United States: Oil And Gas Industry Update - May/June 2016

Sabine Bankruptcy Judge Authorizes Rejection Of Gas Gathering Agreements

In In re Sabine Oil & Gas Corp., 2016 BL 70494 (Bankr. S.D.N.Y. Mar. 8, 2016), Judge Shelley C. Chapman of the U.S. Bankruptcy Court for the Southern District of New York permitted Sabine Oil & Gas Corporation ("Sabine") to reject three gas gathering and handling agreements with Nordheim Eagle Ford Gathering, LLC ("Nordheim") and HPIP Gonzales Holdings, LLC ("HPIP"). All of the agreements are governed by Texas law.

In connection with its efforts to restructure, Sabine filed a motion to reject the gathering agreements with Nordheim and HPIP. Sabine argued that it could not deliver the required minimum amounts of gas and condensate and that rejection would save it as much as $115 million. Nordheim opposed the motion to reject, arguing that rejection was not a proper exercise of Sabine's business judgment because the agreements included dedications that were stated to be covenants running with the land, which would continue to burden the debtor's interests following rejection. While HPIP did not oppose rejection, it also argued that the relevant hydrocarbon dedications were covenants running with the land which would survive rejection. Sabine's response to the objections was that, among other things, the purported dedications lacked the requisite intent and privity to establish covenants running with the land and were not consistent with real property conveyances under Texas law, as they lacked traditional real property terms and were instead more consistent with services agreements.

Judge Chapman held that Sabine's rejection of the midstream agreements was a proper exercise of Sabine's business judgment, but she determined that the questions of Texas real property law were not properly before the court because the court could not adjudicate the issues in the context of a motion to reject an executory contract. In a nonbinding portion of the court's analysis of applicable Texas law, however, the court noted that the agreements fail to meet Texas's five-part test for covenants running with the land, remarking that "none of the covenants run with the land either as a real covenant or as an equitable servitude." In particular, the court explained that the covenants merely identify the rights and obligations related to the services to be provided under the agreements and do not convey interests in the underlying real property.

The court recognized that, in the event that the agreements were later determined to include covenants running with the land, the producer would likely be required to work out a deal with existing gatherers on terms consistent with the dedications, notwithstanding Sabine's rejection of the agreements. If, however, it were ultimately determined that the agreements do not contain covenants running with the land—which, as noted, the court indicated in dicta was its understanding of Texas law—the producer would be free to seek other providers of midstream services.

After reading her bench decision to the parties at the hearing on Sabine's motion to reject the agreements, Judge Chapman stated that "[i]t might be time to talk about a commercial resolution of some of these issues, but that's for you and your clients to decide."

Quicksilver Drops Motion to Reject Midstream Agreements in Connection With Closing of Sale to BlueStone Natural Resources

On April 7, 2016, Quicksilver Resources Inc. ("Quicksilver") announced that it had closed the sale of its U.S. assets for $245 million to BlueStone Natural Resources II ("BlueStone") in connection with Quicksilver's bankruptcy cases and pursuant to an asset purchase agreement which had been approved by Judge Laurie Selber Silverstein of the U.S. Bankruptcy Court for the District of Delaware in January 2016. Under the original terms of the asset purchase agreement, BlueStone's obligation to close the transaction was conditioned on the court's issuance of a final order approving the rejection of three gas gathering and processing agreements and a joint operating agreement between Quicksilver and Crestwood Midstream Partners ("Crestwood"). Crestwood and BlueStone have announced that they entered into new, long-term gathering and processing agreements in the Barnett Shale, replacing the three agreements which had been subject to rejection, and the rejection motion has been withdrawn with the consent of both Crestwood and BlueStone.

The Quicksilver transaction comes on the heels of the March 8, 2016, ruling in Sabine (discussed previously). In its motion to reject the agreements with Crestwood, Quicksilver advanced arguments similar to those made in Sabine.

Quicksilver initially sought to reject the agreements with Crestwood on the basis that rejection was necessary for BlueStone to consummate the court-approved sale of Quicksilver's assets. Crestwood countered that the agreements contained covenants running with the land or, in the alternative, equitable servitudes and that such covenants (or servitudes) could not be rejected in bankruptcy. In amici curiae ("friend of the court") briefs, the Gas Processors Association and the Texas Pipeline Association argued that the issues before the court involve nuanced Texas property law and that the decision of the court would have profound implications on the oil and gas midstream industry. In its reply to Crestwood's objection, Quicksilver contended, among other things, that Crestwood could not meet its burden of establishing either a covenant running with the land or an equitable servitude under Texas law.

