Alerts

Bankruptcy Courts Contemplate Debtors' Rejection of Real Property Covenants in Midstream Contracts

Alerts / December 3, 2020

Over the past four years, midstream firms have struggled to adapt their long-standing practices and adjust their long-held expectations, which were fundamentally disrupted by the outcome of the landmark bankruptcy case, In re Sabine Oil & Gas. Midstream providers have since developed and relied on certain mechanisms and carefully drafted contract language in order to bind upstream companies and their successors in interest to obligations and restrictions contained in midstream agreements. Even after Sabine, it was generally accepted that if an upstream party’s contractual obligations were drafted to be covenants running with the land, the midstream partner would have a real property interest that was sufficiently tied to the minerals at issue and hence not subject to rejection in bankruptcy. However, recent bankruptcy case law developments have renewed uncertainty among energy industry participants and stakeholders, with courts entertaining the possibility that even real covenants that run with the land may be subject to rejection in Chapter 11 proceedings.

The relationship between upstream exploration and production (E&P) companies and midstream service providers has historically involved overlapping interests and an inherent symbiosis, with an ultimate goal of profitably getting hydrocarbons downstream for end user consumption. As valuable consideration for access to infrastructure and other critical midstream resources, E&P companies contract with midstream partners and often promise to dedicate to the performance of the agreement all hydrocarbons produced from a defined area of interest (a "dedication"). In exchange for the dedication, a midstream provider typically acquires the exclusive right and obligation to service the dedicated production, which may involve gathering, transportation, processing, treating and other services necessary for readying production to be brought to market.

In light of the constricted consumer demand for and oversupply of energy commodities, and the corresponding decline in oil and gas prices and futures over the past several years, however, the relationship between upstream and midstream firms has become more contentious and unpredictable. Expansive drilling plans that once looked promising are now proving to be increasingly uneconomic. E&P companies have curtailed production from active wells, cut operating budgets and halted future development. As a result, many upstream producers are not meeting their minimum volume commitments and are running up significant demand/deficiency fees.[1] With upstream companies evaluating their options in an effort to reorganize, reprioritize and return to sustainable profitability, many have filed for bankruptcy in the hope of using their authority to reject midstream contracts to free themselves from various costly obligations owed to midstream providers.

Before 2020, courts generally agreed that if the dedications were truly covenants running with the land, they were not executory contracts subject to rejection in bankruptcy. This alert highlights new developments in a line of energy industry bankruptcy cases, which developments may very possibly incentivize E&P companies to file for bankruptcy in certain jurisdictions so they can reject covenants contained in midstream agreements — even covenants that run with the land. This may allow E&P debtors to strip the restrictive covenants in a reorganization or in preparation of a Section 363 sale. Unless the midstream firms have valid and perfected liens or interests collateralized by upstream assets to secure their rights under the contracts in question, they may be left with only unsecured claims that are unlikely to return much value.

Background

In light of the long-term commitments necessary to build out midstream assets, midstream providers have historically sought to enter into agreements that bind the successors of their upstream partners to certain promises: namely, producers’ dedications. However, the nature and benefits of this customary feature of midstream agreements were called into question in the 2016 Sabine bankruptcy case. In Sabine, the United States Bankruptcy Court for the Southern District of New York held that a midstream gathering agreement did not include real covenants that ran with the land under Texas law (despite the plain words of the agreement indicating otherwise). Instead, the Sabine court concluded the covenants at issue were undertakings personal to the debtor producer and the midstream service provider. Consequently, the upstream debtor was permitted to use its business judgment to reject the midstream agreement as an executory contract under Section 365 of the Bankruptcy Code.

Midstream providers have since pivoted with respect to their negotiating priorities and contracting practices, including by attempting to draft dedications to be rejection-proof, even under Sabine scrutiny. But over the past several years, a slew of conflicting bankruptcy decisions has muddied the waters and resurfaced the question of whether, and under what circumstances, bankrupt upstream companies may reject midstream agreements, and their obligations set forth therein relating to, e.g., dedications and minimum volume commitments.[2]

Recent Post-Sabine Developments: Extraction and Southland Resources

As described above, until recently, it was widely accepted that real property covenants are not executory and hence not subject to rejection. However, two Delaware bankruptcy cases, Extraction Oil and Gas and Southland Resources, have brought rejection of oil and gas contracts back to the forefront of the discussion. In both cases, the Delaware bankruptcy courts held that, even if a midstream services agreement contains covenants that run with the land under state law,[3] an upstream debtor may nonetheless reject the agreements and emerge from bankruptcy unburdened by, or alternatively sell its property free and clear of, the real covenants. Unless the midstream provider has a secured interest in the upstream assets, its rights are those of unsecured creditors entitled to a mere contract claim against the bankrupt debtor.

