[Editor's note: A version of this story appears in the August 2020 edition of Oil and Gas Investor. It was originally published July 2, 2020. Subscribe to the magazine here.]

Many distressed E&Ps and their midstream partners could be flying blind into a litigation collision course as the number of expected bankruptcies and reorganizations ramps up in the third and fourth quarters.

That’s because recent upstream/midstream disputes have in many cases centered around whether an E&P in Chapter 11 bankruptcy can reject midstream agreements they are unable to meet. In 2016, a court ruled that Sabine Oil and Gas Corp. could reject its agreements because they did not include covenants that “run with the land” as defined by Texas bankruptcy law.

Until that decision, those types of agreements were understood to fall under the province of “covenants that run with the land.” So, when it was handed down, the decision was viewed by many to be a game-changer. Turns out, subsequent rulings over contracts like these—particularly cases involving Badlands Energy Inc. and Alta Mesa Resources Inc.—have shown that the game continues to change.

Liz Freeman
Liz Freeman (Source: Jackson Walker LLP)

“I think there are some people that had the belief that, since ‘Sabine,’ ‘Badlands’ and ‘Alta Mesa’ came out, that issue is settled,” Liz Freeman, partner with Jackson Walker LLP, told Hart Energy. “That’s not it at all. What we have are guidelines.”

In “Sabine,” the U.S. bankruptcy court in the Southern District of New York interpreted Texas law when it ruled that Sabine Oil and Gas Corp. could reject agreements with midstream operators because the agreements did not “touch and concern the land.” In “Badlands,” a Colorado court ruled, based on Utah law, that the E&P could not reject the agreements because they contained covenants that run with the land. Also, the midstream operator’s transportation of dedicated reserves involved real property that satisfied the condition of having to touch and concern the land. The Texas court interpreting Oklahoma law reached a similar conclusion in “Alta Mesa.”

It All Depends

So, what does that mean for the next bankruptcy case involving an E&P seeking to reject its midstream agreements based on covenants running with the land? Not a whole lot.

“You don’t see the exact same dedication language in every single agreement,” Freeman said. “You really have to take a look at each one and do a very fact-intensive analysis as opposed to just knowing that you could have a processing agreement, it has covenants, therefore it’s rejectable or it is not. I think there is going to be a lot of litigation over individual agreements.”

Mike Blankenship, Houston-based partner with Winston & Strawn LLP, echoed Freeman.

“While the opposite holdings in ‘Badlands’ and ‘Alta Mesa’ do add a certain level of comfort for midstream operators in these regions,” he told Hart Energy in an email, “the reality is that these determinations are fact-specific so every new case going forward will have its own singular set of facts and potential challenges in establishing that their agreements are real property covenants.”

Complicating the issue is integration. A midstream operator could be providing an array of services to its upstream customer, including processing, marketing and transportation, that may be deemed rejectable by an E&P.   

Much depends on how the contracts are structured, Freeman said. Are they sufficiently integrated to be all-for-one, one-for-all? Or can an E&P pick and choose among those agreements, deciding which to assume and which to reject?

“We have a framework of analysis but there’s no easy answer in this,” she said. “This is going to be really complicated and very hairy.”

Getting Along

Rejection of agreements might be a logical courtroom strategy, but an E&P hoping to continue operations has to consider the reality of how that work will get done.

“Often the most important considerations revolve around who has the leverage and whether the producer has realistic alternatives for its midstream needs,” Isaac Griesbaum, partner with Winston & Strawn, told Hart Energy. “In particular, the likelihood of a third-party midstream company being able to offer similar or better terms and service based on the contract rates, service level, available capacity, capital flexibility, asset locations and other key commercial and operational requirements (as well as the timing of being able to provide service at all) are frequently the driving factors.”

Handling these issues effectively is particularly critical in a cyclical and relationship-driven business such as oil and gas.

“Operators don’t forget service providers who were unwilling to work with them during tough times,” said Chris Cottrell, an associate at Winston & Strawn who worked as a landman for an E&P before joining the firm. “Failing to strike balance now will almost certainly guarantee that volumes find their way into other midstream systems once existing commitments begin to expire.”

Not Your Father’s Bankruptcy

In prior downcycles, disputes tended to center around royalty interest, environmental liability, and plugging and abandonment obligations, Freeman said. Those won’t go away in this round but newer challenges heavily involve midstream. In some ways, that relates to the different economic environment since the last downcycle.

“The difference now is that so many companies that previously built their own gathering systems spun those systems off in an effort to raise capital in the past number of years,” she said. “So now you have a situation where you have an E&P company that is entering into contracts with midstream providers.”

Frequently, these providers are operating assets that the E&P company had owned and operated. So, in the past, the E&P could control the rates. Not so when dealing with a third party.

“Sometimes the midstream provider is a public entity with an entirely different structure and ownership,” Freeman said. “It’s a somewhat new challenge that a lot of E&P companies didn’t deal with in prior cycles.”

Through May, 18 E&Ps had declared bankruptcy, according to the Haynes and Boone LLP Oil Patch Bankruptcy Monitor. That number doesn’t include the recent filings of Chesapeake Energy Corp. and Extraction Oil and Gas Inc., and it pales in comparison to the 51 that Haynes and Boone recorded in the first two quarters of 2016. But the year is only half over and it is likely that some midstream companies will soon find themselves counted among the distressed.

“It seems almost certain that the headwinds faced in the upstream sector will have a domino effect on the rest of the sectors,” Blankenship said. “Although U.S. shale production only accounts for about 1/10 of the global supply, it accounts for a large portion of the global drilling activity and almost all of the growth in U.S. midstream and export-oriented storage and refining sectors.”

For midstream operators, a big concern will be the credit-worthiness of their upstream partners, Cottrell said. Griesbaum noted that lenders will seek to limit their exposure to oil and gas companies. While the impact on midstream might be delayed, the sector should have a clear idea of how significant it will be by the end of the third quarter, he said.

“All signs point to stress in the market,” Freeman said. “There have been a number of companies that we’ve worked with that have been able to have an out-of-court restructuring. Whether companies are forced to file bankruptcy cases or whether they’re able to restructure their debts outside of court is something to be seen, but we know that there will be a lot of restructuring.”