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Can a Gathering Agreement Survive the Bankruptcy of the Producer?

The oil and gas industry is at the beginning of a significant downturn. Oil and gas prices are down, supply is up, demand is flat. Another in the never-ending cycle of a boom-and-bust industry, now exacerbated by appearance of a potential coronavirus world epidemic and a sharp reduction in demand for hydrocarbons in China.

As in the past, a downturn in the industry results in a rise in bankruptcies, and this downturn is no exception. Two recent bankruptcy cases illustrate a new wrinkle in disputes arising from failed companies: Monarch Midstream, LLC v. Badlands Production Co., 608 B.R. 854 (Bkrtcy.D.Colo. 2019), and Alta Mesa Holdings, LP v. Kingfisher Midstream, LLC, 2019 WL 7580122 (Bkrtcy.S.D.Tex. Dec. 20, 2019).

For producers to get their oil and gas to market, the production must be gathered and delivered to a pipeline that transports the production to a purchaser. In the past few years producers have formed affiliated companies to construct gathering systems for their production. Producers dedicate their reserves to long-term gathering contracts with these affiliated midstream affiliates. The midstream companies are thereby guaranteed a predictable cash flow that they can use to borrow the money needed to construct the gathering systems. Producers may later sell or spin off these midstream companies, generating cash the producers can use to further develop their reserves.

But what happens when prices decline? Producers are saddled with paying the gathering fees for production that is worth less. In some markets, the gathering costs for natural gas are now exceeding the price the producer can get for the gas. Producers then may turn to bankruptcy law to try to rid themselves of the onerous gathering agreements.

In 2016, Sabine Oil & Gas Corporation sought bankruptcy protection in the bankruptcy court of the Southern District of New York. It then sued its midstream gathering company Nordheim Eagle Ford Gathering, LLC, in bankruptcy court, seeking to cancel its gathering agreement with Nordheim. Sabine Oil & Gs Corp. v. HPIP Gonzales Holdings, 550 B.R. 59 (Bkrtcy.S.D.N.Y. 2016) Bankruptcy law allows a company in bankruptcy to “reject” an “executory contract.” If a contract is rejected, the other party to the contract may make a claim for damages for rejection of the contract but may not enforce the contract. The other party becomes a creditor in the bankruptcy proceeding. Sabine sought to reject its gathering agreement with Nordheim.

But a debtor in bankruptcy cannot reject a contract which imposes a “real property covenant” on the debtor’s property. Such a contract is not an “executory contract.” Whether a contract imposes a real property covenant is a question decided under the laws of the state in which the debtor’s property is located. In Sabine’s case, its oil and gas leases were in the Eagle Ford area of South Texas, so the court analyzed the issue under its reading of Texas law.

Texas law imposes three requirements to determine whether a contract imposes a real property covenant that is binding on successors to the original parties:  does the contract “touch and concern the land,” are the parties to the contract in “privity of estate,” and did the original parties to the contract intend to bind their successors? In Sabine, the court held that the gathering agreement did not “touch and concern the land,” and that the parties were not in “privity of estate.” So Sabine could reject its gathering agreement with Nordheim and it was free to sell its leases not burdened by the obligation to use Nordheim’s gathering system, or enter into a new gathering agreement with Nordheim on more favorable terms.

The two more recent bankruptcy cases, Alta Mesa and Badlands, both reject Sabine’s reasoning and hold that the gathering agreements at issue in those cases cannot be rejected. The Alta Mesa court applied Oklahoma law and the Badlands court applied Utah law – but the tests for whether a contract imposes a real property covenant in those states are the same as in Texas. More litigation on this issue can be expected.

It might seem bizarre to determine the rights of the parties under a gathering agreement by application of ancient principles of state law applied to restrictive covenants on real property. The two topics seem to have little to do with each other. In none of these cases is there any policy discussion on the interests of the parties or the purpose of bankruptcy law.

The practice of “dedicating” a producer’s leases to gathering agreements is more recently being applied to a new development in the industry – independent companies who contract with producers to dispose of produced water from their leases. Like gathering companies, these new companies offer to construct and operate the infrastructure necessary to gather and dispose of producers’ produced water. Companies like H20 Midstream and Waterbridge Resources are acquiring produced water assets from producers in the Permian and entering into long-term contracts with those producers to dispose of their produced water. Producers see an opportunity to generate cash from the sale of those assets, badly needed to continue their operations. The disposal companies rely on the long-term contracts to lock in the disposal fees they will receive and use those contracts to finance their acquisitions and operations.

For both midstream gathering companies and disposal companies, the ability of their contracts to survive the bankruptcy of the producer is important to their business model. If their contracts can be rejected in bankruptcy as executory contracts, those who finance their operations will be less willing to do so.

The issue of “dedication” to gathering agreements can also arise outside the bankruptcy context. Chesapeake was the first big operator in the Barnett Shale. It constructed its own extensive gathering system to get its Barnett gas to market, held by its affiliate, Chesapeake Midstream. The gathering agreement between Chesapeake and its midstream affiliate provided very favorable terms to the midstream company. Chesapeake then spun off its midstream affiliate, raising substantial sums in the market. But when Chesapeake later sought to sell its Barnett Shale production it was unable to do so because of those onerous gathering agreement terms; as a result, it had to buy out the gathering contract before selling its leases, at a substantial cost.

So how does this issue affect royalty owners? If a gathering or disposal agreement is a contract that imposes real property covenants on the oil and gas lease, it affects not only the value of lessee’s interest in production but also the lessor’s royalty interest. High gathering and disposal costs make the reserves less valuable; if the lease allows the lessee to pass those costs through to the royalty owner, the royalty owner is also saddled with those costs.

Years ago a similar problem arose with gas purchase contracts. Before deregulation of the gas market it was common for producers to enter into long-term gas purchase contracts with gas purchasers, dedicating the gas reserves to the contract for years or even for the life of the leases. When gas prices rose, royalty owners sued their lessees, arguing that their leases required payment of royalties based on the “market value” of the gas unimpaired by the price the lessee was stuck with under its long-term gas contract. In Texas Oil & Gas Corp. v. Vela, 429 S.W.2d 866 (Tex. 1968), the court held that the royalty owner was not saddled with the contract price but could sue for royalties based on current market value. Perhaps a similar argument could be made that royalty owners’ share of production should not be burdened with above-market costs for gathering or produced water disposal imposed by long-term contracts their lessees have imposed on their leasehold interests.

One part of the argument on whether a contract “touches and concerns the land” is that the producer has assigned to the midstream or disposal company easements across the oil and gas leases to gather the gas or produced water. But while an oil and gas lease grants the lessee the right to use the surface of the land for its operations, it may not allow the operator to grant easements to third parties for the gathering or disposal operations. If that is the case, perhaps a gathering or disposal agreement cannot impose burdens on the land itself, either the surface or mineral estate, and therefore does not touch or concern the land.

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