The catch-22 of the Redwater case

Who gets the profits from selling a bankrupt oil and gas company?

When an oil and gas company goes bankrupt, should profits from the sale of remaining assets go first to lenders, or to pay to clean up the environmental mess left behind? That question is the crux of the Redwater legal case currently unfolding in Canada’s Supreme Court.

Stuck between a pumpjack and a hard place

From a public interest perspective, the preferred outcome of the case would be for the Supreme Court to overturn the Alberta Court of Queen’s Bench 2016 ruling in favour of creditors. This would uphold the decades-old principle that polluters and their financial backers are accountable for the messes they make, and prevent a precedent from being set where the public would effectively subsidize banks’ investments by taking on the long-term financial and environmental risks.

For Alberta’s conventional oil and gas industry, neither outcome of the case is ideal. If the Supreme Court sides with the Alberta Energy Regulator (AER), lenders will be more critical in evaluating liability costs, thereby reducing companies’ access to credit. On the other hand, if the Supreme Court sides with the creditors, it would create an incentive for companies to abandon environmental liabilities, resulting in a dramatic increase in facilities designated “orphaned.” This has already begun to unfold in Alberta following the Queen’s Bench ruling, with an exponential increase in sites being offloaded since 2016 into the industry-funded Orphan Well Fund. If the Supreme Court upholds the decision this trend will continue, resulting in significantly higher orphan well levies for operating companies to manage the dramatic increase in financial liability from mismanaged oil and gas companies. Either way, the oil and gas industry faces tangible impacts at a time when it is already financially strained under the weight of increasingly limited access to credit flow and backlogged cleanup obligations. This catch-22 is the result of decades of regulatory mismanagement as the oil and gas industry and the government alike sought to operationalize the “Alberta advantage.” In this case, it’s amounted to a low barrier and low-cost industry environment with little long-term accountability. This approach ultimately created the fiscal train wreck occurring before our eyes.

History of oil and gas liability mismanagement

Inactive wells are oil and gas sites that are no longer producing but have not been properly plugged, decommissioned, and reclaimed but still have a financially capable licensee to manage cleanup if and when the company chooses to. “Orphan wells,” on the other hand, are inactive wells that no longer have a legally responsible and/or financially capable owner to manage the cleanup. The public and environmental risks posed by inactive and orphaned wells in Alberta have been on the regulator’s radar since the early 1980s. A first rendition of an Orphan Well Fund was established in 1986, followed by the Long-Term Inactive Well Program in 1997. Finally — under the auspices of the Energy Statutes Amendment Act legislation and still in effect today — the Licensee Liability Rating Program (LLRP) was established in 2000. Despite all of these initiatives, Alberta’s inventory of inactive (and orphaned) wells has continued to grow, increasing from 25,000 in 1989 to over 80,000 in 2016.

The reason for the ongoing failure of the current system to substantively address the backlog of inactive wells is threefold. First, the calculations used in the LLRP, around which the system is designed, are fundamentally flawed. Using industry averages for both an operation’s presumed profits and clean-up costs ignores critical context for each company’s financial health and liabilities. Second, there are insufficient incentives in the LLRP to encourage cleanup. In many cases continuing to pay rent and maintenance on a surface lease is far cheaper than abandoning the mine and reclaiming the site. Third, the system still lacks regulated timelines for well abandonment and reclamation. Regulated timelines act as a deadline for cleaning up a company’s own mess after it has completed its operations. These are common practice in other oil and gas producing jurisdictions in North America, including New Mexico, Colorado, North Dakota, and Texas. Despite twice being recommended by provincial regulators in 1989 and again in 1996 this common sense approach has not been implemented in Alberta.

From weathering crisis to charting solutions

Regardless of the outcome of the Redwater case, Alberta’s inactive well problem sorely needs lasting solutions. As a step in the right direction, in December 2017 the AER introduced more stringent requirements under Directive 067 to apply more scrutiny when granting licenses and mandate ongoing reporting requirements on their eligibility. Moreover, as an interim measure after the Alberta Queen’s Bench 2016 ruling, the AER has raised the ratio of assets to liabilities companies must hold under the LLRP from 1:1 to 2:1. However, the interim measure has not been enforced, due in part to the fact that enforcing it would push many companies that are close to the brink of insolvency into bankruptcy.

As the problems with the LLRP are systemic, long-term solutions must be more revolutionary. At minimum, this should include phasing in full security deposits for all wells and facilities (to be returned in phases to the licensee as properties are abandoned, remediated, and reclaimed); and, regulated timelines for the abandonment, remediation, and reclamation of inactive wells and facilities. The situation today is a result of decades of deliberately facilitating a low-cost environment at the expense of long-term responsible management, and the industry will need to accept its responsibility and manage the accrued liability. While these changes arguably change the financial landscape for existing assets in the short term, this approach offers a longer-term route out of the catch-22 generated by the Redwater case by protecting responsible companies from shouldering the burden of their barely solvent peers’ liabilities — either through increasingly hefty levies or making investors wary of investing in Alberta. More broadly, it ensures that in the long run, as the world transitions towards decarbonized energy systems and competition in oil and gas markets gets fiercer, Albertans will be protected from the financial and environmental legacy of decades of free-for-all development.

In our previous blog, “A liability iceberg in Alberta exposed by the Redwater legal case,” we discussed how the Redwater case has exposed a liability bubble in Alberta's conventional oil and gas sector, and in our next blog, “Redwater will reverberate across Canada,” we discuss how the Redwater case will have immense legal, fiscal, and environmental impacts on all resource extraction industries across Canada.