CHAPTER 1 STRATEGIC PATHS FOR ENERGY COMPANIES IN DISTRESS

• Jurisdiction: United States

Bankruptcy and Financial Distress in the Oil & Gas Industry: Legal Problems and Solutions (Oct 2020)
CHAPTER 1
STRATEGIC PATHS FOR ENERGY COMPANIES IN DISTRESS
Sarah Link Schultz ^*
Matthew Warren ^†

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SARAH LINK SCHULTZ handles large, complex restructuring cases and out-of-court corporate reorganizations for public and private companies, as well as for alternative investment funds. She routinely handles representations for both debtors and creditors. Sarah is dedicated to understanding the intricacies of her clients' businesses and tailors legal strategy to meet those commercial objectives.

MATTHEW WARREN is a finance partner in King & Spalding's Chicago office, advising clients on restructuring matters with a particular emphasis on distressed debt and insolvency issues. Mr. Warren represents lenders and bondholders, as well as companies, in connection with restructuring and insolvency related matters. Mr. Warren was named to the American Bankruptcy Institute's 2019 "40 Under 40" Emerging Leaders in Insolvency List. He was also recognized for his work in Bankruptcy and Restructuring by Chambers USA 2019 and Turnarounds & Workouts named him a 2018 Outstanding Young Restructuring Lawyer. Mr. Warren is a member of the American Bankruptcy Institute and teaches as an adjunct professor of Bankruptcy Law at the DePaul College of Law. He regularly speaks and writes on bankruptcy topics.

ABSTRACT

Financial distress is not new to the energy industry. In the last decade alone, the industry has experienced two of the worst energy crises since World War II. The first was the result of a sudden plunge in oil prices between 2015 and 2016. The second resulted from another plunge in oil prices that was further exacerbated by the COVID-19 pandemic. During distressed times, energy companies may think that their options are limited because of burdensome debt obligations, contracts, leases, or the regulatory environment. Not so. For each period of financial distress, options exist that a company can pursue to maintain the value of the business as a going concern and emerge from financial trouble successfully. To pursue those options, though, the company must undertake an in-depth analysis of its operations, its capital structure, the macroeconomic environment, and the restructuring options available, whether in-court or out-of-court. In doing so (and doing so early), energy companies may be able to restructure their balance sheets, streamline their operations, and exit financially distressed times in a position to succeed.

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INTRODUCTION

The energy industry has experienced one of the most financially turbulent decades in recent memory. Between mid-2014 and early 2016, the global economy experienced one of the largest oil price declines since World War II, triggered by the Organization of Petroleum Exporting Countries' announcement that it would no longer act as a swing producer of oil. The reaction was swift. West Texas Intermediate oil prices declined 52% in six months, falling from a high of $105 per barrel in mid-2014, to $50 by the beginning of 2015, and bottoming out at $26 per barrel in February 2016.¹ That decline led to oil and gas companies experiencing severe financial distress. At least 67 companies filed for bankruptcy in 2015.² The total number of companies that filed for bankruptcy between 2015 and 2017 was about 300.³

The downturn was not the sole source of the problem, though. Oil and gas companies were in many cases over-levered, with unwieldy capital structures that did not provide the flexibility necessary to navigate that period. Moreover, many companies were parties to undesirable contracts and leases, further restraining operations. And on top of those problems, the regulatory framework in place at the time put a further burden on energy companies.

By mid-2017, however, the energy industry recovered, and companies that had restructured their debt obligations were thought to be in a better position to succeed. Oil prices recovered, and there was a reduction in drilling and operating costs.

But in late 2019, the COVID-19 pandemic and yet another significant drop in oil and gas prices—enhanced due to government-instituted travel restriction—erased much of that recovery. Oil and gas reserves increased dramatically (which helped keep prices further depressed). The result was over thirty-five North American oil and gas producers filing for bankruptcy between January and August 2020.

