CHAPTER 10 ACQUIRING OIL & GAS ASSETS FROM A DISTRESSED SELLER OUTSIDE OF BANKRUPTCY

• Jurisdiction: United States

Financial Distress in the Oil & Gas Industry
(Feb 2010)
CHAPTER 10
ACQUIRING OIL & GAS ASSETS FROM A DISTRESSED SELLER OUTSIDE OF BANKRUPTCY
Christopher L. Richardson
Davis Graham & Stubbs LLP
Denver, Colorado

Christopher Richardson is the managing partner and a partner in the Corporate Finance & Acquisitions Group at Davis Graham & Stubbs LLP in Denver. His corporate practice focuses on mergers and acquisitions and financing work, primarily in the purchase and sale of privately held companies. Many of his transactions have been in connection with leveraged buyouts and buildups of platform or portfolio companies. In addition, he has substantial experience in transactions involving oil & gas and coal companies in both the context of purchase and sale transactions as well as day-to-day operational matters. He also has significant financing experience, and has represented venture capital groups, institutional lenders and equity participants in loan and restructuring matters. Chris has represented western coal producers in various aspects of their operations. He has represented Rio Tinto Energy, Colowyo Coal Company, Peabody Energy, Westmoreland Coal, Triton Coal Company, Vulcan Capital Management, and Montana Power in matters ranging from utility bankruptcies, preparation of long-term coal supply agreements, joint-venture coal projects and in major purchase and sale transactions and structured financings. Additionally, he has substantial experience in bankruptcy and creditors' rights matters. He has worked with creditors, debtors and creditors committees in numerous Chapter 11 proceedings (Standard Metals, MiniScribe, Colorado-Ute Electric Association, Formus Communications, NII Holdings, Schwinn Bicycles, among others), buying and selling companies out of Chapter 11, as well as reorganizing or liquidating debtor companies. Recently, he represented a purchaser in successfully acquiring the assets of an oil and gas company in a competitive auction in a Wyoming bankruptcy matter. Chris is currently representing an oil & gas client with a significant unsecured claim in the Sem Crude bankruptcy pending in the Delaware bankruptcy court. He has lectured on acquisition agreements, deal structures, debtor-creditor issues, including the impact of bankruptcy on environmental laws, lessor-lessee relationships in bankruptcy, bankruptcy current developments, and the sale of assets in a bankruptcy.

Table of Contents

Introduction

Identifying the Distressed Seller

Transaction Risks for a Buyer or Seller Where the Seller Is a Distressed Seller

Structure of the Acquisition

Confidentiality Agreements

Exclusivity or No-Shop Provisions

Risks to the Buyer Notwithstanding A Good Sale Process

Environmental Claims and Royalty and Tax Claims

Tax Payment Issues

Environmental Claims

Successor Liability Issues

Fraudulent Conveyance Risks for the Purchaser

Conclusion

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Introduction

Since the summer of 2008, the oil and gas industry has been hit with a series of extraordinary changes both within the industry and in the world's financial markets. Beginning with the belief frequently discussed in 2007 and 2008 that the world had reached "peak oil,"¹ oil was rightly viewed as a finite resource. With the rapidly increasing demand emanating from the robust economies of China and India, it was widely believed that the world was rather quickly going to have to pay significantly more for this dwindling but essential commodity. Prices for oil and gas spiked in the United States, pushed upward in part by the weakening of the U.S. dollar. Banks, hedge funds and private equity companies flooded oil and gas companies with their funds following the upward spike in energy prices. Second lien financings were common with the lenders and borrowers confident that such increased debt levels were sustainable and preferred over dilution that would result from an IPO or follow-on offering.

Economists have debated the point, but it is not clear whether the price spike in oil and gas in the first half of 2008 was demand-driven or the convergence of a series of speculative forces.² The increase in price was rapid and to many, sustainable. Whatever the precise cause, the next chapter of this story is well known. Oil and gas prices plummeted in the fourth quarter of 2008, with oil hitting 2004 price levels in early 2009.

