Royalty Motion Best Practices: The Lease Operating Expense ("LOE") Dilemma

By Gregg Laswell

Royalty Order Introduction

The Royalty Motion, or the Oil & Gas Obligations Motion, is a critical filing for exploration and production companies entering a Chapter 11 Restructuring. This Motion requests permission for the Debtor to pay outstanding pre-petition obligations for the following oil and gas industry-specific expenses: royalty and working interest obligations, joint interest billings, transportation costs, lease/land rights maintenance costs, and in some cases, lease operating expense “LOE” - the costs associated with maintaining and operating producing oil and gas wells.

From the Debtor’s perspective, requesting and ultimately receiving permission to pay all pre-petition LOE is an aggressive but reasonable strategy, and if approved, could potentially save time, money, and effort throughout a Chapter 11 reorganization. From the Creditor’s perspective, objecting to the Debtor’s attempt to pay all outstanding pre-petition LOE can go a long way in forcing a debtor to re-evaluate its relationships with vendors and in preventing cash from leaving the estate before a global settlement is reached. The pros and cons of allowing full payment of pre-petition LOE must be fully understood by all case parties before the Royalty Motion is entered as a Final Order.

Debtor’s Stance & Defense

It is in the best interest of an exploration and production company on the verge of a Chapter 11 filing to persuade both the other case parties and the Bankruptcy Court to grant the Debtor permission to pay 100% of outstanding pre-petition LOE free of any restrictions. Doing so helps maintain vendor relations and ultimately reduces the number of case parties to reach an agreement within the negotiation of a global settlement. To preserve and maximize value of the estate, a Debtor must maintain production levels throughout the length of the bankruptcy. This requires vital work from numerous vendors who supply materials to operate, maintain, and repair producing oil and gas wells. Permission to pay pre-petition LOE costs goes a long way in maintaining relationships with these vendors who instead of worrying about getting paid, can focus on providing services that maintain the integrity of the producing wells. A Debtor, already burdened by bankruptcy reporting requirements and focused on obtaining agreement for a global settlement, should be freed of the added task of maintaining vendor relations or at times, replacing vendors.

Furthermore, work performed and ultimate payment by these vendors for LOE is often protected by liens, meaning these vendors are entitled to priority payment in full for the work performed despite the bankruptcy. Should payment be disallowed, there is often costly litigation associated with proving out and reconciling lien status. Since LOE vendors have a secured interest, the Debtor’s benefit of maintaining debtor/vendor relationships far outweighs any timing gains associated with foregoing payment in the short-term and prevents additional litigation expenses associated with lien perfection.

Since LOE is the primary operating expense of an exploration and production company, paying all pre-petition LOE significantly reduces the number of parties that comprise the UCC thus decreasing the work required to negotiate and ultimately achieve a global settlement.


Creditor’s Stance & Defense

Rejecting a Debtor’s request to pay all outstanding pre-petition LOE grants a level of power and leverage to the Creditor as it prevents cash from leaving the estate until it can be fully vetted while also forcing the Debtor to identify its truly “critical” vendors. Critical vendors will be identified and have their pre-petition balances paid in full, while the Debtor can use the added leverage of a large unpaid balance to negotiate more favorable terms with or even replace vendors with out of market rates. Lowering costs will leave the Debtor in a more favorable position post-bankruptcy to the benefit of the Debtor and a majority of the Creditors.

These unpaid trade vendors will fall into the unsecured creditor class and have to fight for their portion of the estate. While many of these vendors could have an interest secured by lien rights, a majority will ultimately be willing to accept less than 100% payment on their claim to reach a global settlement out of convenience and to prevent excessive litigation costs associated with perfecting liens thus freeing up value to other creditor classes. In cases where a Creditor is unsatisfied with a Debtor’s operations and believes there is significant value to be obtained by replacing trade vendors and renegotiating contracts, or where forcing trade vendors into the unsecured claim pool could create value for other Creditors, the Creditor’s counsel should persuade the Bankruptcy Court to disallow payments for pre-petition LOE costs until all case parties can reach a global settlement.

Give and Take

The Royalty Motion is a critical First Day Order for exploration and production companies and one that can set the tone of a Chapter 11 case. Both the Debtor and Creditor groups should weigh the pros and cons of allowing or disallowing payment of pre-petition LOE costs as they position themselves for the best possible settlement. From either perspective, having a financial advisor and legal counsel with knowledge of Oil & Gas best practices is essential to obtaining the best result.

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