The Effect of Mechanic's Liens in the Oil and Gas Industry

Recent trends in the Oil and Gas industry, particularly the decrease in prices for crude and natural gas, suggest that mechanic’s liens are quickly becoming a problem for exploration and production companies. In this article, William Snyder draws on his experience advising Oil and Gas clients and their constituents to explain the filing process and explore the possible effects of mechanic’s liens on companies.

In January 2020, the price of natural gas fell below $2.00 per million British thermal units (MMBtu), the lowest it has registered in over three years. As commodity prices for West Texas Intermediate (WTI) crude decrease along with demand for natural gas, companies are reducing drilling in order to manage expenses. According to Baker Hughes, the number of active rigs in the U.S. is down by 186 compared to last year’s count^[1], representing a 22 percent decrease.

Unfortunately, when an oil and gas exploration and production (E&P) company reduces the number of shale well completions, cash flow typically decreases due to the rapid decline in production, which in turn puts its ability to pay its contractors at risk. When the E&P company significantly delays payment to or can no longer pay contractors, they, in turn, can file a mineral or mechanic’s lien on the property to secure a future payment. Once a lien is filed, it may supersede the interest of a senior secured lender.

Recent trends in the oil and gas industry, along with our experience advising oil and gas clients and their constituents, suggest that liens are quickly becoming a problem for E&P companies. In our view, it is in the best interest of the senior secured lender that contractors be paid before the contractor resorts to a lien, as it becomes significantly harder for a company to sell assets once a lien is filed.

Under Chapter 56 of the Texas Property Code, a mineral contractor or subcontractor can file a lien on mineral properties for the mineral activities generated on the property. Mineral activities are described as “digging, drilling, torpedoing, operating, completing, maintaining, or repairing an oil, gas, or water well, an oil or gas pipeline, or a mine or quarry.”^[2] When a property owner is unable to pay the contractor, the contractor can file a mineral or mechanic’s lien on the mineral properties in the amount that has not been paid.

In Texas, oil and gas exploration companies that reorganize in bankruptcy are routinely faced with mounting liens because the vendor has six months to file the lien from the last date of service. As a result, these liens have the potential to move a vendor from an unsecured class to a secured class. Especially since the oil and gas downturn in 2014, most contractors are well versed in this issue and are quick to file a lien on a well in the event of a payment default. At Dune Energy, an E&P company, CR3 was engaged as Chief Restructuring Officer (CRO) ahead of its bankruptcy filing, in part to deal with the mechanic’s liens that were filed against the company.

Numerous issues must be considered to establish the validity and value of these liens, which are critical to determining the waterfall of proceeds. The first variable is to determine if there is a pre-existing lien on the property, which typically is held by a mortgage from the Reserve-Based Lender (RBL). It is not uncommon to find situations in which the company took on additional leases after the loan was made and did not inform the RBL until after the lease was acquired, in which case there is no mortgage on the property. In this instance, if a contractor has filed a lien on a property, it may find itself in a first secured position on a specific well, property or unit. The second variable is to determine the overall value of the properties in excess of the RBL mortgage to determine if there is sufficient value to pay the contractors that filed liens. However, some recent sales have not even cleared the RBL, and the issue is moot in those instances.

Aside from the RBL, the validity and priority of the liens must be taken into consideration. Each state has mandated specific steps to file and record a lien against a property. Contractors must follow the procedures and file the documents properly or they may find themselves in an unsecured situation due to poor filing procedures. The timing of the filing could also affect the priority of their claims, depending on whether other contractors also filed liens. Additionally, the well must have sufficient value to cover the liens. Depending on the production of the well, there may be circumstances in which the remaining value of the well will not cover the liens that are filed. This may create a deficiency claim, as the liens are property specific and do not transfer to other properties.

If a value is attributed to the liens, it is critical to propose a bar date to sort out the issues and establish a waterfall payment. Once a bar date is established, the debtor has time to sort out the lien issues related to the properties in order to distribute funds accordingly. The process for the debtor is very arduous and time-consuming, and therefore sufficient time needs to be allocated to this process.

In an E&P bankruptcy, it is important to establish a process to address liens early in the case due to the inherent stakeholder implications.  The process and aspects of properly validating a lien, as described above, ultimately determine if each property has sufficient value to pay the liens and mortgage.

About CR3 Partners, LLC

CR3 Partners, LLC is a national turnaround and performance improvement firm that assists, guides and collaborates with management teams and their constituents facing any sort of transition, stress or distress. William Snyder is a Partner in CR3’s Dallas office. Greg Baracato, a Partner in CR3’s Dallas office, Cade Kennedy, a Director in CR3’s Dallas Office, and Edwin Clark, a Manager in CR3’s Dallas office, contributed additional research for this article.

[1] Baker Hughes on January 25, 2020: https://rigcount.bakerhughes.com/rig-count-overview
[2] Texas Constitution and Statues: https://statutes.capitol.texas.gov/Docs/PR/htm/PR.56.htm