By – When credit is cheap, commodity prices are adequate, and the wells are economic, it is easy for an operator to forget about its working interest partners in the drilling of a well. Oftentimes, letter agreements are negotiated that allow for well costs to be paid via joint interest billing in lieu of cash calls. However, when commodity prices sour, the operator and her balance sheet are left in the hurt locker.
To preface the below, I’m not an accountant or an attorney, so if I make a mistake, please email me.
Accounts receivable (“AR”) are an asset on the balance sheet and in the best scenario, the non-op actually pays their bills and this AR is replaced with cash on the balance sheet. In the event non-op does not pay their bills, and the well is economic, the receivables can usually be collected from a non-op owner, by netting their expenses against their revenues. As we all know, best-case scenarios rarely happen.
Assume the Belleauwoodsman well is proposed with an AFE for completed well costs of $5mm. Assume again that the well was actually drilled and completed for $5mm and that it now has a PV10 value of $7.5mm (I know the shale skeptics are already shaking their heads…). Oscar Oil is the operator and has a 50% WI, November Oil is the sole non-operating working interest owner and owns the remaining 50% WI. The value of the Belleauwoodsman to each party is $3.75mm ($7.5mm * 0.50).
If November never paid for any of her costs, she would owe Oscar $2.5mm ($5mm * 0.50). Accordingly, Oscar would carry an AR balance of $2.5mm.
If November can’t be netted and she continues to not pay her bills (which would be odd considering her asset is worth more than her liability, but maybe she is strapped for cash) and Oscar and November can’t reach a settlement, Oscar can file a lien against November’s oil and gas leases with the county clerk. Both model form joint operating agreements and Oklahoma Corporation Commission forced pooling orders grant the operator the right to lien against non-ops who do not pay their bills.
If the lien leads to a successful foreclosure, it is likely Oscar will be made whole. After all, November owes Oscar $2.5mm, but the value of her share of the Belleauwoodsman is $3.75mm. So the $2.5mm AR is replaced on the balance sheet with an entry for an increase of reserves (also an asset). Again, not legal or accounting advice, but that’s the way it appears from the cheap seats.
In this case, we will take the Oscar and November from the above situation, but instead of a PV10 of $7.5mm, the Belleauwoodsman now has an 8/8ths PV10 of $3.75mm because commodity prices dropped 50% in a week (not that the situation is remotely plausible…). Both Oscar and November mark down their share of the well from $3.75mm each to $1.875mm each ($3.75mm * 0.50). Remember, November still owes Oscar $2.5mm in well costs (and Oscar has a $2.5mm AR balance). If November didn’t pay her bills when times were good (and her share of the well was worth more than her bills), what would incentivize her to pay it now that she is underwater by $0.625mm ($2.5mm-$1.875mm)? Probably not much.
So, Oscar files a lien and forecloses on November’s interest. Now Oscar has acquired an asset worth $1.875mm (the reserves), but loses an asset worth $2.5mm (the AR). Oscar’s balance sheet will take a hit and she will have to explain to her lenders why she didn’t collect November’s share of her well costs sooner and why it went to foreclosure (but better than being an unsecured creditor in Oscar’s bankruptcy proceedings!).
One should see if an Oscar has a number of wells with delinquent Novembers, this could lead to big issues. Be on the lookout for these situations and get those JIBs out the door early. Thanks for reading and please comment if you have anything to add to the discussion.