CREDIT ISSUES IN INTERNATIONAL OIL & GAS TRANSACTIONS

• Jurisdiction: Derecho Internacional

International Mining and Oil & Gas Law, Development, and Investment
(Apr 2013)
CHAPTER 23A
CREDIT ISSUES IN INTERNATIONAL OIL & GAS TRANSACTIONS
Mitchell Ayer
Partner, Thompson & Knight
Houston

MITCHELL E. AYER is a Partner in Thompson & Knight's Oil and Gas Practice Group and Bankruptcy Practice Group in the Firm's Houston office. He represents service companies, lenders, and oil and gas companies in various collection and bankruptcy matters. Mr. Ayer also counsels clients in acquisitions and dispositions of oil and gas properties and natural resource companies. He has several reported oil and gas cases in state and bankruptcy courts. Mr. Ayer is Board Certified in Oil, Gas, and Mineral Law and Business Bankruptcy Law. Mr. Ayer received his J.D., magna cum laude, from the University of Houston Law Center, his M.B.A from Cleveland State University, and his B. A. from Wittenberg University. He is a frequent speaker on oil and gas credit matters. Mr. Ayer was named to The Best Lawyers in America® 2012 for Oil & Gas Law and has been named to Texas Super Lawyers® for multiple years. He is currently President of the Houston Bankruptcy Inns of Court and is past chair of the Houston Bar Association Oil and Gas Section. He served on the legendary Coast Guard Cutter Bibb from 1972 to 1974.

Contents

I. CREDIT DECISION

II. CREDIT SUPPORT

A. Guaranty

1. Parent Guaranty

2. Individual Guaranty

3. "Bad Boy" or springing guaranty

B. Advance Payment

C. Letter of Credit/standby letters of credit

D. Periodic renewal of password and/or discontinue services

E. Security/Assignment of oil and gas interests

F. Statutory liens

1. Mechanicman's and materialmens liens for provision of goods and services

2. First purchaser liens for sale of oil and gas

G. For Working Interest owners

1. Operator/non-operator lien

2. Non-consent penalties: forfeiture of interest for non-payment

3. Withering Option (new in 2012 JOA)

4. Restrictions on sale of working interest to financially capable assignee

5. Trust fund for decommissioning obligations (new in 2012 JOA)

6. Offset rights

7. Sale while in default (new in 2012 JOA)

8. National Oil Company Carry (new in 2012 JOA)

9. Default if Indemnification Not Paid (new in 2012 JOA)

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III. QUOTE, BID, PURCHASE ORDER CHECKLISTS (for vendors)

IV. LEGAL DOCUMENTATION & CONTRACT

V. INVOICING

VI. COLLECTION

VII. ENFORCEMENT THROUGH THE COURTS/ARBITRATION

VIII. CONCLUSION

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INTRODUCTION¹

The purpose of this paper is to give an overview² on how to get paid on oil and gas transactions. Credit departments have a critical rule in the extension of credit and successful collections. This requires an understanding of the role of the credit department and the role of the lawyer. This presentation is principally from the viewpoint of service providers and working interest owners.³

The basic steps in the credit and collection process are as follows:

I. CREDIT DECISION

Credit risk management is predicated on the existence of risk and uncertainty. Credit risk arises whenever a party is exposed to loss from a borrower, counterparty, or an obligor who fails to honor their debt obligation as they have agreed and contracted.⁴ A more varied but also descriptive definition of credit is given by the Economist Dictionary of Economics, which states that credit is the "use or possession of goods or services without immediate payment," that "credit enables a producer to bridge the gap between the production and sale of goods," and that "virtually all exchange in manufacturing, industry and services is conducted on credit."⁵

Any transaction which does not involve immediate payment in cash has a credit decision - whether conscious or not. On the next page is the credit information checklist used by one of the leading service companies.

The amount of credit must be sufficient for both estimated costs plus indemnification obligations. In case of a blowout, or major spill, these can be huge. BP incurred in excess of $61 billion for the Macondo spill and cleanup.

