The energy industry, and the oil and gas market in particular, has been suffering from a persistent malaise since late 2014. In December 2015 oil and natural gas prices plummeted to unprecedented lows. As a result, the North American oil and gas industry has faced an unprecedented wave of chapter 11 filings and other restructuring transactions. These restructurings have presented courts and the industry with many unique issues. Where a company’s capital structure allows it, there has been a trend of gravitating away from traditional bankruptcy filings and leaning towards prearranged equitisations. This trend is likely the result of a desire to reduce chapter 11 costs and diminish the risk of a resulting liquidation.
Interestingly, however, the manner in which many oil and gas companies have restructured has run the gamut of alternatives and the percentage of debt that has been restructured has been wide-ranging. More than 90 oil and gas companies filed for bankruptcy in 2015 and at least another 48 filed in the first half of 2016. Cash has not been readily available due to credit downgrades in the industry. This lack of capital has simplified restructurings and created an environment where debt exchanges and equitisations are commonplace. This article focuses on the manner in which debtors in a number of cases either equitised their entire capital structure, equitised some debt, or reinstated a large amount of earlier debt.
Magnum Hunter Resources is an example of full equitisation. MHR equitised its entire capital structure so that the debtor could come out of bankruptcy as quickly and smoothly as possible. The company emerged as a virtually debt-free entity, extinguishing more than $1.1 billion in debt. MHR was able to exit bankruptcy in less than five months.
Swift Energy initiated an in-court restructuring where an ad hoc unsecured out-of-the-money group of noteholders agreed to provide $75 million in debtor in possession financing, junior to a $330 million prepetition first lien revolver. The senior unsecured notes received 96 percent of the equity. The existing equity-holders retained a 4 percent interest, plus warrants for up to 30 percent of the equity. Swift exited bankruptcy in four months, with its debt reduced by approximately 75 percent, exchanging more than $875 million in senior notes for equity in reorganised Swift.
Halco´n Resources is a slightly different case insofar as the company emerged from bankruptcy with more than $1 billion in reinstated debt. Under its prepackaged chapter 11, Halco´n’s $1 billion third lien notes will be equitised into 76.5 percent of the equity and receive a $50 million payment in cash. The unsecured notes will receive 15.5 percent of the equity, in addition to warrants for 4 percent and $37.6 million in cash. The first and second lien debt, however, totalling approximately $970 million, will be reinstated with a coupon rate of 8.625 percent on $700 million of notes and 12 percent on $113 million on notes.
It remains to be seen which strategy will be the most effective: full equitisation, reinstatement of debt, or something in the middle. The particular facts of each situation matters greatly. Although there have been more than 140 oil and gas bankruptcies over an 18-month period, only one case gives some insight as to what will foreshadow the elements of a failed restructuring.
In June 2016, Hercules Offshore filed for chapter 11 – the second time in 10 months – due to, in part, a sustained negative operating cashflow of $450,000 per day resulting from low commodities prices. In its first filing, Hercules shed approximately $1.2 billion in debt, leaving it with $450 million in exit financing. Even though the company shed 99 percent of its debt, it was still unable to sustain itself in the marketplace. It remains to be seen whether other oil and gas companies suffer a similar fate and, if so, under what circumstances.
Gas gathering and midstream agreements
Putting aside difficulties in reorganising capital structures, energy companies often have burdensome midstream contracts or gas gathering agreements. Gas gathering agreements tend to have covenants that purport to “run with the land” and there is often litigation about whether such covenants are subject to rejection.
Under section 365 of the US Bankruptcy Code, a debtor is allowed to reject, assume or assume and assign executory contracts. The issue that has created a split in the courts is whether the gas gathering agreements “run with the land” and are thus subject to rejection.
In Sabine Oil & Gas, the bankruptcy court applied Texas law and concluded that gas gathering agreements can be rejected notwithstanding purported covenants running with the land. The court’s decision cleared the way for Sabine, and other chapter 11 debtors, to seek renegotiation of midstream agreements. MHR, Penn Virginia and SandRidge Energy had similar disputes with gas gathering/midstream contract counterparties, which all settled. These settlements are a testament to the manner in which these issues can be consensually resolved in the current oil and gas distressed environment.
Whether the number of oil and gas bankruptcy filings will continue to rise remains to be seen but it is clear that debtors are taking different approaches in restructuring their debt. Some debtors, like MHR, are choosing to fully equitise their capital structure and emerge debt-free. Halco´n, on the other hand, reinstated approximately $1 billion worth of prepetition debt. And then there are cases that fall in between where debtors emerge with some debt and equitise a portion of its capital structure.
It is unclear which approach is the most effective, but the circumstances of each debtor will necessitate a different approach. Energy companies should also be aware of the various issues that have been heavily litigated, such as the rejection of gas gathering and midstream contracts, given that these agreements are connected to important services.
James Sprayregen and Brian Schartz are restructuring partners at Kirkland & Ellis LLP and George Klidonas is a restructuring associate at the firm. They focus their practices on financial restructurings, insolvency and debtors’ and creditors’ rights, and they generally represent debtors, creditors and distressed investors in complex workout, insolvency, restructuring and bankruptcy matters.