Private and Public Capital Raises and Exit Transactions in Today’s Shale Plays Greg Matlock, Ernst & Young

Stephen Olson, Jones Day

6th Law of Shale Plays Conference September 10, 2015 Pittsburgh, PA

Current Industry Overview Since September 2014, the

price of WTI has decreased approximately [__]%, from an average price of $92.58/bbl to [$40 - $45/bbl] near the end of August 2015.

Over the same time period, the price of natural gas has decreased approximately 34%.

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Supply/Demand Imbalance The global hydrocarbon supply and demand imbalance

continues to widen, with predictions that the imbalance will continue to widen well into 2016. OPEC could potentially increase crude oil production to

a record 33 million barrels a day after international sanctions are removed against Iran. Per Iran, the country can boost output by 500,000/bbl a

day within a week following the removal of the sanctions. As of mid-August 2015, the global oil market was in

surplus by about 3 million barrels a day.

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Rig Count Reduction Since August 2014, the US

rig count decreased by approximately 54%.

Over the same period, the rig count in the Marcellus decreased approximately 31% and approximately 50% in the Utica.

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Shale Play Impact Current pricing and economic conditions present

serious challenges for exploration and production companies, causing companies to consider: cut cap ex budget

scale back drilling programs

asset sales

reduction in asset acquisitions

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Shale Play Impact With sustained lower commodities prices, borrowing

base redeterminations in the fall of 2015 will likely result in reduced borrowing ability under a typical e&p company’s reserve-based lending facility, leading to reduced liquidity.

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Fall Redeterminations

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Company Redetermination Other Risk Factors

Resolute Energy September Thinning liquidity. No further borrowing capacity

Midstates Petroleum October Covenant violation in 2016

SandRidge Energy October Minimum liquidity requirement of $150m that kicked in July 1

Halcon Resources* October Earnings decline

Linn Energy October Diminishing free cash flow

Goodrich Petroleum October Recent Eagle Ford asset sale significantly reduces Goodrich's high quality assets; Continued preferred stock distributions could decrease liquidity

Samson Resources November Minimum liquidity requirement of $150m that kicked in July 1

Swift Energy November Hiring of Lazard to advise on cap structure, financing alternatives and related strategic opportunities; 2017 bondholders tapping Blackstone as FA

Penn Virginia* November Covenant Compliance; Liquidity drain.

Alta Mesa Holdings* November Liquidity crunch in 2016

Energy XXI December Liquidity crunch in 2016

Source: Debtwire E&P Restructuring Roulette Table * Has operations in Marcellus and/or Utica shale plays

Shale Play Impact The steep production decline curves of ordinary

shale wells requires e&p companies to constantly drill new wells to sustain or increase revenue. Given the reductions in liquidity and resulting

reductions in capital expenditures and drilling programs, shale plays may see amplified damage as the e&p companies cannot maintain earnings without constant drilling. Impact with trickle down to the

oilfield services sector and other related industry verticals.

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Raising Capital to Address Liquidity Needs

As mentioned, e&p companies active in shale plays need to actively drill to maintain and attempt to grow revenue, and in some cases to avoid forfeiture of leases.

Drilling activity equates to increased activity in the services sector.

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Raising Capital to Address Liquidity Needs

To fund the large capital commitments needed for the technology-intensive drilling programs inherent to shale plays, companies must seek capital infusions from alternative means, including: Joint Ventures Second Lien Financings Debt Exchanges Production Payments (royalty trusts, taking public,

etc.) IPOs (multiple structures)

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Joint Ventures Several JV structures are

being used to provide drilling capital – some are distinct legal entities, others are unincorporated ventures Tax treatment options for JVs: JOAs typically create a

partnership for tax purposes Effects of partnership tax

treatment on the “carrying” and “carried” partner

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DrillCo Structure Not a separate legal entity Investor receives a working interest in new wells

drilled and completed on the subject properties In return, Investor funds all or a significant portion of

the development costs of each well Once the Investor receives a stated IRR, some of

Investors WIs revert back to Company Company is typically operator Drilling and operating plan agreed to

by Investor

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Recent DrillCo Examples

Linn Energy – GSO (LOI Dec 2014, Signed July 2015) GSO commits $500 million to fund 100% of Linn’s

drilling program

Initially, GSO has 85% WI, Linn has 15% carried WI

Upon GSO’s achieving a 15% annualized return, GSO will have 5% WI, Linn will have 95% WI

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Recent DrillCo Examples (con’t) Legacy – TPG (Signed July 2015) TPG commits $150 million initially to fund part of Legacy’s

horizontal drilling program in the Permian Basin TPG gets an 87.5% WI in the properties, Legacy keeps

12.5% TPG funds 95% of drilling costs and gets 87.5% WI

– Legacy funds 5% of drillings costs and retains a 12.5% WI (7.5% carried WI)

Upon reaching a 1x ROI, TPG has 63% WI and Legacy has 37% WI Upon reaching a 15% IRR, TPG has

