The Redwater Decision – Why citizens may soon be liable for more oil and gas industry messes

By Michael Ganley
June 26, 2018

All across this province, from the banks of the Peace River to the barley fields of Lethbridge County, 155,000 holes have been drilled in the ground that share four characteristics: They were made to release oil and gas from the Earth’s crust; they’ve produced as much hydrocarbon as they’re going to; the land around them has not been returned to its pre-drill-bit state; and they have not yet been rendered safe. In many cases, the holes and the fractured cracks around them have not yet been filled with cement as required. There may still be road access to the wellhead. In some cases the detritus of drilling operations rusts in place: oil tanks, separators, dehydrators and the like.

Most of these exhausted wells are still owned by one company or another. Generally the company will continue to pay the landowner a small yearly lease fee rather than pony up $100,000 or more to do a proper reclamation. This simple economic decision means most companies carry an inventory of old wells along with their producing ones.

Within this 155,000 number is a smaller but growing subset of wells that have no viable company to oversee a cleanup. Their last owner went broke. Recently estimated to number about 2,900, they’re known as orphan wells because the former owner left their care to other industry players and, potentially, to the public.

All of these wells pose a series of risks: to nearby homes and communities from released gas and explosions; to the local environment from water and soil contamination; and to the global environment from leaking greenhouse gases. Their kind has been around since the earliest days of the oil and gas industry, and mostly they haven’t made it onto the public’s radar. Companies paid the yearly lease fees and did some reclamation. Any wells that did come from bankrupt companies were managed by the Orphan Well Association (OWA), a non-profit unique to Alberta that remediates abandoned wells, pipelines and other oil and gas facilities. The association is funded in part by fees levied on all oil and gas companies and in part from any remaining assets of bankrupt companies, which are sold to pay the cleanup bills.

But two factors have recently clashed to turn these wells—particularly the orphans—into an urgent story. The first is the evisceration of the oil and gas industry since 2014, which has caused a lot of bankruptcies and foisted more wells on the OWA than it can manage. The second involves two matters of law that are central to determining whether or not the public will be on the hook for the cleanup. Over the last couple of decades, the federal government has made changes to the Bankruptcy and Insolvency Act (BIA) which, according to a decision of the Alberta Court of Queen’s Bench, allow creditors of bankrupt companies to jump in front of the provincial oil and gas regulator when it comes to divvying up bankrupt companies’ assets. Then there’s the doctrine of federal paramountcy, which boils down to the question whether a court may strike down a provincial law that frustrates the purpose of a federal law. In this case, should federal bankruptcy law trump Alberta’s rules around abandoned wells, or vice versa?

A time of reckoning is at hand for the province’s regulatory regime that oversees old wells and the protection of the environment.

That question was answered in the Court of Appeal’s April 2017 decision in Orphan Well Association v. Grant Thornton Ltd., better known by the name of the company at the centre of the dispute, Redwater Energy. Redwater was a relatively small oil and gas producer when it went bankrupt in 2015. It owned 127 wells but only about 20 of them were still valuable producers. The remainder were in various stages of decline or had stopped producing altogether but still needed to be capped and the surface reclaimed. The court ruled (in a split decision) that the federal law did trump the provincial.

This means Redwater’s orphaned wells—and those of many other bankrupt companies—pose risks to the established order, to the industry that might have to share in the cost of cleaning them up, and ultimately to the public, who could end up backstopping the operation. Redwater was appealed to the Supreme Court of Canada, which heard the case on February 15, 2018, and reserved its decision to spring or summer. Regardless of which way that decision goes, a time of reckoning is at hand for the province when it comes to the regulatory regime that oversees old wells, the assignment of bankruptcy risk and the protection of the environment.

It’s fair to say the regulations governing oil and gas exploration in Alberta have become exponentially better than they were in the wildcatting days of the 1960s and 1970s, when virtually no provision was made to ensure environmental liabilities would not be foisted on the public or on other industry players. Over a number of iterations, the arc of the rules has been to increase protection of the public interest, but it’s also fair to say we’ve a long way to go.

The industry is overseen by the Alberta Energy Regulator (AER), which issues a separate licence for each of the 450,000 oil and gas wells in the province and imposes conditions on licensees for the operation, disposition and eventual shutting-in of the properties. Those end-of-life obligations include cementing-in various formations deep underground, “capping” the well and restoring the surface to its original condition.

The C.D. Howe Institute took a crack last September at gauging the total cost of Alberta’s well liabilities. It estimated that the reclamation cost just for the wells orphaned at the time would be between $129-million and $257-million. Then the institute applied a financial stress test on still solvent companies and found the potential exposure ranges from $338-million to $8.6-billion, depending on future bankruptcy rates and well cleanup costs. Those numbers are set to climb steeply after the March bankruptcy of Sequoia Resources, which had licences for 2,300 wells.

