(peshkov)

The crash of oil prices beginning in late 2014 has led to over 90 exploration and production companies in the United States and Canada filing for bankruptcy over the last 21 months, companies with combined debt obligations well over US$60 billion.

The current downturn has had dramatic effects on exploration and production companies, but it has also had a profound impact on midstream counterparties, and both of their respective debt holders and other stakeholders. In particular, a new shadow has been cast on the rights and obligations under gathering and processing agreements. Midstream companies now feel the dramatic effects of the new hammer wielded by a debtor in a bankruptcy filing. In the latest round of E&P company bankruptcies, some of the E&P companies, to generate more money to pay secured creditors, have used the bankruptcy rejection process to modify uneconomic contracts related to gathering, processing, and transporting oil and gas (midstream agreements) with their midstream counterparties.

Most recently, courts outside of Texas have confirmed that these contracts can be rejected and, applying Texas law, have decided that the obligations regarding acreage dedications and other obligations under midstream agreements are not interests or servitudes that “run with the land.” The final word on these issues, however, may ultimately rest with Texas courts (or even with a legislative response), as a result of the extreme uncertainty cast by one recent decision of a New York court in particular. For now, the midstream industry is covered by a cloud of uncertainty moving forward in negotiating new and amended gathering agreements.

‘Sabine’ Decision

The midstream industry, along with the corporate and bankruptcy bar, are now keenly focused on the decision of the U.S. Bankruptcy Court for the Southern District of New York in the Sabine Oil & Gas Corp. bankruptcy proceedings rejecting a gas gathering agreement as an executory contract (In re Sabine Oil & Gas, 547 B.R. 66 (Bankr. S.D.N.Y. 2016)) and determining, more importantly, that the agreements and commitments for transferring the produced gas, water and condensate of the debtor were not covenants that “run with the land,” nor were they equitable servitudes (In re Sabine Oil & Gas, 2016 Bankr. LEXIS 12905 (Bankr. S.D.N.Y. May 3, 2016)) (Sabine decision).

While many articles have addressed the underlying issues outlined in the decision, the question remains how the Texas courts will rule on the issue and what the practical implications are given this new cloud of bankruptcy uncertainty. This summer, U.S. Bankruptcy Chief Judge David R. Jones of the Southern District of Texas, and one of only two Southern District judges hearing “complex” cases under a new “work order” entered in the Southern District, mentioned that he might reconsider the rationale outlined in the Sabine decision if it is properly presented to him. Moreover, any such decision by Jones may not be handicapped by some of the more troublesome facts before the New York bankruptcy court in the Sabine decision, including the lack of “horizontal privity.”

Competing Financial Interests Behind Midstream Agreements

E&P companies like Sabine enter into oil and gas leases with property owners that allow E&P companies to drill wells and extract oil and gas from the land. However, once the E&P companies succeed in finding natural gas, limited options exist to move the produced natural gas from the wellhead to the ultimate consumer. Even with the heavily developed oil and gas fields in Texas, it is crucial to take the next step, moving the gas along a “gathering” line to be processed and to reach a larger pipeline to move the gas to the consumer.

These same E&P companies almost always finance the acquisition of the leases and the costs associated with the exploration and drilling with reserved based loans that are secured by mortgages on the leaseholds along with other liens on the producer’s production and related rights against the assets. The midstream companies, in turn, finance the development of gathering lines and processing facilities with secured loans as well, premised (until the recent Sabine decision) on the notion that the E&P companies’ leaseholds, as a result of filed contracts containing acreage dedications, will ultimately bear the cost of transportation and processing obligations as such obligations “run with the land” as a real property right, notwithstanding the mortgage on the oil and gas lease. So how did this industry assumption get turned on its head, and what factors under Texas law lead might be at issue for reconsideration by a Texas court, perhaps under a less favorable set of facts to the E&P company lender?

