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Experts Say Sabine Ruling Not Precedent, But Midstream Advised to Fortify Contracts

One day after a federal bankruptcy court judge ruled that Sabine Oil and Gas Corp. could terminate some of its gathering contracts as part of its recovery in Chapter 11, industry experts said they don't believe the ruling sets a precedent in the midstream sector, but are advising midstream companies to fortify their contracts with producers.

In the long-anticipated ruling Tuesday, U.S. Bankruptcy Court for the Southern District of New York Judge Shelley Chapman ruled that the Houston-based exploration and production (E&P) company could reject natural gas and condensate gathering agreements it signed with Cheniere Energy Inc. subsidiary Nordheim Eagle Ford Gathering LLC, as well as gathering, treating and processing agreements with HPIP Gonzales Holdings LLC (see Daily GPIMarch 8; Shale Daily,July 15, 2015; Jan. 14, 2015; May 6, 2014).

Nordheim and HPIP had argued that the agreements cannot be rejected because they are covenants that run with the land under Texas law. Chapman disagreed.

Midstream Clients Advised to Fortify Contracts

Haynes and Boone LLC’s Jeff Nichols, chairman of the energy finance practice group in Houston, told NGI that he was not surprised by Chapman's ruling, since the bankruptcy process is designed to favor borrowers. He said Chapman rejected the contract, but she also provided a nonbinding ruling on the nature of Texas law.

"Because the judge laid out her view of Texas law, it would be unlikely that people would try to come back and challenge that," Nichols said Wednesday. "She allowed for the possibility of another hearing on the issue of whether the covenant ran with the land.

"The parties involved have to be wondering about this, as they do the calculus on whether to have a full hearing on that issue. She has already signaled that it would be an uphill battle. That's persuasive for other cases, companies and counterparties on whether or not they would try to challenge the rejection."

Regardless, Nichols said the ruling was still troubling for midstream companies, especially if they have minimum volume commitments (MVCs) in their contracts. "If they have MVCs, they would be ripe for rejection because they would be uneconomic," he said. "They may try to restructure some of these arrangements to the extent they have any leverage with the distressed companies. But if they do it right before filing bankruptcy, then that restructuring may be subject to challenge.

"If midstream companies are dealing with a producer that's about to file, there's not a whole lot they can do to fortify their situation, as far as changing the structure to create a covenant running with the land. Going forward, we've already talked with [midstream] clients on ways to fortify their contracts to create a better case, that it would be a covenant running with the land."

Nichols said the master limited partnership (MLP) model, and the incentive exploration and production (E&P) companies had to spin off their midstream assets into separate entities, are part of the reason behind a dearth of applicable laws.

"By pulling it apart, they created a new legal situation that isn't well developed," Nichols said.

Sabine Ruling Said Not a Big Deal

In a note Wednesday, analysts with Tudor, Pickering, Holt & Co. (TPH) acknowledged that the Sabine ruling "brought another blow to the midstream space" -- case in point, Williams Partners LP, potentially exposed to Chesapeake Energy Corp. (see Daily GPI,Feb. 18), saw its stock price tumble more than 10% on Tuesday. But TPH said the Sabine ruling is "not as big a deal as the headlines would suggest...the data point is less impactful than the stock reaction..."

"While the ruling establishes a precedent that some gathering contracts may be rejected and treated as an unsecured claim, it's important to note that there are other midstream contacts held by Sabine that they did not attempt to reject," TPH said. "These appear to be written with language that elevates them to a claim that [the contracts hold] 'runs with the land' status.

"In the current environment, a midstream investment decision should assume some E&P counterparty risk, particularly as it relates to above-market fees and/or minimum volume commitments above current production levels. The good news, kind of, is that with the Alerian MLP Index [AMZ] down more than 50% since late 2014, arguably all of that risk has been priced in -- and then some."

Analysts with Deutsche Bank, in a separate note on Wednesday, concurred.

"We view this as a sentiment headwind, as most midstream companies and investors were operating under the assumption that contracts that had 'run with the land provisions' associated with their MVCs would hold up in court," Deutsche analysts said, repeating an earlier assessment that "contract structures vary significantly, so it is hard to gauge the overall impact on the [midstream] sector."

