Law Roundtable

The U.S. shale boom, financial-market reforms and ongoing regulatory uncertainty have changed the game plans of many producers and service companies in recent quarters. Low gas prices, pauses in drilling activity, decisions to move rigs and the pickup in financings and M&A are part of companies’ efforts to remain agile during a challenging chapter in the industry’s history.

Many energy law practices have a prominent role in these activities, as they are tasked with helping their clients navigate these transactions. Oil and Gas Investor recently polled six energy lawyers to get a pulse on the industry and emerging legal trends in the energy space.

Panelists include Alan Rafte, partner and head of Bracewell & Giuliani LLP’s energy, finance, infrastructure and real estate practices; James (J.J.) McAnelly, also a partner at Bracewell & Giuliani; Bob Thomas, partner, head of the energy section, and chair of the property and finance practice group of Porter & Hedges LLP; Doug Atnipp, co-chair of Greenberg Traurig LLP’s energy and natural resources practice; Aaron Ball, attorney and solicitor, Looper Reed & McGraw PC; and Buddy Clark, partner and energy practice group chair, Haynes and Boone LLP.

Here they discuss their energy industry challenges, preferential rights in M&A deals and what engagements are keeping them busy these days.

Investor: What are the most pressing issues facing your energy clients?

McAnelly: Regulatory uncertainty and impediments, and the way they affect offshore activities on the Outer Continental Shelf. Regulations for the area are in the formulation stage, and as a result you have the deepwater moratorium on drilling, the shallow-water de facto moratorium, and increased difficulty in getting completion and drilling permits. The upcoming elections could be a solution to some of these issues.

Rafte: While I expected the regulatory uncertainty offshore would suppress transaction activity, there are a number of large Gulf of Mexico packages for sale, though it doesn’t seem like a prime time to sell, since uncertainty tends to depress prices. But several smaller companies want to exit the Gulf, and there are enough bigger players in the area to buy their assets.

Thomas: I’m seeing a high volume of deals in the shales, specifically, in the Marcellus, the Louisiana side of the Haynesville, and the Eagle Ford. Deals in these plays have produced a number of issues for companies. Many of them paid a lot of money for the leases in some of the best parts of these shales, and these leases are often paid up with a primary term of about three years. After that, they require continuous drilling to maintain the leases.

As a result, we’re seeing many companies forming joint ventures to sell down their positions, or going out to raise equity. In the Gulf of Mexico, you’re seeing several companies taking cash-flow hits and selling Gulf assets, with some also bolstering their onshore portfolio.

Also, many producers are having to wait three to six months or longer to get their wells fractured. It’s difficult to access enough fracturing capacity to execute a reasonable plan for drilling and production, while having sufficient cash flow to support the operation. Not being able to timely fracture your wells raises issues about whether the minimum lease requirements have been met to maintain the leases in effect.

Atnipp: The availability of capital for middle market transactions. Also, the unstable regulatory environment and a long-term outlook for depressed natural gas prices. The uncertainty in regulatory changes, particularly in the Gulf in the wake of Macondo, and in the Marcellus shale with increasing regulation based on concerns over fracing and environmental issues, is making it difficult (and with respect to the Gulf, in some cases impossible) to operate. Furthermore, depressed gas prices are causing clients to rethink current investments and operating levels in gas plays such as the Haynesville and Marcellus.

The markets will eventually open up to make capital more readily available. However, lenders are closely scrutinizing transactions and taking on higher-grade assets. The midterm elections might be the solution to the regulatory burdens that have been imposed on the energy industry.

Ball One of the biggest challenges facing U.S. companies is their ability to take advantage of the opportunities in foreign markets like Colombia and Brazil. Entry into these and other developing markets is challenging since the regulatory models (from labor laws to rules governing hydrocarbons development) are very different than what U.S. companies are accustomed to and financing is more complex. Likewise, the explosion in gas shale-play investment by foreign firms has been an adaptive challenge for companies accustomed to a much more centralized and structured regulatory environment.

