Faced with a precipitous decline in oil prices and uncertainty about where oil prices will settle, lenders (banks and direct lenders alike) have been cautiously assessing the size and health of their exposure to the oil and gas sector. Conversely, for distressed debt investors the current environment presents opportunities to purchase debt below par owing by otherwise robust companies who are currently overleveraged. Already we are seeing significantly increased activity in this space by private equity houses, funds, and high-net-worth individuals.
The effect of the steep decline in oil prices may not be felt for a while where an exploration and production (E&P) company has protected itself through commodity hedging. However, the hedging is unlikely to be for more than a 12-24 month period, so if oil prices stay low for a prolonged period of time, the problem has only been deferred, not removed. Further, even where the E&P companies have been able to scale back by cutting discretionary spend, decommissioning and mothballing rigs, and deferring capital expenditure on development and revenue enhancing projects, a sustained period of low commodity prices is going to have serious consequences for many companies. The first casualties have been the smaller, independent E&P companies without the deep-pockets or diversified revenue streams of their larger counterparts and the oil service companies.
For borrowers, it is important that there is continued engagement with lenders well before the point when capital is needed. Both parties need to engage in "you help me and I help you" discussions well before the onset of any financial distress to facilitate pragmatic solutions which are in the interests of both. Lenders need to be cognisant of the fact that in a "twilight zone", directors will be concerned to avoid any personal liability for UK concepts such as wrongful trading and US concepts such as breach of fiduciary duty. Borrowers, on the other hand, need to manage the lenders' expectations by communicating with them well in advance of any delay in filing audited financial statements, failure to satisfy relevant going concerns test or announcements to the relevant regulatory authorities where securities are listed.
Lenders may well insist on preparing contingency plans which are likely to cover a range of options from the divestment of non-core assets, through refinancing the debt from other sources, debt for equity arrangements and schemes of arrangement to pre-planned insolvency processes. This in turn will require a detailed consideration of the rights and options open to all relevant stakeholders. For example, a default under an RBL facility may result in cross-defaults under bond issuances, mezzanine facilities or letters of credit. Similarly, the impact of any restructuring, change of control or insolvency process needs to be considered in the context of any termination rights or consent requirements under joint venture agreements, licenses, leases, and other key contractual arrangements to ensure continuity of supply. The position will of course differ dependent upon the relevant governing law, the type of insolvency process, and the impact and requirements of that insolvency process in the jurisdiction where assets are situated, where different. For example, the termination of a contract by a counterparty typically would infringe the automatic stay triggered by the Chapter 11 process in the US, whereas it would not infringe the moratorium triggered by an administration process in the UK. Other knotty issues to be considered would include the treatment of mineral, working and royalty interests, secret vendor liens and privileges, decommissioning costs and other HSE issues, and the impact of a default by a joint operating agreement party followed by insolvency, particularly where the defaulting party is the commercial affiliate of the State party to the project.
Even if not directly affected now by the steep decline in oil prices, borrowers may be adversely affected by the financial distress of others with whom they do business in this sector, just in the same way as the automotive manufacturers were a number of years ago with the Tier 1 and Tier 2 suppliers being the first casualties in the downturn faced in the automotive industry. For borrowers and lenders alike, few will be immune to any adverse impact of the sharp decline in oil prices. Consequently, anticipation and consideration of the above mentioned issues requires careful planning and communication, particularly against a backdrop of multiple jurisdictions and potentially ever changing financial stakeholders with the distressed funds being very active in this sector.