Sabine Oil Bankruptcy Ruling: This Changes Everything

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If you’re a player in the oil and gas business, a recent ruling in bankruptcy court proceedings for Sabine Oil and Gas Corporation has dramatically changed the game.

The energy exploration and production (E&P) company filed for bankruptcy in July 2015, and the final ruling on its motion to reject gas-gathering agreements with two midstream companies came May 4, 2016.

Here is some background information about the case:

Houston-based Sabine held that it had a right to reject the gathering agreements because doing so would be in the best interests of the company’s bankruptcy estate. The bankruptcy court judge ruled in Sabine’s favor, holding that the agreements failed to satisfy property law requirements in Texas and overruling the midstream companies’ objections that the covenants in the agreements should not be subject to termination.

Why is this such a game-changer, and what does it mean to you?

The ruling is important because it sets a precedent for E&P companies to reject a type of agreement that many have long considered not subject to invalidation through the contract rejection process in bankruptcy proceedings.

What the ruling means to you depends on whether you’re an E&P company or a midstream company. But either way, be prepared for an end to business as usual when it comes to agreements for midstream companies to invest in pipeline infrastructures with the expectation of E&P companies ultimately running oil and gas through them.

Back when oil was at $110 a barrel, there wasn’t much risk associated with such contracts; after all, E&P companies were thriving, and the prospect of bankruptcy seemed remote to most. Midstream companies secured generous financing based on the agreements, with the expectation that the investment would pay off when the oil and gas in the ground ultimately went through their infrastructure.

But then the unthinkable happened, energy prices dropped precipitously and stayed down. Suddenly E&P companies were in trouble and for the first time, they raised the possibility of renegotiating the agreements they’d made with midstream companies – agreements that had until then been thought of as bankruptcy-proof. That’s where Sabine and the midstream companies it had been doing business with found themselves on May 4.

Let’s review the implications that the ruling in Sabine’s case has for both types of companies.  

Does this mean E&P companies are now free to renegotiate – or outright terminate – agreements that midstream companies thought they could rely on?

As someone whose career has included running several E&P operations, I really don’t think that this ruling ultimately gives them carte blanche to summarily reject all the contracts whose terms are no longer as favorable to them as they once seemed. Any E&P company that’s thinking “Great! I can file for bankruptcy, get rid of these onerous contracts, lower my transportation rates and just start over!” would frankly not be acting in good faith, and that’s something any bankruptcy judge is likely to frown on.

I think a more likely scenario for an E&P company that has been squeezed by the economics of today’s energy market would be a situation in which the midstream companies with whom they have agreements will be motivated to work things out in a way that doesn’t put anyone out of business. Renegotiation is certainly more of a possibility than it was when the kind of contract in the Sabine case was considered ironclad and immutable.

It’s also important to remember that there were some very specific circumstances at work in the Sabine case, having to do with the presentation and its interpretation that may very well not apply in another case. My bottom-line advice would be to avoid jumping to conclusions about how this will work in another case until you and your attorneys have carefully considered the specific circumstances. The same advice goes for midstream companies.

Should midstream companies be worried that this ruling could send their valuations plummeting – or even put them out of business?

The initial panic that broke out when the ruling was announced tells us that there was some real fear that it could put midstream companies out of business practically overnight. We did see midstream market valuations drop 5% in short order. But we’ve also seen some recovery as things have started to settle, and I think that’s going to continue. I counsel a lot of midstream companies, and while I agree with many observers that this introduces a new level of risk to their business, I don’t think the situation is hopeless.

Our recommendations for midstream companies who’ve contracted with E&P companies:

  • Now is a good time to go back with your attorneys and business advisors, and take a close look at those agreements.
  • Evaluate where the contracts are tight and where they seem to pose risk, and assess, what if anything you need to do to control that risk. While it’s unlikely you’re going to be looking to sign a new gathering agreement with an E&P company anytime soon, the time will eventually come when you’re going to want to do that.
  • Be very cautious about how the contract is structured.
  • Look at financing tools like a volumetric production payment (VPP) arrangement wherein any up-front investment you make is in exchange for a certain volume of minerals in the ground.

For now, the best course of action is to hunker down until we see how things shake out.

There are other cases working their way through the courts at this time to keep an eye on.  For example, many were watching closely to see what Chesapeake Energy Corporation would do with regard to its gathering agreements with Williams Partners. Would they reject the contracts with Williams, and if so, would Williams survive it? Chesapeake recently announced it had come to an agreement to terminate current gathering contracts with Williams and to renegotiate contracts with Williams in its Mid-Continent operating area, moves which seem to be serving Chesapeake well. As of this writing, the company’s stock was up more than 7.5%.

What should E&P and midstream companies do going forward?

Three key guidelines for energy companies in the wake of the Sabine ruling are:

  1. Keep in mind these three little words: back to basics.

Both E&P and midstream companies had gotten somewhat cavalier with contracts in the days of $110-a-barrel oil. Perhaps the upside of the current downturn – and of the Sabine ruling – is that companies are afforded the opportunity to return to some of the fundamentals of doing business in this industry.

  • E&P companies are going to have to reach down into the minerals if they’re going to get payments from midstream interests that want to build the pipeline infrastructure in the field.
  • In addition, midstream companies are going to have to find ways to deal with the commodity exposure of having those minerals.

But that’s the reality of today’s business and legal climate.

  1. There’s no returning to business as usual.

Make no mistake: Getting back to basics doesn’t mean going back to business as usual.  The pressure on energy companies created by the Sabine ruling will eventually ease up, but that doesn’t mean everyone should just plan on returning to what they were doing prior to Sabine filing bankruptcy. For example, midstream companies can’t be thinking “I’ve got a contract, so I’ve got nothing to worry about” – not when the door’s been opened to contracts being subject to renegotiation and termination in ways they never were before. E&P companies can’t just expect to get upfront payments from midstream companies for drilling without giving up a title interest in the minerals in exchange.

  1. It’s time to “get real.”

Expectations of easy financing and big payoffs are simply not realistic when oil prices are low and bankruptcies are changing the contracts game. It’s time to take those expectations down a notch, even as we leave some room for optimism about prices going back up. After all, a small rise in the price of crude was one of the contributing factors in the late summer uptick in Chesapeake’s stock. But for now, the smart money is on companies that factor in recent trends in the market and the courtroom and adjust their expectations accordingly.