In the acquisition of natural gas gathering systems, processing plants and related midstream assets, one of the primary focuses of the legal due diligence process will be the gas gathering and processing agreements associated with these midstream assets. These agreements typically have long terms, and much of the value of the target assets is based on the fees to be paid under these agreements for various midstream services.
The services performed under a gas gathering agreement typically include treating the raw gas from the wellhead to remove hydrogen sulfide, CO2 and other impurities; dehydrating the gas to remove excess water; moving the gas from the wellhead to a processing plant; and compressing.
The services under a gas processing agreement typically include separating the dry gas from the NGL mix contained in the wet gas stream.
The gas gathering and processing services are often provided under separate contracts between the producer/shipper and midstream company, but may all be contained in one contract.
For convenience’s sake, “GGP agreement” refers to a contract between the producer/shipper and midstream company covering the above-mentioned gas gathering and processing services, and “midstream assets” refers to the natural gas gathering systems, processing plants and related midstream assets used by the midstream company to perform its services under the GGP agreement—and which assets are the subject of the proposed sale.
Because so much of the value of the midstream assets depends on the fees to be paid under the associated GGP agreements, it is important that the terms and conditions of these agreements are carefully reviewed prior to a buyer’s entry into a purchase and sale agreement to buy such assets or the equity of the entities owning such assets, and prior to being bound by such agreements.
Summarized below are several key provisions in GGP agreements, along with various issues associated with these provisions, which the potential buyer of the midstream assets should carefully review and consider in its legal due diligence review of the GGP agreements.
GGP agreements will describe the level of service that the producer is entitled to under the agreement. At its most basic level, gathering and processing services are typically provided under a firm service or interruptible service basis, each of which is described below.
Firm service—As the name suggests, firm service provides a producer with guaranteed capacity on the applicable midstream assets up to the amount reserved by the producer. Generally, producers entitled to firm service make a required periodic payment for this reserved capacity—a minimum volume commitment.
Under the firm service arrangement, the midstream company may not interrupt the service except under certain specified circumstances, e.g., certain maintenance of the midstream assets, or force majeure.
Attention should be given to these circumstances under which the midstream company may interrupt service under a firm service arrangement, e.g., what qualifies as a force majeure event, and how long it may persist. Also, the potential consequences to the midstream company of an interruption of firm service should be considered. Under certain circumstances, the producer’s wells, which had produced the gas that the midstream company failed to timely receive, may be released from the acreage dedication under the GGP agreement.
Interruptible service—Unlike firm service, interruptible service does not entitle the producer with guaranteed capacity on the midstream assets. Accordingly, the midstream company may interrupt or reduce the service at any time for any reason, e.g., capacity constraints.
The fees paid by a producer under an interruptible service arrangement—the volumes actually delivered times the applicable rate—are typically lower than under a firm service arrangement. Midstream companies often provide different service levels to a given producer under a given GGP agreement, e.g., firm service up to a minimum volume commitment and interruptible service in excess of that volume.
Volumes vs. capacity
The potential buyer of midstream assets will want to review all of the midstream company’s GGP agreements with all producer counterparties with respect to the midstream assets to be sold to understand the firm service level volumes committed to all producers. The buyer should then compare this with the midstream assets’ throughput capacity to confirm that the system has sufficient capacity to perform on the firm service commitments under all such agreements.
The same analysis should be done when it is contemplated that, following the closing of the acquisition of the midstream assets, new GGP agreements for firm service be entered into with third parties.
This is important since the existing GGP agreements providing for firm service typically contain covenants that the midstream company will not enter into new GGP agreements with third parties that provide for equal (firm) service. That is, unless the midstream company reasonably expects that such new commitment would not cause the system to become oversubscribed in relation to the planned capacity and expected volumes for the system.
The fee structure under GGP agreements is typically fee-based, percent-of-proceeds, cost-of-service or keep-whole, and is often a hybrid of them. Each of these fee structures, and some of the benefits and risks associated with each, is set forth below.
Fee based—Under a fee-based arrangement, the midstream company will receive a fixed fee for its services, e.g., $0.18 per million British thermal units of gas gathered. Clearly, this type of fee arrangement can help protect the midstream company from declining commodity prices. With the rate fixed, the major variable impacting the midstream company’s revenues would be the volume of gas gathered and processed.
Conversely, a fixed-fee arrangement will limit the potential of the midstream company to benefit from increases in the price of commodities. From the perspective of the midstream company, fixed-fee arrangements that extend over long time periods, which is typically the case under GGP agreements, should take inflation into account, e.g., through an annual adjustment of a base fee according to a rise in a specified inflation index.
