Excerpt from Practical Guidance

COVID-19, Contango And Energy's New Economic Reality

By Cameron Kinvig
Law360 is providing free access to its coronavirus coverage to make sure all members of the legal community have accurate information in this time of uncertainty and change. Use the form below to sign up for any of our weekly newsletters. Signing up for any of our section newsletters will opt you in to the weekly Coronavirus briefing.

Sign up for our Transportation newsletter

You must correct or enter the following before you can sign up:

Select more newsletters to receive for free [+] Show less [-]

Thank You!



Law360 (May 26, 2020, 5:25 PM EDT) --
Cameron Kinvig
Cameron Kinvig
It comes as no surprise that the coronavirus pandemic sweeping the world has wreaked havoc in the energy industry. Combined with ongoing discord between the OPEC+ nations (those Middle Eastern nations part of OPEC, plus Russia, Mexico, Venezuela, etc.), the supply glut of oil and natural gas caused by decreases in economic activity related to COVID-19 has hobbled an already weak market.

This unique set of circumstances, which is unprecedented in both speed and scope, have combined to create significant uncertainty, forcing companies into bankruptcy and markets into turmoil. This article identifies and explains some of the unique challenges facing energy companies and markets in this new economic reality.

Of immediate concern are the following:

  • The concept of an inefficient market, termed contango, where short-term and long-term energy prices operate differently due to market forces;

  • The possibility of mandatory domestic energy output cuts;

  • Limitations on the availability of physical storage for petroleum-based energy products; and

  • Pressures on banks and energy companies due to reserve-based lending facilities, including the insistence on additional financial covenants, and covenant breach.

Contango

In today's information age, it is assumed that all financial markets — including those trading in energy futures — are largely efficient. Information is released into the market, and market pricing generally adjusts in an efficient and somewhat uniform way almost simultaneously.

For significant changes in policy or market demand, pricing often reacts to increased or decreased risk before the change ever occurs, as the market often expects these types of changes weeks or months ahead of when they happen. In stable markets, short- and long-term energy prices generally maintain a close relationship with each other, because the market understands the cyclical nature of energy demand, and that producers will automatically adjust output accordingly.

For instance, if the spot price of oil is $40 per barrel, the futures price for delivery 2 months in the future may be very close to that figure, if not slightly lower. However, the coronavirus pandemic has significantly altered market behavior, seemingly overnight.

While the coronavirus pandemic does not directly affect the availability of or production capacity for energy products — as it does with many agricultural products — it has placed significant downward pressure on short-term energy prices, thanks to curtailed travel and decreased demand. Because very little is certain regarding the anticipated longevity of the pandemic, energy market pricing has become particularly inefficient.

Short-term prices are significantly depressed — with oil futures for May delivery actually dropping to negative $37.00 per barrel the day before the futures contract expired (largely because of a lack of available storage for those taking physical delivery of the oil). This means, of course, those holding futures contracts on April 29 had to pay third parties to take possession of the physical commodity represented by the futures contract on May 1 — at a significant loss.

However, longer-term energy futures prices have been somewhat more resilient, with certain futures contracts hovering approximately $70 per barrel above the May contract low. This significant market inefficiency is referred to as contango — a trading differential that tries to account for strong negative market forces in the short term, with unknown effects in the long term.

While contango has occurred throughout recent history in times of conflict or political uncertainty, the current level of market inefficiency is unprecedented. Contango provides significant profit opportunities for those that utilize arbitrage investment strategies. Unfortunately, to fully utilize arbitrage in a contango scenario, one must have the ability to take physical possession of a commodity — here, oil or natural gas.

When oil futures swung far into negative territory at the end of April, it was because there was a lack of storage capacity available for those seeking to utilize an arbitrage strategy. Most storage capacity at oil terminals throughout the world was full, and excess oil production was being stored in dozens of enormous oil tankers floating offshore.

Negotiating the use of this excess storage on behalf of your clients is neither quick, nor simple, but is instead a job for savvy counsel using forethought. A good practitioner will keep abreast of market inefficiencies that begin to materialize, and assist their arbitrage-focused clients with these medium-term storage negotiations, in an effort to help them take advantage of market inefficiencies that present themselves during periods of extreme contango, as we are experiencing now.

If one is successful at anticipating the market and negotiating savvy storage deals, seven-, eight-, and possibly even nine-figure monetary rewards may accrue for one's clients.

Output Cuts

In times of pricing pressure, with demand staying constant or dropping, there are few ways to control energy prices other than to reduce supply.

