Summary

• Low oil prices may have a significant impact on reserves reports, financial statements and reserves based credit facilities of oil-weighted energy companies in Canada. How will reserves reports and write-downs impact reporting issuers' 2015 continuous disclosure obligations under Canadian securities laws? What other legal consequences could result?
• Reserves Disclosure – Does an oil and gas reserves report that shows a reduction in reserves volumes or, more particularly, future net revenue trigger an immediate disclosure obligation before full reserves information is filed? The answer depends on the company's particular circumstances, but early disclosure may be prudent or even required this year.
• Asset Impairment in Financial Statements – This year's reserves reports will require many oil and gas companies to conduct an impairment review of their assets when preparing financial statements. For some companies, assets will need to be written down on the balance sheet and an impairment charge recognized in the income statement, perhaps in magnitude sufficient to result in a large non-cash loss.
• Management's Discussion and Analysis – The oil price collapse will require energy companies to think carefully when drafting the liquidity and capital resources sections of their MD&A. Cash flow will be restrained for an undeterminable period. The availability of additional equity will be restricted for most companies and, for many, the continued availability of bank financing will change for the worse.
• Reserves Based Credit Facilities – Many upstream non-investment grade oil and gas companies rely on reserves based credit facilities as their main (and sometimes their only) source of debt within the company's capital structure. Borrowing availability under those credit facilities is likely to be adversely impacted by the drop in oil prices.

The Cascading Consequences of Low Oil Prices

The recent rapid decline in oil prices has already affected share trading prices of exploration and production companies around the world. Those recent low oil prices and, more importantly, continued low forecast prices for 2015 and beyond may also have a significant impact on reserves reports, financial statements and reserves based credit facilities of oil-weighted energy companies in Canada. Some relief may be provided by hedging contracts but if low prices persist then the relief will only be temporary.

Reserves and financial statements for oil and gas public companies (called reporting issuers under Canadian securities law) must be announced by news release and filed on SEDAR (the System for Electronic Document Analysis and Retrieval, at www.sedar.com). The announcement and filing deadline is 90 days after year-end for reporting issuers with securities listed on the Toronto Stock Exchange and 120 days for reporting issuers listed on the TSX Venture Exchange (and other junior exchanges in Canada and elsewhere). Most companies have a December 31 financial year-end, which results in 2015 calendar filing deadlines of March 31 and April 30, respectively.

A few companies have already announced summary 2014 year-end reserves information. Full reserves information is required by Canadian Securities Administrators National Instrument 51-101 – Standards of Disclosure for Oil and Gas Activities (NI 51-101). It will follow later, typically in a company's annual information form and often coincident with the release and filing of audited annual financial statements.

For some companies, application of impairment tests under GAAP (which, in Canada, is International Financial Reporting Standards, or IFRS), will require that the carrying value of oil and gas assets on the company's balance sheet (called a statement of financial position under IFRS) be written down and recognized as an impairment charge in the income statement.

A number of companies, mainly internationally but also in Canada, have already announced large write-downs due to low oil prices. Others will surely follow.

How will reserves reports and write-downs impact reporting issuers' 2015 continuous disclosure obligations under Canadian securities laws? What other legal consequences could result?

Reserves Disclosure

The two principal components of an NI 51-101 reserves report are reserves volumes and the net present value of future net revenue from those reserves. The first is measured by volume (mcf, bbls and boe) and the second in dollars (with the most oft-cited measure using forecast prices and costs before income taxes and applying a 10-percent discount rate – NPV10).

Immediate disclosure is required if the contents of a new reserves report constitute a material change from previously filed reserves information. Material change is the general Canadian securities law trigger for immediate disclosure, whether the change relates to reserves or to any other aspect of the company's business, operations or capital. A material change is one that "would reasonably be expected to have a significant effect on the market price or value of a security of the issuer".

Does a reserves report that shows a reduction in reserves volumes or, more particularly, future net revenue trigger an immediate disclosure obligation under NI 51-101?

The fall in oil prices is an external economic event that impacts virtually all oil and gas companies. Share trading prices have already reacted. Immediate disclosure of reserves report results is generally required only if a company is particularly affected in a material way. For example, the company might have, in contrast with its peers, low netback producing or high cost development properties that are rendered uneconomic by current and forecast low oil prices.

Even if there is no legal obligation to do so, many companies will issue a news release summarizing December 31 year-end reserves well before they file full NI 51-101 reserves information. Companies that have not historically done so should consider whether a news release is warranted this year due to the effect of low oil prices on the estimated value of future net revenue from their reserves. For some companies, immediate disclosure by news release is strongly recommended if the likely consequence of the reserves report will be an asset write-down due to the application of accounting impairment tests.

Inclusion in a news release of required and appropriate disclaimers is more important this year. The typical reserves disclaimer says (usually in many more words) that there are numerous uncertainties in estimating reserves volumes and future revenue from those reserves, and that actual reserves and revenue could differ materially from the estimates. The forward-looking nature of the information must be acknowledged, which is easy to do. The more challenging requirements are to state the material factors or assumptions used to develop the information, identify risk factors and, in the future, compare actual results to the information being disclosed now. Too often, extensive non-specific "boilerplate" language is used by companies. Well-crafted disclaimer language, tailored to the company, acts as a partial defense against possible investor complaints when future outcomes are (almost inevitably) wrongly predicted.

Financial Statements

This year's reserves reports will require many oil and gas companies to conduct an impairment review of their assets (accounting advice should of course be sought on this point).

For an oil and gas company, producing properties have assigned reserves. Those properties are tested for impairment when triggers occur. The recent steep decline in commodity prices and market capitalization strongly suggests that many companies will be conducting impairment tests in early 2015.

