R&I Update: Hot Topics in Oil and Gas Restructurings, Volume 2

Can Gathering Agreements Be Rejected as Executory Contracts?

March 10, 2016

“The carnage is going to be terrible,” cried a recent Dallas Morning News headline. “It’s a hellacious problem,” lamented another article. It’s no secret the energy sector has come upon hard times. Oil prices are down 70 percent from their mid-2014 levels. This prolonged price slump has imperiled oil producers: A recent Deloitte report predicts that up to a third may seek bankruptcy protection this year. And because production relies upon an elaborate, interconnected system to take raw crude to the market, the bankruptcies of oil producers will cause significant downstream effects. Or midstream effects, rather.

Midstream pipeline operations comprise a $500 billion segment of the energy sector. The fracking boom contributed to recent growth − investors spent $30 billion a year constructing gas-gathering pipelines and related facilities. Typically, a midstream operator obtains a “gathering agreement” and/or processing agreement from an oil and gas producer, under which the operator collects oil, gas and/or liquids from a specific geographic area for the life of the contract. For example, it is common for a producer to dedicate the entirety of its production from a specific geographic location to a midstream operator. In that case, the producer must use the operator’s gathering services for all dedicated production for the life of the contract. The expected security of these gathering agreements has facilitated the financing and construction of midstream gathering systems: The contracts guarantee a minimum revenue stream to the operator and have been seen to convey an interest in property similar to an easement. The reliance aspect of these dedication arrangements has been thrown into doubt.

Section 365 of the Bankruptcy Code is the source of doubt. The authority allows a trustee or debtor-in-possession to assume or reject executory contracts to which the debtor is a party. (A contract is executory if each party’s obligations are so far unperformed that the failure to perform one excuses performance of the other.) By rejecting an executory contract, the debtor is deemed to breach it. For this breach, the counterparty can assert an unsecured claim for damages against the debtor’s estate. Little consolation − the prospect of an unsecured creditor recovering anything substantial from the debtor’s estate is often slim.

In contrast, a debtor cannot reject a counterparty’s interest in real property. So naturally, oil and gas producers in bankruptcy want gathering agreements to be considered executory contracts. Midstream operators, on the other hand, want gathering agreements to be considered interests in real property. The distinction between the two is hardly clear: Property interests are defined by state law, and cases that address the question in a direct and binding manner are few and far between.

Three years ago, however, the Fifth Circuit Court of Appeals provided a rare insight − albeit in the context of a § 363 sale. In In re Energytec, Inc., the court considered whether a pipeline could be sold free and clear of a party’s interests. Applying Texas law, the Fifth Circuit held that a contract that granted a transportation fee and the right to consent to any assignment of the producer’s interests in the pipeline was a covenant that ran with the land. It therefore could not be ditched in a bankruptcy sale. Three factors guided the Fifth Circuit to this conclusion. First, simply, the contract stated that it ran with the land. Second, privity concerns surrounding the initial conveyance of rights in the pipeline had been satisfied. Third, and perhaps most importantly, the rights in the pipeline touched and concerned real property. On this point, the Fifth Circuit analogized the pipeline to “a subsurface road for natural gas[.]” The land under which the pipeline ran was less valuable because of the encumbrance. And the transportation fee could be viewed as a fee for the use of the land, which necessarily relates to real property.

Three years later, two bankruptcy courts are considering whether gathering agreements constitute executory contracts or covenants that run with the land. Moreover, they are doing so in the context of § 365 of the Bankruptcy Code. In re Sabine Oil & Gas Corporation is pending before the Bankruptcy Court for the Southern District of New York, while In re Quicksilver Resources, Inc. is pending before the Bankruptcy Court for the District of Delaware. The facts of the cases are substantially similar. In each, a producer entered bankruptcy and is trying to reject as an executory contract a gathering agreement into which it entered with a midstream pipeline operator. In this respect, Sabine and Quicksilver may portend the fate of midstream pipeline operations as a whole. Indeed, whether a gathering agreement is an executory contract or a covenant that runs with the land does not appear to have been previously litigated to a conclusion.

