Stunned by a judge’s advisory ruling in early March that could put many contracts with upstream partners up for renegotiation, midstream operators warily await a more definitive ruling in the Sabine Oil & Gas bankruptcy case as the realization sets in that a key advantage in putting deals together could be lost.

The ruling by U.S. Bankruptcy Judge Shelley Chapman authorized Sabine to reject gathering and processing contracts with two midstream companies, Nordheim Eagle Ford Gathering LLC and HPIP Gonzales Holdings LLC because the E&P could not meet minimum production requirements and faced substantial financial penalties of up to $35 million.

The argument by the midstream companies that the “covenant running with the land” language in the contracts would preclude rejection by the debtor was put aside for another day, but the judge made it clear in a non-binding ruling that the agreements in question do not “run with the land” in her interpretation of Texas law.

“From a practical standpoint, what it says is, all these contracts that rely on acreage dedications are in play,” bankruptcy attorney David Ross of Babst Calland told Hart Energy. The hard line that midstream companies had assumed they could take, that the “covenant” language assured them of payment because the agreement was tied to the land and not to the owner, is now open to be challenged.

‘Runs with the land’

As Chapman discussed in her ruling, the concept of “covenants running with the land” was created in old English law and tested in court in Spencer’s Case in 1583. English courts over time stopped finding that affirmative covenants—those that required a party to do something—run with the land. However, Chapman wrote, U.S. courts still uphold the concept in affirmative cases, though less often in cases involving negative covenants (those that prevent a party from doing something).

Although the case was heard in federal bankruptcy court in the Southern District of New York, federal judges apply state law where it is necessary, Ross said. In this case, Chapman found no applicable binding decision by the Texas Supreme Court on this issue, noting that while the midstream companies were engaged to perform services for Sabine, that does not imply that a real property interest was conveyed to Nordheim and HPIP.

Time to rethink

For operators, it’s time to reexamine agreements in place.

“From an industry perspective, the recent ruling on the Sabine deal definitely makes you think hard about the structures that you’re willing to do,” Brett Wiggs, CEO of Oryx Midstream Services, told Hart Energy. “From our perspective, we felt it was extremely important to be willing to take risk side-by-side with the producer.”

However, Oryx does not engage in combination land dedication and minimum volume commitments like those in the Sabine case. Its contracts are pure dedication or pure volume commitments.

Oryx also operates in a sweet spot of the still-thriving Permian. In other less attractive areas, low prices have made similar business structures much more complicated.

“From an E&P operator’s perspective, there’s one less arrow in the quiver about how you actually get midstream service to your wells,” Jay Hammond, an attorney at Babst Calland, told Hart Energy. “You can’t really trade on your land position because the dedications may not be valuable to the midstream operator.”

“From a midstream perspective,” he said, “you are probably going to be much more focused on getting a commitment fee or something like that, than before the ruling, even though that may not be the most cost-effective structure.”

In the end, the key point for E&P operators and midstream providers will likely be physical proximity.

“Assuming existing gathering infrastructure and assuming the gas will be produced at some price, the dynamic between a gatherer on the one hand and a producer on the other is really dictated by where the gatherer’s pipeline is located vis-à-vis the E&P operator’s acreage,” Hammond said. “If you’re the only gatherer in real proximity to a production field, well, the E&P operator is going to have to deal with you, regardless of whether or not the gathering contract can be rejected in bankruptcy.”

The question is then one of who holds the cards—upstream or midstream.

New deal

Figuring out how to restructure deals is the challenge now.

“So what does [the ruling] do?” Ross asked. “It made the alternative that the midstream companies may ask for something different. At the beginning of a contract, they may ask for credit. They may ask for cash. They may ask for a commitment fee. Maybe they ask for liens on the real estate. I think that is a lot different than what the industry has historically seen.”

One exception is Navigator Energy Services LLC, a Permian Basin midstream operator that has maintained strict criteria with its contracts.

“We’ve contracted consistently and responsibly and conservatively,” Matt Vining, the company’s chief commercial officer and co-founder, told Hart Energy. “When crude was at $100, I got laughed at when I asked for credit protection mechanisms from our producers. That doesn’t look so silly now. We feel pretty good.”

Those who don’t feel so good are looking at ways to renegotiate agreements.

“When I say renegotiate, most of the gathering agreements have a minimum quantity, guaranteed payments,” Ross said. “But if the producers don’t have cash, and they’re not producing enough quantities because of the [low] gas price, these guaranteed payments are at risk and the producers are going to say, ‘listen, we can’t afford to make these payments.’”

In that situation, section 365(a) of the U.S. Bankruptcy Code allows the debtor, in this case Sabine, to accept or reject executory contracts depending on what is known as the “business judgement” test (whether the agreement is good or bad for the business).

Chapman wrote that courts generally accept the debtor’s decision unless it is shown that the contract rejections were the “product of bad faith, whim or caprice,” which neither midstream company argued was the case.

Expect more of same

Going forward, lingering low commodity prices can be expected to push more producers into bankruptcy court.

“Historically, if a producer was having financial issues, the midstream company may not be as open to renegotiating but clearly ‘Sabine’ has turned the cart upside down,” Ross said, referring to the case. “The midstream people were just sitting back and saying, ‘hey, covenants run with the land. There’s nothing you can do to our agreement. You’re stuck with it.’

“What the ‘Sabine’ case says is, that may not necessarily be the case,” he said. “What you’re probably going to see is the midstream companies considering renegotiating some of these gathering agreements because the practical answer is, if the producer goes away, is there necessarily anybody else to step in and replace them? A couple of years ago, I’m sure people were standing in line, but I’m not sure that it’s the case today."

Joseph Markman can be reached at jmarkman@hartenergy.com and @JHMarkman