[Editor's note: A version of this story appears in the April 2020 edition of Oil and Gas Investor. Subscribe to the magazine here.]
As producers seek to deliver on investor demand for free cash flow from ongoing drilling operations and the reduction of debt, the industry has seen a rapid emergence of large-scale water management companies. Further, because most producers constructed their water infrastructure assets purely to service their own production, inefficiencies and excess capacity on these systems became prevalent across the Permian Basin.
Armed with billions of dollars of non-deployed capital, private-equity-backed players have entered the water management market over the past few years to capitalize on both the increased efficiencies they could offer through the interconnection of these independent water systems and their operational expertise. The water companies’ desire for assets, coupled with the producers’ need for liquidity, has set the stage for the rapid emergence of a more sophisticated water management industry.
In the most common (and straightforward) transaction, an upstream producer sells some or all of its water assets to a water management company for cash pursuant to a purchase and sale agreement. Simultaneously with the closing of the transaction, the producer dedicates its leasehold interests to the water management company for the provision of services related to the gathering and disposal of produced water (gathering agreement) and, if water supply assets are included in the transaction, the producer commits to acquire all of its supply water for drilling operations pursuant to a water supply agreement.
One challenge presented by an outright sale of a producer’s water assets is that most producers do not build or operate their water assets as standalone systems for third-party use. As a result, special attention must be given to ensure that the necessary real property interests, permits and equipment are correctly identified and transferred.
In some transactions, the producer contributes or sells its water assets to the water management company in exchange for equity interests (or for a combination of cash and equity) in the water management company. When the producer receives equity interests as consideration, the producer will have an ongoing interest in the water management company, which can be beneficial from an economic perspective and also may provide the producer with governance rights (i.e., a board seat, a board observer position and/or approval rights on the water management company’s ability to take certain actions).
The terms of the equity interests to be held by the producer will be subject to negotiation, including, among other matters, whether the equity interest is a preferred or common interest, the producer’s governance and approval rights and the producer’s ability to transfer its equity interests. Because the water management company may engage in transactions with competitors of the producer, the parties are often careful to limit the producer’s ability to participate in board meetings or receive information relating to such competitors.
Another way for a producer to monetize its water assets while still maintaining day-to-day operational control of such assets is to bring in a limited financial partner. In such transactions, the producer transfers its water assets to a special purpose vehicle (SPV) in exchange for a controlling share of the SPV. The financial partner contributes cash to the SPV in exchange for a minority share (which cash may be immediately distributed to the producer). At closing, as with an outright sale, the producer and the SPV enter into a gathering agreement and/or supply agreement. In order to provide the services under these agreements, the SPV enters into an operating agreement with the producer whereby the producer operates and maintains the water assets on behalf of the SPV. The ultimate effect is that the producer continues to operate the water assets as it did before closing, but the financial investor is entitled to a share of the profits the SPV earns as the service provider under its long-term water contracts.
Common issues that arise in water infrastructure transactions
Perhaps the biggest issue producers face when divesting their water assets is loss of control of day-to-day operations and the related loss or reduction of firm capacity. By owning the water assets, the producer has sole and exclusive control over source water delivery and/or produced water disposal, and operations are not subject to capacity limitations. When asset ownership is relinquished, however, capacity may be provided to other producers on the system and no longer available to service the requirements of the original owner.
Another issue that typically arises in these transactions involves the transfer of the necessary land rights for the assignee to continue operating the water assets after closing. Rights-of-way and easements, for example, present a host of issues if not transferred or otherwise addressed correctly, as producers generally construct water infrastructure pursuant to their existing oil and gas leases, and such leases will be retained by the producer after the water assets are transferred. While it may be relatively straightforward to identify a produced water pipeline to be conveyed in a transaction, actually separating such pipeline from the producer’s underlying real property interests must be done carefully and in accordance with the language in the granting instruments, which often do not directly address such separation or, in certain cases, specifically prohibit it.
The inability to transfer disposal permits can also result in the producer retaining disposal assets it intended to transfer. Although the transfer process for permits issued by the Railroad Commission of Texas (RRC) to operate Class II disposal wells is relatively straightforward, recent enforcement actions undertaken by the RRC have demonstrated a willingness to reassess, and in some cases significantly decrease, the permitted disposal capacity for a particular disposal well. Given this development, both producers and water management companies have increased their diligence efforts to better understand the risks that may be present in a given transaction.
Transferring freshwater permits and registrations can also present issues, especially in the case of a transfer of such assets to an SPV or other entity that will not be directly operating the freshwater wells or an entity that will be providing freshwater supply services to third parties. Care must be taken to comply with the specific transfer requirements of the applicable groundwater conservation district.
