Law of Unintended Consequences
How to navigate the world of Alberta’s changing Liability Management Rating
WITH GREEN SHOOTS NOW EMERGING
from what has been one of the worst downturns in energy in a generation, one thing has been abundantly clear to us: Governments and regulators do not seem to have particularly auspicious timing with respect to changing the rules of the game. Nowhere is this more evident than with respect to the oil patch in Alberta. On the heels of an ill-timed royalty review, the province has enacted new rules with respect to the treatment of liabilities that relate to the abandonment and reclamation of wells.
By way of background, earlier this year, a precedent-setting bankruptcy case pitted the province against creditors. At issue was where a producer’s obligation to clean up an old well ranked relative to the obligations of banks and lenders. In the insolvency of Redwater Energy, the Alberta Energy Regulator (AER) asked for a ruling that would prioritize that any money raised through the sale of the company’s assets be used first to decommission its roughly 70 inactive wells. The crux of the case seemed to be centred around whether or not the province should be on the hook for these obligations. Unfortunately for the province, the court ruled in favor of the creditor, thus allowing financial institutions to recuperate outstanding debts ahead of any decommissioning activities. As such, those assets would fall under the responsibility of the Orphan Well Association (OWA), which is not particularly well-funded, and will be even less so if there is a wave of bankruptcies yet to come.
In response to the ruling, the AER has rolled out more stringent financial requirements for companies looking to transact in oil and gas assets. Previously, producers were required to post security if their Liability Management Rating (LMR) fell below 1.0 as part of a standardized formula. The new regulatory measure requires that purchasers of AER-licenced assets have an LMR of 2.0 or greater, pro forma proposed acquisitions. The implication is that potentially acquisitive companies like Pine Cliff Energy and Cardinal Energy may have difficulty executing their business strategies, especially since both have historically relied on acquisitions to grow. By enacting these changes, the province is obviously trying to protect taxpayers from liability for the large numbers of abandoned and yet-to-be-reclaimed wells.
Approximately 72 percent of licenses in the province currently have an LMR less than the critical 2.0 threshold. Despite an average LMR of 3.7 province-wide, the implication is clear that the government has thrown a wrench into the industry’s ability to transact during the downturn. Penn West Petroleum’s CEO recently said he believes there are 500 or so companies that are now effectively frozen out of the asset transfer market.
A significant part of the solution to the industry’s woes seems to be the ability of producers to transact. Assets from weaker hands need to be transacted into the hands of stronger, better capitalized companies. Impediments to the healing process are almost certain to increase bankruptcies and impair the ability of some companies to emerge from this commodities rout any stronger—if at all. The curious irony is that this has the potential consequence of accelerating bankruptcies, and could even see an influx of wells enter the orphan well fund. In the absence of a softening of this AER stance, investors might want to increase their weighting to defensive entities with strong balance sheets, access to capital and LMR ratios above 2.0—or perhaps even look outside of Alberta.