When crude oil prices tumbled more than 50% since June 2014, more than $263 billion of market value was erased because of the decline in energy stocks. Oil and gas companies and investors alike have been maneuvering to adjust to lower prices ever since. Producers need new capital sources, while alternative asset investors are searching for lucrative opportunities to put their capital to work.
Despite reduced borrowing bases and some failed covenants, commercial bank lenders have shown their willingness to be flexible thus far, working with E&P companies and granting waivers or amendments, or reducing credit lines, rather than declaring defaults.
However, concerns remain that lenders this fall will begin to tighten the noose in the next round of covenant certifications and borrowing base re-valuations if oil remains at its current price range of about $59-$60/bbl.
If these traditional sources of funding were to dry up, hedge funds and other alternative asset investors may increasingly become the go-to source of investment and operating capital for challenged segments of the industry.
“There are a lot of people who borrowed a lot of money based on higher price levels,” the Blackstone Group’s CEO said a few months ago, “and they’re going to need more capital.”

New opportunities for investors
Cash-strapped oil companies with geologically sound asset bases and restricted access to capital present attractive opportunities for investors. A number of energy-focused funds have raised billions of dollars to target the oil and gas sector. Buying debt directly at a discount is one avenue for hedge funds to invest in oil companies.
Hedge funds are also issuing new senior debt to oil companies to cash out distressed bonds or entering into other arrangements with oil companies. An example was Quantum Energy Partners’ commitment of $1 billion to a joint venture with Linn Energy LLC for the acquisition and development of oil and gas assets.
In addition, the unique characteristics of oil and gas assets offer other, potentially more advantageous, structures for investors to put capital to work in the oil field.

Linn Energy-GSO Capital
Linn Energy and GSO Capital Partners pursued one such opportunity in December. GSO committed up to $500 million to fund 100% of the drilling costs of new Linn wells in exchange for an 85% nonoperating working interest, with Linn retaining a 15% carried working interest.
Once GSO achieves a 15% annualized return, GSO’s working interest would drop to 5% and Linn’s would increase to 95%.
This arrangement benefits the otherwise cash-strapped Linn by enabling it to develop prospective producing assets and add new cash flow streams with no capital outlay, while mitigating drilling risk and avoiding the potential loss of mineral leases because of the failure to meet development requirements.
In addition to working interest transactions, a long-standing tool in oil and gas investments has been the sale of royalty interests. A key characteristic of royalty interests (and a reason for their relative popularity) is their status as real property interests, meaning these are generally outside the bankruptcy estate of the granting company. This places the royalty investor in a superior position to other creditors in the event of the granting company’s bankruptcy. However, this bankruptcy-protected status has recently been subject to scrutiny.
The most common types of royalty-based transactions are overriding royalty interests (ORRIs), volumetric production payments (VPPs) and monetary production payments (MPPs).
A key difference between an ORRI and a VPP or MPP is the term of the interest. Traditionally an ORRI would continue throughout the productive life of the asset (or for a specified number of years). A VPP continues until the investor receives the agreed volume of production or the proceeds therefrom, and an MPP continues until the investor has received an agreed dollar value or rate of return from production proceeds.
Production payments are thus more similar to financial investments, where the investor is entitled to certain benefits from oil produced by the assets’, denominated in dollars, rate of return, or volume. In fact, the Financial Standards Accounting Board considers MPPs “borrowings” but considers VPPs a transfer of a mineral interest. VPPs can also function as hedging instruments, in that a large consumer or distributor of oil can pay upfront for rights to a specified volume of oil as it is produced.

Benefits and risks
Oil companies in need of capital stand to benefit in several ways from these transactions. Royalty-based investments can provide them access to cash to continue drilling programs and develop assets with little or no capital outlay. Continuing drilling programs can be critical, as maintaining oil leases often requires drilling a minimum number of wells.
These transactions also provide additional revenue streams for oil companies and enable them to attract and retain top talent, particularly for positions requiring specialized or institutional knowledge.
Use of Proceeds and Other Safeguards. When considering a royalty investment, investors would be wise to seek certain safeguards on the use of the investment proceeds. For example, investors could have oversight of the drilling program and the ability to steer funds to the company’s best drilling prospects, increasing the likelihood of realizing a high return.
Investors could also require safeguards with respect to how companies drill and the terms on which they contract with affiliated entities and third parties. Investors should also ensure that funds are used to fully satisfy amounts owed to service companies to avoid the creation of materialmen’s liens on the assets.
In addition, investors should note that royalty interests only entitle the interest holder to a share of proceeds from production. Unless established by contract, royalty interests do not provide investors operational rights or recourse against or control of the oil company that owns or operates the wells.
Structural Risk. As with other alternative investment structures, there is a risk the transaction could be challenged, particularly in the event of bankruptcy. As noted earlier, royalty interests are considered real property interests defined by state law, and thus are outside the bankruptcy estate of the granting company.
However, the court in the ATP Oil & Gas Corp. bankruptcy case entertained a challenge as to whether certain sales of royalty interests by ATP should be recharacterized as debt financings instead of real property dispositions. The Bankruptcy Court refused to dismiss the creditors’ claims, holding that a fact-specific analysis of the transactions was required, including the extent of the royalty owner’s exposure to commodity prices and levels of production, both of which can vary based on how the royalty interest is structured.
If an ORRI, VPP or MPP were recharacterized as a debt financing instead of a sale of a property interest, the royalty investor’s status would be reduced to that of an unsecured creditor of the granting company. The ATP Bankruptcy Court ultimately did not rule on the issue because the acquirer of the bulk of ATP’s assets settled the claims of the royalty interest owners. However, the trustee in ATP’s converted Chapter 7 bankruptcy has indicated that it may challenge certain royalty-based transactions relating to the remaining assets.
Because any recharacterization of royalty-based transactions as debt financings would be a major change in established law, energy investors should continue to monitor developments in this case.
As traditional sources of credit continue to tighten, oil companies in need of capital infusions will increasingly find alternative financing structures attractive. Investors seeking lucrative returns should consider the unique investment opportunities oil and gas assets present. Royalty-based investments may become even more popular due to their flexible structure, ability to target specific assets, and potential bankruptcy advantages.

--Jeffrey Schlegel and Omar Samji are partners in Jones Day’s Houston office. Isaac Griesbaum and Kit Rockhill are associates in the Houston office.