Those numbers are why an unlikely alliance appeared before the Supreme Court in February to argue against the creditors. Environmentalists, the OWA, the AER, the Canadian Association of Petroleum Producers (CAPP), and the governments of Alberta, Saskatchewan and BC have all taken the position that bad wells should not be split from the good ones. They all know that the decision of the Supreme Court threatens to upend the regulatory system that has governed oil and gas development in the western provinces for decades.

Few people are paying attention. Lawyers are aware of the change, but the AER and industry have continued to play by the old rules.

Darren Baumgardner has been down and up the rabbit hole that is abandoned wells a few times over the years. The Edmonton businessman lives on 40 acres about 10 minutes’ drive west of the city. On one corner of his property sits an oil and gas well drilled in the early 1970s, together with the 600-metre road that was built to access it. The well was still producing when Baumgardner bought the property in 2001, but it was in decline. It stopped producing in 2013, but the company that owns the lease on his property prefers to pay him $3,500 a year rather than take the steps needed to fully remediate the land. He understands why. “If you have an orphan well that would cost you $250,000 to clean up, and you’re 50 years old, and your other option is to continue to pay me $3,500 per year.… Even your kids would be better off to pay the $3,500.”

Baumgardner is no anti-oil crusader—he even considered buying the well himself and re-fracking it to see if he could make a bit of money. But no deal was made, and when the owner came to him and said the company wanted to shut the well in and reclaim the land, Baumgardner had almost no negotiating power. “They have a half-mile of road on my farm going back to the well,” he says. “Just to reclaim that road, which has two feet of rock to be picked up and moved, I got a quote for $80,000. They said they were quoted $20,000.” Again, there was no resolution, and the well and road still sit on his property, both literally and figuratively. They’re on a prime part of his land and are driving down its market value. “The only way to fight would be to go to court,” he says, “which takes forever.”

Advocates of the current system—with the AER doing most of the regulation and the industry-funded Orphan Well Association taking care of any messes—say it provides a reasonable balance between competing interests. They support the AER’s appeal of the Redwater decision to the Supreme Court. “We welcome the high court’s deliberation and decision,” says Brad Herald, vice-president of western Canadian operations at CAPP. “The balance that was in the system between the credit community, landowners, the oil and gas industry and the government has been upset by the lower court determinations.”

That balance was struck primarily through two policies. The AER collects the industry levy that’s funnelled to the OWA to deal with orphan wells. The levy was set high enough to deal with the number of orphaned wells being created when the general market for oil and gas was good, but has not stood up well through the low prices of the last few years.

The second way the AER has managed old wells is with the Liability Management Rating (LMR), which requires companies to provide a bond if their financial strength falls below a set asset-to-liability threshold. Companies with more liabilities than assets were required to post a bond to bring them back to even.

At the time of Redwater’s bankruptcy, producers were playing by these rules and by court decisions affirming them and holding that the AER was not a “creditor” under the Bankruptcy and Insolvency Act, because it wasn’t trying to collect money owed, but instead trying to protect the public interest. Thus the regulator wasn’t subject to the priority provisions of the BIA, which grants the first money to secured creditors. That reasoning was cemented in law by the Alberta legislature, and an entire system of regulations grew up around those rulings, including the AER’s liability ratio and the rules surrounding orphan wells. The players in the oil and gas sector—including the lenders—therefore determined their risks and rewards based on those rules, apportioning liabilities as among the operators, the lenders and the public.

The federal government amended the BIA in 1991 and in 1997, however, and a 2012 decision by the Supreme Court signalled to anyone who was paying attention that the old rules governing the Alberta system were at an end. The problem, says University of Calgary law professor Fenner Stewart, is that few people were paying attention. “Some lawyers took note of this change, but the AER and the oil and gas industry continued to play by the old rules,” he says. “The AER’s well reclamation program and the ratio system—it’s all predicated on the idea that [the public] has first priority over well assets.”

For a while, times were good and few companies were going bankrupt, so nobody noticed the discrepancy. Then something happened that nobody predicted—hydraulic fracturing. “Oil was supposed to be $200 a barrel by now,” Stewart says, “and we’d stop paving the streets in Calgary with asphalt because it’s too expensive and we’d just move to gold instead.” But fracking did happen, the price of oil and gas went in the toilet and investments in the oil and gas sector suddenly didn’t look so good. Cue the effort to unload the worst of the liabilities.