Clark It’s a combination of commodity-price predictability and regulatory predictability. Anyone who has been in the industry for the last 25 years has seen the disruptions caused by wild gyrations in prices for oil and gas. I think one reason we did not see as much disruption over the last two downcycles was the ability of producers to hedge price volatility. Producers can thank their bankers in part for that, because most of our reserve-based lenders required borrowers to maintain hedges on a substantial percentage of their production up to two years out. The income from the hedge contracts has enabled the producers to smooth out the price fluctuations and continue to meet debt service.

But because commodity prices, especially gas, have been depressed since November 2008, a lot of the hedge protection is running off. And without an uptick in projected commodity prices, it will be hard for a lot of producers to replace their hedge protection at attractive prices. This comes just at the time that the hedge market is being buffeted by regulatory uncertainty under the Dodd-Frank Act.

Producers are worried that their ability to mitigate commodity-price risk through financial hedges will be severely restricted, which is a good example of the other pressing issue: regulatory predictability. Weighing the unpredictability of future regulations has a chilling effect on producer appetite to put more dollars in the ground.

Investor: What engagements best illustrate what your energy practice is focused on these days?

McAnelly: We see some of the regulatory lethargy affecting the offshore areas trickling into onshore. Currently we represent a large Outer Continental Shelf player whose deepwater operations in the Gulf are on hold and it is contemplating the redeployment of its rigs elsewhere in the world. We’re also analyzing the direction of the new OCS legislation for clients. The expansion into some of the onshore oil plays, especially the Bakken and Niobrara, is also generating engagements.

Rafte: Another thing that was precipitated by the Gulf disaster is BP Plc’s need to sell assets. We represented Apache Corp. in a $7-billion transaction it did in July 2010. The Macondo incident has spawned a lot of business for us, though not necessarily related to the oil that was in the water. Over the last year or so we’ve also done a number of shale joint ventures, representing companies that wanted to raise capital effectively and share risk.

Thomas: The shales have kept our entire energy team extremely busy with acquisitions, divestitures and joint ventures. The JVs have often included international companies coming into U.S. shale plays and private-equity funds investing in the shales.

Atnipp: We do a lot of energy finance work. However, during the last 18-plus months, the bulk of our work for our clients has been debt restructuring, workout and bankruptcy-related work with few “new money” deals closing.

Ball Registration of exploration and production companies with Colombian regulators; negotiation of joint-venture, farm-in, and joint operating agreements; financing and development of a port facility in Brazil; compliance issues for U.S. companies operating abroad; and advising non-U.S. companies on choice-of-entity, corporate governance, and a wide range of start-up and operational issues in the U.S. market.

Clark Over the last six months we have worked on a number of high-yield debt offerings, more so than straight-up bank loans. Energy producers are seeking to retire higher-coupon debt or accumulate capital for expansion, or both. Unfortunately, the high-yield market’s appetite is not insatiable, and not all producers fit the profile to issue debt in this market. But it is clearly a great opportunity for companies with the right leverage and property mix to be able to attract public debt holders. For a couple of our clients, it’s an important step toward an initial public offering.

We have also worked on a few bankruptcy-related acquisitions. One example is Newfield Exploration Co.’s acquisition of TXCO’s Eagle Ford properties in connection with TXCO’s reorganization plan last spring. We worked closely with Newfield as the stalking-horse bidder, and helped strategize with its negotiations with Anadarko for their $310-million joint bid.

Investor: Regarding financial reforms, are you seeing any effects yet on clients’ ability to raise money or hedge?

Rafte: We have a huge hedging derivatives practice representing some large financial institutions, which are definitely being affected. There was a pause for them recently as they looked at some of their structured deals, unsure about where the new drilling regulations were going. From a producer’s perspective, some of the flexibility they had previously may go away if banks are unable to provide some of the “more exotic” products, but we shouldn’t see much impact on basic financial tools.

Ball We have not seen any immediate impact. However, the recently passed Dodd-Frank Wall Street Reform and Consumer Protection Act includes a provision known as the “Volcker Rule.” It requires that federal banking agencies jointly adopt provisions to prohibit banking entities from investing in or sponsoring hedge funds, venture-capital funds and private-equity funds, subject to certain exceptions. The full impact of the provisions won’t be evident until the regulations are issued.