Coordinated supply cuts have been utilized for years by the OPEC nations — with Saudi Arabia taking the lead. Because the oil and gas industries in these producer countries are largely owned or controlled by central governments, they are easily able to increase or decrease output via temporary well shut-ins, or refusal to sell produced oil on the open market.

Because the U.S. cannot easily control the oil and gas industries via centralized national planning, it generally acts in a reactionary fashion to hydrocarbon supply cuts initiated by OPEC nations, yet benefits from rising prices once supply cuts are realized. While this has been the general pattern over the past 40-plus years, the price deterioration related to COVID-19 has changed U.S. behavior. 

Unfortunately, worldwide oil and natural gas price declines were not caused solely by demand deterioration related to COVID-19. Instead, significant price declines were caused by economic and political friction between Saudi Arabia and Russia — who could not decide on an appropriate amount of production cuts to stem pandemic-related price declines.

In an effort to break the will of the other, each chose to increase oil production to maximum levels immediately, flooding the market with oil it did not need, and ultimately could not store. The market reacted in a predictable way, with oil prices plummeting from stable levels.

While such movements generally occur over a period of weeks, this movement essentially occurred overnight, causing spot (daily) oil prices to drop to the lowest levels seen in decades. Futures prices sunk dramatically as well, eventually moving well past ordinary contango-conditions, and into the radically negative territory discussed above.

In an effort to support flagging oil prices, the wider agreement reached by the OPEC+ nations on April 12 saw 23 countries agree to collectively withhold 9.7 million barrels of oil a day from global markets. This represented a supply cut of close to 10% of the approximately 100 million barrels of oil utilized by industrialized nations each and every day.

Yet, an agreement for nations to collectively cut oil supply is not the same as those nations actually cutting supply. 

For instance, curtailing production may be relatively easy for state-owned oil companies throughout the Middle East. They simply take their production orders from OPEC, regardless of supply contracts, and decrease production accordingly. But production curtailment within the U.S. is much more difficult, legally dubious, and possibly damaging to oil wells and formations themselves.

In Texas, for instance, the Railroad Commission (the state entity charged with regulating the oil and gas industry) has not required production curtailment — known as proration — since 1973. Even though Texas producers have been asked to curtail one million barrels of oil production per day, the Railroad Commission has so far refused to order this curtailment, citing legal concerns. Instead, the commissioners have consulted the state's attorney general for guidance.

Similarly, state regulators in Oklahoma have followed suit, stating that if producers found it economically infeasible to produce hydrocarbons in a low-rate environment, the situation may be excusable under governing lease documents, but would not necessarily be mandated by the state itself.

The worry with any U.S. production curtailment order is that ordered well shut-ins will cause damage to certain wells, permanently shutter others, and possibly create significant liability for states which pass these curtailment mandates. But without meaningful production cuts across the worldwide production spectrum, oil and gas prices will continue to sag to historically low levels.

While low prices naturally discourage U.S. oil and gas companies from producing hydrocarbons, the lack of a national mandate does cause concern for state-owned entities. If demand falls to 70 million barrels a day, as projected by some, this issue will only become more pressing.

Physical Storage

For those clients whose business it is to physically store oil, the current market climate may create a historic opportunity for future profits. Their ability to lock in extremely low spot prices for oil now, along with the ability to store the same for several months, creates two ways to profit.

First, those entities can sell futures contracts now for future delivery of the oil they are storing, locking in substantial profit at the price differential as it exists today. Second, they can physically hold the oil for as long as needed or wanted, and take advantage of a future spot price for oil whenever they so choose.

The problem, of course, is that there is only so much global capacity for the physical storage of oil. And that capacity — estimated to be roughly 4.4 billion barrels worldwide — is roughly 70% full right now, and filling by more than 10 million barrels per day.

With onshore storage largely filled to capacity, oil producers and traders have turned to offshore floating storage via large oil tankers. This, of course, is an expensive proposition. The average monthly cost to store a barrel of oil offshore via tanker is roughly $4.50 — or approximately $9 million for an average-sized tanker full of oil. With spot prices so low, storage for more than a few months becomes infeasible, even during times of significant contango pricing inefficiencies.

As worldwide demand for oil continues to fall faster than production can be curtailed, you may find that your clients are in need of future storage for oil they may not be able to market, but yet must produce. In such an instance, negotiating a contract for short- to medium-term storage is key.

This may be done directly with a ship brokerage firm, or with trading parties who have reserved storage capacity in anticipation of future storage needs. If your clients can locate unused storage capacity, it is key to finalize negotiations for the same quickly — not only because storage is often preferable to shutting in production, but also because storage capacity is rapidly becoming scarce at any price.