Percent-of-proceeds/Percent-of-liquids—Under a percent-of-proceeds arrangement, the midstream company will process the producer’s gas and, as payment for such services, keep an agreed percentage of the proceeds from the sale of the NGL and/or residue gas—or alternatively, a percentage of an index-based price minus certain adjustments.
Under a percent-of-liquids arrangement, the payment received by the midstream company is a percentage of the extracted NGL. The midstream company will then market these gas liquidsand keep the proceeds from their sale.
Under either of these arrangements, the midstream company’s revenues will be directly impacted by changes in commodity prices. For this reason, some percent-of-proceeds or percent-of-liquids arrangements will include a fee floor to help limit the commodity price risk to the midstream company.
Cost-of-service—Under a cost-of-service arrangement, the midstream company will receive a cost-of-service fee, e.g., providing for recovery of specified variable and fixed costs and expenses plus a return on invested capital in exchange for certain services.
Keep-whole—Under a keep-whole arrangement, the midstream company will retain the NGL extracted from processing and return the processed natural gas, or value of the natural gas, to the producer. This arrangement is beneficial for the midstream company when NGL prices are high and rising.
Aside from understanding the basic fee structure of a GGP agreement outlined above, GGP agreements will include several terms and conditions that will impact the amount of revenue collected and/or the profits earned under the GGA agreement.
These terms and conditions include:
Minimum purchase commitment—GGP agreements providing firm service to the producer typically include a commitment from the producer to deliver a specified minimum volume of gas to the midstream company over a given period of time, or else make a payment to the midstream company based on the difference between the minimum volume commitment and the amount of gas actually delivered to the midstream company.
A pro-producer provision, which is sometimes included, allows the producer to apply volumes delivered in excess of the minimum purchase commitment in a given year to a different year in which the actual volumes delivered are below committed volumes.
Fuel and gas lost or unaccounted for—The GGP agreement will typically include, with respect to the producer’s volumes delivered into the midstream company’s system, caps on gas consumed as fuel and gas lost or unaccounted for. In the event that the midstream company were to exceed the permitted cap, typically expressed as a percentage of volumes delivered to the system by a producer in a given period, the midstream company would need to incur additional costs to replace the gas used as fuel or lost and unaccounted for in excess of the cap.
Conditioning fee for nonconforming gas—GGP agreements generally require that gas entering the midstream company’s system conform to certain quality specifications. In the event that the gas does not conform, the GGP agreement will often give the midstream company a right to charge the producer a conditioning fee to get the gas in conformity with the quality specifications, as well as a right to refuse receipt of the gas.
Recoupment of environmental compliance costs—It can be difficult to foresee with much clarity the amount of environmental compliance costs that may be necessitated by future environmental laws, e.g., costs relating to modifications to facilities, reducing or monitoring emissions into the environment, payment of additional fees, and to model the effects of these additional costs in any detail. GGP agreements will often include a provision enabling the midstream company to adjust the fees to be paid by the producer to offset these additional environmental compliance costs associated with the midstream assets.
A more balanced version of this type of provision would require the parties to negotiate in good faith higher fees to be paid by the producer, taking into consideration the change in environmental laws, which impose these additional environmental compliance costs upon the midstream company.
In the GGP agreement, the producer will, subject to limited exclusions, typically exclusively dedicate and commit to the performance of the GGP agreement all interests of the producer and its affiliates in oil and gas leases, whether presently owned or acquired in the future, covering lands located within a defined geographic area. Often this can cover one or more counties and all gas produced therefrom or attributable thereto, and all interests of the producer in all oil or gas wells (whether then existing or drilled in the future) on lands covered by any such oil and gas lease or on other lands within the geographic area.
Attention should be given to any carve-outs from the acreage dedication, e.g., for gas which, pursuant to separate contractual arrangements, is dedicated to a different midstream company.
Review of the acreage dedication provision should confirm whether the following provisions, which are fairly typical and which benefit the midstream company, are included:
- The producer shall use commercially reasonable efforts to terminate existing—or future, in the event that the producer acquires interests in additional oil and gas leases in the dedicated area subsequent to the effective date of the GGP agreement—GGP agreements with third parties in the dedicated area. This requirement to terminate may be subject to the midstream company having to match the fees under such midstream services agreement with third parties to the extent that such fees are more favorable to the producer;
- The producer shall cause existing or future affiliates of the producer with interests in the dedicated oil and gas leases, wells and produced gas to be bound by the GGP agreement and execute and join as a party to the GGP agreement; and
- The acreage dedication contains language indicating that the dedication is a covenant running with the land.
