IT  CAN  BE  EXHAUSTING  TALKING  ABOUT  THE  GOVERNMENTS  LLR  (“LICENSE  LIABILITY  RATIO”) SYSTEM   BECAUSE  OF  HOW  MANY  FLAWS  THE  PROGRAM  INHERENTLY  CARRIES.

Companies are given a liability ratio based on the licensee’s total assets divided by the cumulative facility and wellbore liabilities. Theoretically this is a good idea, but this is an unfair way to judge companies because the system takes no accountability for the financial health of the company.  In the latest downturn, several companies declared bankruptcy but not because   they   went   broke   abandoning   wells.   The common theme was companies had insufficient funds to cover the interest payments on their debt financing.  I believe many companies with low LMRs should be applauded, they are still fighting to stay alive while providing benefits to all Albertans. These operators are providing royalty income to the government, employing a variety of individuals, and abandoning inactive sites on their own dime, not someone else’s.  Throwing wells to the Orphan Well Association (OWA) is the worst case scenario.
If the LLR system can’t identify companies at risk, why are we using it?  The system, which hasn’t been updated in years, needs to progress into something current and powerful.  The current netbacks used by the Alberta Energy Regulator (“AER”) go back almost a decade and the liabilities associated to sites can be drastically high or low.  It’s just a very simple ratio of assets divided by liabilities.  There is no consideration or any external revenue generated from third party processing or financial gains from hedging strategies.  There is no way to detect which companies are on the brink of default and stopping these companies from accepting more licenses of which they will never be able to abandon.
What if instead of trying to manage a fictitious asset to liability ratio, the regulators developed a system where licensees disclosed a Liability Management Plan (“LMP”).  An LMP created by producers would be a realistic financial model to abandon all the wells, pipelines, and facilities they hold a working interest in.  As most operators, can attest to, efficiencies are created with economies of scale. If companies could create an LMP that suggests that it will abandon field sites once set number of wells (say 20%) become inactive for a minimum of 10 years, it could be a highly efficient project. Regardless of how cash is spent, an LMP financially discloses the environmental cleanup costs and is burdened against the asset. Finally, an LMP requiring approval from the regulators forces operators to disclose a reasonable and attainable timeframe to complete their abandonments.
The problem arises when producers defer dealing with liabilities to an unrealistic timeline.  The governing agencies have a major reason for concern, because businesses will resist deploying any capital on projects that don’t generate value for the shareholders.  Most licensees would suggest that the most economical abandonment project will be once all wells are suspended and abandonments can all be done at once.  This is unreasonable because there is minimal cash flow remaining at the very tail end of a field’s development.  In addition, facilities have significant risk for substantial cleanup costs which get abandoned at the end of the project.
What if instead of trying to manage a fictitious asset to liability ratio, the regulators developed a system where licensees disclosed a Liability Management Plan (“LMP”).  An LMP created by producers would be a realistic financial model to abandon all the wells, pipelines, and facilities they hold a working interest in.  As most operators, can attest to, efficiencies are created with economies of scale. If companies could create an LMP that suggests that it will abandon field sites once set number of wells (say 20%) become inactive for a minimum of 10 years, it could be a highly efficient project. Regardless of how cash is spent, an LMP financially discloses the environmental cleanup costs and is burdened against the asset. Finally, an LMP requiring approval from the regulators forces operators to disclose a reasonable and attainable timeframe to complete their abandonments.
The problem arises when producers defer dealing with liabilities to an unrealistic timeline.  The governing agencies have a major reason for concern, because businesses will resist deploying any capital on projects that don’t generate value for the shareholders.  Most licensees would suggest that the most economical abandonment project will be once all wells are suspended and abandonments can all be done at once.  This is unreasonable because there is minimal cash flow remaining at the very tail end of a field’s development.  In addition, facilities have significant risk for substantial cleanup costs which get abandoned at the end of the project.
The benefit of an LMP system is a measurable program made to suit the needs of both the AER and the licensee. The system would be auditable and companies would be forced to execute the plan that they developed.  Each wellbore, pipeline, and facility is unique and a site-specific cost can be estimated by the operator’s historical abandonment projects. In the event service costs are reduced, like what we experienced in this recent downturn, the model can be regularly adjusted.  The asset retirement obligation (“ARO”) is the total cost to retire each of the cumulative licenses held by the company and is inflated/discounted to a present value.  The current LLR system does not include any non-operated asset values or liabilities, while the LMP and ARO assessment includes every entity in which the operator holds an interest.
