Bankruptcy Court Pushes Domino on Oil and Gas Industry

On March 8, a federal bankruptcy court declared that Sabine Oil and Gas Corporation’s contracts used to secure pipeline gathering infrastructure could be nullified, raising major concerns for midstream gas companies.  This ruling could have even broader implications, as oil and gas producers around the country are increasingly filing for bankruptcy.

Sabine O&G is an oil and gas exploration and production company that held several contracts (or gathering agreements) with midstream companies that build pipelines to bring oil and gas to market.  The gathering agreements are contracts to build low-pressure pipelines to bring gas from the area of production (e.g. well head) to a transmission main for transport to market.  The midstream company agrees to make the required infrastructure investments in exchange for long-term contracts with the production company for use of the pipes. With the shale oil and gas boom, demand for these midstream gathering agreements has been strong in order to build infrastructure in previously unserved areas.

In general, gathering agreement terms require the production company to either send certain amounts of product down the pipes at set fees, or make penalty payments. This construct provides financial certainty to the pipeline developers that make huge upfront capital investments.

Sabine’s production had dropped below minimum thresholds forcing it to pay penalties – costs that could be avoided if the courts rejected the contracts in bankruptcy.  For Sabine, shedding the take-or-pay contracts would save $115 million. 

Cascading Financial Woe

The court’s actions inject uncertainty to midstream companies and their investors who thought these contracts were beyond reproach (even in bankruptcy) because they are set up like real-estate interests (or land conveyances) that run with the land, are secured by the oil and gas assets in the ground, and would have to be transferred to future owners of the oil and gas lease. As such, securing the financing to build the pipeline projects was facilitated, based on certainty of cash flow for payback. The Sabine case doesn’t answer these land conveyance questions definitively, but it raises significant uncertainties. 

With at least 67 U.S. oil and gas companies filing for bankruptcy in 2015 and more on the way, scrutiny over midstream contracts will increase.  It is unclear how other courts will view these contracts in bankruptcy or how the case will fare under appeal. But, if other jurisdictions agree with the NY court there could be serious trouble for the midstreams, with cascading impacts on the whole industry

Cash starved oil and gas production companies would begin lining up bankruptcy efforts to get out of these expensive contracts.  Midstream companies may try renegotiating contracts preemptively to try and stop the bleeding.  Investors would increase borrowing rates to midstreams, assessing greater investment risk to the projects. This would make gathering agreements for new projects more expensive, increasing the overall cost of oil and gas development.  As you can see, a significant feedback loop is created.

Many Master Limited Partnerships (MLP) – that invest heavily in midstream companies in order to create reliable dividends for investors – fell in response to the court’s decision.

The NY court’s decision is not binding due to ambiguities in Texas law, and the decision can be appealed.  The industry and its investors are looking to at two other bankruptcy cases, Quicksilver Resources and Magnum Hunter Resources for next steps.

Christina Simeone

Kleinman Center Senior Fellow
Christina Simeone is a senior fellow at the Kleinman Center for Energy Policy and a doctoral student in advanced energy systems at the Colorado School of Mines and the National Renewable Energy Laboratory, a joint program.