Who’s Who Legal brings together Paulo Valois Pires of L O Baptista, Steven Otillar of Akin Gump and Brad Roach of Gibson Dunn to discuss issues facing energy lawyers and their clients in the industry today.
Paulo Valois Pires: In Brazil, I would say the discussions on the bills presented to Congress which, when approved, will allow other companies besides Petrobras to operate in the pre-salt polygon. This could be a major change with new opportunities for IOCs intending to participate in the pre-salt venture.
Steven Otillar: While there have been myriad changes in many US jurisdictions with respect to unconventional and onshore operations to regulate hydraulic fracturing, to ensure disclosure of chemical proppants and to regulate operational matters such as reinjection wells and methane capture, one of the the most dramatic regulations issued recently relate to offshore oil and gas operations.
Six years after the Macondo blowout in the Gulf of Mexico, the US came out with comprehensive offshore well-control and safety regulations. While there was substantial industry input after draft regulations were introduced, many IOCs have indicated the cost of complying with the final regulations issued will exceed $25 billion. In the current low-price environment, the regulations could force number of players out of the market and have a dramatic impact on future offshore activities.
In addition to my domestic practice, I represent a number of clients in several emerging markets, most importantly Mexico. We have seen a number of regulations ranging from metering regulations and submission of appraisal and development plans to new bidding rounds, with their attendant tender rules and form contracts that regulate a company’s rights and ability to explore, develop and produce hydrocarbons in Mexico. There are certainly far too many to list here, but the overall industry response is positive. The sentiment seems to be that the Mexican government is moving quickly (by emerging market standards). The regulators tend to recognise when they have deficiencies in issued regulations or policies, and they try to respond to industry feedback. New entities such as CENEGAS and ASEA have now been created and are also publishing their internal regulations (relating to natural gas transportation and environmental regulation, respectively).
Brad Roach: The position in Asia has been different to the challenges faced by oil and gas producers in North America, who have had to shut-in production and reduce drilling due to the depressed oil price. Accordingly, while companies have suffered from reduced prices for oil and oil-linked gas/LNG prices, the degree of financial stress has been different in that it is still economic to produce but cash flow has been significantly reduced. Against this backdrop, there have been a few sale processes involving large E&P companies, Chevron, Shell and ConocoPhillips are in the process of divesting certain assets in Indonesia, Myanmar and Thailand. Most companies are focusing on reducing costs and non-essential exploration and capital expenditure and downsizing headcount to operate in a lower oil price environment.
Paulo Valois Pires: Yes, we have seen a consistent M&A trend in Brazil. Petrobras has announced a huge divestment programme involving upstream, midstream and downstream assets. Our firm has been also deeply involved in the acquisition of distressed assets from upstream companies that have filed for judicial recovery.
Steve Otillar: In the US, private equity-backed management teams continue to lead A&D activity in the more productive basins. The deals we are seeing are very targeted on oil and gas horizons that can effectively produce returns in the high teens and above, based on current prices. There are some funds that are seemingly acting as aggregators taking acreage positions from larger E&P companies, presumably being able to cash-flow under current prices or weather the storm until higher prices solidify, and which provide substantial upside. From a price standpoint, most deals still seem to be focused on production, offering little value for proven undeveloped resources. I agree with earlier posts that echo reports in the industry: perhaps more than US$180 billion of investment capital remains on the sideline for A&D activity, waiting for buyers and sellers to finally agree on valuations in the current commodity price environment.
Brad Roach: Between 2009 and 2015, private equity sponsors raised about US$251 billion for investment in the energy sector. The continuing slump in oil prices is likely to strengthen their activity as distressed companies need funds to continue operations and are forced to divest assets to service debt. Private equity might be the only source of liquidity for many E&P companies, given the unwillingness of debt and equity markets to provide capital due to the oil price volatility and uncertainty regarding its outlook. Asia is a very different market for private equity sponsors compared to North America given the time it takes to commercialise a discovery, and the role of host governments who own typically own reserves using production sharing contract models and regulate their monetisation. There are a handful of active private equity sponsors in the market (KKR–Mandala, Brookfield/Macquarie– Quadrant Energy) but a lot of dry powder waiting in the wings looking for opportunities in a very competitive market for assets given NOC participation in most major assets sales.
Paulo Valois Pires: Private equity sponsors are looking for opportunities to buy distressed assets from domestic oil and gas suppliers. The drop in oil prices and real devaluation have aggravated the financial status of certain suppliers, who have filed for judicial protection under the recovery law and have approved programmes for the divestment of distressed assets. Private equity sponsors have been playing an important role in the acquisition of these certain assets.