In the United States, demand for gasoline began to drop in the first quarter of 2008 as the price for oil continued its upward push. People drove less and businesses focused on finding ways to do more with less. By the time the pricing bubble burst, demand was down throughout

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the United States and the rest of the world, as we careened toward the deep recession that engulfed us in the fall of 2008 and continues today.³

Compounding the difficulties in the drop in demand were the dramatically increased production costs incurred by E&P companies reflecting the spike in the commodity prices and the impact on the service providers and vendors to the producers. The costs in production remained high even as oil prices and gasoline prices fell, further compounding the earning woes for E&P companies. Taken together, E&P companies slashed their 2009 budgets, cutting capital and exploration line items with a vengeance. Companies became defensive with their capital investments, delaying or cancelling many significant capital projects, especially projects with high marginal costs of production such as off-shore drilling. While reducing expenditures of the company, the diminished exploration efforts further compounded some companies' status with their lenders as their oil and gas reserves shrank with a negative impact on the company's balance sheet.

As these problems spread through the oil and gas industry, another equally destructive force surfaced - the banking crisis and financial meltdown that hit the U.S banking and capital raising industries in the late summer and fall of 2008. Institutions thought to be too large to fail, disappeared or were propped up by the federal government. As the pricing for oil and gas production collapsed in the fall of 2008 and exploration efforts faltered, there was a massive waive of borrowing base redeterminations under senior credit facilities. The price drop itself reduced the borrowing base; however, cash strapped companies had failed to replace production or reserves, thus again compounding the producers' problems with their lenders. And, as we all

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know, major oil and gas lenders throughout the country and the world had (and have) their own financial problems which furthered tightened credit markets, thus limiting refinancing alternatives with the result being increased consolidation in the industry.⁴

With this as the backdrop, we turn to the topic of this paper - acquiring oil and gas assets from a distressed seller outside of bankruptcy.⁵ The financial distress of the seller can be the result of many causes - a lack of working capital caused by increases in operational costs coupled with a fall in the price of the production from the property, a decline in the borrowing base from the reduced reserve value, or a breach in a loan covenant. In any case, we have a decision by a company (with a little help from its lenders no doubt) that it must sell its assets and complete the sale quickly.

Identifying the Distressed Seller

For our purposes, we will assume that the seller is not in bankruptcy and not subject to any receivership proceedings. Signs of distress in public companies are more easily detected given the extensive periodic reporting requirements imposed on public companies by the Securities and Exchange Commission ("SEC"). Long before any breach of a material obligation of the company, the company's quarterly and annual reports plus any required filing brought about because of material events, should have informed the company's investors and other interested parties of the company's financial situation. If, for example, the company defaults under its credit agreement or enters into a forbearance agreement, the 8-K filing required by applicable SEC regulations will so advise the world. Additionally, if the company has publicly

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traded debt securities, the ratings of the debt will likely be down-graded by the applicable ratings agencies providing further notice to the world of the economic distress of the company.

Other than a bankruptcy filing or SEC disclosure for a public company, there are a variety of other signs that evidence the distressed company. While the most obvious signs of distress relate to excessive debt levels, there can be other causes of financial distress that are not remedied by simply restructuring the debt of the company. Does the company suddenly replace its CFO or accountants? Is a workout person or restructuring officer brought on board? If the company is overleveraged, was this caused by changes in costs and revenues in the industry or simply poor management? Or both?

If the company is subject to covenant defaults under its credit facilities, it is common for the company and its lenders (both the senior and second lien lenders, if any) to have entered into forbearance agreements or amendments to credit agreements that will provide limited relief for the borrower in exchange for its focused efforts to reduce debt through either a capital raise or sale of assets. Obviously, finding willing investors, even "vulture investors," can be difficult, so the asset sale effort is more common. By the time many distressed companies initiate capital raising or asset sale efforts, their trade debt may be too high for an equity investor to want to make a new investment. The company will no doubt require working capital for drilling programs or acquisition efforts and no thoughtful investor will want to see its new investment simply reduce debts or not otherwise have the benefits of a restructured balance sheet.⁶

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