As the dual crises of the COVID-19 pandemic and a Russo-Saudi price war rock global oil markets, the force majeure is strong with many oil and gas companies. (Read on for more Star Wars puns.) But the legal battle over midstream oil and gas contracts is only just beginning.
Since the breakdown in OPEC talks and the spread of the coronavirus pandemic in early March 2020, oil benchmark WTI has plunged as low as $18 per barrel. The contango has been as wide as $10 per barrel in some markets. International demand has fallen off a cliff, leaving domestic oil production with nowhere to go. At current production levels, the United States will exhaust its domestic oil storage capacity within three to five weeks. You're not alone if you've got a bad feeling about this. Producers, terrorized into unprecedented collective action, have taken the astonishing step of asking the Texas Railroad Commission to hold an emergency hearing to reduce production allowables across the state.
A number of parties — including producers, marketers and midstream asset providers — have invoked contractual force majeure provisions with respect to the COVID-19 crisis. This has had a ripple effect across the midstream value chain, disrupting the flow of oil and market differentials. But with extraordinary disruption comes both extraordinary risk and opportunity. Below are a few practical, proactive tips for owners and operators of midstream assets to navigate the ongoing crises:
- Review force majeure provisions in all logistics, storage and marketing contracts. The market-standard force majeure provision accounts for disruption of pipeline service and some forms of adverse governmental action, but contains exceptions for a party's financial hardship or inability to pay. If the Texas Railroad Commission cuts allowables such that performance of take-or-pay contacts becomes problematic, could it abrogate a party's obligation to tender an MVC or make a deficiency payment? What happens to time-limited deficiency credits? It depends on the specific contractual language in question. For those transactions more often subject to UCC terms (think trucking and certain marketing contracts), the "impracticability of performance" standard contained in
Tex. Bus. & Comm. Code § 2.615 may apply with similar effect in lieu of a contractual force majeure provision.
- Prepare to request credit assurance. Cratering prices and production are usually followed by industrywide rating agency downgrades. No doubt this will push many prominent industry players into precarious financial predicaments. Fortunately for midstream providers, it’s common for most midstream tankage and pipeline contracts to contain broad, sweeping provisions enabling the asset operator to request financial assurance. Don't be a stuck-up, half-witted, scruffy-looking nerf herder. Letters of credit, surety bonds and cash pre-payments can help to mitigate default risk and underwrite the quality of cash flows and usually provide relief even in the context of bankruptcy.
- Prepare to right-size working capital facilities for marketing desks. If a wave of defaults on take-or-pay contracts floods the industry, marketing affiliates of MLPs and midstream asset providers could very well step in to fill underutilized capacity on major pipeline systems. Most working capital facilities contain covenants with respect to commodity volumes and aggregate indebtedness and other restrictive terms that may no longer match the new reality. These facilities may need to be right-sized, and certain covenant waivers obtained, to better fit the current environment.
- Analyze logistics paths and identify high-consequence risks. As mentioned earlier, a single contractual default or declaration of force majeure can trigger a cascade of similar such occurrences throughout a logistics path, disrupting the flow of oil and revenue streams to multiple parties. The effect can move upstream, downstream or in both directions with respect to any singular asset or market. Given that most commercial contracts contain bespoke terms, midstream providers should review all key provisions and identify obligations and remedies under the likely range of possible outcomes.
- Prepare HSE and accounting staffs to conduct and defend audits. Although health, safety and environment (HSE) programs are paramount, many distressed companies will be under pressure to cut costs. Your lack of faith is not disturbing — storage and pipeline contracts typically contain an invisible Force-choke in the form of robust requirements for maintaining an effective HSE program, and a mechanism allowing one party to audit the other in connection therewith. Midstream providers would do well to step up safety audits of counterparties to ensure compliance with government regulations and good industry practices, and be prepared to defend themselves against similar action. Because the same audit provisions often extend to metering, measurement and accounting obligations, every company's mid- and back-office should be prepared for heightened scrutiny from counterparties. For some companies, auditing customers, vendors and partners can be a means of recovering unrecognized revenue during a downturn.
- Creativity Presents Challenges. Storing oil in parked railcars, previously decommissioned tank farms and across international borders all come with unique regulatory hurdles and costs. Industry players would be wise to consult HSE experts and counsel prior to making such arrangements.
Be vigilant, we must. The consequences of a prolonged downturn will have significant impacts on midstream contracts, producer viability and the capital markets for years to come. May the force majeure be with you as we navigate these challenging times.
McGuireWoods has published additional thought leadership analyzing how
companies across industries can address crucial business and legal issues
related to COVID-19.