Because the water assets being transferred are usually fully integrated into the producer’s ongoing operations, a comprehensive transition services agreement is usually necessary for a period of time following closing to assist the water management company with assuming full control of the system.
Water gathering and supply agreements
Two of the most common agreements in water transactions are the gathering agreement and the supply agreement. While these services are sometimes covered in a single “full-cycle water agreement,” many parties prefer to execute separate standalone agreements for these distinct services, especially because the roles (and thus, the corresponding provisions in the agreements) are reversed in the agreements (the producer delivers produced water under the gathering agreement and receives source water under the supply agreement).
Although it is common for producers to engage a single water management company to handle both water disposal and water supply, occasion sometimes necessitates that a producer use separate water management companies to service its assets, even within the same area. Although there are many similarities between water agreements and the typical gas and liquids midstream agreements, special attention is required for certain aspects that are unique to water gathering, disposal and supply, a few of which are noted below.
The gathering agreement governs the relationship between the producer and water management company for the delivery, transportation and disposal of produced water. In addition to an acreage dedication made by the producer (and exceptions and reservations therefrom), a gathering agreement typically includes provisions addressing custody and control, service priority, capacity commitments, system buildout, water quality, measurement and indemnification obligations. The producer’s ability to obtain more favorable terms is influenced by, among other things, (i) the size of the dedication, (ii) whether the gathering agreement is a standalone agreement or part of a larger infrastructure acquisition, (iii) development areas where zones of excess pressure are known to exist, (iv) the distance (and time) needed to make the initial receipt point connections (and any additional connections), (v) capacity constraints on the system and (vi) the producer’s anticipated pace of production operations.
A producer possessing bargaining strength will likely obtain firm service priority and remedies for service delays and capacity curtailments, including make-whole reimbursement, rig down-time expense, fee reductions and/or accelerated releases of its real property interests from the acreage dedication. These remedies help to align the producer and the gatherer with respect to providing flow assurance throughout the term of the gathering agreement. Remedies for producers with less bargaining strength are typically limited to a temporary release from the dedication of the water volumes the gatherer does not or cannot accept. To the extent that a temporary release event persists for a specified amount of time, the release can become permanent in order to permit the producer to contract with another service provider.
Other typical provisions in a gathering agreement include ownership of skim oil contained in produced water, representations and warranties from the producer regarding the delivered produced water and from the gatherer regarding sufficient capacity on the gathering and disposal system to service producer’s forecasted production, and rights and remedies of the parties with respect to water that fails to satisfy the quality specifications under the agreement. Additional complexity is introduced if high levels of hydrogen sulfide are present in produced water due to the expensive treatment cost and applicable state and federal environmental and safety regulations.
The supply agreement governs the relationship between the producer and the supplier for the delivery of source water for production operations. Source water may be limited to fresh water or a mix of fresh water and treated or recycled water. In addition to the reversal of roles as noted above (i.e., the water management company is the water deliverer under a supply agreement), there is usually less pipeline infrastructure required under a supply agreement because flexible surface lines that can be easily relocated between sites are often used to deliver water from the source to the drill pad.
Another key difference from a gathering agreement is that the supply agreement does not include an acreage dedication. Instead, the producer generally commits to obtain all of its water requirements for operations within a specified geographic area from the supplier. Remedies for failure to timely deliver or for the delivery of off-specification water, such as make-whole provisions and commitment releases, are usually similar to those contained in a gathering agreement.
In cases where the water management company provides both the gathering and disposal services and has the ability to treat and redeliver produced water as source water, sometimes the firm water-sourcing obligations are tied to the volume of produced water delivered by the producer under the gathering agreement.
As producers look to strengthen their balance sheet and renew favor within the investment community, the industry should continue to see the monetization of water assets as a viable solution.
Moreover, due to the extremely large volume of water required for oil and gas fracking operations, and the resulting large volume of produced water requiring a home, new disposal well permitting and recycled and treated water options and requirements, among other issues, will continue to be critical issues for producers and water management companies.
As was, and continues to be, the case with traditional gas and liquids midstream transactions, new complexities will continue to surface within water service agreements to address evolving regulatory and environmental requirements as well as public policy considerations.
Dale Smith is a partner in Bracewell LLP’s business and regulatory group and advises clients on financing and energy transactional matters. Lytch Gutmann is a partner in the firm’s corporate and securities group and represents public and private companies in a variety of corporate transactions. Molly Butkus is a partner in the firm’s oil and gas projects group and represents E&Ps, midstream companies, water management companies, private equity funds, purchasers and sellers in all aspects of upstream and midstream transactions. John Stavinoha is an associate in the firm’s oil and gas projects group whose practice focuses on representing E&Ps, midstream and water management companies, and private-equity funds.
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