After Redwater: What Now?

2019-02-07

Victor Kroeger

According to a recent Supreme Court of Canada decision released on Thursday, January 31, 2019, the assets of insolvent exploration and production companies must go first to reclaiming abandoned wells before paying creditors. The majority 5:2 decision — Orphan Well Association v Grant Thornton Ltd. (o/a Redwater) — overturned an Alberta Court of Appeals judgment in February 2018 and largely bucked predictions Canada’s highest court would side with the previous interpretation of Canada’s Bankruptcy and Insolvency Act (BIA).

Lenders, receivers, resource firms, investors and the public are all understandably concerned about the potential ripple effects Redwater will have across the sector and the broader Canadian economy. The decision calls into question how creditors will recoup their losses when exploration and production companies become insolvent and how investors will respond to the increased risk of playing in the Canadian resource sector.

In addition, the Alberta Energy Regulator may now be tasked with realizing on the producing assets of insolvent companies to satisfy abandonment and reclamation obligations as such claims will take precedence to secured lenders. Below is a discussion of some of the potential implications and what to expect in the new landscape.

NEGATIVE: Lending Embargo and Loss of Junior and Intermediate Companies

With recent low energy prices, banks have already curtailed their lending appetite to firms in the oil and gas sector. Following the Redwater ruling, banks may pull back from junior and intermediate exploration and production (E&P) companies altogether until they can make sense of the new landscape and amend their lending policies.

In the short term, this will reduce investment in oil and gas exploration and production — and (by association) the money that trickles down to oilfield service outfits and other ancillary businesses, such as hotels, house builders, restaurants, etc.

Could that mean only larger exploration and production outfits will survive? Time will tell. However, many junior and some intermediate E&P companies have already disappeared due to a lack of pipeline capacity, low energy prices and the disallowance of income trusts. As large E&P companies usually prefer to work with larger oilfield services (OFS) companies and demand pricing and payment concessions that are untenable for smaller outfits, it’s likely the disappearance or consolidation of smaller OFS companies will ensue.

NEGATIVE: Reduced Foreign Investment

The Redwater decision brings certainty to the exploration and production landscape. But unless energy prices significantly rebound, current legislation does not promote foreign investment in Canada’s energy sector — which has already been on a steep decline of late. This may further negatively affect Canada’s faltering dollar and gross national product.

NEGATIVE: Orphan Well Glut

Even where producing and economic E&P assets exist, recoveries will need to be allocated to satisfy abandonment obligations, so banks may opt to walk away from any loans to insolvent E&P companies. This could have an unforeseen impact on regulators because they may now have to contend with not only the uneconomic wells, but also producing wells through the Orphan Well Fund.

The economic impacts will be broad and significant. Provinces will lose out on royalties, as the Orphan Well Fund currently does not the power nor the capability to operate E&P properties. Counties could lose out on property tax revenue. Landowners will struggle to recoup surface lease payments. OFS companies will lose out on revenue. And communities will see a further reduction in economic activity.

NEGATIVE: Fewer Transactions

Well transfers will involve significantly more regulatory scrutiny due to licence liability rating (LLR) recalculations. Therefore E&P companies will likely be more hesitant to purchase E&P properties. This, and the delay in completing transactions, could mean sharp discounts on the sale price or — potentially — a complete halt to transactions. 

NEGATIVE: Fewer Formal Insolvency Proceedings in the Short-Term

Formal insolvency proceedings provide economic value by ‘recycling assets’ through sales and by assisting companies to restructure their affairs while dealing with all stakeholders in accordance with statutory obligations. In most cases, insolvent E&P debtor assets will be insufficient to cover any and all well abandonment obligations and lenders will be hesitant to appoint receivers in insolvency cases as a result.

Conversely, even when they wish to, receivers may be hesitant to accept those appointments as there may be no funds to pay the administration costs. Regulators may still appoint receivers, but in the short-term, expect fewer formal appointments.

NEGATIVE: Unclear Status vis a vis Other Priority Creditor Claims

The Redwater decision offers little guidance for where well abandonment obligations fit among unremitted payroll deductions, Wage Earners Protection Program Act obligations, unpaid GST and PST, workers compensation, etc. It is likely that this will result in court challenges to re-determine priorities established prior to the Redwater decision.

