COVENANTS RUNNING with the land or executory contracts? A mere two years ago, few pondered the legal characterization of gas dedications contained in the thousands of gathering, processing and transportation contracts between oil and gas producers and their midstream counterparties. Today this issue is of profound importance to the US energy industry. Since the beginning of 2015, more than 85 US oil and gas producers have sought bankruptcy protection in the wake of plummeting commodity prices. At the forefront of these bankruptcy proceedings— most notably in the legal cases of Sabine Oil & Gas Corp. and Quicksilver Resources Inc. —producers and midstream companies have squared off over whether the dedications in gathering and processing agreements are real property interests, and therefore immune from the reach of the bankruptcy court, or executory contracts that may be jettisoned through the restructuring process.
The domestic shale boom has resulted in markedly increased domestic oil and gas production and a surge in the associated oil and gas infrastructure. Over the last decade and a half, midstream companies have collectively invested billions of dollars in developing the infrastructure necessary to gather, process and transport domestic oil and gas. In exchange, these midstream companies contract with producers for a promise of payment based on the volume of oil and gas gathered, processed or transported, and dedications of the underlying oil and gas interests/mineral interests and associated acreage. The fees charged to producers under the gathering and processing contracts are designed to provide midstream companies, over a period of time, a return of and on their capital investment.
From the midstream perspective, gas dedications operate as security by burdening the oil and gas interests, thereby binding all successors to the terms of the original bargain. Midstream companies have historically undertaken the large capital investments, and their lenders have financed these midstream projects, with the understanding that these dedications are real property interests that bind successors to the mineral interests. That is, regardless of any change to the leasehold ownership, any hydrocarbons produced from the subject acreage remain dedicated to the midstream company and subject to the terms of the gathering and processing contracts. Midstream companies have traditionally filed memoranda of the agreements in the real property records to put potential transferees on notice of the dedication. This is because producers routinely transfer or otherwise divest themselves of all or a portion of their mineral interests after granting the dedication to the midstream company.
The midstream sector has posited that judicial determinations that dedications are not covenants running with the land or equitable servitudes, and therefore subject to rejection in a bankruptcy proceeding, will have negative consequences to producers and consumers. The Gas Processing Association, a midstream trade association, has stated that such “a determination would threaten the sanctity of thousands of bargained-for agreements between midstream companies and their producer counterparties; would undermine investor confidence in midstream
companies, raising the cost of capital to invest in infrastructure; would force midstream companies and producers to include more costly assurances in their contracts, such as, reservation charges, secured collateral or other guarantees; and would undermine the market in which mineral interests are transferred by threatening the dedications that underpin midstream investments.”
In Sabine, the only court case thus far to rule on the characterization of dedications, Sabine sought court approval to reject four of its midstream contracts. In a landmark ruling, US Bankruptcy Judge Shelley Chapman determined the gathering and processing contracts between Sabine and its midstream counterparties were executory contracts—not real property interests— and could therefore be rejected. The judicially authorized rejection of the four gathering and processing agreements is estimated to have saved Sabine as much as $115 million.
There is currently an ongoing appeals process in the Sabine case. And it is further important to note that the Sabine decision is not binding precedent. Therefore, another court interpreting a different midstream agreement is free to reach a different conclusion.
In other producer bankruptcies where the covenant running with the land issue has been raised, most notably Quicksilver Resources Inc. and Emerald Oil Inc., the producers and their midstream counterparties have been able to work out commercial resolutions to re-negotiate existing gathering and processing agreements. The commercial agreements have prevented further court rulings on the issue.
Sabine’s rejection of the Nordheim and HPIPP contracts enhanced its prospects for a successful restructuring; and other financially strapped producers will undoubtedly seek to leverage this uncertainty into more favorable commercial arrangements with their midstream counter-parties. This may take the form of using the bankruptcy process to reject existing midstream agreements. Or it may lead parties to renegotiate existing midstream agreements. Either way, the possibility of an outright rejection or renegotiation of existing midstream agreements creates substantial uncertainty for the midstream industry.
Additionally, financially solvent producers can expect new challenges in their commercial negotiations with midstream service providers. With the enforceability of dedications in question, midstream companies are more likely to seek additional assurances in their contracts, such as, minimum volume commitments, reservation charges, secured collateral or other financial commitments.
Doubt over whether midstream agreements are as secure as parties previously believed is but one of the consequences of the current oil bust. And this consequence has the potential to fundamentally change the way producers and their midstream counterparties analyze the risk involved in the large scale midstream infrastructure projects that transport oil and natural gas across the nation.
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