A common frustration shared by many licensees in the industry is that operators are continuously being told how they need to run their business. If oil and gas producers don’t want to be told how they need to deal with their liabilities, they should present a plan on how they intend on dealing with them. By companies taking ownership on dealing with inactive sites, governing agencies job becomes ensuring that plans are acceptable and that companies are accountable for their past declarations.
This approach is no different than the Enhanced Production Audit Program (“EPAP”), in which operator’s executives declare annually the state of their controls, and ensure compliance in measurement/production reporting.  Companies have a date of declaration and each year they disclose to the board their measurement control issues. This allows the operators to remain in control of their business and not only enables trust in the system but forces accountability to the industry.  Liabilities compound very quickly on a “do nothing” case and is the reason governing agencies step in with strict rules.
An example of government intervention is the AER’s Inactive Well Compliance Program (“IWCP”), implemented in 2015 due to the industry’s lack of attention to inactive wells. Suspended wells are categorized based on risk and Directive 13 provides guidelines on how these wells must be maintained. In 2015, over 30,000 wells were non-compliant due to licensees not submitting their inspections or by ignoring the downhole requirements. The government identified these wells and operators were given five years to bring all the wells into compliance. The program is still in effect and after the first year more than 13,000 were properly suspended or abandoned. Although many were frustrated with this program and the costs associated to the program, it’s simply irresponsible to defer dealing with this issue. I am very confident that when the IWCP is complete, further programs will be rolled out on how companies need to deal with abandoned sites that have not been reclaimed.
Companies confirm their asset values by engaging third parties to perform independent reserve evaluations on all their producing entities.  These reserve reports provide annual cashflows and total asset values of all the producing wells (as well as proved/probable future locations).  ARO assessment can be layered into this evaluation to identify at risk companies lacking the cash flow to fulfill even the most conservative LMPs.  If a company wanted to sell an asset, the regulating agency could request that both the purchasing and selling entity demonstrate their ability to fund the new post transaction LMP. This sounds reasonable to me.
The reality is companies aren’t as profitable as previous years, and the government needs to be reasonable on how to deal with oil and gas producers.  Ten years ago, with > $10/mcf gas prices, Alberta was punching shallow gas wells at an incredible rate.  Today at $3/mcf gas prices, these wells are marginally economic, and many of these wells are less profitable then a vending machine. These sites can’t be burdened with more regulations, especially as they pose minimal risk to the public and environment when they produce minor volumes at low pressure. An LMP is company specific, and some companies/assets should be given relief during difficult financial times. History has proven that commodity prices are cyclical, so perhaps the government could work with licensees and provide relief at the bottom of the economic cycle.  The benefits of a healthy oil and gas industry is beyond measure, and cooperation with the government is needed to maintain confidence to both the public and investment communities.
Three years ago, oil properties were selling for as much as $150,000 per flowing barrel and revenue generated from oilfields were so prolific that liabilities were insignificant.  Over the past six months, we are seeing assets being exchanged for nominal values because liabilities bear far too much risk for some companies. In my opinion, companies shouldn’t be scared of liabilities but they should be aware of them. Thousands of wells are abandoned each year with hundreds of millions being deployed to retire projects.  With this much investment into abandonment and reclamation projects, new technologies will be developed to bring costs down and efficiencies up.
Although each operator continues to strive to outperform its competitors, producers win and lose together.  Collectively, the industry has a challenge on how the government should identify at risk companies and deal with inactive sites. The existing LLR system is flawed and collectively the industry needs to find a solution.  Hopefully we can consider an LMP system which financially models every well, pipeline, and facility abandonment while allowing operators to maintain control of their own destiny.

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Published: The Negotiator, April 2017

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