Many participants in the oil and gas industry will have experienced déjà vu as oil prices have once again crashed, this time due to the destruction of demand associated with COVID-19 and the price war between Russia and Saudi Arabia.
What path lies ahead for the industry in the coming months and years? In this alert, we set out a few thoughts (and some questions) to help oil and gas companies navigate the current landscape
Operational disruption and supply chain risk
Oil and gas activities are generally considered essential activities by governments and have been mostly exempt from the lockdown measures.
However, continued operations will likely become increasingly difficult due to workforce shortages as employees are infected by the coronavirus and the practical difficulties in many cases of social distancing. Companies should, therefore, be prepared to operate skeleton crews to continue operations, with disruptions expected for the maintenance, inspection, repair and replacement of equipment and drilling activities.
Operators will also need to consider:
- third-party contractors who work on-site and the alignment of COVID-19 policies; and
- the prospect of sealing off wells as a result of the reduced number of personnel on drilling rigs falling below the level required by health and safety regulations and the reasonable and prudent operator standard.
As regards supply chain disruption, thought beyond the initial supplier in the supply chain will be required to identify who has supply chain risk, as disruption among second-tier and third-tier suppliers could ultimately affect both service companies and operators. For a comprehensive outline of how to protect yourself from supply chain disruption, please see our summary.
As the situation deteriorates, many industry participants are reaching for the force majeure (FM) provisions in their key contracts to excuse failure to perform or to exit. Whilst these are typically designed to cover a situation where contractual performance is impossible, difficult or onerous to perform as a result of exceptional events outside either party's control (for example a global pandemic), relying on a FM clause is very heavily dependent on the factual circumstances and the drafting of the specific clause. The choice of the contract's governing law will also influence the availability of FM and similar reliefs including possible change of law relief.
Depending on the situation, there are also likely to be several steps that a party seeking to claim FM should take in order to maximize its chances of success, for example:
- identify the specific measures (as opposed to coronavirus in general) and evidence the actual impact these measures have had on it;
- mitigate the impact of such measures; and
- submit the contractually required notices on time.
In addition, it is important to note that inability to pay, changes in market conditions and economic hardship associated with contractual performance are generally excluded as grounds for FM relief in common law jurisdictions. For a global guide to FM and international commercial contracts, please see our summary here, and for a guide to the application of FM to the US energy sector, please see our summary.
As instability and uncertainty increase, so will the number and types of disputes due to businesses becoming unable (or unwilling) to perform existing contractual obligations. For an overview of the implications of COVID-19 for the future of dispute resolution, please see our summary.
We expect a renewed focus on credit risk associated with counterparties as financial stress flows through the sector. This suggests that an extension of payment terms and innovative financing structures, which leverage stronger balance sheets and help sustain weak counterparties while mitigating creditors' risk (e.g. through share and/or asset security), may again become prominent.
As energy supply is generally considered a matter of national interest, measures are increasingly being implemented at a national level to provide some relief to the local oil and gas industry from the adverse impact of COVID-19.
We have summarized in an appendix to this alert the measures taken to date by the following key producing countries: Angola, Argentina, Australia, Brazil, Canada, China, Colombia, Egypt, Equatorial Guinea, Indonesia, Mexico, Mozambique, Norway, Pakistan, Russia, Saudi Arabia, South Africa, the United Arab Emirates, the UK and the US.For an overview of key measures to support employment and the economy being taken by governments in response to COVID-19, please see our Government Intervention Schemes Multi- Jurisdictional Guide, available here.
The COVID-19 pandemic is shattering long-held assumptions about the global economic and political order, with a clear shift towards direct government involvement in national economies and an increased risk of nationalization worldwide. For a comprehensive report on the global nationalization risk, please see our report available here.
Borrowing base financing facilities
The fall in the oil price will put many upstream producers into default under their borrowing base facilities at the next borrowing base redetermination. Producers may be sheltered from the risk of payment default for as long as any commodity price hedges remain in place and are in the money.
Lenders will have to decide whether to either:
- waive the default (typically as part of a debt restructuring on the basis of "amend and extend"); or
- enforce their security rights.
In light of the 2014/15 price slump, given the practical difficulties and risks associated with enforcement, we expect lenders to opt for the former in most circumstances.
Banks have strengthened their balance sheets significantly since the 2008 financial crisis, which may give them more scope to support borrowers through this period. Conversely, those banks looking to reduce their exposure to the resources sector, in response to the climate change emergency and the energy transition, may look hard for an exit from distressed loans.
Consolidation through the acquisition of distressed assets is a textbook response to slumps in the industry; and some did it successfully following the 2014/15 price fall. Given the speed, scale and volatility of the crisis, it is premature to gauge the buy side interest. In many countries, governments have tightened their oversight of foreign investment rules to protect vulnerable domestic companies laid low by the crisis. Foreign acquirers will need to navigate these new rules. For an overview of the countries taking a more stringent approach towards foreign investment, please see our summary here.
Likewise, acquirers should consider whether any government support received by the target comes with conditions that impede any planned post-merger restructuring and integration. As always, understanding the existing debt package and anticipating/negotiating the lender reaction to a new (solvent) buyer will be important, and the absence of contractual protections under the acquisition agreement will need to be borne in mind. Finally, given the practical difficulties of due diligence in the coming months, we wonder whether any buyers will prefer assets they already know and in any countries which they assess as being at lower risk of any second wave of COVID-19.
Impact on energy transition
The effect of the oil price crash and COVID-19 on the delivery of governments' decarbonization agendas remains unclear. The International Energy Agency, EU leaders and various asset managers have all reaffirmed their commitments in different ways to the energy transition. News is also expected from the European Commission over the coming days.
If you would like to discuss any of the issues raised in this alert, please get in touch with your usual Baker McKenzie contact or our dedicated COVID-19 team. Further news, regional law perspectives and other information can be viewed at Baker McKenzie's Beyond COVID-19 Resource Center.