One irony of the appeal to the Supreme Court is the role of a publicly owned bank, ATB Financial. ATB was Redwater’s principal creditor and petitioned the company into bankruptcy in the first place. The Court of Appeal’s decision makes clear that ATB was fully aware of Redwater’s environmental liabilities before lending it money. The bankers even had a third-party engineering report done on their estimated cost; ATB took these liabilities into account when determining the interest rate and other terms of the loan. Nonetheless, Redwater’s receiver, Grant Thornton Ltd., has chosen to pursue this case to have those liabilities hived out of the company. The consequences don’t sit well with CAPP’s Herald. “We see the financial community as the gatekeeper to that risk,” he says. “They’re in a terrific position to look into the balance of risks and to adjust their interest rates accordingly.” In a statement, ATB welcomed the certainty which the Supreme Court decision will give, “so all parties understand the rules of how assets are distributed in the case of a bankruptcy, and can conduct their business accordingly.”

In light of the Alberta Court of Appeal’s decision in Redwater, both the AER and the provincial government have taken steps to close some loopholes and tighten some requirements. The AER in 2016 doubled the liability management ratio required, meaning companies now need twice as many assets as liabilities to avoid having to post a bond. It has also worked with the provincial government to prevent operators who have a record of disclaiming liabilities from getting their hands on new well licences.

The provincial government, for its part, has loaned $235-million to the OWA to clean up orphan wells, although that amount is already insufficient in light of the Sequoia bankruptcy. Energy Minister Margaret McCuaig-Boyd has also pressured the federal government to amend the BIA to ensure that the public and responsible industry operators are not left with the environmental burden of irresponsible operators. The response McCuaig-Boyd got from Ottawa—essentially, to monitor the situation—was “not the response I’d hoped for,” she says.

McCuaig-Boyd’s department is also conducting a review of the entire system. “We know Albertans are anxious,” she says. “Redwater has shown how Albertan communities and industry are exposed to the risk of being forced to pay for inactive wells. This clearly violates Alberta’s polluter-pay principle.”

The Supreme Court decision in Redwater, whenever it is delivered, will inevitably look backward, at a former framework and at how it interacted with the BIA. Equally important for Albertans is the path forward, and how we ensure that no similar risks fall to the public—or to solvent industry players—in the future.

In its September report, the C.D. Howe Institute recommended a regulated combination of bonds and insurance for companies seeking new licences. Under the plan, a company would be required to post a bond to ensure some money is available to clean up the well at the end of its life. The value of the bond would be less than the expected cleanup cost, to recognize the public interest in encouraging economic activity and to allow the little guys a chance to get into the game. The institute also recommends mandated insurance for inactive and suspended wells. The idea is that the cost of premiums would prompt more companies to clean up more wells in timely fashion.

Minister McCuaig-Boyd wouldn’t commit to any of those recommendations, deferring to an upcoming report on the situation being prepared by her department. “There are a lot of good ideas out there,” she says. “We just have to make sure we find what works best for industry, what works best for Albertans and what’s doable.”

Environmental groups such as EcoJustice Canada, which had intervenor status at the Supreme Court hearing, call for full securitization of environmental liabilities. U of C’s Stewart, however, says a full bonding requirement would be prohibitively expensive for many smaller companies and would be considered by many in the industry as government caving in to Big Oil, because only the biggest companies could afford it. “The oil and gas industry has a long history of wildcatters and a mythology of the small business owner who can make it rich,” he says. “A 100 per cent bond would be spun as the provincial government in the back pocket of Big Oil. It’s prohibitive.”

Many Albertans hope the Supreme Court puts things back as they were. “We had a system that was working quite well.”

CAPP’s Herald agrees that the full securitization cure could be worse than the disease. “It would mean a lot of dead capital—in the multiple billions of dollars,” he says. He’s hoping the Supreme Court overturns the Court of Appeal and puts things back as they were. “We had a system that was working quite well, which involved the two parts: the liability management regime and the deposits. That system was continuing to evolve, but it worked quite well.”

As if the fate of thousands of abandoned and orphaned wells weren’t enough for a single court decision, Redwater will have repercussions for all kinds of contentious areas of federal–provincial interaction. That includes the construction of interprovincial pipelines, an issue that hits close to home for Albertans. BC has taken steps to delay Kinder Morgan’s expansion of its Trans Mountain pipeline, which would triple the amount of bitumen that can be carried from Alberta to a marine terminal at Burnaby. The federal government has constitutional jurisdiction over the pipeline and has approved it. If federal paramountcy means the BIA trumps Alberta laws at issue in Redwater, then it follows that the Kinder Morgan pipeline—duly approved by the federal government—will be built despite opposition from both the government of BC and the City of Burnaby.

But that’s a battle for another day. For now, we await the Supreme Court decision in Redwater. Then, whatever the result, it will fall to elected officials, industry and the public to ask whether Albertans are getting the results we want from the systems we’ve built up around the exploitation of our natural resources—and if not, what we’re going to do about that.

Michael Ganley is a former editor of Alberta Venture. He’s now project manager with Edmonton’s Ketek Group.