Investment uncertainty in Alberta is a self-inflicted wound

January 2017 | PROFESSIONAL INSIGHT| FINANCE & INVESTMENT

Financier Worldwide Magazine

As the Rolling Stones recognised back in 1969, you can’t always get what you want, especially when it comes to securing new investment. The energy industry in Alberta is acutely aware of this lesson, as it has suffered not only a decline in revenue and investment in recent years, due to the sustained drop in global oil & gas prices, but significant regulatory interference has also stifled the market for potential sales, despite there being large numbers of prized assets available at significantly discounted prices.

Drop in capital investment

Capital investment was the largest contributor to Alberta’s economic growth between the 1990s and 2014. Government statistics indicate that oil & gas investment accounts for approximately 52 percent of the total capital investment in Alberta. Since the start of 2015, total mining and oil & gas investment is estimated to have fallen by 36.4 percent because of an economic downturn caused by lower oil & gas prices. Specifically, oil sands investment is estimated to have dropped by 37 percent, while investment in conventional oil & gas has fallen by an estimated 38.3 percent.

The decline in investment and oil & gas prices has had an effect, increasing the number of insolvent exploration and production (E&P) companies. According to the Alberta Energy Regulator (AER), in September there were approximately 85,000 inactive wells in Alberta and the stewardship of these properties is an issue that has been thrust into the spotlight as a result of the increased number of E&P insolvencies. This has led to questions being raised about the priority of environmental claims and the role of energy regulators in the insolvency proceedings of E&P companies.

Redwater proceedings

These issues came to a head in Redwater Energy Corporation (Re), where the court of Queen’s Bench of Alberta held that certain sections of the Oil and Gas Conservation Act and the Pipeline Act were inoperative to the extent that they are used by the AER to prevent the abandonment or renunciation of an insolvent debtor’s assets by a court-appointed receiver or trustee.

Before this decision, there was considerable regulatory uncertainty in oil & gas insolvencies due to the AER’s stated position in a number of insolvency files that it would not agree to transfer well licences associated with a debtor’s oil & gas assets unless all of the abandonment and reclamation obligations of the debtor were dealt with, either through a sale of those properties, or by providing sufficient funds to conduct such abandonment and reclamation. Effectively, the AER required satisfaction of environmental liabilities as a condition precedent to agreeing to transfer licences to a purchaser in a court-approved sales process.

In Redwater, the court officer in the receivership and bankruptcy proceedings, and the secured lender, challenged the AER’s position on the transfer of Redwater Energy Corp.’s well licences. The court ultimately held that the court officer could renounce its interest in certain assets of the debtor and that the AER could be compelled to transfer the well licences to a purchaser in those circumstances, bringing what was hoped to be some semblance of certainty to court officers and lenders in this sector. The AER and Orphan Well Association (OWA) immediately appealed the decision to the Alberta Court of Appeal. A full panel of the Court of Appeal heard the appeal on 11 October 2016, but, to date, no decision has been rendered.

On 20 June 2016, the AER also released Bulletin 2016 – 16 (Bulletin – 16) which outlined its response to the Redwater decision and created significant new uncertainty for both solvent and insolvent parties with respect to the sale of oil & gas properties. Bulletin – 16 specified three interim regulatory responses to Redwater, which became effective immediately. Of particular concern was the AER’s new requirement that all transferees have an LMR of 2.0 or higher post-transfer to receive licence transfer approval, which represents a significant departure from the current licence transfer requirements.

Previously, Directive 006: Licensee Liability Rating Program and Licence Transfer Process, only required a transferee to have an LMR of 1.0 or higher. As a result, under Bulletin – 16, the AER could deny a licence transfer application, even when the potential purchaser had an LMR of 1.65 and, as result of a sale, its LMR either remained unchanged or increased post-transfer but remained below 2.0.

Impact on sales

Borrowing base financing is often called reserve-based lending and involves the extension of credit to a borrower based on the expected present value of future commodity production, taking into account factors such as the volume and type of reserves and the expected future commodity price, among other things. Where the expected future price of a commodity drops, the amount that the borrower is able to borrow, or have outstanding, may be reduced.

In the currently depressed energy market, many licensees have been forced to market both core and non-core assets in an effort to ensure they comply with their existing credit facility obligations or the recalculation of their borrowing base, which is generally done twice a year.

As of the 5 November 2016 LMR Report, only 237 of the 769 licensees in Alberta had an LMR of 2.0 or higher. Accordingly, Bulletin – 16 has had the effect of significantly reducing the number of eligible bidders for oil & gas assets, which, in turn, is likely to reduce potential offers for distressed oil & gas assets (both in number and quantum) and further increase the risk of distressed owners becoming insolvent. Those licensees with an LMR of 2.0 or greater now face decreased competition for the purchase of distressed assets and one effect of this decrease in competition may be a decrease in the price paid for distressed assets. Bulletin – 16, therefore, has the probable effect of not only increasing the number of orphan wells but also decreasing the recovery from allowed transactions by artificially restricting the number of eligible purchasers.

In response to heavy criticism from industry, the AER has made attempts to soften its stance with respect to the new LMR requirements. On 8 July 2016, the AER released Bulletin 2016 – 21 which relaxed the absolute minimum LMR requirement in Bulletin – 16. The AER’s current policy is that it will look at proposed deals on a case-by-case basis and may allow a licence transfer to occur when a transferee can provide evidence that it will be able to meet its obligations throughout the life cycle of energy development of its assets with an LMR of less than 2.0. Contrary to the AER’s stated goal of protecting the public, the new LMR policy may actually result in an increase of orphan properties, due to the increasingly limited pool of purchasers who are eligible to assume these obligations and, in the absence of clear criteria, creates more uncertainty than the absolute LMR threshold.

To increase the number of prospective bidders, to ensure the integrity of sales processes, and to maximise the value of debtors’ assets, court-appointed receivers and trustees may be left with no other option except to disclaim all licensed assets that could negatively impact a potential purchaser’s LMR. As a result of Redwater, creditors have increasingly begun to request language in receivership orders that specifically recognises the right of receivers to disclaim assets, even though the receivership order in Redwater contained no such provision. Unless the Redwater decision is upheld by the Alberta Court of Appeal or the provincial government introduces legislation which deals with abandonment obligations in a way that does not conflict with the federal bankruptcy regime, this practice is unlikely to stop.

To date, the AER’s arguments have received mixed treatment by courts in Alberta. However, the release of Bulletin – 16 and the fact that the AER continues to question the ability of court officers to disclaim assets indicates that, until the Court of Appeal determines whether or not to allow the appeal of the AER and the OWA, it will continue to advance arguments and interim measures to address the surrender of oil & gas properties in Alberta. This regulatory uncertainty is likely to have a continued negative impact on parties seeking to address the significant drop of investment in the province. In the event the appeal is not allowed, the provincial government is expected to introduce new legislation to address the impact on the AER of the Redwater decision. Only time will tell if the Alberta government will recognise its impact on the economic recovery process and stop creating what is currently a toxic environment for capital.

Kelly Bourassa and Ryan Zahara are partners and Chris Nyberg is an associate at Blake, Cassels & Graydon LLP. Ms Bourassa can be contacted on +1 (403) 260 9697 or by email: kelly.bourassa@blakes.com. Mr Zahara can be contacted on +1 (403) 260 9628 or by email: ryan.zahara@blakes.com. Mr Nyberg can be contacted on +1 (403) 260 9707 or by email: chris.nyberg@blakes.com.

Kelly Bourassa, Ryan Zahara and Chris Nyberg

Blake, Cassels & Graydon LLP