In the higher commodity price environment of 2010 to 2014, upstream companies either sold gathering systems to raise capital and/ or incentivized midstream companies to construct assets on their behalf. This typically resulted in long-term agreements that included such terms as minimum volume commitments (MVCs), dedicated acreage and, in some cases, guaranteed cash flow. At the time, both the E&P and midstream companies benefited from the contractual relationships.

E&P companies entered into such agreements in the higher commodity price environment when projected production resulting from active drilling programs substantially exceeded the MVC or other guarantees. Therefore, E&P companies were not concerned with meeting their contractual obligations at the time.

During the depressed commodity price environment over the past two years, E&P companies have slashed capital spending and revised their drilling pro¬grams. Consequently, in certain instances, production is expected to be less than originally projected, and as such, E&P companies now have a lower probability of meeting their volume commitments.

In an acquisition context, the obli¬gation arising from the MVC likely will not make its way into the reserve report. As such, E&P companies look¬ing to acquire producing properties should consider volume commitments and/or other contractual obligations when preparing their bids.

For financial reporting purposes these obligations can potentially be a liability.

Midstream benefits

Owning and operating gathering sys¬tems can be lucrative to midstream companies as they can market their infrastructure to multiple producers in the area and thereby expand the poten¬tial revenue streams from the systems. Further, the steady revenue stream derived from predominately fixed-fee contracts is attractive to investors in midstream companies.

While the steady revenue stream offered by gathering systems is attrac¬tive, midstream companies should consider counter-party and commodity price risks when acquiring or construct¬ing gathering assets. The need to con¬sider these risks has been brought to the forefront in the recent low commodity price environment. In considering a potential acquisition, midstream com¬panies should evaluate the ability of the E&P companies to meet their volume commitments as well as meet other financial obligations.

While the agreements are legally binding contracts, MVCs have been challenged in recent bankruptcy pro¬ceedings. Sabine Oil & Gas Co., for example, argued its contracts should be rejected in bankruptcy since it could not provide the required volumes or pay the deficiency. The gathering pipeline companies that were counterparties to Sabine argued that, under Texas law, the contracts were covenants that run with the land. The bankruptcy court ruled against the notion that the covenants run with the land and rejected the con¬tracts. (See following story.)

The potential impact of the ruling in Sabine has raised concerns for mid¬stream companies’ ability to enforce the terms of gathering agreements in distressed situations. In some cases, it has been advantageous to both parties to renegotiate contracts.

Accounting implications

Once an acquisition is closed, the acquiring company is required to allo¬cate the purchase price to all assets and liabilities acquired at fair value under Accounting Standards Codification (ASC) 805, Business Combinations. Assuming the acquisition includes a gathering contract containing certain obligations as described above, then the contract should be valued.

For example, assume the contract includes an MVC and the expectation is the projected volumes (in the reserve report) will be less than the mini¬mum. In this case, the present value of the projected shortfall is valued and recorded as a liability on the acquiring company’s balance sheet. Similarly, if the properties acquired are subject to contractual gathering rates that are either above or below the market rate at the time of closing, an asset or liabil¬ity (depending on whether the contrac¬tual rates are above or below market, respectively) is required to be recorded on the balance sheet to account for the off-market contract.

Once recorded on the balance sheet, the assets/liabilities are amortized and are evaluated periodically to determine if the carrying amount on the balance sheet requires adjustment pursuant to relevant Generally Accepted Accounting
Principles. Additionally, U.S. Securities and Exchange Commission disclosure requirements related to contractual obligations should be considered for public companies.

Fair value

Upon purchasing a gathering system, a midstream company must record at fair value the acquired tangible and intangible assets. In most cases the tan¬gible assets include gathering pipelines, related compression and associated rights of way. Intangible assets typically include customer contracts inclusive of obligations such as minimum volumes, dedicated acreage, etc.

If the producer experiences hard¬ship and the agreements are renego¬tiated or cancelled, the tangible assets may be subject to impairment testing under ASC 360, Property, Plant, and Equipment. Adverse changes to the agreement may be considered a trig¬gering event under ASC 360, where the assets (tangible and intangible) are tested for recoverability under step 1, and if they fail the recoverability test, are impaired in step 2. If goodwill is recorded in a transaction, the goodwill is subject to annual impairment testing under ASC 350, Intangibles—Goodwill and Other.

Key takeaways

Acquisitions of oil and gas properties have become more complex in situations where gathering systems are owned by a third party. Typically, the agreements were put in place in a higher commodity price environment where projected production was expected to exceed minimum volume or other commitments. Given the decline in commodity prices over the last two years, it has become difficult for E&P companies to meet their contractual obligations. As such, agreements in place for gathering should receive consideration by prospective buyers of E&P properties as they could have economic and accounting implications.

At a minimum, prospective buyers should consider the related contracts when developing a bid for the prop¬erties. The risks associated with mid¬stream ownership of gathering systems is not unilateral to E&P companies.

Gathering system owners face the risk that the producer has financial hardship in the future, and may not be able to meet their obligations. As such, it is important for midstream companies to consider commodity price and counter-party risk when performing their due diligence in connection with the potential acquisition of gathering systems.

Paul Legoudes is a managing director within the Valuation Advisory Services group at Opportune LLP.