November 2016, Vol. 243, No. 11
Legal Perspectives
Sabine Ruling: What Pipeline Companies Can Do To Protect Their Contracts
Houston-based Sabine Oil & Gas Corp. recently announced confirmation of the oil and gas exploration and production company’s plan of reorganization, allowing it to emerge from its Chapter 11 bankruptcy proceeding with just $350 million of its original $2.8 billion in debt.
Facilitating that outcome, to a significant degree, was a May decision by New York Bankruptcy Judge Shelley Chapman that allowed Sabine to reject approximately $100 million in contractual obligations owed to two pipeline companies premised upon her interpretation of contract language creating a “covenant running with the land.. That language is included in most transportation agreements for the express purpose of making obligations bankruptcy-proof.
In June, the judge rejected a request for an immediate appeal of the ruling and refused to stay enforcement of the decision, which would have allowed review by a higher court before the effect of the ruling was imposed. This interpretation of Texas law could also be certified to the Texas Supreme Court, which the judge agreed has not enunciated its view on this issue. The New York judge refused to stay the case pending appeal, finding the Texas law issues not to be “novel,” and citing the harm that would come to Sabine from a stay.
The midstream sector relies upon such transportation and gathering commitments to justify investment of billions of dollars annually to build and support the infrastructure necessary to transport oil and gas. In exchange for that capital expenditure, producers agree to make long-term commitments to ship product allowing recoupment of the pipeline’s front-loaded costs. This business model dictates every term of the agreement, from pricing to volumes.
With over 80 E&P bankruptcies filed since January 2015, and no indication of any immediate uptick in oil prices, the prospect of more filings seems certain. While the decision is not binding on other courts, three other E&P companies with bankruptcies then pending in Delaware–Quicksilver Resources, Magnum Hunter Resources Corp. and Swift Energy–recently used the Sabine decision or similar arguments as leverage to renegotiate their midstream contracts after motions were filed to reject them.
In one respect, the Sabine situation was unique in that the producer had an available transportation alternative, which is not a viable option for many upstream companies. But in an environment of uncertainty and instability, the Sabine decision–still subject to appeal–injects a potential business risk into relationships that did not exist at the time the agreement was negotiated.
This gives E&P companies greater leverage to renegotiate their midstream agreements, but renegotiation of rates may not be possible, even if it is the parties’ preference. In addition to publicly filed tariffs which must be considered, pipelines subject to FERC regulation cannot violate anti-discrimination requirements prohibiting disparate treatment of similarly situated shippers which rate modification might trigger.
To address this uncertainty, midstream companies may consider their options, including:
*Modifying contracts to more specifically identify the real property interest being created by the agreement, perhaps including the pertinent mineral estate and wells;
*Exploring whether the increased risk associated with rejection in bankruptcy means that the market rate for transportation should increase; or
*Fashioning a secured debt obligation to be paid off over the duration of the agreement in an effort to increase the probability of payment or elevate the priority of the obligation in bankruptcy.
Absent some significant turn of events in the court system or a dramatic increase in oil prices alleviating the financial pressure placed on producers, this decision is yet another challenge facing the industry with no easy, reliable solution.
Ken McKay is a shareholder in Baker Donelson’s Houston office and a member of the Business Litigation Group, as well as the Oil and Gas industry service team. He concentrates on commercial, energy and real estate litigation, with a particular focus on eminent domain and land use matters throughout the United States. He can be reached at kmckay@bakerdonelson.com.
Comments