Midstream Providers Can Prepare for the Next Wave of Restructurings
Even before coronavirus concerns, the slump in oil demand placed considerable financial stress on oil exploration and production companies. With Saudi Arabia and Russia unable to reach an agreement on crude production, oil markets plunged further. That plunge led to a corresponding decline in high-yield bond prices issued by many U.S. producers. Although many of these bonds do not mature until 2021 or later, U.S. producers still face considerable stress. Oil's steep decline, coupled with borrowing base redeterminations on producers' reserve-based loans, is likely to result in decreased liquidity and a rash of loan defaults for over-drawn, cash-strapped borrowers. Moreover, producers unable to profitably produce long-term at current price levels, may cut production and see decreased cash flows, each leading to restructurings or distressed asset sales.
In the last wave of exploration and production (E&P) distress, producers threatened to utilize a provision in the U.S. Bankruptcy Code (the Code) that allows the rejection of executory contracts to renegotiate midstream agreements that the producers viewed as burdensome or whose minimum financial commitments restrained the financial flexibility that the producers needed during the downturn. In those renegotiations, there was a clear difference of opinion about whether these type of contracts were indeed rejectable as executory contracts or whether they were better understood as covenants running with the burdened land that could not be rejected in bankruptcy. Some of these threats worked out well for the producers, who were able to restructure and avoid bankruptcy. But other producers eventually did enter bankruptcy and tested the producer's ability to reject well-drafted midstream contracts.
Indeed, one of the tools the Code generally provides debtors is the ability to 1) reject any executory contract under Code Section 365 and 2) treat the damages arising from rejection as an unsecured claim. This tool is often necessary to restructure feasibly or sell assets for higher value but has a critical limitation: Debtors can use Section 365 to terminate a contract but not unwind a conveyance of a real property interest. As midstream agreements typically include not only contractual payment and performance provisions but dedications (or conveyances) of oil and gas mineral rights (or real property interests), many midstream companies objected to efforts to reject midstream agreements. To do so, the midstream companies had to demonstrate the agreements "run with the land" and therefore constituted a real property conveyance that a debtor could not reject. These issues were of critical importance: If E&P companies could not shed these agreements, restructurings would be thrown in peril. Indeed, many restructurings, asset sales and creditor recoveries hinged expressly on midstream agreement rejection.
This note focuses on the ability to reject a midstream agreement and how midstream providers can prepare for the next wave of restructurings.
Sabine: Midstream "Services" Do Not Run with the Land
The first high-profile midstream rejection dispute arose in the Sabine bankruptcy case in New York. Sabine had multiple dedication contracts it desired to reject. Under each contract, Sabine paid monthly gathering fees and had to make deficiency payments if it did not meet minimum delivery requirements. Sabine's counterparties argued that the dedication covenants contained in the agreements "ran with the land" and therefore amounted to real property covenants not impacted by rejection.
In Sabine, Texas law governed the midstream agreements and whether those agreements did "run with the land." Although the issue was not settled under Texas law, the New York bankruptcy court heard the dispute. Under Texas law, some Texas courts had required "horizontal privity of estate," or a demonstration of "simultaneous existing interests or mutual privity between the original covenanting parties as either landlord and tenant or grantor and grantee" to conclude contractual covenants "run with the land." As the midstream providers did not identify any governing authority rejecting this horizontal privity requirement, the Sabine bankruptcy court adopted it as settled Texas law. According to the court, because the covenants at issue did not reserve any real property interest in the subject real property, no horizontal privity existed. The Sabine court further found that the covenants at issue could not just affect the land, but had to affect the owner's interest in the land. Under Texas law, following extraction, the minerals no longer were a real property interest but rather became personal property. The contract, according to the court, dealt with personal property rights and not real property interests. In other words, according to the Sabine court, the midstream agreements represented mere personal property service agreements – under which the services related to real property but did not create an actual real property interest. In many respects, the Sabine court would not allow a service provider to prevent a debtor from using the powerful tool of Code Section 365 simply because the services touched a real property interest.
In reaching its decision, the Sabine court distinguished a U.S. Court of Appeals for the Fifth Circuit case, Energytec, that held an agreement relating to a pipeline system did run with the land. In Energytec, the debtor's counterparty received a monthly transportation fee based on gas flow and could veto the debtor's assignment or further sale of production or mineral interests. In addition, the counterparty had a lien on the pipeline system. Certainly, the lack of these protections harmed the Sabine counterparties.
Sabine Sets the Tone and Moots Developments
Other E&P companies aggressively used the Sabine ruling to negotiate material modifications to midstream contracts as part of their in-court or out-of-court restructurings. Indeed, with litigation uncertain and benefits less than clear, midstream companies settled with debtors, and bankruptcy courts did not have occasion to revisit Sabine. For example, in Sandridge Energy, the influential Bankruptcy Court for the Southern District of Texas suggested the Sabine ruling was incorrect, but the parties settled in any event. Despite this soft guidance, parties did not litigate the issues in a Texas court. That guidance, however, no doubt helped midstream companies in subsequent negotiations.
Outside of Texas Midstream Companies May Have Greater Rights
Although many agreements involve Texas-based minerals or Texas choice-of-law provisions, the laws of other states may provide greater protection or clarity for midstream companies. In fact, producers outside of Texas may be at greater risk of restructuring. For example, in North Dakota – the heart of the Williston Basin – whether a covenant "runs with the land" is an issue governed by state statutes that provide clearer guidance for parties and courts.
And in Badlands Energy, a Bankruptcy Court for the District of Colorado found that under Utah law, both a gas gathering and processing agreement and a saltwater disposal agreement constituted covenants running with the land over the dedication area. In Badlands, the court's conclusion rested on the fact that 1) the dedications and commitments touched and concerned the land they burdened and were in writing, 2) the parties intended the same run with such land, and 3) there was privity of estate between the parties. In distinguishing Sabine, the Badlands court found that the dedications burdened the minerals in the ground, not the mere as-extracted production. Critically, the Badlands court also rejected, based on guidance from the Utah Supreme Court, the notion that horizontal privity was necessary. In fact, the Badlands court stated:
[T]o … require that there must be some such succession between the covenanting parties themselves—that there must have been a grant or conveyance between them at the time of the covenant or possibly some continuing interest of tenure, easement, or otherwise—is supported neither by ancient land law nor by modern policy."
How Midstream Companies Can Prepare and Strengthen Their Positions
While midstream companies cannot change the law or unilaterally modify agreements to protect their interests, they can take action to prepare for and strengthen their positions. First, midstream companies should carefully review their contracts to assess their relative strengths and weaknesses. Restructurings move quickly; parties must use this time to prepare. Second, be sure that all authorized real property rights granted are recorded in the public record. This action helps evidence the parties' intent of conveying real property interests. Third, if a counter-party is in default, use that default to extract meaningful contractual concessions. Finally, consider forum-shopping. E&P debtors typically forum shop for the best venue to file a Chapter 11 proceeding. Indeed, courts in New York and Delaware have proven more favorable for midstream contract rejection. Prior to a bankruptcy filing, a midstream company may seek a declaration from a state court that its agreements do "run with the land." Fighting that dispute in a more neutral forum or forum that more commonly adjudicates mineral rights disputes may prove beneficial and provide less risk than a dispute in a foreign bankruptcy court.