NEGATIVE: Employees and Contractors

Due to the recent energy downturn, the energy sector has already experienced a massive number of layoffs, pay cuts and cutbacks of contractors. The heightened uncertainty and reduced restructuring options for struggling E&P and OFS companies almost guarantee these will continue.

NEGATIVE: Fewer Restructuring Opportunities

The spirit of the Division 1 proposal provisions of the Bankruptcy and Insolvency Act and the Companies’ Creditors Arrangements Act is to encourage the restructuring rather than liquidation of businesses in financial distress. Central to most restructuring scenarios is the ability to disclaim uneconomic agreements – including oil and gas leases. The Redwater decision effectively takes that off the table.

A growing number of E&P companies – previously prime candidates for restructuring — will now slowly waste away; taking with them local jobs and economic stimulus. 

POSITIVE: Stimulate Government and Regulatory Improvements

As resource investment continues to decline, the Redwater decision could be the necessary push provincial and federal governments need to advocate for and expedite pipeline approvals.

Further, the decision could also spur changes from provincial governments to modify the current liability management rating regime. Most U.S. states require companies to post a reclamation deposit on wells prior to receiving drilling approval. If enacted across Canada, a similar mandate could address the abandonment issue for future drilled wells.

POSITIVE: Legislative Improvements

The Supreme Court of Canada used an extremely narrow definition of Section 14.06 of the BIA in determining that only the receiver and / or trustee have protection from personal liability in insolvency cases with existing environmental obligations. Ideally, the federal government will key into this nuance and revise the legislation — expanding the definition so insolvent companies may also take advantage of that provision in the future. 

POSITIVE: (Some) Economic Benefits

While E&P companies (and associated professionals) will likely face tough times ahead, the Redwater decision will undoubtedly increase funding for wellsite reclamation companies. As more businesses face insolvency and more wells require reclamation, the number of contracts and labour required to perform that work may provide some respite by putting unemployed or underemployed people to work in struggling provinces.

Additionally, as the Redwater decision diminishes the value of a company’s assets, struggling firms may have no other option than to offload properties at a deep discount. This could be a lucrative opportunity for cashflow-positive and high LLR exploration and production businesses to acquire inexpensive assets. 

POSITIVE: Environmental Stewardship

There is an obvious argument that exploration and production companies have a moral and ethical obligation to reclaim abandoned wells and return the land to its native state. The Redwater decision does show a commitment to the protection of both the environment and local stakeholders by ensuring an insolvent company contributes to its reclamation duties.

Company Considerations

In light of the Redwater decision, there is an added emphasis on the following matters companies need to address:

E&P Companies

  • Understand and monitor abandonment obligations on all properties that are licenced to them and properties on which they are joint venture partners
  • Assess how the abandonment obligations will affect borrowing capacity and determine how to address any funding shortfall
  • Be more strategic in packaging properties for sale
  • Work with the regulator

OFS Companies

  • Determine if providing well and facilities abandonment services is within the company’s expertise or if this expertise is attainable
  • Identify and sell surplus assets
  • Assess client mix

Both E&P and OFS Companies

  • Budgeting, cash flow management and variance analysis will become even more important
  • Work with your banker – they also want to find a solution
  • Work with your professional advisors
  • Address issues early to provide an opportunity for more corrective alternatives

The New Landscape

The Supreme Court’s Redwater ruling will have a noticeable ripple effect throughout the insolvency sector. We will strive to work more closely with energy regulators across Canada in situations where lenders walk away from untenable exploration and production loans and there are still economic assets in the business that need to be realized on to satisfy abandonment and reclamation obligations.

Finally, there is the continued (and growing) concern of consumer insolvencies which — combined with existing and unsustainable debt troubles that have been persisting with rising interest rates — future layoffs and economic hardship is likely to exacerbate. There is a growing need to educate consumers about how to manage their finances, while drawing awareness to the safety nets available to assist in consumer insolvency situations — providing hope for the future and a financial fresh start.

Based out of Calgary, Victor Kroeger, CIRP, LIT, CPA, CA, CFE, is a Licensed Insolvency Trustee and Director of Corporate Recovery, Western Canada at MNP LTD. To learn more, contact him at 403-298-8479, email [email protected] or visit us online at MNPdebt.ca.