Deutsche analysts added that E&Ps would still need gathering and processing work, unless they're willing to shut in or plug their wells -- something that's unlikely. Consequently, longer contracts would continue to be viewed as more economical.

"That said, the impact on contract renegotiations should be seen as the more important takeaway," Deutsche analysts said. "This ruling should give E&Ps significantly more leverage in these discussions, as the threat of filing and canceling these contracts is now likely more legitimate. While this not necessarily the first step a producer would want to take, it may appear to be a more viable option for those with significant midstream commitments that they see as onerous."

Although Williams, because of its exposure to Chesapeake, is "the name most investors are focusing on right now," Deutsche analysts said they don’t believe the Sabine ruling would set precedent for the midstream sector.

"Most of our names have disclosed their exposure to weak E&Ps and appear to be pushing for more stringent collateral where exposed. And not all E&P bankruptcies will bring midstream contract disruptions," the bank’s analysts said, using the example of the "still positive relationship" between Summit Midstream Partners LP and Samson Resources Corp., the latter of which filed for Chapter 11 last September (see Shale Daily,Sept. 17, 2015). "Overall, we see this mainly as headline risk rather than cash flow risk for our names right now."

Deals Still Working, Say Operators

During Chesapeake's 4Q2015 earnings call last month, CEO Doug Lawler lauded the deal it struck with Williams last September, when it renegotiated two gathering agreements in the Haynesville and Utica shales (see Shale Daily,Feb. 24;Sept. 8, 2015). Lawler also said recent firm transportation agreements in the Haynesville, Barnett and Eagle Ford shales -- including with Energy Transfer Partners LP for its ETC Tiger Pipeline, which carries natural gas from the Haynesville/Bossier Shale -- would boost earnings before interest taxes depreciation and amortization by $50 million.

"We continue to work with all of our midstream partners in each of our major operating areas to find cost-effective, mutually beneficial solutions reflective of the current operating environment," Lawler said. "By leveraging Chesapeake's future midstream business opportunities for incremental dedications, for gathering services, processing, fractionation, liquids handling, and marketing, we expect to continue to negotiate improved gathering processing and transportation costs for our company in 2016."

Chesapeake has denied that it is considering a bankruptcy filing and over the past week, its stock price, although meager, has more than doubled (see Daily GPIFeb. 8).

During its 4Q2015 conference call, the subject of Chesapeake was front and center. CEO Alan Armstrong said his company has "a very strong relationship with Chesapeake" and downplayed the bankruptcy rumors.

"They are paying their bills in a timely manner, as usual," Armstrong said. "We've recently been paid for the MVC related to the Haynesville, and we fully expect them to pay the MVC invoice on the Barnett when it's due. It's not due yet, but we're excited about continuing to work with them on that and fully expect that to come through as well...From our view, they are continuing to reduce their costs and operate efficiently and effectively to maintain liquidity."

Armstrong said Williams was aware of the credit risk continuing low commodity prices could have on producers, including Chesapeake. But he added that Williams liked its argument that its contracts have a strong conveyance of interest in unproduced gas, and that the company's covenants run with the land and are not subject to rejection in bankruptcy proceedings.

"We certainly are following current bankruptcy cases like Sabine where the general question is at issue," Armstrong said. "But people should understand that the ultimate outcome in individual cases will turn on specific facts and circumstances.

"Regardless, even if the court were to rule we don't have such legal rights, our gathering lines are physically connected to Chesapeake's wellheads and pads...All of these systems were built out specifically for their needs, and generally at their direction as to the size and scale that they needed to be able to produce volumes on a projected basis."

Midstream companies are closely watching developments in two other cases in Delaware's federal bankruptcy court. Quicksilver Resources Inc. [No. 15-10585] wants to terminate its gathering and processing contracts with Crestwood Midstream Partners LP (see Shale DailyMarch 18, 2015). Meanwhile, Magnum Hunter Resources Corp. [No. 15-12533] wants to reject similar contracts one of its subsidiaries signed with Texas Gas Transmission LLC (see Shale DailyDec. 17, 2015).

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