What the past ten years have shown is that financial distress is not new to the energy industry. Although the effects are difficult and require making tough decisions, companies are not without options during financially distressed times. Indeed, such times may create opportunities for companies by allowing them to reorient themselves. As was the case during the previous energy crisis, companies may have the opportunity to emerge as leaner entities with better balance sheets, less burdensome contracts and leases, and simplified corporate structures. As this Article will show, energy companies in financial distress may have options available that can allow companies to navigate financially difficult times and emerge successfully.

This Article proceeds in three parts. The first part identifies factors that can cause financial distress for an energy company, focusing on internal and external sources. It also addresses key drivers in a distressed scenario that, recognized early, can position a company to better navigate a

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crisis. The second part addresses the restructuring options available to a company both in- and out-of-court, along with the benefits and costs of each approach, the different types of in-court restructurings a company can use to reorganize, and relevant considerations for bankruptcy cases in the event a company decides to pursue an in-court restructuring. Finally, the third part provides an overview of key considerations a company should contemplate if and when it decides to file for bankruptcy. Those considerations include pre-bankruptcy planning, where to file the case, and relevant legal issues that energy debtors should consider. By understanding the factors causing financial distress, the options available in those situations, and how to approach a bankruptcy filing, a distressed energy company may be able to emerge from a turbulent period successfully.

I. AN OVERVIEW OF CERTAIN KEY FACTORS THAT MAY DICTATE A RESTRUCTURING SITUATION

An economically viable company experiencing financial distress needs to reorganize its capital structure in an orderly manner.⁴ Whether that restructuring occurs through an out-of-court workout or a chapter 11 bankruptcy filing, without action to address its issues head-on, the company risks substantial costs that may include losing customers, suppliers, and key members of the workforce; being unable to take advantage of desirable investment opportunities; or needing to divert further resources, attention and time away from the business to focus on restructuring-related matters as distress worsens.⁵

The general goal of all parties in a distressed scenario is keeping the business viable as a going concern.⁶ The alternative? Liquidating the business and—what accompanies most liquidations—a reduction of overall recoverable value to the detriment of all company stakeholders.⁷ To meet that goal, a company must assess several key factors so it can best determine what options are available: (1) the sources of financial distress—both internal and external; (2) the company's capital structure and main stakeholders; (3) the value of the enterprise as a going concern; and(4) the amount and availability of liquidity. A thorough analysis of these factors will help the company know what options are available and shape the backdrop against which to negotiate.

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A. General Overview of Common Causes of Financial Distress

Financial distress can be caused by both internal and external factors, although external factors may cause or worsen many of the internal problems. Indeed, they are often two sides of the same coin. The cause, or causes, of financial distress for a company and potential solutions or mitigants to the causes, along with the company's capital structure and terms of material debt and intercreditor related documentation, are often the most significant factors in determining the path of a workout or restructuring, the mechanics by which a restructuring will be effectuated, and determining the long-term viability of the business.

1. Internal Causes Financial Distress and Potential Solutions

Typical sources of internal financial distress stem from a few main sources. The first and most significant source is the company's keystone debt obligations and other material contracts with third parties. For example, the company may be overlevered, resulting in too much debt for an otherwise viable company to service. This problem is not uncommon in the energy sector as the energy industry is a highly capital-intensive line of business. Further hindering a company's attempts to delever, the loan documents governing that company's key debt facility(ies) may be overly constricting—e.g., high interest rates, unfavorable terms constraining operations, and burdensome restrictive covenants that the company is no longer able to comply with in the current, and perhaps previously unanticipated, market climate. A second common source of internal stress is that the company may be locked into expensive executory contracts or leases with vendors, equipment manufacturers, and material suppliers—hampering the company's cash flow and liquidity. Poor management, high levels of management turnover, or both can also exacerbate each of these problems.

But for each internal cause of financial distress, solutions may potentially exist to resolve the problem. An energy company with too much leverage may be able to negotiate a consensual exchange or liability management...