15% WI, Legacy has 85% WI and all undeveloped interests revert to Legacy

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Recent DrillCo Examples (con’t)

Lonestar – IOG (Closed July 2015)

IOG commits $100 million to fund Lonestar’s incremental drilling program in the Eagle Ford Funds go towards new wells meeting investment

criteria Initially, IOG has 90% WI, Lonestar has 10% WI Upon IOG’s achieving certain investor returns,

Lonestar’s WI increases to 90%

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AcquisitionCo Structure Separate legal entity

Investor funds the acquisition of properties and receives all or substantially all of the initial equity in the new entity

New entity may get ROFR on acquisitions

Company has a collar for its own participation in acquisition

After Investor receives a stated IRR, equity splits adjusted

New entity operates and receives a management fee

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Recent AcquisitionCo Example Linn Energy – Quantum

(LOI March 2015, Signed July 2015) Quantum commits $1 billion to fund targeted

acquisitions through an AcqCo managed by Linn

Linn can participate with a WI of 15-50% in each acquisition

Upon Quantum’s achieving certain investor returns, Linn can earn a promoted interest in AcqCo

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Second Lien Financings Debt that comes in above high yield unsecured

bonds and below first lien secured debt

Typical HY bond indentures have permitted lien baskets that allow for priming second lien debt

First lien lenders allow the additional debt provided a portion used to pay down facility

Gives investor interest in collateral

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Second Lien Financings (con’t) Doesn’t solve the company’s problem of being

overlevered in depressed commodities prices

Creates issues with unsecured HY bond holders

Many E&P companies have significant amounts of HY bonds maturing in the next several years

Recent second lien financings: [Kit to insert examples]

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Debt Exchanges As noted, many E&P companies have HY bonds

maturing in the next several years

Launch tender and exchange offer to push out maturities

Higher coupons, cash consideration

Could increase overall debt service

Proceeds used to pay down facility in advance of redetermination instead of working capital

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Various Property Interests

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Royalty Interest Royalty Interest – real property interest entitling the

interest holder to a share of revenue from production without bearing the costs of exploration and production

Types Overriding Royalty Interests (ORRIs)

Production Payments – VPPs

– MPPs

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Types of Royalty Interests ORRI - Overriding Royalty Interest Holder entitled to a percentage of proceeds from the

sale of oil & gas produced from a lease or well Typically survives for the life of the lease or well, but

can be a term royalty Low oil prices devalue ORRIs since production is less

valuable As oil prices rise, ORRIs are more valuable, possibly

enabling investors to monetize prior to the end of the productive life of the asset or expiration of the term

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Types of Royalty Interests

VPPs – Volumetric Production Payments Holder entitled to a specific volume of production (or

proceeds from that volume)

Value is linked to oil prices, similar to ORRI

MPPs – Monetary Production Payments Holder entitled to a fixed $ amount generated from

production

Low oil prices mean a larger volume of production is required to meet the return

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Benefits to Companies Provide development capital Maintain drilling programs Comply with leases and avoid

forfeiture due to lack of drilling Provide additional revenue

streams Attract / retain talent Retain ownership of assets Long term upside

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Benefits to Investors Real Property Interest Real property interests excluded from property of the

estate and cannot be sold as an asset or rejected as an executory contract

The bankruptcy code provides a safe harbor for investors in production payments by excluding these from the property of the estate, provided that the investor does not “participate in the operation of the property”

Law is relatively untested as to scope and full meaning of requirement that investor must not “participate in the operation of the property”

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Benefits to Investors Flexible structure

Potential oversight of drilling programs and ability to target specific assets Must be negotiated because royalty interests do not

entitle investors to operational rights by default

Steer funds to better drilling locations

Input on commercial/operational decisions, contractual terms with third parties

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Common types of ownership

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Type Characteristics Term Working interest

► Granted by owner of mineral interest ► Entitles holder to share of production ► Bears all development and operating costs ► Intangible drilling cost and depletion deductions

Continues through production or a specified term

Royalty ► Retained by owner of mineral or fee interest when leasing operating rights to another party

► Entitles holder to receive share of gross income or production from mineral interest (net of production/severance tax)

► Does not bear development or operating costs ► Depletion deductions

Perpetual

Overriding royalty

► Carved out of operating interest ► Otherwise, similar characteristics as royalty

Linked to term of operating interest

Production payment

► Right to receive a specified share of gross production from a mineral property

► Limited in quantum, (e.g., dollar, time or volume) ► Commonly treated as debt for tax purposes

(with certain exceptions) ► If treated as debt, not entitled to depletion

Duration is shorter than interest from which it is derived

Net profits interest

► Entitled to share of gross production, net of operating (and sometimes development) costs

► Not directly liable for payment of costs ► Depletion deductions

May be perpetual or limited, depending on instrument

Overview

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Corporations MLPs

Yieldcos

Up-C

Corporations

The traditional corporate structure generally results in two levels of tax (double taxation) – the public corporation pays tax on its earnings, and the shareholders generally pay tax on distributions received from the public corporation. Well recognized and accepted in the public market. Historically, a desirable form of accessing public

capital for a variety of reasons/circumstances: Insufficient qualifying income – traditional public

company is not subject to any qualifying income or qualifying asset tests; long-term capital expenditure needs; desire to reinvest or grow through acquisition, as opposed to distributing out profits Global investor base Value based on prospective earnings growth

(as opposed to a cash yield-based valuation)

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Historic Shareholders Public

Public Company

Operating Subsidiaries

100-X% X%

A traditional corporate IPO is the most common and well-known form of accessing public capital.