Reserve-Based Lending Facilities, Additional Covenants and Covenant Default

Like many other companies, energy producers maintain long-term borrowing relationships with banks. However, unlike other companies, energy producers generally borrow funds based on the value of oil and natural gas reserves they control that remain below ground.

This relationship is called reserve-based lending, and the value of the collateral used to support such lending is called a borrowing base. Banks assess the value of a borrowing base twice per year, and either increase or decrease the level of indebtedness a company may incur based on things like oil price forecasting, the amount of reserves currently proven up and the progress of any new or future developments.

Volatility generally works against the borrower, and causes banks to tighten credit terms. If your customer's borrowing base is reduced by its lender to below the current amount of debt outstanding, the deficiency, as it is termed, often must be repaid within six months, lest the borrower be declared in default.

The market currently understands that there is significant pricing pressure on oil producers — with existing oil and gas loans trading at discounts of close to 30% off of their par value. So, especially during this COVID pandemic, when your clients likely need cash the most, banks are going to be very wary about requests to increase borrowings in any significant way.

Even though borrowing bases are generally reevaluated on a set schedule twice each year, you should make your clients aware that banks reserve the right to make a redetermination of borrowing base availability at any time. And if this redetermination occurs early, your clients may find themselves with a borrowing base deficiency, or with a decreased borrowing base, leaving them with with little or no remaining borrowing capacity.

Even if your clients find their borrowing base unchanged after redetermination proceedings, it is entirely possible they will find their bank insisting on the insertion of significant additional lending covenants to protect the bank's position. One of the most popular additional covenants being inserted by banks into reserve-based lending agreements right now is a so-called "anti-cash hoarding" provision, which effectively stops your clients from being allowed to draw down the full amount of their revolving credit facilities to hold as emergency cash.

These covenants often restrict the maximum amounts of cash a business may hold on its books at any one time, as long as debt is outstanding on the bank's revolving credit facility. From a bank's perspective, if your client is holding extra cash, it should use that to pay down its revolving credit facility, rather than sit on it in the form of extra cash.

But, of course, these restrictive covenants make it difficult for your clients to respond to emergency cash needs. You should also make your clients aware that once additional restrictive covenants are required, banks will be particularly sensitive to any breach or impending breach of these additional covenants, and may require heightened reporting to monitor your client's financial situation.

You should also ensure that your clients are very much attuned to the coverage ratio covenants, and "material adverse change" requirements that are likely found in their reserve-based loan documentation. In good times, a short breach of a coverage ratio may be excused, or even go unnoticed. And, of course, strong financial performance never triggers a default due to a material adverse change in a borrower's financial situation.

However, in today's lending environment, a bank will be sure to scrutinize each and every coverage ratio in a detailed and increasingly timely manner. A bank may even attempt to declare your client in default if these ratios are met, but your client's core business has significantly declined due to what the bank perceives as a material adverse change in its financial condition.

In short, your clients should be aware that banks will use the COVID-19 pandemic as a mechanism to protect their interests at all costs, even if it means pushing your clients prematurely into default.

Conclusion

COVID-19 has evolved from a mere public health concern, to a public health crisis, to a universal financial pandemic. It has caused a completely unprecedented decrease in demand for basic resources such as oil, and has crippled almost every industry dependent on transportation.

While the health aspects of the pandemic continue to roll along unabated, and will likely continue to do so until treatment options and/or a vaccine become widely available, the financial aspects of this pandemic are coming to a head right now.

Counsel representing energy producers, processors or any of those affected by the dramatic decrease in fuel demand should ensure that their clients have sufficient contingency plans for pricing volatility and commodity storage, can decrease production if required, and are well-versed on their rights should banks become aggressive in an existing lending relationship.

Simply put, until times return to something close to normal, counsel's main goal should be to help their clients survive.



Cameron Kinvig is a content manager for Lexis Practice Advisor, and formerly served as general counsel and chief financial officer for X-Subsea, a multinational oil and gas services company.

This article is excerpted from Lexis Practice Advisor®, a comprehensive practical guidance resource that includes practice notes, checklists and model annotated forms drafted by experienced attorneys to help lawyers effectively and efficiently complete their daily tasks. For more information on Lexis Practice Advisor or to sign up for a free trial, please click here. Lexis is a registered trademark of RELX Group, used under license.

Law360 is owned by LexisNexis Legal & Professional, a RELX Group company.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

For a reprint of this article, please contact reprints@law360.com.

Hello! I'm Law360's automated support bot.

How can I help you today?

For example, you can type:
  • I forgot my password
  • I took a free trial but didn't get a verification email
  • How do I sign up for a newsletter?
Ask a question!