The settlement in Quicksilver highlights the industry's reaction to the question of whether gas gathering and processing agreements are protected from rejection in bankruptcy if they include "covenant running with the land" language of the type routinely used in the industry for years (or whether, in fact, the covenants themselves can survive the rejection of the underlying midstream agreements). As the validity of these contract provisions continues to be challenged in bankruptcy cases, parties are beginning to renegotiate the underlying commercial arrangements both in and outside of court.

For example, in addition to Quicksilver, Swift Energy Co. ("Swift Energy") (also a chapter 11 debtor in the District of Delaware, but before Judge Mary F. Walrath) recently settled a similar rejection dispute by renegotiating a gas services agreement with Eagle Ford Gathering LLC. (Jones Day represents Swift Energy in its chapter 11 case.) Another Delaware chapter 11 case involving attempted midstream contract rejection is that of Magnum Hunter Resources Corporation. Bankruptcy judge Kevin Gross is expected to provide a ruling at a later date, which may provide further guidance on how bankruptcy courts can be expected to rule on this issue. In the meantime, since the landscape remains uncertain, the industry is likely to see continued efforts to renegotiate contracts.

Sabine Bankruptcy Judge Issues Binding Ruling That Covenants in Rejected Midstream Agreements Do Not Run With the Land

On May 3, 2016, Judge Chapman issued a binding ruling in the Sabine chapter 11 cases that the covenants in the rejected midstream gathering agreements "do not run with the land either as real covenants or as equitable servitudes." See Sabine Oil & Gas Corp. v. HPIP Gonzales Holdings, LLC (In re Sabine Oil & Gas Corp.), 2016 BL 140707 (Bankr. S.D.N.Y. May 3, 2016).

After Judge Chapman authorized Sabine to reject the gathering agreements on March 8, 2016, Sabine commenced adversary proceedings against Nordheim and HPIP, seeking a declaratory judgment that the covenants contained in the agreements do not run with the land.

The court granted Sabine's motion for summary judgment in that proceeding for substantially the same reasons articulated in the March 8 opinion. Among other things, the court concluded that, in accordance with Texas law, the covenants in the agreements do not "touch and concern" Sabine's real property. "By the plain terms of the [agreements]," the court wrote, "the mineral dedications concern only minerals extracted from the ground, which indisputably constitute personal property, not real property, under Texas law."

The court also concluded that, even if "horizontal privity of estate" were a requirement under Texas law for a covenant to run with the land, such privity does not exist between Sabine and Nordheim or between Sabine and HPIP. The court explained that horizontal privity is created by "the conveyance of an interest in property that itself is being burdened with the relevant covenant, not the conveyance of an interest in property that is distinct from (even if somewhat related to) the property burdened by the covenant."

Finally, the court ruled that the covenants at issue do not limit the use of or burden Sabine's mineral estate such that they could run with the land as equitable servitudes, because the agreements with Nordheim and HPIP "are fundamentally service contracts relating to personal property of Sabine."

The treatment of covenants running with the land and similar rights that parties have historically incorporated into midstream gas and handling agreements varies from state to state. The court's rulings with respect to dedications in such agreements that do not qualify as real property interests under Texas law could have a significant impact on the oil and gas industry moving forward. The potential that the existence of such dedications will not be deemed to be an impediment to rejection of the underlying agreements in other bankruptcy cases, and that such dedications themselves might not be protected in a bankruptcy, may affect other oil and gas producer bankruptcies in the near term and may deter other midstream companies from building infrastructure in the future in reliance on long-term producer dedications on similar terms.

On May 13, 2016, Nordheim filed a motion seeking permission to appeal directly to the Second Circuit Court of Appeals Judge Chapman's rulings in Sabine authorizing rejection of the gathering agreements and finding that the covenants in the agreements do not run with the land under Texas law. On May 17, 2016, Judge Chapman authorized Sabine to enter into an alternative gas gathering agreement with DCP South Central Texas LLC.

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