It should not come as a surprise to anyone that Alberta's oil & gas industry does not function well during times of uncertainty. Industry and investors like stability. While we are starting to see signs of recovery, the recovery is slow and uneven. In previous downturns we have seen junior oil & gas companies play a key role in recovery, however lack of access to affordable capital as well as the unintended consequences of recent regulatory actions are making it difficult for juniors to actively participate in the industry. Their absence is noteworthy.
The failure of the juniors to thrive in the new environment is in part due to actions taken by the Alberta Energy Regulator (AER) to manage Alberta's orphan well programme. It has been almost one year since the AER decided, without warning, to make a significant and controversial change to its licensee liability rating programme (LLR programme) by doubling the required liability management ratio (LMR) for purchasers of licensed assets and, at the same time, put the oil & gas industry on notice of future pending regulatory changes to address the Redwater decision.
In the Redwater decision, the courts ruled in favour of the receiver and trustee of an insolvent oil company being able to disclaim the company's uneconomic non‑producing wells. The AER took the receiver and trustee to court to compel it to fulfil its obligations with respect to the abandonment and reclamation of the disclaimed wells. The receiver and trustee, in turn, asked the court to approve a sale process that did not include the disclaimed wells. The lower court sided with the receiver and trustee, finding that the federal legislation took priority over the provincial legislation. On 24 April 2017 the Alberta Court of Appeal, in a 2-1 decision, affirmed the lower court's decision and on 28 April 2017 the AER, unhappy with the outcome, announced it would appeal the Redwater decision to the highest court in Canada.
The purpose of the LLR programme is to minimise the risk to the orphan fund posed by unfunded well, facility and pipeline abandonment and reclamation liability. The orphan fund, which is 100 percent funded by the oil & gas industry through a levy administered by the AER, pays for the abandonment and reclamation of wells, facilities and pipelines included within the LLR programme if a licensee or working interest participant defaults on its obligations to do so. There are over 83,000 inactive wells alone in Alberta and this number will increase as the resource depletes and continuing low commodity prices make marginally producing wells uneconomic to produce. The LMR, which is at the heart of the LLR programme, is a ratio of the licensee's deemed assets value to its deemed liabilities. The AER's premise being the higher the LMR number, the better the company's financial wherewithal. The LMR of each and every licensee in Alberta is calculated and published monthly by the AER.
The AER now requires that for a well, facility or pipeline licence transfer to be approved, the purchaser must have an LMR of 2.0 or higher immediately following the transfer; previously, purchasers were only expected to have an LMR of 1.0. This change had an immediate and chilling effect on merger & acquisition activity in Alberta as the oil & gas industry reacted to the goal posts being moved, for some companies mid-deal.
One of the more drastic (and measurable) consequences of this policy change was to significantly decrease the pool of qualified purchasers of licensed assets. In July 2016, when the policy was first introduced, 43 percent of licensees had an LMR below 1.0. The number of licensees below the required standard soared to 70 percent with an LMR requirement of 2.0. What is interesting is that the number of licensees and these percentages remain largely the same today, with 523 of the total 756 licensees in April 2017 (or 69 percent) having an LMR below 2.0. The hardest hit category has been emerging junior oil & gas companies, which, generally speaking, are the smaller companies that average between 0 and 1000 boe/d. The bigger juniors, who average between 1000 and 10,0000 boe/d, are an even split, with about half below 2.0. All of the senior producers, except one, have an LMR above 2.0. Another trend apparent from the published data is market fluidity. The overall number of licensees is similar, but just under 10 percent of the companies listed in July 2016 are no longer licensees, while new licensees have replaced them. For those that are no longer listed, 75 percent of these companies had an LMR under 2.0, which is a good indication of just how the AER's changing metrics may have affected certain players. We know that some of these companies went bankrupt, while others were purchased. Already beleaguered by the collapse in oil & gas prices, and the almost non-existent access to public market capital, this policy change, left unchecked, will make it difficult for junior oil & gas companies in the Western Canadian sedimentary basin to survive, with the seniors dominating and scooping up the smaller players.
As the number of inactive and abandoned wells in Alberta continues to grow, some critics think that an LMR of 2.0 does not go far enough to protect the public. Others say the LMR is a flawed measure, and that raising the standard is actually counterproductive. Making it harder for licensees, principally junior oil & gas companies, to transact may actually increase the likelihood of bankruptcy and insolvency and result in more uneconomic non‑producing wells becoming the Orphan Fund's responsibility.
In recognition of some of the unintended consequences of its decision, the AER later announced that it would consider approving licence transfers on a case-by-case basis for purchasers with an LMR of less than 2.0. The problem, however, is that this process is not a transparent one. There are no guidelines or timing assurances. Approval requests that are considered by the AER to be non-standard are given to the newly created Proactive Life Cycle Management Group, which has been described by people in industry as "an abyss".
What is clear is that these measures were intended to be temporary stop-gap measures to give the AER time to work on more comprehensive regulatory changes to the entire liability management programme. What that will look like remains to be seen. Representatives from the government and the AER continue to meet with industry, landowners and other stakeholders. Many are watching what the AER will do with this feedback. We have been waiting almost a year for a more permanent set of rules to be put in place. The oil & gas industry should be prepared for the goal posts to be moved again, which will hopefully bring more certainty to all stakeholders and address, in a concrete way, the concerns around the disappearance of the junior oil & gas companies.
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