Midstream and E&P Pipeline Contracts May Be Rejected in Bankruptcy Cases

On March 8, a U.S. bankruptcy judge ruled that debtor Sabine Oil & Gas Corporation (Sabine),¹ an upstream company, was permitted to reject pipeline contracts with midstream gatherers. U.S. Bankruptcy Judge Chapman for the Southern District of New York did not make a final determination as to whether the contracts were covenants running with the land under Texas law—though she did provide an advisory, non-binding decision that they were not, and invited the parties to negotiate or make separate filings with the court.

What You Need To Know

• A U.S. bankruptcy judge has held that midstream gatherer contracts may be rejected in a bankruptcy case.
• Midstream companies should review pipeline contracts to evaluate risk of rejection in the event of a bankruptcy by the upstream producer.
• Oil and gas producers should consider negotiating for price reductions in unfavorable contracts.

Background

Under Section 365 of the U.S. Bankruptcy Code, debtors may assume, assume and assign, or reject executory contracts which are contracts with obligations owing by both counterparties. Debtors with unfavorable contracts may exercise their business judgment to reject contracts that are burdensome. Sabine sought to reject pipeline agreements with Nordheim Eagle Ford Gathering, LLC where it had agreed to deliver certain volumes of gas and liquid hydrocarbons produced from a designated area at set fees or make deficiency payments if below the minimum commitments.² Nordheim agreed to gather, treat, dehydrate, and re-deliver the gas produced by Sabine and to pay for the construction of a gathering system of pipelines and treatment facilities. There was a separate conveyance from Sabine to Nordheim of land in connection with the construction and operation of the gathering system. As Sabine was unable to deliver sufficient amounts of fuel to meet the targets, it would have to make deficiency payments to Nordheim  in the amount of $35 million over the term of the contract. Sabine also sought to save $80 million by rejecting two gathering and drilling contracts involving the same land with another midstream gatherer, HPP Gonzales Holdings, LLC (an affiliate of High Point Infrastructure Partners LLC). The contract stipulated that Sabine must drill at least one well annually through 2017 and if it did not, that it must purchase HPP’s gathering and disposal facilities. Upon rejection of the contracts, the nondebtors would have unsecured breach of contract claims in the bankruptcy case and Sabine could enter into new, more favorable contracts with others.

Analysis

It remains to be seen if the contracts will be held to be inextricably tied to the land. The contracts provided that Sabine’s delivery of products was a covenant running with the land and leasehold interest. The pipeline companies posit that the obligations were covenants running with the land or equitable servitudes under Texas state law and were therefore not subject to termination or avoidance and would survive bankruptcy rejection of the contracts. While Judge Chapman held that she could not procedurally make a final determination pending further filings, she advised in a non-binding ruling that under Texas law, the agreements would not satisfy the requirements necessary to be deemed covenants running with the land. The court’s ruling included the following findings: the midstream agreements failed to “touch and concern” Sabine’s real property interests; that under Texas law, transporting or gathering produced gas is not a right that falls within the scope of the five traditional real property rights (also known as “sticks”); and that these agreements only burdened Sabine’s personal property interests in already-extracted products.

Similarly, in another pressing bankruptcy case, the Quicksilver Resources case before the U.S. Bankruptcy Court for the District of Delaware, the purchaser of its oil and gas fields conditioned the purchase on the rejection of above market contracts with pipeline company Crestwood Equity Partners LP. Parties are currently litigating whether the contracts stay with the land as Crestwood has argued.

Decisions in these cases may encourage oil and gas producers to ask pipeline companies for reductions on fees and volume commitments in unfavorable contracts entered into when oil and gas prices were higher or threaten bankruptcy rejection. Midstream companies stand to lose when these types of agreements are rejected, missing out on the benefit of their bargain in the agreement as well as failing to recover the costs for their own often substantial infrastructure development.

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¹ Sabine is an independent energy company engaged in the acquisition, production, exploration, and development of onshore oil and natural gas properties. The bankruptcy case is Case No. 15-11835.

² Nordheim is a midstream company that gathers, treats, transports and processes mineral products from wells before the products enter the commercial market.