The Delaware courts largely tracked the Sabine analysis, in addition to considering the possibility that even covenants tied to a real property interest (and thus running with the land) may still be subject to rejection under Section 365 of the Bankruptcy Code. The cases may increase the likelihood of distressed E&P companies filing for Chapter 11 protection as a means to escape obligations in midstream contracts that are no longer financially feasible or attractive.

Practical Implications for Industry Participants and Stakeholders

Upstream Companies and Distressed Asset Purchasers

The recent post-Sabine case law developments open the door for E&P companies to possibly reject in bankruptcy certain real covenants by which they would otherwise continue to be bound under their midstream agreements. Upstream debtors stand to benefit in many ways, primarily attributable to the fact that unburdened real property interests hold greater value. Another likely result is that struggling upstream companies will be able to negotiate new midstream contracts with more favorable terms than those contained in their current agreements. Furthermore, upstream debtors in possession may very well have greater leverage and receive more competitive bids in Section 363 sales due to the heightened value of unencumbered assets.

The recent Delaware case law developments also present an opportunity for successors in interest to possess upstream assets free and clear of preexisting affirmative and restrictive obligations customarily characteristic of midstream agreements. Extraction and Southland Resources not only bolster and extend Sabine, but also provide clarity and impart an element of certainty as to E&P debtors’ rights and the ability to reject real covenants in midstream contracts that would otherwise depress the value of upstream assets (and would ultimately make such assets less attractive to prospective purchasers). Another practical implication of these cases is that interested buyers may enjoy a lightened burden of contract diligence when evaluating upstream assets in a 363 sale — at least in a Delaware forum.

Midstream Providers

Midstream providers make substantial financial investments to build pipeline gathering systems and processing facilities, which in turn allow E&P companies to focus their CapEx budgets on traditional upstream operations. The recent post-Sabine case law developments reinforce the reality that midstream firms may need to renegotiate their agreements with their financially distressed upstream partners or face being unsecured creditors in bankruptcy. Surely, midstream companies will continue to try to cause upstream parties’ covenants in midstream agreements to be inextricably linked to such parties’ real property interests (e.g., by insisting on covenants that constitute a conveyance of a real property interest, such as a royalty interest, as opposed to a mere promise of payment for services; by drafting dedications to cover unproduced reserves, as compared to dedications of produced gas; by connecting or having the right to connect their gathering systems to upstream partners’ wells; or by imposing a minimum drilling obligation or negotiating hard consent-to-assign provisions).

Conclusion

The depressed economic climate of the oil and gas industry and of capital markets as a whole has corresponded with an uptick in upstream companies, which are in need of financial flexibility, declaring bankruptcy and negotiating distressed asset acquisitions. While recent post-Sabine bankruptcy case law developments suggest a brighter outlook for E&P companies contemplating reorganization and restructuring, midstream providers will need to manage their expectations and insist on contract protections and other mechanisms by which they can adequately protect their long-term investments.

BakerHostetler has oil and gas and bankruptcy attorneys with extensive experience in developing practical approaches, implementing strategic solutions and otherwise assisting companies with managing risk and uncertainty inherent to the energy industry.

Authorship Credit: Mark Jones, Joe Esmont, Kristin Kluding and Scott Prince


[1] In addition to dedications, midstream contracts often include an obligation of the upstream party to produce a minimum amount of oil or gas for processing (a “minimum volume commitment”). Failure to meet minimum volume commitments typically results in the upstream party being required to pay a demand fee to compensate for the deficiency.
[2] See, e.g., Monarch Midstream, LLC v. Badlands Prod. Co. (In re Badlands Prod. Co.), 608 B.R. 854 (Bankr. D. Colo. 2019) (applying Utah law to determine that gathering agreement was a covenant running with the land); Alta Mesa Holdings, LP v. Kingfisher Midstream, LLC (In re Alta Mesa Res., Inc.), 613 B.R. 90 (Bankr. S.D. Tex. 2019) (applying Oklahoma law to determine that gathering agreements were covenants running with the land).
[3] Real property interests are created and defined by state law.

Baker & Hostetler LLP publications are intended to inform our clients and other friends of the firm about current legal developments of general interest. They should not be construed as legal advice, and readers should not act upon the information contained in these publications without professional counsel. The hiring of a lawyer is an important decision that should not be based solely upon advertisements. Before you decide, ask us to send you written information about our qualifications and experience.

Related Industries