United States: Old Rules; New Facts – Disruption In The Mid-Stream Gathering And Processing Space

On March 8, 2016, Judge Chapman of the United States Bankruptcy Court for the Southern District of New York ruled that Sabine Oil and Gas Corporation was able to reject the gas gathering agreements (the "Gathering Agreements") it had with Nordheim Eagle Ford Gathering, LLC and HPIP Gonzales Holdings, LLC. Though Judge Chapman had telegraphed her ruling during the February 2, 2016 hearing on the Debtors' rejection motion, the decision surely comes as a surprise to many market participants, financing parties and others interested in the mid-stream space who had previously viewed those companies' cash flows as somewhat protected from commodity price fluctuations.

Background

While the facts leading to rejection are by now familiar to many, some background bears repeating. Sabine is an independent energy company engaged in the acquisition, production, exploration and development of onshore oil and gas (i.e., it's an "E&P company"). Sabine filed for bankruptcy on July 15, 2015, and two and a half months later, filed its motion under 11 U.S.C. § 365 to reject the Gathering Agreements. In general terms, these agreements required Sabine to deliver to the counterparties a minimum amount of gas and/or other liquid hydrocarbons or other liquids, pay the counterparties a fee associated with the delivered products and, if Sabine failed to deliver the required amounts, pay the counterparty a deficiency fee. In exchange, the counterparties agreed to construct a pipeline and related infrastructure – essentially at their own cost – to transmit and process all of Sabine's gas and liquid hydrocarbons from a defined area.

Each of the Gathering Agreements contained a provision stating that the Agreement constitutes a covenant running with the land and is binding on successors and assigns. These provisions take on out-sized importance in a bankruptcy because rejection of a contract that contains covenants running with the land should not eliminate the covenant under 11 U.S.C. §365. While the debtor cannot be compelled to continue to perform under the agreement – i.e., absent rejection Sabine could not be forced to continue to deliver its gas to Nordheim – preventing rejection gives the counterparty leverage as its interest in the debtor's property must be dealt with as part of the plan process. However, as Nordheim and HPIP discovered, just because you call it a covenant that runs with the land does not mean that you have been successful in creating one.

Ye Olde English Law

The concept of a covenant that runs with the land – a right or obligation that burdens the land itself and is not personal to the owner – has its roots in English law established during the rule of Elizabeth I. Indeed, Judge Chapman cited Spencer's Case, from 1583(!), as establishing the test for whether a burden ran with the land. While the test has evolved over time and may be different from state to state, the use of covenants to burden real estate has become quite common.

In Texas, where the subject real property was located, a covenant runs with the land when: (1) it touches and concerns the land; (2) it relates to a thing in existence or specifically binds the parties and their assigns; (3) it is intended by the original parties to run with the land; and (4) the successor to the burden has notice. As Judge Chapman pointed out, many courts also require horizontal privity between the parties; that is, some additional transactional element to their relationship such as a conveyance of the property burdened by the covenant. In other words, a covenant running with the land cannot be created in a vacuum, but rather must be connected to some other transaction, such as a conveyance of all or a portion of the property that is burdened by the covenant.

Ultimately, Judge Chapman found that the Gathering Agreements failed several portions of the covenant test. First, she ruled that there was not horizontal privity between the parties because "the Debtors did not in the context of a relevant conveyance reserve any interest for Nordheim or HPIP." Judge Chapman also found that the Gathering Agreements do not grant Nordheim or HPIP a real property interest in the Debtors' mineral estate (oil and gas in the ground is considered real property, but once extracted is considered to be personal property) but rather only give the counterparties the right to transport or gather gas that has been produced by Sabine.

The court also determined that the Gathering Agreements did not "touch and concern" the land, that is, the gas in the ground. Instead, these Agreements cover only what happens to the gas produced by Sabine after it has been extracted from the ground. The "dedication" of all of the gas produced from a defined area does not change this. As the court held, "the "dedication" does not constitute a burdening of the Debtors' property interests, but rather an identification of what property and products are the subject of the Agreement and will be made available to the gatherer in furtherance of the purposes of the Agreements."

So, What Does it All Mean

1. A potential reprieve for E&Ps?

Low oil and gas prices have been a drag on E&P revenues for quite some time. And, the impact of those decreasing revenues has been exacerbated by out of market or otherwise unprofitable agreements with mid-stream counterparties that offer only limited relief in the face of falling commodity prices. 1 E&P financial conditions appear set to get even worse as the next round of RBL re-sets may further decrease availability under their senior loan facilities. Following Judge Chapman's ruling in Sabine, 2 Texas E&Ps have an additional tool in their belt with which to negotiate. While such renegotiations may not themselves be enough to save the industry from the wave of bankruptcies many expect, the cash savings could, in the right situation, assist with a restructuring or provide an otherwise unavailable recovery for unsecured creditors.

We note that some analysts have viewed the minimum payment obligations E&Ps owe under mid-stream agreements as secured debt presumably because of the purported conveyance of real property interests in the minerals in the ground to the mid-stream counterparty. Plainly, Judge Chapman's decision in Sabine suggests that a re-evaluation of recovery scenarios in the event of an E&P bankruptcy is in order.

2. Stress for the Mid-Stream

In this case, any potential benefit to the E&P sector is a detriment for the mid-stream. These companies have long been thought of as stable, secure investments and we have seen mid-stream MLP investor presentations touting the protected nature – because of the supposed security afforded by the mid-stream agreements and their covenants running with the land – of their distributions to investors. These assumptions have now been called in to question and we expect to see increasing pressure on the mid-stream segment. Additionally, re-negotiation of gathering agreements to market prices may adversely impact the ability of mid-stream companies to service debt and/or make distributions to investors.

3. A way forward?

While currently low commodity prices will likely restrict new drilling, as prices rise again (assuming they do) new drilling will eventually follow. In that case, how can the mid-stream service providers (and their financing parties) protect their interests? Under the Sabine formulation, a transfer to the mid-stream provider of an interest of some kind in the mineral rights themselves may be necessary to create a covenant sufficient to protect the mid-stream's interests. But, this may be difficult to achieve in practice as it may be difficult to secure the E&Ps' RBL lenders' consent to the transfer or other encumbrance of their collateral.

Judge Chapman's decision will not be the last word on this issue; indeed, Judge Silverstein's decision on Quicksilver Resources' rejection motion is expected to be issued soon. Unless Sabine, Nordheim and HPIP all settle with each other, it won't even be her last word (although we don't expect her to reach a different result) on the subject. Given the "unspeakable quagmire" that is the law of covenants, we expect uncertainty to reign until definitive decisions are made by the highest courts of the various states in which oil and gas fields are concentrated.

Footnotes

1 For example, Sabine's agreement with HPIP required Sabine to continue to drill new wells in the dedicated area and, if Sabine stopped drilling, gave HPIP the right to put its gathering system to Sabine at a pre-determined price.

2 It bears noting that Judge Chapman's decision in Sabine is preliminary in nature. Judge Chapman felt that certain Second Circuit precedent requires her – to her frustration – to hear the dispute again in another proceeding. In our view, given the reasoning in this opinion, it is unlikely that Judge Chapman will change her mind.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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