Sabine and Quicksilver are each noteworthy for an additional reason. Sabine is important because the Bankruptcy Court in that case recently ruled that the gathering agreements at issue are executory contracts the debtor can reject. The binding portion of the opinion is brief: The court noted that it cannot make substantive legal rulings in the context of a motion to reject unless the issue to be adjudicated “is scheduled simultaneously with an adversary proceeding or contested matter[.]” Thus, the court granted the debtor’s motion to reject its gathering agreements after finding that decision to be a reasonable exercise of business judgment − for which element the objecting midstream operators produced no evidence or argument.

However, after making this ruling, the Sabine court provided detailed “non-binding analysis” that concluded that the gathering agreements are not covenants that run with the land under Texas law. Following a historical survey of real property interests, the court noted that the gathering agreements lacked horizontal privity; they did not grant midstream pipeline operators interests in property in conjunction with a conveyance of land. Instead, the court viewed the agreements as delineating contractual rights and obligations with respect to pipeline services to be provided. Further, the court thought that the rights granted to the midstream operators did not fall within the traditional five “real property sticks” identified by Texas law; they did not grant the operators the right to develop land, lease land, or receive bonus payments, “delay rentals” or royalties. In addition, the court determined that the gathering agreements “do not appear to satisfy the ‘touch and concern’ prong” imposed by Texas law. Notably, the court wrote that Texas law considers extracted minerals to be personal, not real, property. And under the court’s reading of the gathering agreements, the midstream operators possessed a right only to extracted oil and gas, not the raw materials resting under the southeast Texas soil. Finally, the court viewed the particular gathering agreements before it as granting fees to midstream operators according to the amount of oil and gas they received, rather than the volume of those commodities that passed through the pipeline. Importantly, this non-binding portion of the Sabine court’s opinion is not a precedential adjudication of rights and obligations, under Texas law or otherwise.

The Sabine opinion may already be having an impact. On March 4, 2016, another Texas oil and gas producer, Magnum Hunter Resources, asked for permission to reject its pipeline contracts. The request asserted that no damages would inure to the midstream operator by the rejection of its gathering agreements. On March 10, 2016, however, Magnum and the operator told the court that they had reached an agreement: Magnum is withdrawing its motion to reject the gathering agreements, and the operator will receive an unsecured claim for $15 million, among other things. This compromise provides some insight into the negotiating leverage the Sabine opinion has wrought.

Quicksilver is important because it indicates the diminishment in value real property suffers as a result of being encumbered by a pipeline and related gathering agreement. Specifically, Quicksilver Resources has a bidder willing to pay $245 million for its assets, and that sale is scheduled to close by March 31, 2016. But that bid is contingent upon Quicksilver breaking its pipeline operation contract. If it cannot, Quicksilver will take a $150 million loss: The next highest bidder, which is willing to accept the contract, has offered only $93 million.

Notwithstanding the ominous signs that Sabine and Quicksilver pose for pipeline servicers, the conflagration may be contained in two ways. First, whether a gathering agreement is an executory contract or an interest in land is heavily dependent upon the document at issue. Midstream operators, therefore, can foreclose undesirable results by monitoring the contractual language of their gathering agreements. Second, a trustee or debtor-in-possession will reject a contract only if doing so provides value to the estate. Pipeline operators provide a vital service: Without them, oil and gas never get to market. If rejection means that a pipeline will lay dormant for lack of an operator or that a new operator must invest significant resources to build a new pipeline, economics will prevent the debtor from rejecting the agreement.

From the pumpjack to the pipeline, the energy sector faces profound challenges. Despite their traditional insulation, midstream operators are not immune from these hardships. Yet, with the assistance of experienced counsel, midstream pipeline operators can protect their contractual rights and minimize the impact of these troubled times on their businesses.

To read the previous installment in this series, please see “R&I Update: Hot Topics in Oil and Gas Restructurings, Volume 1” and “R&I Update: Hot Topics in Oil and Gas Restructurings, Volume 2, R&I Update: Hot Topics in Oil and Gas Restructurings, Volume 3, and R&I Update: Hot Topics in Oil and Gas Restructurings, Volume 4.”

McGuireWoods’ Restructuring and Insolvency Department has 36 lawyers working from most of the firm’s 21 offices, including in New York, Texas, and London. They have significant experience in energy insolvencies.