An impairment test is done at the level of a cash generating unit (CGU), which is generally a field or combination of fields (for example, three gas fields that all flow into the same processing plant). A CGU is written down if the carrying value exceeds the recoverable amount. Recoverable amount is defined as the higher of value in use and fair value less costs to sell. Often, the recoverable amount is based on proved and probable reserves discounted at current market rates (10 to 20 percent depending on the nature of the reserves; that is, the volumes that are proved versus probable).

In contrast, exploration and evaluation properties are generally undeveloped/unproven lands without assigned reserves. Those properties can be very significant for international companies and some domestic companies. They have less stringent impairment triggers, but the current market is making it more likely that an impairment test will be required. Impairment testing of those assets is often more subjective, because there are no assigned reserves. Values must be supported by contingent resources, internal development models or recent land sales.

If assets are determined to be impaired, they are written down on the balance sheet and recognized as an impairment charge in the income statement, often in magnitude sufficient to result in a large non-cash loss.

An asset write-down and impairment charge is disclosed in the company's announced and SEDAR-filed financial statements. No additional filings (such as a material change report) are typically required, but the importance of the news, even if expected, makes confidentiality before announcement particularly important.

MD&A

Financial statements must be accompanied by management's discussion and analysis (MD&A). MD&A is a narrative explanation, through the eyes of management, of how the company performed during the period covered by the financial statements, and of the company's financial condition and future prospects.

Details of an asset write-down and impairment charge are contained in notes to the financial statements and discussed in MD&A. Those details are largely descriptive. In contrast, the impact on liquidity and capital resources, two of the required items to be addressed in MD&A, can be more difficult to address because each is forward-looking.

The oil price collapse will require energy companies to think carefully when drafting the liquidity and capital resources sections of their MD&A. Cash flow will be restrained for an undeterminable period. This will adversely impact maintenance and growth plans and could create real liquidity risks for some companies. In addition, the availability of additional equity will be restricted for most companies and, for many, the continued availability of bank financing will change for the worse (as discussed in the next section with respect to reserves based credit facilities).

Our expectation is that securities commissions will review MD&A more closely this year. Some companies will receive comment letters questioning their disclosure.

Reserves Based Credit Facilities

Borrowing availability under the reserves based credit facilities of many exploration and production companies is likely to be adversely impacted by the drop in oil prices. Many upstream non-investment grade companies rely on reserves based credit facilities as their main (and sometimes their only) source of debt within the company's capital structure. While well-hedged companies will be less affected by fluctuations in oil prices, at least for a while, companies without hedging protection will undoubtedly be discussing with their lenders the repercussions of projected future decreased cash flow.

Under reserves based credit facilities in the Canadian market, a company is able to borrow up to the lower of the "borrowing base" (based on the net present value of the revenue expected to be derived from the company's proven reserves, customarily using a 10-percent discount rate) and the lenders' aggregate committed amounts under the credit facility.

The borrowing base is customarily redetermined twice a year, often with an option for one additional lender redetermination (usually subject to certain parameters to justify the review) and sometimes one borrower requested redetermination, in each case in a twelve month period. During redetermination, each lender will conduct its own review based on that lender's internal guidelines (including its own price forecast, but customarily subject to consideration of the borrower's current hedging arrangements). The lender will subsequently agree or disagree with the borrower's request for a certain borrowing base amount, or the amount proposed by the agent under the related credit agreement.

There may be some limited protections for a borrower during a borrowing base review. Some credit agreements, for example, contain language requiring the lenders to redetermine the borrowing base in accordance with "customary practices for loans of a similar nature". Some credit agreements also offer the borrower the chance to replace a lender if that lender redetermines the borrowing base at a level lower than what is acceptable to other lenders.

Despite certain protections, a borrower has little recourse if the lending syndicate unanimously decides on a borrowing base that is lower than anticipated. If the principal amount outstanding under the credit facility exceeds the then applicable borrowing base, the company will be required to repay the excess amount, typically within a 30 to 60 day period (or provide additional collateral to support the overage; reserves based credit facilities are typically secured loan arrangements). An inability to address the shortfall in the required time period may trigger an event of default under the credit agreement, with no further time to cure.

Reserves based credit facilities in Canada often revolve for an initial one-year term that is extendible for further one-year periods with lender consent. Lender consent for extension is highly discretionary and therefore subject to changing economics and lender concerns over the future liquidity of the borrower. If the facility is not extended, the company will be required to repay the outstanding loans at the end of a further one-year period, and no new borrowings will be available under the credit agreement.

Some reserves based credit facilities contain financial maintenance covenants as a means for the lenders to monitor the borrower's EBITDA over a period of time and its liquidity at certain times during the year. The ability of the borrower to generate sufficient cash flow to carry on operations and to cover debt service obligations as they become due is of the upmost importance to lenders. In an environment of rapid commodity price declines, many sub-investment grade borrowers are at an increased risk of tripping such covenants. Moreover, if other debt facilities exist, decreased cash flow resulting in an inability to meet those debt-related obligations can trigger a cross default in other lending facilities. Finally, loan pricing that is pegged to a leverage ratio will also be adversely affected if the margins that exist in the credit agreement increase quite substantially in connection with, for example, an expanding debt-to-cash flow ratio.

Other Consequences

Less immediately, but no less directly, the fall in oil prices can trigger many other legal consequences. Included are consideration of executive and employee compensation plans (many of which are tied to share trading and/or financial and operational results), vulnerability to take-over bids and/or shareholder activism, the potential need to examine strategic alternatives (in effect, putting out the "for sale" sign), balance sheet restructuring and even insolvency.