In addition, the buyer’s review of the GGP agreement should include identifying the midstream company’s obligations to make well connections and incur other capex on behalf of the producer for the producer’s wells (and available caps on those obligations), as well as the potential consequences of not meeting those obligations, e.g., release of the well pad from the acreage dedication if the well connection is not made timely or at all.
On a related point, the buyer will also want to understand who—the midstream company or the producer—is responsible for obtaining any rights-of-way needed to make the well connections and who pays for obtaining the rights-of way. The buyer will also want to determine if there is a cap or some other mechanism to limit the midstream company’s exposure, in the event payment for the rights-of-way is the midstream company’s responsibility under the GGP agreement.
Running with the land
Because the midstream company incurs substantial costs in constructing various infrastructure to gather and process producer’s gas, and it is through the GGP agreements that the midstream company recoups its investment, the midstream company will want to ensure that the GGP agreement is not rejected in a future bankruptcy proceeding of the producer.
Toward this end, the midstream company typically requires that the GGP agreement include a provision providing that the acreage dedication is a real covenant that runs with the land. If the acreage dedication is deemed to be a real covenant that runs with the land, a real property interest, then a producer should not be able to reject the GGP agreements as executory contracts in a bankruptcy proceeding of the producer.
In the Sabine Oil & Gas Corp. bankruptcy proceedings this past year, Bankruptcy Judge Shelley Chapman issued a final ruling that allowed Sabine Oil & Gas, an oil and gas E&P that was the debtor in the proceeding, to reject gas gathering and related agreements with two midstream companies as executory contracts.
Judge Chapman ruled that these agreements could be rejected as executory contracts because the agreements did not constitute or contain covenants running with the land under applicable state (Texas) law.
Clearly, midstream companies do not want to find themselves in this position, and it would behoove the potential acquirer of midstream assets to review the language of the acreage dedication/covenant running with the land provisions contained in the GGP agreement relating to such midstream assets. When reviewing the language in a GGP agreement which purports to create a covenant running with the land, the following matters, among others, should be kept in mind:
- The requirements as to what constitutes a covenant running with the land varies state by state. Some jurisdictions have a horizontal privity requirement so the language in the agreement purporting to create a covenant running with the land—and the circumstances under which the covenant was purportedly created—should be carefully reviewed in light of the applicable state law on this point;
- As a more specific iteration of the above point, one should review the interest that is conveyed to purportedly meet the “touch and concern” element of the test for covenants running with the land, to make sure it is a real property interest. Specifically, the dedication should cover the producer’s interests in the applicable oil and gas lease (real property interest), and not just the produced gas (a personal property interest); and
- It should be confirmed that a memorandum of the GGP agreement was filed in the real property records of the applicable county(ies) to meet the notice requirement that is generally required for a covenant to run with the land.
As is customary in M&A transactions, the buyer should review the GGP agreements to identify any consents that the proposed transaction structure would require be obtained prior to the closing. Thus, in the proposed sale of one or more entities owning the midstream assets, the agreements should be reviewed to identify whether they have change-of-control provisions requiring consent or notice. And if the proposed transaction structure of the sale of the midstream system is via asset sale, the agreements’ assignment provisions should be reviewed to identify whether the producer’s consent is required for the assignment of the agreements.
As always, careful attention should be given to the particular language used in these provisions.
The buyer will also want to understand what consent requirements the GGP agreements may impose on a potential sale of the producer or its assets, and considerations similar to those in the immediately above paragraph would apply to any such sale. In addition, the agreements should provide that—if the producer transfers or disposes of any interests in the oil and gas leases which are the subject of the acreage dedication—then any such disposition shall be expressly subject to the GGP agreement and shall state such in the instrument of conveyance.
This article has only provided a general overview of some of the key provisions in GGP agreements that acquirers of natural gas gathering systems and processing plants should review in connection with their legal due diligence review. There are others not discussed here due to space constraints, including force majeure, indemnities, renewal and termination rights, and remedies.
Because so much of the value of the gathering system and/or processing plant depends on the associated gas gathering and processing agreements, buyers would be well-advised to devote careful attention to the key provisions of the associated gas gathering and processing agreements, including those set forth above.
Greg Krafka is a shareholder in Winstead PC and a member of the firm’s corporate, securities and M&A practice group and energy industry group.
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