Steven Otillar: They are playing a critical role, and seem to be out in front of riskier plays such as continued unvonventional development in the US and new market entrance into Mexico. The first exploration block in Mexico were awarded to private equity backed entities and the first private retail gasoline operations in Mexico are backed by private equity sponsors. We do not see substantial private equity participation in major infrastructure projects in Mexico due to the lower returns, but it seems the marjority of active asset buyers in the space are backed by private equity.
Paulo Valois Pires: Yes. Most of the insolvency disputes are related not only to the downturn of oil prices but are also a result of compliance issues arising from the so-called “Car Wash” investigation, which have severely punished major contracts involved in corruption disputes.
Steve Otillar: In the 2008 Great Recession, we saw 62 US E&P companies file for bankruptcy protection. As of January 2016, the number had only been 35 bankruptcy filings. The difference was that in 2015, many companies were able to drastically reduce CAPEX and increase debt, and they were supported by relatively robust hedges on their production. Since the beginning of the year, with no material price recovery, hedges rolling off and no further savings from cost-cutting, filings have increased and already surpass the total number of E&P company filings in the Great Recession. Estimates put the amount of equity and debt currently involved in bankruptcy restructurings at almost US$34 billion.
While prices have recovered from the US$20/barrel level, most believe the current market trend is “lower for longer”. Strategies of issuing additional equity, securing additional debt, selling non-core assets, and reducing LOE and overhead costs have largely been done. Thus, for a highly leveraged company, the rational decision may be to seriously consider restructuring to strengthen the balance sheet and allow for long-term survivability and success.
Our firm has been involved in most of the US and international insolvency proceedings in the energy space, both in-court and out-of-court, representing a variety of stakeholders.
Paulo Valois Pires: Yes, this is the trend in most Latin American countries. We have been seeing companies looking to buy producing upstream assets for low prices, with the expectation that the oil prices will increase in the upcoming months. This has been the strategy of certain players.
Steven Otillar: From a domestic and international perspective, we have seen no slowdown in our work for private equity funds. They perceive the value in many segments, but their interest in the United States is basin-by-basin specific. All assets are not created equal, and while there can be relatively robust activity in the Permian Basin, areas with higher lifting costs continue to suffer.
Internationally, funds such as Riverstone have been active, investing dollar for dollar with domestically raised funds in some international markets. Firms such as KKR have invested billions in sale-leaseback transactions with entities such as PEMEX, that arguably lack the liquidity necessary to continue exploration operations and certain capital improvements in the current price environment.
Overall, however, I do not believe that buyers and sellers have reached a meeting of the minds on where prices will settle. Until that time, we will continue to see sellers offering non-core assets, and using other levers to strengthen their balance sheet. The difficulty of this strategy, however, can lead businesses to delay the inevitable, and then sellers will have substantially less leverage in purchase and sale negotiations which become necessary to satisfy any debt obligations.
We have also seen a significant uptick in purchases and sales through organised and pre-arranged bankruptcy processes. These can provide benefits to a buyer to receive assets free and clear of claims and provide the seller with much needed breathing room to handle any defaults under their existing capital structure.
Steven Otillar: Legal competition in the US domestic market has been fierce in the last several years. Many firms have been opening up energy practices, particularly in Houston for their upstream practices. These plans have been in the works since before the price crash in late 2014, and they have seemed to continue unabated. In the last year two major firms opened substantial offices in Houston, taking talented associates and partners from a variety of firms. Having been at a firm for one year that ended up exiting the market in a dramatic fashion, I remain wary of new entrants that may not be used to the cyclical swings of the energy market, and appreciate being at a firm with Texas roots and a long history in the energy space. It remains to be seen whether these new entrants will have the staying power to remain in the market long term.
Unlike 2014, where the pressure was on maintaining and expanding legal capacity, 2015 and beyond have seen pressure on maintaining workflow within certain segments of the industry. Domestic unconventional A&D that kept many firms extremely busy has substantially dried up and has been replaced by financial restructuring and corporate reorganisation. Firms with these disciplines have remained busy, while others have suffered. One relatively large firm with offices around the country in the key oil and gas jurisdictions simply closed its doors at the end of 2015 in light of the collapse of certain types of domestic oil and gas work.
Firms are also under price pressure from oil and gas clients, who are all suffering, and we strive to find alternative billing arrangements to ensure that our clients not only receive value from our services, but appreciate we want to be their partners for the long term.