For energy funds whose investor base includes an investor covered under the Volcker Rule provisions, that investor’s ability to maintain its investment position in the fund will depend on the size of that position relative to the size of the fund and the aggregate amount of similar investments by that investor. As a result, an investor covered by the Volcker Rule provisions may need to reduce (or even eliminate) its position. This could mean less money to go around for potential investments. As oil and gas investments are often long-term affairs, these new rules could have an adverse impact on our ability to raise money for new projects.

Clark Financial reforms, economic conditions depressing demand levels, and the debt leverage of clients pre-crash are all critical factors in whether they are able to raise the capital necessary to fund investments. We have seen two clients try to launch public debt this past summer, only to pull their plans because of market changes.

On the other hand, we are talking with other clients about launching a $300-million-plus, unsecured high-yield offering that is expected to receive favorable pricing. The difference is the underlying debt load of these companies and the market’s perception of their ability to service the additional debt. My advice to anyone who can raise the debt would be to take the plunge now while rates are historically low.

Hedging is another issue. The Dodd-Frank Act could potentially severely restrict our industry’s access to this risk-management tool. Bottom line is: less flexibility in hedge products, less liquidity in hedge markets, and more collateral required will result in more costs to producers.

Investor: Your views on the E&P sector now? How have clients’ needs changed recently?

Rafte: People have been scrambling for capital to fund their projects, faced with low natural gas prices and regulatory uncertainty. As a result, many of our projects have shifted from gas to oil. We’ve also seen some pickup in M&A activity as people rationalize their portfolios.

Thomas Companies are still focused on finding emerging oil and gas areas. The sector is emphasizing oil over gas and producers are trying to match up capital budgets with cash flows. Also, this past year has been very transaction heavy, and I would expect buying and selling to continue at an even faster pace for the remainder of the year because of the pending increase in the capital gains tax, to be effective January 1, 2011.

Atnipp: While there is seemingly a lot of activity in the M&A market for large transactions in unconventional resources, the middle-market transactions involving conventional resources are relatively sparse. We have seen less demand for legal services from E&P clients. However, while we don’t do title work, it is my understanding that title examiners are extremely busy as companies are developing the assets they have.

Ball While M&A activity is still ongoing, more clients are in planning mode—looking to get the house in order by engaging in tax, liability and operations planning in anticipation of taking advantage of new opportunities in 2011. Most of our clients are confident that increasing demand and intense activity in foreign markets will create a robust environment for energy next year.

Clark In spite of the adverse business and regulatory climate, independent producers continue to account for more than 68% of oil and 82% of gas produced domestically and, according to a recent report from the Independent Petroleum Association of America, independents are investing 150% of their domestic cash flow back into domestic oil and gas development.

Name another industry that has seen the price of its product cut in half (oil) or more than half (gas) over such a short period without the bloodbath that would surely follow. Layer on top of that the uncertainty of regulatory oversight, threatened fundamental tax law changes targeted directly at our industry, and the federal government’s repeated threats of carbon taxes or caps, renewable electricity portfolio mandates, and uneconomic alternative energy schemes. If not for the indomitable spirit of our industry, we would see more folks folding up shop.

Investor: In M&A transactions, are you dealing with more issues around preferential rights?

Rafte: Definitely. It’s hard to say if the trend will continue. I wouldn’t say that the activity is drastically more prevalent than it was five or 10 years ago, but the amount of acreage implicated tends to be larger now, so the stakes are bigger.

Clark Absolutely. We continue to pursue issues related to a case in which we prevailed over Chesapeake Energy Corp. and Gastar Exploration Ltd. concerning a pref right election in late 2005 on behalf of our client, Navasota Resources. Notwithstanding Navasota’s proper election to the pref-right notice, Gastar and Chesapeake went ahead with their closing. Two and a half years later, the appellate court agreed with Navasota. The properties have since been assigned to Navasota, but issues over past revenues and cost allocations, as well as other actions by Chesapeake and Gastar during the period Chesapeake held the properties, have been sent back down to the trial court.