Master Limited Partnerships

In contrast to corporations, partnerships generally do not pay federal income tax at the entity level; however, publicly traded partnerships are taxed as corporations unless 90% of the gross income is “qualifying income” (the “Qualifying Income Test”).

The most prominent category of qualifying income relates to natural resources activities.

Consider new proposed regulations on “qualifying income”

Consider “variable pay” MLPs as an alternative

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A master limited partnership (“MLP”) is a partnership or limited liability company that is traded on a stock exchange.

Sponsor

LP

Public

Lenders

GP 2%/L/IDRs LP

Assets

LLC

100%

TYPICAL MLP ORGANIZATIONAL STRUCTURE

Master Limited Partnerships Distribution Characteristics MLPs typically pay out all of their “available cash” (essentially cash receipts less cash

expenses and reserves) on a quarterly basis (partnership agreement requirement; not legal requirement).

One of the hallmarks of the traditional MLP has been the relative stability in its quarterly distribution payments; the primary goal of most MLPs has been to maintain or grow distributions every quarter, with any decrease in quarterly distributions typically perceived negatively by the market.

Typically, half of the LP interests are subordinated units retained by the sponsor. During the subordination period (typically 3 years), the subordinated units do not receive distributions until the common units receive the MQD.

The sponsor retains incentive distribution rights (IDRs) that receive an increasing percentage (typically 13%, 23% and 48%) of distributions after the MQD and certain target distribution levels have been satisfied.

The classic MLP is a pipeline company with long-term transportation agreements and low capital expenditures, which provides for stable to increasing cash distributions over time

MLPs have historically managed cash flows through: (1) distribution coverage, (2) long-term contracts and (3) hedging

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Yieldco A Yieldco owns assets, that are not “MLP-able” assets.

In 2013, a new type of vehicle went public with a story very similar to an MLP but without possessing assets that would qualify for pass-through tax treatment. Like MLPs, Yieldco and similar companies are positioning themselves as vehicles for investors seeking stable and growing dividend income from a diversified portfolio of lower-risk high-quality assets. More of these types of vehicles are in the planning stages.

Domestic versus foreign “YieldCos” and development of the broader market

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Typical Yieldco Organizational Structure

Comparison of Traditional MLP and Yieldco Structures

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Typical Yieldco Organizational Structure Traditional MLP Organizational Structure

UP-C Structure

In using this structure, the public company (“IPOCo”) typically owns a substantial equity interest in a subsidiary holding company (“Holdings”), which owns the operating assets. The equity interests in Holdings not held by IPOCo are typically owned by the pre-IPO investors, which may consist with individual investors, private equity funds or others.

The pre-IPO investors in Holdings have the right to exchange their Holdings equity interests for shares in IPOCo, at which point IPOCo gets a stepped-up tax basis in the Holdings equity interests (which results in tax savings to IPOCo through additional depreciation and amortization) and the pre-IPO investors are taxed on any gain recognized as a result of the exchange.

The pre-IPO investors and IPOCo may enter into a tax receivable agreement pursuant to which IPOCo would pay the pre-IPO investors a portion (typically 75% to 85%) of the tax benefits realized from the basis step-up resulting from the exchanges.

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The UP-C Structure — which offers tax benefits to pre-IPO investors and sponsors — likely will expand among companies.

Historic Members

Public

IPOCo

Holdings LLC

100% Class B Shares Majority voting power Non-economic interest

Operating Subsidiaries

100% Class A Shares Minority voting power

100% economic interest

100% Class B Units Exchange Right

100% Class A Units Sole Managing Member

Tax Receivable Agreement

IPOCo

Typical UP-C Organizational Structure

Comparison of Conventional Public Co. & UP-C Structures

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Historic Shareholders Public

Public Company

Operating Subsidiaries

100-X% X%

Typical Conventional Public Company Organizational Structure

Historic Members

Public

IPOCo

Holdings LLC

100% Class B Shares Majority voting power Non-economic interest

Operating Subsidiaries

100% Class A Shares Minority voting power

100% economic interest

100% Class B Units Exchange Right

100% Class A Units Sole Managing Member

Tax Receivable Agreement

IPOCo

Typical UP-C Organizational Structure

Closing Remarks Current economic conditions continue to present a

challenging environment for exploration and production companies.

Evaluation of various forms of accessing capital (debt, private joint venture capital, public markets) is critical, including any operational or future growth constraints (or obligations) that are inherent in each option.

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