On March 8, 2016, Judge Shelly Chapman, presiding over the Chapter 11 cases of Sabine Oil & Gas Corporation and its affiliates ("Sabine"), granted Sabine's motion to reject certain midstream agreements between Sabine and Nordheim Eagle Ford Gathering ("Nordheim") and between Sabine and HPIP Gonzales Holdings, LLC ("HPIP"). Although the ruling as a procedural matter determined only whether rejection of the agreements was justified under section 365 of the Bankruptcy Code, the Court's analysis of the agreements under Texas law presaged a subsequent ruling on the nature of the agreements. In a nutshell, she previewed a determination that none of agreements are covenants that run with the land either as a real covenant or as an equitable servitude. Instead of a priority interest in a mineral estate, these midstream gatherers simply have agreements for the transportation and processing of oil and gas products which can be rejected (breached) and which constitute unsecured claims upon rejection.
Although Judge Chapman's ruling only deals with rejection for the moment and it has no direct precedential effect in other cases involving midstream agreements on the broader issue, it is likely that it will serve as guidance for producers struggling under unfavorable midstream agreements.
Each of the agreements at issue in the Sabine case states that the agreement itself is a covenant that runs with the land, enforceable against Sabine and its successor and assigns. However, the designation only indicates the counterparty's intent, it is not dispositive of its interest in the debtors' assets under Texas law. Both Nordheim and HPIP recorded their agreements, which, according to the Court, served to provide notice, not elevate their interests. The primary terms of the agreements relate to the rights and obligations with respect to the oil and gas products rather than the land or leasehold interests from which they come.
Pursuant to the Gas Gathering Agreement with Nordheim, for example, Sabine agreed to dedicate all of the gas produced by Sabine from a designated area and Nordheim agreed to gather, treat, dehydrate and redeliver the gas to Sabine. To provide these services to Sabine, Nordheim agreed to construct a gathering system of pipelines and treatment facilities at its own expense. Sabine agreed to deliver a minimum amount of gas to Nordheim on an annual basis. If it failed to make the minimum delivery, Sabine was required to pay Nordheim. It also paid Nordheim a monthly gathering fee. The Gas Gathering Agreement had a ten year term and was governed by Texas law. The HPIP Condensate Gathering Agreement contains the same terms but it relates to liquid hydrocarbons, gas and other products.
Two other agreements with HPIP were at issue in the motion—a Production Gathering, Treating and Processing Agreement (the "HPIP Gathering Agreement") and Water and Acid Gas Handling Agreement, dated May 2014 (the "Handling Agreement"). The HPIP Gathering Agreement obligated Sabine to dedicate performance of certain leases owned by Sabine and the oil, gas and water produced from the wells located on the land subject to those leases to deliver the oil, gas and water to HPIP. HPIP was obligated to construct, operate and maintain gathering facilities to provide the services to Sabine. The Handling Agreement provides for HPIP to construct, operate and maintain disposal facilities for the water and acid gas produced by Sabine from the land subject to the leases.
The decision turns on Texas law governing the existence of the covenant that runs with the land. Under Texas law, a covenant runs with the land when it (1) touches and concerns the land, (2) relates to a thing in existence that specifically binds the parties and their assigns, (3) is intended by the parties to run with the land and (4) the successor to the burden has notice. There is also a requirement in Texas law that the parties have horizontal privity of estate. This requirement means that the parties must be in privity of estate at the time the covenant is made and the covenant must be part of a conveyance of an interest in the land burdened with the covenant. To touch and concern the land, the covenant must affect the owner's interest or its use of the land.
Moreover, the right to transport and transform products, which is at the heart of these agreements, is not one of the property rights of a mineral estate under Texas law. These property rights include: (1) the right to develop, (2) the right to lease, (3) the right to receive bonus payments, (4) the right to receive delay rental and (5) the right to receive royalty payments.
The Court determined that Sabine simply engaged Nordheim and HPIP to perform certain services related to the products produced by Sabine from its property: "the covenants at issue are properly viewed as identifying and delineating the contractual rights and obligations with respect to services to be provided, and not as reserving an interest in the subject real property."
Sabine, an energy company engaged in the acquisition, production and development of onshore oil and natural gas properties in the US, filed for Chapter 11 protection on July 13, 2015.
Conclusion
As drillers tapped shale reserves in states such as North Dakota, Texas and Pennsylvania, pipeline companies invested heavily to bring oil and gas to market. With oil now down to about $35-$40 a barrel, US crude production has gone in reverse, meaning fewer barrels to move. Traders have been shoving excess oil into storage tanks, also diminishing volumes on some pipelines. The Sabine decision and the upcoming decision in the Quicksilver bankruptcy case may have a broad impact on the oil and gas industry for both upstream oil and gas producers and midstream gathering and transportation companies. In the Quicksilver bankruptcy case, two trade groups have filed amicus briefs warning a ruling in Quicksilver's favor could "disrupt the foundational principles underpinning the midstream industry." The outcome of those cases will not change the fact that oil and gas producers need pipes and processing equipment to get their hydrocarbons to market. But it could arm them with significantly more leverage as they renegotiate contracts that some practitioners and midstream companies may have thought were sacrosanct. Faced with losing all their revenue from gathering systems that cannot be moved to another oilfield, midstream companies are going to have to renegotiate many of their contracts. The new terms will likely include lower rates and minimum volume commitments, with kickers to increase those rates if oil and gas prices recover.
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