[co-author: Kenryo Mizutani - Articling Student]
Following the Redwater decision (Orphan Well Association v Grant Thornton Ltd., 2019 SCC 5), and the steadily increasing number of orphaned oil and gas sites, governments have been evaluating opportunities to modify their approaches to liability management and address growing inactive well inventories. Notwithstanding that Alberta and Saskatchewan have historically adopted similar regulatory regimes, the two jurisdictions are diverging in their approach to liability management.
Following the amendments to the Oil and Gas Conservation Act and Pipeline Act in April 2020, which increased the authority of the Orphan Well Association, there were subsequent amendments in December 2020 to further introduce regulatory changes to the liability management of oil and gas wells and facilities. For our earlier commentary on Alberta's new Liability Management Framework, see Alberta Announces New Liability Management Framework and Advancing Alberta's New Liability Management Framework.
The new Liability Management Framework introduced a new definition of "closure" and expanded the Alberta Energy Regulator's (AER) discretion to establish closure quotas and require a closure plan for all or some of a licensee's wells and facilities. In addition, eligible requestors may ask licensees to prepare a closure plan regarding wells or facilities that have been abandoned or remained inactive for over five years.
With respect to ensuring financial health of licensees, the new Liability Management Framework requires licensees to provide financial information. In furtherance of the AER's increased focus on financial health, the AER has proposed amendments to Directive 067 to require ongoing financial disclosure and will be replacing the licensee liability rating program with a licensee capability assessment.
In February 2021, the Ministry of Energy and Resources of Saskatchewan published a notice of proposed regulatory changes including amendments to the Oil and Gas Conservation Regulations, 2012 and introduction of a new regulation, the Financial Security and Site Closure Regulations. The amendments are intended to address the following risks:
- the high percentage of inactive infrastructure and risk that the industry will be faced with higher orphan levies as a result of insolvencies;
- the Redwater decision and resulting challenges to raising capital as lenders reevaluate their ability to recover; and
- impacts on Saskatchewan’s competitiveness.
The proposed regulatory changes in Saskatchewan include:
- introduction of the Inactive Liability Reduction Program to gradually reduce the percentage of inactive wells and facilities through prescribed annual reduction targets;
- enhancing the existing Licensee Liability Rating formula to reflect the licensee's actual assets and liabilities; and
- codifying methods for determining additional security required for transfers between licensees involving a high percentage of inactive wells and facilities.
Under the Inactive Liability Reduction Program, which is expected to start in January 2023, the Ministry will require licensees to retire a percentage of their inactive wells and facilities every year. While Alberta has discretionary power to set a reduction quota, Saskatchewan has a prescriptive quota for each licensee that is determined by multiplying each licensee's total inactive liabilities with a prescribed annual percentage that is indexed to the industry average netback. Therefore, each licensee is obligated to complete its own share of liability reduction, which is linked to the overall industry performance for any given year.
The Ministry will calculate the total deemed liability for each licensee as calculated through the Licensee Liability Rating to account for abandonment or decommissioning, reclamation, and remediation. The total deemed liability for each licensee will be used to determine the annual target spend for each licensee. If the licensee has posted security with the Ministry in an amount to satisfy the annual target spend, it may obtain access to the posted security for carrying out the closure work. In the event that licensees spend beyond the prescribed annual target, these amounts will be carried over to the subsequent years. In the event that licensees fail to meet their prescribed annual targets, the Ministry may impose penalties. Further, any transfers or divestments of liabilities during the year will not affect the required annual target for the licensees.
As larger producers transfer wells to junior producers where such transfers include a high percentage of inactive wells and facilities, the proposed regulation includes a new Proportional Risk Transfer Model to account for new risks associated with transfers of inactive wells and facilities that may pose additional risks to such infrastructure becoming orphaned. The proposed Proportional Risk Transfer Model includes a formula to weigh the ability of licensees engaged in transfers to handle liability. In particular, it considers whether transfers result in increased risks of the transferees due to the accumulation of liabilities.
Further, unlike the conventional Licensee Liability Rating, the enhanced Licensee Liability Rating is modified not to simply consider the ratio of asset and liability values, but also to include annual net income for each licensee to address cash flow and solvency.
Key elements of the two provinces' proposed approaches to managing liability are summarized below:
|License Liability Rating Calculation
||Asset value over liabilities, where asset value considers production volume of the licensee and industry netback, for a return period of three years. For the purpose of assessing deemed liabilities, the AER relies upon estimates for closure as set out in Directive 011 which was last updated in 2015.
The AER has announced an intention to move away from the LLR to focus on the licensee capability assessment.
|Saskatchewan is seeking to enhance the current LLR calculation which has historically been calculated the same as is done by the AER. Under the proposed approach:
Asset value will be calculated based on monthly production and the actual price of oil/gas sold as reported for royalty purposes for a 12 month basis and then modified based on estimated operating costs, transportation costs and freehold royalties/taxes.
Liability will be calculated based on actual expenditure data for abandonment and reclamation under the Accelerated Site Closure Program.
|Annual Spend Program
||The Inventory Reduction Program will establish annual industry site closure spending targets over a five-year rolling period to reduce overall inactive wells and inventories.
AER may set closure spend targets (closure quotas).
|The Inactive Liability Reduction Program establishes a benchmark before the commencement of the program in January 2023 and requires licensees to retire a percentage of their inactive liabilities each year (Annual Prescribed Percentage).
The Annual Prescribed Percentage is linked to the industry average netback. The annual prescribed percentage is multiplied with a licensee's total value of inactive liabilities to determine the Annual Reduction Target.
||No changes proposed to the use or collection of security.
||Saskatchewan has similar security provisions to Alberta, however as part of their proposed amendments they are proposing additional certainty in terms of when security would be collected as well as the ability to access security held for the purpose of complying with annual closure spend obligations.
||• Net profit margin (three-year average)
• Cash flows from operations to debt
• Debt to equity
• Current ratio
|• Cash flow from operations
• Current and total assets and liabilities
• Debt servicing expenses
• Earnings subject to tax
• Depreciation and amortization
• Netback stockholder's equity
• Operating costs
• Transportation cost
• Freehold royalties
While both Alberta and Saskatchewan are adopting approaches to encourage companies to spend annually on reducing liabilities, the Alberta requirements provide additional discretion, while the Saskatchewan amendments appear to be focused on providing increased certainty in terms of calculating liabilities and clarifying the circumstances in which security will be required and when it can be used. Only time will tell as to which approach will be more successful at managing liability, however in the interim, there are components of each program which can assist lenders and parties to a transaction in assessing the environmental liabilities associated with same.