The global oil industry is facing its biggest crisis in peacetime in 100 years, as the toxic combination of the Covid-19 pandemic and oversupply drive prices to record lows.
While some producers will have hedged against falling prices, those arrangements will come to an end over the next few months, with the potential for serious impairment to both equity and bond valuations if conditions do not improve.
Hedging arrangements will buy management teams time to implement cost-cutting measures, but restructuring or insolvency may be inevitable for a significant number of businesses unless relationship banks are willing to provide forbearance. Even then, the weight of the debt burden may prove overwhelming and, whatever happens, management teams will be under scrutiny from their shareholders, lenders, bondholders and regulators.
Pinsent Masons acted on one of the industry’s largest cross-border collapses arising out of the 2014-15 price crash, giving us some insight into what might happen next. The longer the crisis, the more damage is done to underlying assets.
An oil price crash to $20 or $30 a barrel, or less, is likely to be damaging to a large variety of exploration and production (E&P) businesses, well run or otherwise. In such distressed circumstances, a small minority of managers may make rash decisions in order to protect their business or team or finances, rather than doing the right thing.
Restructuring or insolvency may be inevitable for a large minority of businesses unless relationship banks are willing to provide forbearance. This may involve cutting budgets which cause the breach of fundamental license obligations, compromise the safety of operations or generate environmental risks. Managers may also be tempted to take credit from suppliers knowing they cannot be repaid, or to misstate financials in order to obtain forbearance from banks or other creditors.
Stronger E&P companies biding their time before picking off cheap assets during this period of distress should be alert to the potential ‘corrosion’ risks to target assets if they leave it too long before making an offer. One cannot escape the possibility that there may be increasing incentives to hide damaging issues from potential buyers the longer this crisis continues.
Host states have been known to terminate hydrocarbons licence arrangements on grounds of economic distress short of insolvency. Financial difficulties may also trigger defaults under joint operating agreements and agreements with suppliers, as well as under finance documentation.
It is less well understood that in many jurisdictions, particularly in the Middle East, Africa and South Asia, licences – or licence interest documentation – may be imperilled, even if only one member of an unincorporated contractor association is insolvent. If only one joint venture partner, which need not be the operator, falls into distress, then the host state may have the opportunity to terminate licence arrangements for all joint venture partners. It is critical that E&P companies audit their licence arrangements and institute precautionary measures to guard against the insolvency of one of their joint venture partners should this seem likely.
Directors of distressed companies may eventually have to align to the interests of those higher up the credit chain such as banks, bondholders or speculative bridging lenders. Experience shows that these parties may contemplate litigation when little value can be salvaged elsewhere. They may target directors, offices, advisors, host states and other entities with deep pockets, as well as seeking to protect and ring fence assets.
This will create major challenges for office holders whose attentions are likely to be focussed on saving their business. It will be important for management to carefully study default provisions across their contracts and engage with creditors and other counterparties early in the process to pre-empt such disputes. Good relationships should also be maintained with team members, whose testimony may be critical in any formal process.
For buyers under long-term oil and gas sales agreements with ‘take or pay’ arrangements, the benefits of lower oil prices may be outweighed by the inability to find buyers or use for the product or, failing that, storage capacity.
We expect to see discussions around take or pay commitments and whether they can be diluted in the current price climate. Unless force majeure provisions assist, the distressed buyer may need to consider whether the take or pay provision is enforceable under English law or under the law of other common law jurisdictions.
Although reported cases where a buyer has succeeded in such circumstances are rare, the English courts have accepted the principle that such provisions could amount to penalty clauses as a matter of principle, and therefore be unenforceable. Against the backdrop of recent case law on the law of penalties, buyers will need to carefully analyse the structure of the take or pay obligation against the ‘loss’ to the seller it is purporting to cover.
Many long term natural gas and liquefied natural gas (LNG) sales provisions will price against a basket of indices, including oil. The oil price collapse may therefore have severe consequences for the gas price, even though in many such arrangements, particularly in Asia, the ‘S curve’ formula will neutralise the more drastic price effects.
Sellers will be considering whether one of the trigger points for a price redetermination can be relied on for the price to be reopened and, if so, the process to be followed and the basis for any price change. Parties should follow the precise terms of the contract as to how such a price redetermination right can be exercised and on what basis. Failure to do so can result in the loss of rights, as demonstrated by several recently reported court decisions.
Ultimately, parties will need to apply the relevant legal and commercial analysis to calculate where the various competing interests align. Joint venture partners, banks, bondholders, off-takers and regulators may all lose in a default situation, and a negotiated or mediated solution may be the best way forward for all concerned.
Given the many different stakeholders involved, a negotiated solution is likely to be the quickest and most cost effective approach to resolving a cross-border E&P collapse, where a company’s ability to comply with its obligations is permanently impaired.
Akshai Fofaria, Partner and specialist in energy projects and transactions at Pinsent Masons