July 2016, Vol. 243, No. 7

Features

Another Bite at the Apple: Renegotiating Rates with Distressed Shippers

It is no secret that oil and gas producers are facing exceptionally challenging market conditions that have persisted for almost two years. Prognosticators may have different thoughts as to when oil prices will fully rebound, but it is telling of just how dire the circumstances have become when $40 a barrel is celebrated as a source of optimism. The prolonged period of depressed commodity prices has wreaked havoc in the upstream sector. This havoc, however, is no longer confined to the upstream sector and is starting to bleed into the midstream sector.

By way of example, much has been written about a bankruptcy court’s recent decision to allow Sabine Oil & Gas Corp., which filed for bankruptcy in July 2015, to reject gathering agreements with two pipeline operators. That decision is still subject to appeal, but it has already raised significant concerns within the midstream about the possibility that more and more producers will seek to use Chapter 11 protections as a means to renegotiate or rid themselves of transportation agreements that they have entered into with pipelines. The risk to pipelines, of course, is that they stand to lose the benefit of the transportation agreements that they rely upon for revenue, and that in many cases, underpin substantial capital investment by the pipeline.

In these challenging market conditions, pipelines may be interested in acceding to efforts to renegotiate the terms of existing service agreements with distressed shippers on the theory that a service agreement with a lower rate is better than no service agreement at all and an unsecured claim in bankruptcy court. These renegotiation efforts may be affected by the regulatory status of the service provider. In the high profile Sabine decision, the pipeline in the dispute is not subject to the jurisdiction of the Federal Energy Regulatory Commission (FERC) because gas gathering services and service providers are not regulated by FERC.

There is no exception, however, from FERC’s jurisdiction for oil gathering. For pipelines that are subject to FERC’s jurisdiction, renegotiating a customer’s rate is not simply a commercial matter and must be considered within the regulatory framework within which the pipelines exist. While there are certain similarities between the way that oil and natural gas pipelines are regulated by FERC, there are also material differences that impact the flexibility that a pipeline has to renegotiate its rates when faced with a shipper’s potential bankruptcy.

Pipeline Anti-Discrimination Requirements

Pipelines that transport natural gas in interstate commerce are subject to FERC’s jurisdiction under the Natural Gas Act of 1938 (NGA). In contrast, pipelines that transport oil or natural gas liquids in interstate commerce are subject to FERC’s jurisdiction under the Interstate Commerce Act of 1887 (ICA), a statute that was originally designed to regulate the railroad industry and later amended to also regulate oil pipelines in 1906. As a result of being governed by two separate statutes, natural gas pipelines and oil pipelines are regulated differently in many material respects. Broadly speaking, natural gas pipelines are more heavily regulated than oil pipelines. The extensive regulation imposed on interstate natural gas pipelines largely stems from the fact that the NGA is a New Deal, consumer-protection statute.

In contrast, the objectives of the ICA were more limited. Rather than protecting consumers, the aim of the ICA was to protect businesses which relied upon rail to transport their goods from the monopolistic practices of the railroad industry. Although the differences between the NGA and ICA result in a different regulatory and commercial paradigm for natural gas and oil pipelines, there is at least one point of commonality that bears on how both types of pipelines apply their creditworthiness requirements and negotiate with distressed shippers. The point of commonality is that the NGA and the ICA prohibit natural gas and oil pipelines, respectively, from acting in an unduly discriminatory manner. In other words, natural gas pipelines and oil pipelines are prohibited from treating similarly situated shippers differently.

The anti-discrimination requirements imposed on natural gas and oil pipelines are an important consideration for pipelines that are confronted by a shipper’s bankruptcy. Any adjustment of an existing shipper’s rate must be done in a manner that can be reconciled with the anti-discrimination requirements that apply to FERC-regulated pipelines. Somewhat surprisingly, while both natural gas and oil pipelines must have published rates set forth in tariffs on file at FERC, natural gas pipelines have more flexibility than oil pipelines to negotiate rates with their pipelines – a bit of an anomaly when one considers that as a general rule, natural gas pipelines are subject to more heavy-handed regulatory oversight than oil pipelines.

Renegotiating Rates for Natural Gas Pipeline Service

Natural gas pipelines have minimum and maximum rates set forth in their tariffs, and pipelines are free to assess a shipper a rate within the published range. Additionally, natural gas pipelines may enter into what is known as “negotiated rate agreements” where a shipper agrees to pay a rate that may not be within the range set forth in a pipeline’s tariff, subject to the requirement that the negotiated rate must be publicly filed and approved by FERC and that the shipper had the right to elect to pay the maximum rate set forth in the tariff. The ability to charge shippers a rate between a minimum and maximum tariff rate, combined with the additional optionality to use negotiated rates, provides natural gas pipelines with the ability to negotiate with distressed shippers and lower a particular shipper’s rate as a means to retain that shipper’s business.

It is important to note, however, that this flexibility is not totally open-ended, as natural gas pipelines are always subject to the anti-discrimination requirement that they treat similarly situated shippers the same. For example, when a natural gas pipeline has advertised a certain rate incentive for anchor shippers in an open season for a new project, the pipeline could face discrimination complaints if it lowers that rate for one distressed shipper, but not other anchor shippers. Before lowering any shipper’s rate, natural gas pipelines must analyze how to reconcile the rate adjustment with the NGA’s anti-discrimination requirements. In other words, natural gas pipelines need to have a defensible rationale as to why the shipper whose rate is being adjusted is not similarly situated to other shippers with higher rates. This is a fact-specific analysis, but an important one for natural gas pipelines to take if they wish to avoid litigation, regulatory scrutiny, and customer complaints.