Texas State Law Application

Under Texas law, a covenant runs with the land when: (a) there is privity of the estate; (b) the covenant touches and concerns the land; (c) the covenant relates to a thing in existence or specifically binds the parties and their assigns; (d) the covenant is intended by the original parties to run with the land; and (e) the successor to the burden has notice. See Inwood North Homeowners’ Association v. Harris, 736 S.W.2d 632, 635 (Tex. 1987). However, Texas courts have acknowledged that the tests used to determine whether a covenant touches and concerns the land are not “absolute.” Westland Oil Development v. Gulf Oil, 637 S.W.2d 903, 911 (Tex. 1982). Texas courts have noted that two tests have been applied in Texas: (a) whether the covenant “affected the nature, quality or value of the thing demised, independently of collateral circumstances, or if it affected the mode of enjoying it” (El Paso Refinery v. TRMI Holdings (In re El Paso Refinery), 302 F.3d 343, 356 (5th Cir. 2002)); and (b) whether “the promisor’s legal relations in respect of the land in question are lessened—his legal interest as owner rendered less valuable by the promise … [and] if the promisee’s legal relations in respect to the land are increased—his legal interest as owner rendered more valuable by the promise.” Westland Oil, 637 S.W.2d at 911.

Texas courts will likely consider numerous factors to decide these issues, including, but not limited to: (a) the parties’ expressed intent to create (or not create) a conveyance of a real property interest or covenant that runs with the land; (b) definition of the dedicated interests (i.e., minerals in place, production or both); and (c) real property filings recorded or agreed to be recorded.

Express Intent and Benefits to the Land

In reality, most contracting parties have the requisite intent to convey a real interest to the midstream company. Under Texas law, the language used in an agreement is the primary evidence of intent. See Musgrave v. Brookhaven Lake Property Owners Association, 990 S.W.2d 386, 395 (Tex. App. 1999). A valid transfer of an interest in the mineral estate requires “operative words or words of grant showing an intention of the grantor to convey an interest to the grantee.” In addition, courts “attempting to ascertain the intention of the parties … must look to the entire instrument in the light of the stated covenant.” MASGAS v. Anderson, 310 S.W.3d 567, 570 (Tex. App. 2010). Additionally, the notion that a gathering system is not a practical benefit to the value of the oil and gas interests, or do not affect how the interests are used, is hard to argue when the E&P companies expressly contracted for the costs of such system and dedicated their acreage to the gathering system.

Purpose and Value of Dedication Language

The dedication language of a midstream agreement, however, requires careful analysis given the potential implications raised by a rejection of the contract in a bankruptcy case, forcing the reliance on the argument that the obligations run with the land. For example, under Texas law oil or gas in the ground is real property, but once separated from the earth, it instead becomes personal property. See, e.g., Sabine Production v. Frost National Bank of San Antonio, 596 S.W.2d 271, 276 (Tex. Civ. App. 1980). A dedication provision that purports to dedicate an interest in the E&P company’s oil or gas “in place” (i.e., in the ground) would seem to create a covenant running with the land, whereas one dedicating an interest in its oil or gas “as and when produced” (i.e., at the surface or wellhead) may be read by a court to create a mere contractual interest. This distinction and whether the dedication covers “production” or an interest in the mineral estate (i.e., leases and oil and gas in the ground) can be a fundamental distinction in reviewing a particular agreement.

The legal issues presented are often governed by Texas state law and the ultimate arbiter on the proper interpretation of Texas law is the Supreme Court of Texas. See Janvey v. Golf Channel, 792 F.3d 539, 547 (5th Cir. 2015). The Texas Supreme Court could reach a different decision on these issues if it comes before it in the future (including, potentially, on a federal court’s certification of the issue to the Texas Supreme Court), which would provide direction to bankruptcy courts confronting the issue future. Moreover, the Texas bankruptcy courts, deeply familiar with the practices of the oil and gas industry and its structure, may well take a more industry based approach.

Strategic Implications

Given the magnitude of the investments involved in the oil and gas industry by the midstream companies and their respective lenders, and the absolute need to move natural gas to market which can only be financed in a rational market, the Sabine decision and other attempts to reject or divest midstream pipeline agreements and their related obligations are worthy of close attention by Texas courts. Moreover, much like the impact of the Delaware court’s ruling in SemCrude with regard to the effect of the Texas and Oklahoma “first purchaser” liens, the Sabine ruling may provoke a legislative reaction that makes clear that the midstream agreements, provided they meet certain safe harbors, are a conveyance of a real property interest and not avoidable by a bankruptcy court. For now, there are sure to be more attempts to “mess with Texas” and define what real property rights were conveyed by the midstream agreements, and what contractual rights do not “run with the land” under Texas law.