More recently, we have seen where the exercise of a pref right had the ability to derail the closing on the remaining properties in the package. Our client had negotiated, as buyer, a walk right if pref-right elections exceeded a certain threshold. Once that threshold was met, the seller was faced with losing its sale to our client, and being obligated to go through with the sale on the handful of assets that were subject to the election.

Atnipp: Preferential purchase rights are always an important part of an M&A transaction, but we do seem to be having more issues, as AMIs and preferential purchase rights seem to be finding their way into all kinds of ancillary agreements. There is a heightened need for due diligence when undertaking an acquisition to determine the existence and applicability of preferential purchase rights.

Investor: What new legal issues have emerged from interest in unconventional resources?

Atnipp: Many involve the environmental impact of the completion techniques for wells. This is particularly true in the Marcellus, where environmental authorities are taking a close look at fracturing techniques. In the Marcellus, the closer look at hydraulic fracturing is not limited to state environmental authorities. The New York legislature has imposed a drilling moratorium, as has the Delaware River Basin Authority (with overlapping jurisdiction in New York, Pennsylvania and New Jersey). The overriding concern is the potential for contamination of drinking-water aquifers. Drilling opponents seek either a permanent ban or the imposition of bonding requirements that would have the net effect of no drilling.

McAnelly: More basin-wide transactions versus field transactions. There’s also a focus on joint- development agreements between parties, and interweaving that with your standard operating agreement, versus the purchase-and-sale-agreement transactions that characterized much of dealmaking during the previous 10 to 15 years. Knowledge trading has also become a larger component of transactions, along with capital infusions and risk sharing. We’re also seeing the return of private equity and hedge funds to energy.

Thomas Legal issues have surfaced around the operations necessary to maintain leases beyond their primary term, in the event operators can’t complete wells soon after drilling them. It’s of great concern to the lessees because they’ve invested millions of dollars in the leases and drilling and completion operations, and they need assurances that their leases are in full force and effect.

Ball International investment is snowballing to the multi-billions in U.S. shale plays. The Marcellus is a good, representative example of this trend. Earlier this year, British BG Group closed a transaction to acquire Marcellus assets with Exco Resources Inc. for just under $1 billion. India’s Reliance Industries bought a 40% interest in the Marcellus acreage of Atlas Energy Inc., a U.S. E&P company. A few months earlier, in February, Japanese energy conglomerate Mitsui & Co. purchased a 32.5% stake in Anadarko Petroleum Corp.’s Marcellus assets. During the first three months of 2010, there were more than $2 billion of Marcellus shale deals alone, including foreign investments—a record for unconventional oil and gas plays.

In the U.S., earlier this year Pioneer Natural Resources sought bids to develop its holdings in the Eagle Ford in South Texas. Reliance invested $1.15 billion in a joint venture with a subsidiary of Pioneer in exchange for a 45% interest in 212,000 net leased acres in the Eagle Ford play. Chesapeake passed on partnering with Pioneer in Eagle Ford and chose instead to issue preferred stock worth $900 million to sovereign wealth funds from China, Korea, Singapore, Japan, and Abu Dhabi, as well as to private investors. This stock issue follows on a $1.7-billion preferred stock sale in May.

Companies such as Statoil, BP and Total have formed partnerships with U.S. operators in part to gain expertise in horizontal drilling and fracturing techniques in shale and other unconventional formations that they plan to use in other parts of the globe. These kinds of investments indicate that developing countries are as interested in gaining technical knowledge as much as they are in making a profit. I call these companies “knowledge investors.” Of course, this phenomenon of knowledge investors is a threat to the domestic gas market, because it artificially increases production and the valuation of gas shale properties.

The real story in unconventional resources is not in the U.S. but in foreign markets where the volumes and cost of recovery will make the plays much more attractive. Once knowledge investors pull out of the U.S. market and natural gas and natural gas liquids prices stabilize following overproduction and price decreases, it will be those U.S. companies and investors who are poised to take advantage of emerging unconventional resources outside the U.S. who will have the greatest success. M