The oil price plunge starting on March 6 seems like a sucker-punch to the oil and gas industry after the price decreases and market unrest as a result of COVID-19. Midstream companies that rely on long-term producer contracts or steady revenue streams for moving hydrocarbons need to act quickly to mitigate the risks of a potential producer insolvency. Below, we highlight five things to think about on this front. Our energy team is experienced in these issues and invites the opportunity to discuss them with you and answer specific questions you may have.

Covenants Running with the Land

Contracts containing dedications that purport to be “covenants running with the land” or granting other real property rights to the midstream company must rigorously meet specific legal standards, which vary by state, to create a property interest that will survive in bankruptcy. Recent case law has shown that courts will require a dedication to burden mineral interests, and not merely produced hydrocarbons, before the dedication will run with the land – in addition to meeting all other state law elements of a real property covenant. Contracts that don’t withstand scrutiny under applicable state law will be subject to rejection under the usual bankruptcy framework, allowing for the underlying acreage to be sold free and clear of the dedication and related obligations.

Credit Support

Midstream contracts often require one or both parties to post credit support upon triggers that are often subjective. Requiring a producer to post credit support (or to pay-in-advance), can be an important strategic tool to manage risk. Failure of the producer to post required credit support upon demand can give rise to important rights for the midstream company, particularly before the producer has filed for bankruptcy. It is important to be attuned to signs of producer distress and act as early as possible. Signs of producer distress include: slow-paying or seeking accommodations from service providers; declines in the market price of its publicly traded equity or debt; reducing production or curtailing drilling; hiring restructuring advisors; not meeting financial covenants; seeking to refinance debt; and being on target lists for distressed investors.

Re-negotiating Terms

Two key questions to ask are whether accommodations to existing contract terms will help the producer definitively recover from a situation of distress, or just compromise the midstream company’s economics and eventual recovery in any bankruptcy of the producer? And, can accommodations be paired with changes that improve the midstream company’s rights? In exchange for accommodations, the midstream company should seek increased visibility into the financial health of the producer, and consider asking for expanded scope and term of any dedications, pre-payment requirements, a default interest rate, shut-in and termination rights, and/or credit support. In addition, if the midstream rate is above market, then reducing the rate can mitigate the risk of the producer seeking to reject the contract in bankruptcy.

Shut-in & Termination

Self-help remedies like shut-in and termination can be two-edged swords. Even if expressly provided in the contract, the window to properly terminate or shut-in before a bankruptcy filing may be short. And one potential result of such self-help actions may be to accelerate the producer’s bankruptcy filing. In a shut-in scenario, the midstream company can require that pre-filing delinquent amounts be paid before resuming services – but first the bankruptcy court will examine whether the shut-in was proper under the contract and bankruptcy law. If the court finds the shut-in was improper and did not comport with the requirements of the contract, the midstream company could owe damages to the producer. Similarly, in a termination scenario, the bankruptcy court could reinstate the contract if it finds the termination was not proper or valid. In addition, because there is no contract to resume services under once pre-filing breaches are cured, the terms of any going-forward services are subject to fresh negotiations.

Assumption or Rejection?

A final question is whether the midstream company would prefer that the contract be assumed or rejected in the bankruptcy (except of course where the contract has a dedication that is a covenant running with the land that meets the state law test to survive bankruptcy). If assumption is a better business outcome—typically due to an above market contract rate—it is critical to understand exactly what accommodations the producer and its creditors need (and do not need) in order to induce an assumption of the contract. On the other hand, if rejection is the better outcome, the midstream company will dig in, refuse to compromise, look for breaches that cannot be cured, and seek to exercise termination rights post-rejection if needed.

Conclusion

This is a brief overview of certain issues that midstream companies should think about and analyze given the current oil price environment. There are many other issues, including the midstream company’s own financial health, which may need to be considered. Our energy team is experienced in these issues and invite the opportunity to discuss them with you and answer specific questions you may have.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.