The starting point to setting a credit limit is an understanding of the needs and requirements of the customer. What is the customer asking for and subsequently what will be its requirements periodically? If the customer is creditworthy, then would you as a customer want to set a credit limit for the customer higher than what is being sought in order to save time in the future? (i.e. if credit limits are to be increased later due to increased sales volume)

Below is information to look for when establishing a credit limit:

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a. Country Risk - Political and economic position of the country the company is headquartered.

b. Financial Statements: Most important piece of data. Mainly ratios or factors like net worth and working capital are taken, trended, and compared to Industry norms or standards. If liquidity and efficiency ratios are per industry norms, this supports establishing the credit limits. One has to also consider if short-term liquidity is important or meaningful to the nature of the credit or is long-term liquidity more consequential.

Some companies will focus on tangible net worth or net working capital when establishing a credit limit. Another ratio that is of importance is the 'Debt to Equity Ratio'. The ratio shows how the company is leveraged and shows the stake of the lenders compared to the owners. A secured creditor may request to maintain a certain level of debt to equity. Otherwise, upon default, such loans become payable upon demand, which could lead to a sale of assets or prepayment of the loan. If this ratio is within industry norms and to the satisfaction of the secured lender, then a more liberal approach can be taken in setting a credit limit. The "Days Sales Outstanding" also known as DSO is an indication of the quality of a company's receivables. If the DSO is in line with the norms for the industry, then a liberal approach can be taken in setting the limit for this customer.

Also need to consider factors outside the financial statements before making a credit decision. For example, the company that is being assessed might have suits or judgments against them. On the other hand, the financial statements could be unaudited or company prepared.

c. Property Valuation - location of the oil and gas assets. Are other companies drilling in the surrounding areas?

d. Production Data - historic and future expectations.

e. Trade References - details the companies pay history with their current vendors. This provides the willingness of the customer to pay obligations in accordance with the terms of the sale.

f. Bank References - provides the line of Credit established by the applicant with the bank. This provides the ability of the company to pay their obligations.

g. Agency Credit Reports - Credit Agencies generally give two pieces of information in establishing credit limits: Payment performance and Rating.

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h. Payment Performance - This section lists the paying habits of the applicant. The information is collected from different suppliers to the applicant. Similar to trade references. It will give you high credits and the customer's payment habit in different dollar ranges. It is quite possible that, the customer might be a good payer in the dollar range that is being sought from you as a credit limit. Thus increasing your confidence level.

The Credit Interchange Division (CDD), operating as a cooperative venture among PESA⁶ member companies since 1955, facilitates the confidential exchange of up-to-date ledger experience among its member companies and divisions. CID currently maintains a database of over 50,000 ledger entries on nearly 10,000 existing and potential customers. PESA also gives seminars on international credit matters and conducts foreign service officer training.

i. The Rating - Based on certain credit and financial information obtained on the customer (your applicant), the Agencies assign ratings. These ratings can assist you in setting your own credit limits.

j. Past Performance - Credit Limit in this case is based on the past history of the customer as per the information contained in your books. The two elements that you would consider and weigh would be the past:

i. Payment performance

ii. Reputation of the applicant/ How long has the company been in business

iii. Purchase Pattern

II. CREDIT SUPPORT

The credit department will set the amount of credit, payment terms and credit support requirements.

Credit support consists of the many ways that the promise to pay is supported such as:

• Guaranty

1. Parent Guaranty

2. Individual Guaranty

3. "Bad Boy" or springing guaranty

• Advance Payment

• Letter of Credit/standby letters of credit

• Periodic renewal of password and/or discontinue services

• Security/Assignment of oil and gas interests

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o Statutory Liens

1. Mechanicman's liens for provisions of goods and services; and

2. First purchaser liens for sale of oil and gas

o For Working Interest owners

1. Operator/non-operator lien;

2. Non-consent penalties: forfeiture of interest for non-payment;

3. Withering Option (new in 2012 JOA);

4. Restrictions on sale of working interest to financially capable assignee;

5. Trust fund for decommissioning obligations (new in 2012 JOA);

6. Offset rights;

7. Sale while in default (new in 2012 JOA);

8. National Oil Company Carry (new in 2012 JOA); and

9. Default if Indemnification Not Paid (new in 2012 JOA)

A. Guaranty

1. Parent Guaranty.

As more and more international companies are looking to expand their businesses abroad, the importance of parent guaranties should not be ignored. Commonly, an international company planning to operate in another country will form a subsidiary entity to conduct the business in that country. This subsidiary entity ("Newco") typically has very few, if...