiar with the ATP Oil & Gas bankruptcy case. ATP's creditors challenged whether certain royalty-based transactions should be characterized as debt financings instead of real property transactions as has been the expectation of royalty investors in the past. If the ORRI, VPP, or MPP were recharacterized as debt financing, instead of the sale of a property interest, the royalty investor's status would be reduced to that of an unsecured creditor, and the royalty interest would be deemed part of the bankruptcy estate. The Bankruptcy Court refused to dismiss the creditors' claims, saying a fact-specific analysis was required, and ultimately did not rule on the issue because Bennu Oil and Gas, LLC purchased the bulk of the assets from the estate and settled with the royalty interest owners. However, the trustee in ATP's converted Chapter 7 bankruptcy has indicated that it may yet challenge certain royalty-based transactions outside of those sold to Bennu. While any such recharacterization would be a major change in what is currently established law, energy investors should continue to monitor developments in this case.

Conclusion

Oil companies needing to fund capital expenditures will increasingly find alternative financing structures attractive, as will investors seeking lucrative returns. Royalty-based investments may become even more popular than in the past due to their flexible structure, ability to target specific assets, and potential bankruptcy advantages to investors. Jones Day would be happy to discuss our extensive experience with alternative oil and gas financing structures or to answer questions related to specific situations.

Footnotes

1.Huddleson, Tom, Jr., "Falling oil prices have cost Fortune 500 energy companies billions of dollars," Fortune, Jan. 9, 2015, http://fortune.com/2015/01/09/energy-companies-market-value/; Banerjee, Devin, "Oil Drop Hits Private Equity as Carlyle Seen Leading Decline," Bloomberg, Jan. 27, 2015, http://www.bloomberg.com/news/articles/2015-01-27/oil-slide-bites-private-equity-as-carlyle-seen-leading-decline.

2.Patel, Tara, "Big Oil Cuts $20 Billion in Five Hours to Preserve Dividends," Bloomberg, Jan. 29, 2015, http://finance.yahoo.com/news/video-shell-cuts-15-billion-081926372.html; Chamberlin, Alex, "US rig count falls again as companies feel out the market," Market Realist, Jan. 28, 2015, http://finance.yahoo.com/news/us-rig-count-falls-again-162724139.html; Olson, Bradley and Carroll, Joe, "FiveHours and $20 Billion in Cuts: Big Oil Goes Long," Bloomberg Business, Jan. 29, 2015, http://www.bloomberg.com/news/articles/2015-01-29/five-hours-and-10-billion-in-cuts-big-oil-goes-long-i5ijwm8h.

3.Banerjee, Devin, "Blackstone's GSO Commits Up to $500 Million for Oil Drilling," Bloomberg, Jan. 2, 2015,http://www.bloomberg.com/news/articles/2015-01-02/blackstone-commits-up-to-500-million-for-oil-drilling-with-linn.

4.Banerjee, Devin, "Blackstone 'Scrambling' to Invest in Oil and Gas," Bloomberg, Jan. 29, 2015http://www.bloomberg.com/news/articles/2015-01-29/blackstone-scrambling-to-invest-in-energy-assets-james-says.

5.Banerjee, Devin, "Blackstone's GSO Commits Up to $500 Million for Oil Drilling," Bloomberg, Jan. 2, 2015,http://www.bloomberg.com/news/articles/2015-01-02/blackstone-commits-up-to-500-million-for-oil-drilling-with-linn.

6.Banerjee, Devin, "Blackstone's GSO Commits Up to $500 Million for Oil Drilling," Bloomberg, Jan. 2, 2015, http://www.bloomberg.com/news/articles/2015-01-02/blackstone-commits-up-to-500-million-for-oil-drilling-with-linn.

7."Energy Update: Risk and Opportunity Amid Falling Oil Prices" December 2014, "NGP v. ATP: Should Overriding Royalty Interest Owners Be Concerned?" March 2014.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Omar Samji
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions