Trends in Energy Disputes: Impacts on Valuation · Trends in Energy Disputes: Impacts on Valuation...

Trends in Energy Disputes: Impacts on Valuation National 2014 Energy Valuation Conference

William D. Wood Head of Energy & Infrastructure, United States Lauren Varnado Associate, Energy & Infrastructure Disputes

Selected Trends in Energy Disputes Broken, Impaired or

Failed Transactions

Post-Closing Disputes • Representations and

Warranties

Rights of First Refusal Disputes

Environmental Litigation

Interest Ownership Disputes

Fracking-Related Controversies

Royalty and Profit Interest

Catastrophic Events and Natural Disasters

Regulatory Investigations • Domestic

• Multi-Jurisdictional

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Does Venue Matter? Does Trier of Fact Matter?

State Court

Federal Court

Arbitral Tribunal

• Domestic

• International

Administrative Agency

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Role of Valuation in Energy Disputes

Reserves

• Estimation

• Disclosure

Calculation of Economic Damages

• Lost Royalties

• Valuation of Assets

Tax Appraisals

Jurisdiction

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Valuation Standards for Oil and Gas Industry

Convergence of International Financial Reporting Standards and U.S. GAAP

• Significant variations in LIFO, capitalization of exploration and development costs, inventory valuation

• Principles-based IFRS requires more judgment on part of accountants

Litigation risk due to misapplication of IFRS and second-guessing judgment calls

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Valuation Methodologies Applied to Oil and Gas Cases

Asset-Based or Comparable Transaction Approach

Producing assets generally have resale value, without potential upside on commodity prices, operating efficiencies, or other strategic value

Each project has unique characteristics

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Valuation Methodologies Applied to Oil and Gas Cases

Discounted Cash Flow Method Expert models future cash flows over remaining

economic life of venture

• Estimated volume and rate of future production

• Forecast capital expenditures

• Forecast operations expenses

• Forecast oil and gas prices over project life

• Discount rate

Widely-accepted method to value upstream properties to calculate damages

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Discounted Cash Flow Method: Valuing Upstream Oil and Gas Investments Basic Energy Serv., Inc. v. D-S-B Properties, Inc., 367 S.W.3d 254 (Tex. App.—Tyler 2011)

• Royalty owner sought damages for damage to wellbore in negligent well repair

• Damages in form of lost royalties were established with reasonable certainty by expert using discounted cash flow method

• Damages calculated based on net present value reduced by 35% risk factor to account for possibility of dry hole

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Discounted Cash Flow Method: Valuing Upstream Oil and Gas Investments, cont.

Bridas S.A.P.I.C. v. Gov’t of Turkmenistan, 345 F.3d 347 (5th Cir. 2003)

• Affirmed arbitration award against Turkmenistan government and wholly-owned oil company arising out of joint venture agreement

• Panel’s use of discounted cash flow method and selected discount rate to calculate lost profits was proper

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Discounted Cash Flow Method: Tax Appraisals

Key Energy Servs., LLC v. Shelby County Appraisal District, 2014 WL 130547 (Tex. App.—Tyler Jan. 15, 2014)

• Court held expert testimony utilizing discounted cash flow method to value SWD wells admissible for purposes of challenging tax appraisal and assessment

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Selecting Valuation Dates

Selection of valuation dates and benefit of hindsight information is of considerable importance

Fact-based determination

No pre-established practice as to set valuation date or reliance on hindsight information

Impact of Post-Breach Events

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Selecting Valuation Dates, cont.

International arbitration panels have relied on valuations that use hindsight to determine damages for expropriation

Amco Asia Corp. v. Indonesia, 1 ICSID (W. Bank) 569, 614 (May 31, 1990). Tribunal used hindsight information and emphasized that information known after date of wrongful act had to be taken into account:

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Impact of Derivatives?

Derivatives could arguably factor into calculations to increase or decrease damages at stake or force settlement

Could refiner argue for reduction of producer’s damages claim based on fact that producer hedged output?

Could oil trader claim for increased damages based on profits lost from derivatives trades?

Key Issue: Whether use of derivatives is reasonably foreseeable

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Impact of Derivatives?

Cimarex Energy Co. v. Chastant, 2012 WL 6652360 (W.D. La. Dec. 18, 2012). Derivatives did not factor into lost royalties calculation.

• Royalty owner argued that hedge price constituted “market value” under oil and gas lease

• Court held lessee had no obligation to pay royalties on amounts generated by hedging activity in addition to market value of oil and gas production

• Court explained that hedging activity has no effect on market value price received for production—purely financial activity that involves buying or selling financial positions

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Contractual Valuation Formulas

Atlantic Richfield Co. v. Whiting Oil & Gas Corp., 2014 WL 813051 (Colo. Mar. 3, 2014)

Court refused to reform inflexible price term in negotiated production sharing agreement

Price term was tied to annual percentage change in ARCO’s published benchmark price for WTI

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Contractual Valuation Formulas, cont.

Bottom Line …

If future performance is to be tied to benchmark, include economic openers

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Reserve Reports

Reserve report is key to valuation of upstream properties

Risk is main differentiating factor between category types

• Proved

• Probable

• Possible

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Reserve Reports

Potential Basis for Fraud Claims

Reserve reports and offering memoranda can form basis for fraud or misrepresentation claims

Buyers/shareholders may allege reserve estimates were overstated

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Reserve Reports

In re Miller Energy Res. Securities Litig., 2014 WL 415730 (E.D. Tenn. Feb. 4, 2014)

Securities fraud claim based on alleged false statements of value of Alaska oil and gas assets and reserves

Alleged misleading statements were sufficient to state claim • Used 11% of net revenues as assumed cost of extracting oil—“a

figure completely unreasonable and far below industry standards and [defendant’s] own historical drilling costs [of 35%]”

• Included estimated value of reserves that it had no chance of developing within five-year reserve valuation window

• Ascribed overblown value of $110 million to fixed assets (i.e., pipelines and drilling stations)

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Reserve Reports

In re Miller Energy Res. Securities Litig., 2014 WL 415730 (E.D. Tenn. Feb. 4, 2014), cont.

Valuations not protected by statutory safe harbor for forward-looking statements

Shareholders adequately pled individual defendants had knowledge that values were false

• Extensive experience managing Alaska assets

• Signed SEC filings and participated in Alaska acquisition plan

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Reserve Reports

Potential Defense Against SEC Action U.S. SEC v. St. Anselm Exploration Co., 936 F. Supp. 2d 1281 (D. Colo. 2013)

No affirmative misrepresentations were made regarding use of investor funds to identify and acquire oil and gas prospects

Important to Court’s decision was that reserves estimate was supported by reserve report from independent third-party

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Reserve Reports

Claims Against Reservoir Consulting Firms Highland Capital Mgmt., L.P., 402 S.W.3d 719 (Tex. App.—Houston [1st Dist.] 2012).

Holders of bankrupt oil and gas company’s unsecured subordinated notes could not recover against reservoir-evaluation firm for alleged overestimate of proven oil reserves in Guadas Field in Colombia

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Reserve Reports

Highland Capital Mgmt. L.P., 402 S.W.3d 719 (Tex. App.—Houston [1st Dist.] 2012), cont.

No evidence to support damages claims for common law fraud and negligent misrepresentation

• Plaintiffs bought notes years before alleged overestimate of reserves

• Testimony that notes were later “essentially worthless” did not permit inference that notes had no greater value at time of purchase

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Reserve Reports

Highland Capital Mgmt., L.P., 402 S.W.3d 719 (Tex. App.—Houston [1st Dist.] 2012), cont.

Fact issue as to whether reserve estimate was material misrepresentation in violation of Texas Securities Act

Allegation that engineering firm misrepresented process by which proved reserve estimates were calculated was not addressed by cautionary language of “no assurance” of results being as estimated

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Reserve Reports

In re Capco Energy Inc., 669 F.3d 274 (5th Cir. 2012)

Capco claimed engineering firm “vouched” for credibility by representing reserve estimates were “conservative” and if there was any question re characterization as “proved,” would have characterized as “probable”

No evidence that engineering firm embellished reserve report by giving professional assurances beyond the data

Reserve report itself distinguished between “proved” and “probable” and represented estimates were conservative

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Expert Opinion on Valuation

Federal Rule of Evidence 702 Expert qualified “by knowledge, skill, experience, training, or

education” may testify if:

• specialized knowledge will help the trier of fact to understand evidence or determine fact in issue;

• testimony is based on sufficient facts or data;

• testimony is product of reliable principles and methods; and

• expert has reliably applied principles and methods to facts.

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Expert Opinion on Valuation Expert testimony is crucial to claim for lost profits or determining fair market value of oil and gas interest BRC Rubber & Plastics, Inc. v. Continental Carbon Co., 2014 WL

554565 (N.D. Ind. Feb. 11, 2014) • BRC’s vice president could not testify regarding future damages

resulting from breach of Supply Agreement

• Testimony was based on published projections of future natural gas and feedstock oil prices—information outside vice president’s personal knowledge

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Expert Opinion on Valuation

Bottom Line …

While the Rules allow an officer of business to testify as lay witness about business value or projected profits, cannot testify about future damages from breach of contract unless qualified to testify as expert

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Valuing Speculative Rights

Central N.Y. Oil & Gas Co. v. LaDue, 107 A.D.3d 1199 (N.Y. App. Div. June 13, 2013)

Geologist’s expert opinion regarding value of shale gas under landowner’s property not admissible in condemnation proceeding

Expert’s analysis of potential future effects of fracking and value of related rights was “premature and speculative”

• Based on fact that there is no current commercial development of Marcellus in New York due to moratorium against fracking

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Valuing Oil and Gas Allegedly Drained by Hydraulic Fracturing

Establishing damages is particularly complicated in hydraulic fracturing cases

Royalty owners have burden to prove with “reasonable certainty” amount of production reasonably allocable to their land

Battle of experts and expensive discovery

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Valuing Oil and Gas Allegedly Drained by Hydraulic Fracturing

Establishing damages is particularly complicated in hydraulic fracturing cases

Texas Supreme Court has explained difficulty in calculating “drainage” damages:

Coastal Oil & Gas Corp. v. Garza Energy Trust, 268 S.W.3d 1, 16 (Tex. 2008)

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Can Valuation Expert Be Held Liable?

Ellison v. Campbell, 2014 WL 930978 (Okla. Mar. 11, 2014)

Oklahoma Supreme Court affirmed jury award of damages against expert witness for negligence and breach of contract in performance of duties in lawsuit alleging groundwater pollution as result of oilfield waste disposal

Expert did not know reliability of his testing results, did not follow protocol in completing monitoring wells or collect necessary background data

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Can Valuation Expert Be Held Liable?

Ellison v. Campbell, 2014 WL 930978 (Okla. Mar. 11, 2014)

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Establishing Amount-In-Controversy

Valuation of oil and gas interest may be necessary to establish amount-in-controversy for federal court jurisdiction

Proof of “Legal Certainty”

• Party who wants to be in federal court has burden to prove to a “legal certainty” that amount-in-controversy in the case exceeds statutory threshold

• $75,000 in diversity cases, $5 million in CAFA class actions

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Proof of “Legal Certainty”

Kemerer v. Chesapeake Exploration, LLC, 2013 WL 1337376 (N.D. Ohio Mar. 29, 2013)

• Chesapeake failed to establish value of oil and gas lease exceeded $75k threshold amount-in-controversy

• Court held insufficient land manager’s affidavit that it would cost more than $75,000 to reacquire oil and gas rights in plaintiff’s land

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Proof of “Legal Certainty” Kemerer v. Chesapeake Exploration, LLC, 2013 WL

1337376 (N.D. Ohio Mar. 29, 2013), cont. • Land manager’s affidavit failed to address: Estimated future production from lease

Drilling costs

Value of undeveloped acreage

Book value of asset

Production from nearby wells

Third-party offers to lease

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Litigation Trends: Impacts on Valuation

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Valuation of Shale Reserves Increase in investigations by SEC of valuation of shale

production/reserves

Making ‘gassy’ plays look ‘oilier’? SEC has challenged claims by oil and gas companies re scope of shale oil reserves

• SEC has asserted that companies have included less valuable NGLs in estimates of proved reserves of crude oil

• At least 14 companies have been subject of SEC query

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Environmental Claims Fracking has led to significant increase in environmental

claims by state governments/agencies, environmental groups, and landowners

Lawsuits have included claims of air pollution, groundwater contamination, employee exposure to hazardous chemicals, even criminal liability

Plaintiffs seek compensation for past injuries, medical monitoring, dimunition in property value, remediation/restoration, punitive damages

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“Stigma” Damages for Environmental Contamination

Houston Unlimited, Inc. Metal Processing v. Mel Acres Ranch, 389 S.W.3d 583 (Tex. App.—Houston [14th Dist.] 2012

• Affirmed jury award of “stigma” damages for property contaminated by metal processor but since remediated

• Plaintiff proved permanent damage by virtue of permanent stigma caused by temporary contamination

• Real estate expert opined that stigma caused lost market value of $1,396,500—60% reduction from unimpaired value

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“Stigma” Damages for Environmental Contamination

Will landowners now be able to recover stigma damages for alleged contamination?

Texas Supreme Court will decide—has agreed to hear challenge to jury’s award of stigma damages in Houston Unlimited

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Induced Seismicity?

Landowners in Central U.S. are claiming injection wells cause increase in earthquakes

Plaintiffs seek compensation for damage to homes and nuisance

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Environmental Impact Statements Native Village of Point Hope v. Jewell, 2014 WL 223716 (9th

Cir. Jan. 22, 2014)

• Bureau of Ocean Energy Management acted “arbitrarily and capriciously” when estimated only 1 billion barrels of oil were recoverable from Chukchi Sea

• Choice of lowest possible amount of economically recoverable oil not justified

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Bottom Line on Environmental Impact Statements…

Proponents of plans for oil and gas projects that fail to adequately document decision-making process subject determinations to substantial vulnerability in event of challenge to project

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