East Cameron Partners, a subsidiary of Houston, Texas-based Open Choke Exploration, is a small oil and gas producer with producing lease holdings in the East Cameron 71 and 72 gas fields 20 miles offshore of Louisiana. In 2006, it became the first US company to issue a Sukuk, using it to raise $165.67 million. Although the Sukuk was small by the standards of the capital intensive oil and gas industry, it received the kind of attention that far outstripped its monetary value by providing evidence that Western companies, including those in the US, could benefit from Sukuk, in some cases, more so than they could from conventional alternatives.

The Sukuk was structured as a Musharaka between East Cameron and the special purpose vehicle (SPV) in the US to which it sold oil and gas royalty rights. The sale was funded by Sukuk investors who purchased Sukuk certificates from a Cayman Islands-domiciled SPV. The proceeds were used to buy out the 50 per cent equity stake held by a previous financier, Macquarie Bank, as well as to fund capital expenditure and working capital in the already-producing gas field.

Test case
During the expected term of the Sukuk (13 years), proceeds from gas production from the two fields flowed to the purchaser SPV, Louisiana Offshore Holdings (LOH), and were shared between East Cameron Partners and the issuer SPV, East Cameron Gas Company, which passed them along to Sukuk holders with part paying the 11.25 per cent expected return and part paying down the principal of the Sukuk.

Investors were provided additional protection with an over-collateralised overriding royalty interest (ORRI) with the right to receive a greater amount of gas than expected to be necessary to repay the Sukuk investors the principal and expected return.

In addition, the price was hedged using Shari’ah-compliant hedges creating a collar on gas prices between $7 and $8 per one thousand thousand British Thermal Units (MMBtu) on one-half of expected production volume and a put option at $6 per MMBtu on an additional one-quarter of expected production.

US oil and gas law allows leaseholders of federal land to grant an ORRI on a set amount of production from a field. Leaseholders must be US entities registered as oil and gas production companies and approved by the US Minerals Management Service (MMS). In Louisiana, this ORRI is legally recognised as real property, which provides investors with protection greater than many other debtors in bankruptcy proceedings. This protection is created with a ‘true sale’ of the ORRI to an SPV to ensure it is bankruptcy-remote; that is, it is structured to minimise the chance that the ORRI can be included in the issuer’s bankruptcy estate, which would subject it to claims by other creditors.

Not a 'true sale
The East Cameron bankruptcy will provide a test of how Sukuk function in bankruptcy proceedings in the US. The Sukuk structure was chosen for economic, not religious, reasons and therefore the Shari’ah-compliance of the transaction will not be a factor. Instead, it will likely test whether a Shari’ah-compliant securitisation is treated in the same way as a conventional securitisation.

During the bankruptcy proceedings, the lawyers for East Cameron Partners requested a ruling that the sale of the ORRI was in essence a secured loan and not a ‘true sale’. While a final ruling has not been made, an injunction prohibits East Cameron Partners and the two SPVs used in the transaction from exercising any remedies on the ORRI.

As the bankruptcy proceedings move forward, there will be important rulings on the securitisation process and whether Sukuk structures are ‘bankruptcy remote’, at least in this one instance in US courts. Another important issue in the bankruptcy, particularly for the Sukuk investors, is whether the filing was caused or causes a suspension, termination or amendment to the lease held by ECP granted by the Minerals Management Service (MMS), a part of the Bureau of Land Management. According to the Sukuk offering circular, “any suspension, amendment or termination of the Leases will terminate the ORRI and would cause [Sukuk] Certificate-holders to lose the value of their investment”.

Ratings downgrade
The proceedings of the bankruptcy case will not be resolved quickly, but they could have important implications for future US corporate Sukuk issuance if the underlying securitisation structure does not hold up in the bankruptcy courts. Fortunately for the Islamic finance industry in the US, this is unlikely to occur without unusual circumstances, according to a lawyer familiar with the implications of bankruptcy on securitisations.

On 14 January 2009, Standard & Poor’s (S&P) downgraded the credit rating on the Sukuk from CCC+ to CC and put it on negative credit watch as a result of the bankruptcy filing. According to the S&P press release, the downgrade occurred following the “negative impact of the Sept. 3, 2008, hydrocarbon mix shortfall enforcement event on the overriding royalty interest in oil and gas reserves (ORRI)”.

A hydrocarbon mix shortfall enforcement event occurs when the a periodic reserve report shows that stressed reserves are below 90 per cent of the hydrocarbon mix threshold, which was the initial level of proven reserves when the Sukuk was issued, less the volume of production since that date. Proven reserves depend on the volume of oil and gas production that are technologically and economically feasible to produce. Proven reserves include producing (developed) wells, those that are capable of producing but from which no oil or gas are being produced (behind pipe) and those which will be producing when wells are drilled (undeveloped).

The Sukuk offering circular specified certain thresholds for each category of proven reserves under which there was a shortfall enforcement event. The primary credit analyst, John Lampasona, said there “may have been a revision [of the proven reserves] that triggered the enforcement event; however the collateral details for this deal are under review” by S&P. Emails to the company were not returned.

The ratings downgrade by S&P raises questions about the future returns for Sukuk holders even if East Cameron is able to emerge from bankruptcy protection. The explanation of the downgrade focused on reductions in the estimates of proven reserves that are revised periodically under the terms of the Sukuk. Proven reserves can be reduced for two reasons: either there is a reduction in the estimates of actual hydrocarbons in the fields in which the company is drilling, or estimates of the level of reserves for which it is economically possible to recover.

The production from the East Cameron fields for the ORRI held by LOH on behalf of the Sukuk investors is gas and production has been falling steadily since the Sukuk was issued and gas prices have fallen significantly from their peak in 2008, the year when production was at its lowest. If gas prices continue to hover around their current prices, the total volume of production should (pari passu) be increasing in order for the Sukuk holders to expect full repayment of principal and the expected 11.25 per cent return.

Although the bankruptcy filing of East Cameron Partners and the fall in production are unequivocally detrimental for the company and the Sukuk investors, it demonstrates that the Sukuk structure functions in the same way as both equity and debt and can be structured so that risk and reward are shared between the issuer and investors. The Musharaka structure provided investors with a return paid out along a set schedule in the same way that they would if they held a bond through the use of reserve accounts; but the investors are now experiencing losses based on an underperformance of the economic activity their investment financed.

Blake Goud is the Principal of SharingRisk.org. He can be contacted at blake@sharingrisk.org.