April 2016, Vol. 243, No. 4


Upstream Debt May Put Pipelines Under Pressure

Just like everything else, the bankruptcy river flows downstream, and as upstream players look to pass their debt burdens onto midstream operations through a rash of Chapter 11 filings, investors are wondering what is going to happen to all the pipelines as the industry continues to batten down the hatches amid the continued oil price downturn.

Two such companies, Sabine Oil & Gas and Quicksilver, recently filed for Chapter 11 bankruptcy protection, arguing at bankruptcy court that they need to be relieved of their contracts with pipeline operators for shipping their oil and gas from the wellhead – a move that would leave the pipelines with no income, making it nearly impossible for them to stay afloat.

On March 8, Judge Shelly Chapman of the U.S. Bankruptcy Court, Southern District of New York ruled that Sabine Oil & Gas would be able to reject certain contracts with midstream services providers Nordheim Eagle Ford Gathering and HPIP Gonzales Holdings. The court decided that the contracts could be rejected as a “reasonable exercise of business judgement” and due to the lack of challenge to Sabine’s decision making process.

The court did not make “any final determination as to whether the covenants at issue run with the land or as to any substantive legal issue other than granting authority to reject the contracts. This was the larger issue for midstream services providers. The court offered its non-binding analysis that the contract covenants do not run with land, but did not limit Nordheim’s or HPIP ability to file further claims against Sabine’s estate, consistent with what they believe are their rights.

An analysis by Fitch Ratings says the decision could have broader implications for midstream services providers despite it being specific to Sabine’s bankruptcy proceedings and contracts with Nordheim and HPIP.

“Most broadly, it provides leverage for distressed producers with underutilized, expensive commitments to renegotiate midstream contracts or threaten bankruptcy. While it has in the past been assumed that minimum volume contractual commitments and/or acreage dedications could not necessarily be rejected through bankruptcy proceedings, this is clearly not the view of Judge Chapman with regard to the Sabine case,” Fitch stated.

Specific impacts of the ruling will be limited to the names involved. Overall, midstream contracts tend to vary in term and structure across issuers; property law tends to differ state by state; there are practical limitations in using competing gathering and processing services when existing providers are directly connected to the wellhead; and any bankruptcy contract rejection would be expected to be heavily litigated. As such, the decision’s immediate credit impacts for the midstream space are limited, according to the rating service.

“Counterparty risks continue to be a concern for the midstream services space given expectations for continued E&P bankruptcy activity. With the notable exception of Williams Partners, which has outsized exposure to Chesapeake Energy, most investment-grade gathering and processing issuers rated by Fitch have diverse counterparty portfolios with relatively limited exposure to distressed producers, so contract rejection is not an immediate concern.”

Sean Moran, an attorney in the energy division at Buchanan Ingersoll & Rooney, has followed case and offered this comment: “The ruling challenged something that most people had taken for granted — that dedications were necessarily enforceable. It raised issues on topics like privity of contract and estate that we haven’t really looked at since law school.

“We’ll likely see more producers and gatherers reexamine their existing contracts to see if they are properly constructed. In a sustained low price environment, these were conversations that were happening between upstream and midstream companies anyway, but the ruling added a new element to that discussion.”

And from Jefferies comes this observation: “After discussing the case with legal experts, we believe the ruling heightens risks to midstream entities, but stops short of establishing a new legal precedent.”

Sabine and Quicksilver have insisted they should not be obliged to continue using the services of the pipeline operators under Chapter 11 restructuring circumstances, arguing they would be able to save money ($35 million in the case of Sabine Oil, according to a Reuters report) this way. This money, the argument goes, could be better used finding an alternative way of transporting their crude oil and gas.

For the time being, Chapter 11 may save Sabine and Quicksilver from defaulting on massive debt loads, but what of the pipelines? Until recently, pipeline operators felt safe in the knowledge that their contracts were long term and untouchable, banning producers from transporting their oil and gas by any other route or network. That worked well for them, but not quite so well for the producers.

Although the two lawsuits aren’t large enough to cause much of a wake in the industry on their own, a favorable ruling for Sabine and Quicksilver would set a precedent for other energy companies to follow. As a consequence, many midstream companies may find themselves threatened by the upstream bankruptcies, fearing that they will be the ones left holding the bag.

The pipelines are already suffering from their close ties with producers and operators, as the recent stock price fall for Chesapeake Energy and Williams illustrates. As a bankruptcy lawyer with McKoos Smith told Reuters, “It’s a hellacious problem. It will end with even more bankruptcies.”

This downhill action has already hit contracts for new pipelines, as seen by Gazprom’s canceling its $832 million contract with Saipem to lay a new natural gas pipeline in the Black Sea, and Whiting Petroleum’s halting of its deal with Tesoro Logistics to build a pipeline.

Kinder Morgan, North America’s largest pipeline, remains confident despite the precarious position of pipelines in the overall chain. Kinder Morgan investors question how the company can withstand the onslaught of upstream bankruptcies and a hefty percentage of customers with questionable credit.

If an effort to allay investor concerns, Kinder Morgan’s CFO Kim Dang said: “We think if every single one of these guys went bankrupt on us at the beginning of the year, that’s about 2.5% of our revenue.”

To what degree the pipelines – and possibly refineries – will be affected is anyone’s guess, but it’s clear they are now both at the mercy of the upstream momentum, and pipeline operators can no longer maintain the take-it-or-leave-it stance with its customers.

In related news, Southwestern Energy Co. said it and Williams Companies Inc. have negotiated lower rates to gather, transport and process natural gas it produces in West Virginia in exchange for some new business for Williams. Southwestern, which has operations in the Northeast, said the rate reductions will reduce its costs by over $35 million this year. In exchange, Williams will get additional gathering rights on some of Southwestern’s acreage in parts of the Utica and Marcellus shales.

Chesapeake Energy Corp, which has also won price reductions from Williams, said it was aggressively pursuing new deals with its pipeline operators.

By Irina Slav, Oilprice.com

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