Renegotiating Rates for Oil Pipeline Service

At first glance, the requirements imposed on oil pipelines with respect to rates seem to mirror those imposed on natural gas pipelines. Like FERC-regulated natural gas pipelines, oil pipelines must file tariffs at FERC that include the rates the pipeline assesses for transportation service. Like natural gas pipelines, oil pipelines are prohibited from taking any actions that would result in the treatment of similarly situated shippers dissimilarly.

However, there are important differences between the two. The most fundamental difference is natural gas pipelines are contract carriers – meaning that all shippers must have a service agreement with the pipeline and that those shippers with firm service agreements are entitled to use a defined amount of capacity on the pipeline, subject only to curtailment in force majeure circumstances or for other operational reasons. In contrast, oil pipelines are regulated as common carriers under the ICA.

In its purest form, common-carrier pipelines do not have service agreements with their shippers and their shippers do not have firm capacity rights. The exception to this general rule is that to incentivize the construction of much-needed oil pipeline infrastructure, FERC has allowed oil pipelines to enter into throughput and deficiency agreements pursuant to which a shipper, known as a committed shipper, agrees to pay for a certain level of throughput in exchange for special rates and access rights.

To ensure that such arrangements are reconcilable with the anti-discrimination requirements of the ICA, FERC requires pipelines to advertise the availability of special rates and access rights through a transparent open season. To ensure that such arrangements will pass regulatory muster, many pipelines will seek a declaratory order from FERC approving the special rates and access rights on a prospective basis, before the pipeline opts to move forward with a capital investment. Obtaining such declaratory orders has become an expectation for FERC, especially when the access rights offered to shippers include firm capacity.

The increasing use of throughput and deficiency agreements in connection with new oil pipeline projects over the last decade has had the effect of blurring the traditional distinction between contract carriage natural gas pipelines and common-carrier oil pipelines. Importantly, however, oil pipelines are only able to charge the published rate set forth in its tariff. Oil pipelines do not have the flexibility to charge a rate that is within a certain minimum and maximum range of rates. Nor do oil pipelines have negotiated rate authority comparable to natural gas pipelines.

What this means is that oil pipelines have far less flexibility to renegotiate rates of distressed shippers. It is possible that given the current market conditions and FERC’s willingness to date to allow oil pipelines to move toward a paradigm that is more similar to natural gas pipeline regulation, FERC may be receptive to allowing oil pipelines to renegotiate the rates paid by distressed shippers while preserving the higher rates agreed to by other committed shippers. To date, no pipeline has sought to modify an existing declaratory order or sought authorization from FERC to charge a distressed customer a rate other than what the pipeline advertised in its open season and that is being paid by other committed shippers. Under current market conditions, however, it is likely that pipelines will be testing the bounds of just how flexible FERC will be in terms of allowing oil pipelines to negotiate rates with distressed shippers.

Given the regulatory uncertainty as to whether FERC would be amenable to allowing oil pipelines to renegotiate rates with shippers, it is important for oil pipelines to adopt additional safeguards to protect themselves against the exposure created from shipper bankruptcies. Some of these safeguards are of similar importance to natural gas pipelines. For instance, oil and natural gas pipelines may wish to include provisions in their service agreements that provide the shipper will pay the pipeline a defined amount of damages in the event the shipper’s service agreement is rejected by a bankruptcy court.

Oil and gas pipelines may also wish to enforce any credit protection their tariffs or contracts permit or seek to negotiate credit protections in new or amended contracts. These credit protections could include a guaranty of an investment-grade parent company if the shipper is downgraded, the provision of letters of credit, surety bonds or cash deposits to secure payables and termination damages under the contracts, or prepayment requirements.

Of this menu of credit protections, a letter of credit provides the most protection because it can be drawn while the shipper is in bankruptcy. A cash strapped shipper, however, may not have the credit capacity to obtain letters of credit because its banks are likely to be squeezing the available amounts under the shipper’s credit facility. A surety bond provides similar protection to a letter of credit, but the insurance companies that issue the bonds have a reputation in the market of paying slower than banks pay under a letter of credit. Nevertheless, the sureties have shown a willingness to provide bonding capacity to shippers with limited letter of credit capacity. Prepayments are useful but if not carefully structured can be subject to claw back under the bankruptcy preference rules.

It is understandable why many FERC-regulated pipelines confronting today’s challenging market conditions may wish to renegotiate the terms of existing service agreements. Proceeding to do so, however, requires careful consideration of the regulatory framework within which the pipelines exist and do business.

Authors: Mark Lewis and Kirk Morgan are partners at Bracewell LLP’s Washington, D.C. office where they routinely advise oil and gas pipeline developers, owners, operators and investors on regulatory and transactional matters. Their Legal Perspective column will appear regularly in P&GJ. The authors would like to thank their colleagues Alan Rafte, Robin Miles, and Trey Wood for their contributions to this article.