CHAPTER 4 The First Days: Unique E&P Issues

• Jurisdiction: United States

CHAPTER 4 The First Days: Unique E&P Issues

A. Financing an Entity During the Case

To effectively reorganize, an E&P company needs cash, at the very least, for basic operating expenses. The goal is to spend just enough money to retain key employees, maintain the most important leases and/or contracts, pay necessary oil and gas service providers, and otherwise continue to operate the business on as lean a budget as possible. This often does not include new drilling activity. However, there are some cases where putting together and implementing a drilling budget makes sense and, in fact, will benefit creditors by increasing the value of the estate. There are two common scenarios. One is where important leases have continuous drilling obligations that require new drilling to maintain the lease and a determination has been made that there is value on the lease. The other is when an E&P company is a party to a farm-in agreement. In the latter case (where the debtor is earning acreage by drilling), the value of maintaining that contract can be worth expending capital to drill new wells. Toward this end, an analysis of key contracts and leases must be undertaken to prioritize expenditures. Once this is accomplished, an E&P company can estimate the required cash flow. Occasionally, this cash flow comes from the use of cash collateral — primarily accounts receivable from joint interest billings (JIBs) and the proceeds from the sale of production. More often, additional financing is needed in the form of a DIP loan.

JIBs could be a significant source of cash flow where the debtor is the operator and the other non-operating working interest owners own a substantial percentage of the working interest in a given well or lease. Issues could arise if there are mineral lien subcontractor liens threatened or filed against the JIB obligor. If so, it is possible that the JIB obligor will suspend payment of JIBs until mineral liens are released. Where the E&P debtor is the JIB obligor (i.e. the non-operator), there will be a concern on the part of the operators that the debtor will be unable to pay its proportionate share of drilling, completion and LOEs. There are provisions in most standard JOAs aimed at protecting the operator in the event a non-operator becomes a debtor in bankruptcy, such as the operator's right to net the debtor's production revenues against overdue JIB payments and the institution of certain liens to protect against nonpayment. In addition, on the part of vendors, mineral subcontractor liens can be filed against the debtor's working interest if vendors are not being paid. This is an unusual situation, as in most cases the nondebtor operator sees to it that vendors are paid.

In determining the expected net JIB balance, an analysis must be undertaken of whether the JIB obligor has any setoff or recoupment rights and whether any such rights have been exercised. With regard to the lease portfolio, the practitioner must perform a state-by-state analysis to determine what rights, if any, mineral lien claimants have in JIBs. For example, if there are Texas properties, be prepared to argue that JIBs are not subject to the liens of mineral contractors. In other states, determine whether JIBs are subject to the liens of mineral contractors. Either way, the JIB obligor may have the right to suspend payment.

For most E&P companies, the primary source of cash flow comes from the proceeds of production. Under the UCC, depending on the structure of the transaction, some operators have a lien in the production itself to secure payment from the purchaser for the proceeds of production.

B. Mineral Lien Claimants

If interim DIP financing is sought during the "first day" hearings of a bankruptcy case, and if the DIP lender's liens will prime creditors holding senior secured liens, then an offer of adequate protection should be contemplated and made for claimants who will be primed. In addition, even if such liens do not seek to prime the senior mineral lien claimants (i.e., those who would otherwise be first in time, so first in right), adequate protection will have to be offered to the extent that the priming of any bank liens pushes mineral lien creditors further down the line.

C. Royalty and Other Payments

In most oil and gas-producing states, future royalty interests are real property. This is true in states such as Texas,²⁴⁴ Wyoming,²⁴⁵North Dakota,²⁴⁶ Colorado²⁴⁷ and California.²⁴⁸ Generally speaking, Louisiana law also provides that royalty interests are real proper-ty.²⁴⁹ In Oklahoma, a royalty interest that is unaccrued is real property, but once the royalty owner receives his distribution and the interest has been reduced to possession, it becomes personal property.²⁵⁰ The right to receive royalties does not arise until the product is sold. Typically, as to oil, this occurs the following month, and as to gas, this occurs two to three months from the end of the production month.

The Bankruptcy Code does not permit a distribution to unsecured creditors other than pursuant to a confirmed plan of reorganization except in limited circumstances. The question, then, is when is the appropriate time to pay pre-petition royalty claims: (1) during the first days (with the argument usually being that "imminent harm" will come to the estate), (2) between the interim orders and the final orders on DIP financing and/or use of cash collateral, or (3) at the end of a case as part of a confirmed plan of reorganization?

A royalty owner with unpaid pre-petition royalties is arguably an unsecured creditor and not generally entitled to have pre-petition royalties paid except as part of a confirmed plan. A current trend, however, is to have a lease with a termination provision for failure to pay royalties or give royalty owners a secured claim under a statutory or contractual lien. It may be a distinction without a difference because in modern E&P bankruptcies, most often early in a case (usually as part of first-day motions), the debtor seeks to pay pre-petition royalties. The business reasons for the desire to pay unpaid pre-petition royalties include the practical need to have a good working relationship with the landowner on whose land the entity is conducting operations (especially if the mineral interest owner is also the surface owner).

One basis under the Bankruptcy Code for granting a debtor the right to pay pre-petition royalties outside of a confirmed plan of reorganization is found by reading § 105(a) of the Bankruptcy Code together with § 363.²⁵¹ Section 363(c)(1) of the Bankruptcy Code provides that "[i]f the business of the Debtor is authorized to be operated under section 721, 1108, 1203, 1204, or 1304 of this title and unless the court orders otherwise, the trustee may enter into transactions, including the sale or lease of property of the estate, in the ordinary course of business, without notice or a hearing, and may use property of the estate in the ordinary course of business without notice or a hearing."²⁵² A bankruptcy court may also grant relief under § 363(b)(1), which allows a debtor to use, sell or lease property of the estate, after notice and a hearing, outside the ordinary course of business.²⁵³ In some instances, courts have been willing to allow payment of certain pre-petition "critical vendor" claims before the confirmation of a plan, although such "critical vendor" orders are not expressly authorized under the Bankruptcy Code.²⁵⁴ It is in no way cut-and-dried case law that "critical" royalty owners may be paid before other unsecured creditors,²⁵⁵ and this area of the law remains ripe for debate in current oil and gas bankruptcy cases.²⁵⁶

Another argument could be that royalty owners are owed a fiduciary duty by operators and therefore should be paid before other unsecured claimants. Despite the characterization as real property, in most states the duty an operator owes to the royalty owner is not a fiduciary one; rather, each side is simply bound to each other by the terms of the contract: the lease.²⁵⁷

This is not necessarily the case in Oklahoma, where a fiduciary duty has been recognized in certain limited contexts.²⁵⁸ In Young v. West Edmond Hunton Lime Unit,²⁵⁹ the Oklahoma Supreme Court — without recognizing that the relationship between an operator of any oil and gas well is fiduciary in nature — recognized a...