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Sabine Contract Ruling May Spur More Driller Bankruptcies

A bankruptcy judge's ruling that Sabine Oil & Gas Corp. can ditch midstream contracts because they didn't relate to the company's drilling operations will encourage more cash-strapped producers to file for bankruptcy in order to shed unfavorable deals and ratchet up the financial risks for pipeline companies and other midstream firms, experts say.

U.S. Bankruptcy Judge Shelley C. Chapman said Tuesday that Sabine could reject three covenants for gas and condensate gathering services with Nordheim Eagle Ford Gathering LLC and HPIP Gonzales Holdings LLC, saying the company exercised reasonable business judgment and the companies presented no evidence in challenging that judgment.

Low oil prices have already bankrupted dozens of oil and gas producers and are threatening to bankrupt dozens more. The ability to get out from under an unfavorable midstream deal could be the nudge some distressed producers need to file for bankruptcy, a scary financial prospect for their midstream partners, experts say.

“Some of these midstream contracts have required minimum oil and gas volume commitments, with significant payments due if you fail to meet the volume commitment, and otherwise may be untenable given the current market for oil and gas,” said Ian Peck, who chairs Haynes and Boone LLP's bankruptcy and business restructuring group. “Just like every other contract, if you know that you may be able to reject the obligations in bankruptcy, that is another reason to consider bankruptcy as an option.”

It's Judge Chapman's conclusion as to what makes the HPIP and Nordheim contracts with Sabine eligible for rejection in bankruptcy that's sending shockwaves throughout the midstream industry. In a nonbinding ruling, the judge said the contracts should not be considered “covenants running with land” under Texas state law because they only concern the hydrocarbons being pulled out of the ground, not Sabine’s land or its use of it. Covenants running with the land can't be rejected in bankruptcy.

While the ruling isn't binding on Sabine's case or any other bankruptcy cases and is a decision about Texas real property law, Schulte Roth & Zabel LLP distressed investing partner David Karp said it makes clear that a midstream contract doesn't have a covenant running with the land if its dedication covers produced oil and gas as opposed to oil and gas still in the ground.

With the Lone Star State being a primary hub of the oil and gas industry, a large chunk of contracts within the industry are negotiated under Texas law.

“Those midstream companies with dedications of a mineral estate as opposed to simply production are feeling better today as they are still in the game,” Karp said.

For midstream companies that don't have such contractual language in place, Judge Chapman's ruling could put their contracts, many of which are long-term, in jeopardy if their upstream counterpart goes under.

Not only could that put a significant dent in a midstream firm's wallet, but uncertainty over the viability of their contracts could subject the company to more scrutiny from its own lenders and make it a less attractive candidate for financing, experts say.

“The funds for the [midstream] infrastructure weren't all coming out of the pocket of the companies, they're getting financing as well,” said Sutherland Asbill & Brennan LLP partner Mark Sherrill, who works on energy company bankruptcies. “I suspect those lenders and investors are concerned.”

While experts don't discount the significance of Judge Chapman's ruling, they also caution against applying it too broadly. For one thing, the ruling isn't binding on Sabine, Nordheim and HPIP. Also, it's one federal bankruptcy judge's interpretation of specific gathering contracts under Texas state law. Other judges may reach different conclusions, and other midstream deals may be contested under laws of different states.

“That's going to be a highly factual inquiry,” Peck said. “It should be tempered by the actual language of the contracts.”

Midstream companies may get a clearer picture on how bankruptcy courts view the viability of their contracts sooner rather than later. A Delaware bankruptcy judge is poised to rule on whether Quicksilver Resources Inc. can reject midstream agreements inked with Crestwood Midstream Partners LP and several affiliates, which Quicksilver says is a condition of closing for the $245 million sale of oil and gas assets to Oklahoma-based BlueStone Natural Resources.

Meanwhile, Magnum Hunter Resources Corp. is asking a Delaware bankruptcy judge to let it reject a transmission contract with pipeline operator Texas Gas Transmission LLC.

While Judge Chapman's decision doesn't carry any precedential weight, it could prove to be persuasive in those cases and others, experts say.

“New York, Delaware and Texas are the three most significant venues because the vast majority of cases are going to be in those jurisdictions,” Peck said.

Which means midstream companies need to review their contracts to see if they carry any rejection risks. If they do, it might be time to reach out to their upstream counterparties to renegotiate, experts say.

In many instances, bankrupt producers may need their midstream partners as much their midstream partners need them, according to Peck.

“The debtors may not have a lot of options for the transmission of the minerals,” Peck said. “Does the debtor really, at the end of the day, want to reject the contract? What you may see is debtors use the threat of rejection to renegotiate the terms of the contract.”

And producers hold most of the negotiating leverage, even more so after Judge Chapman's ruling. In retrospect, Sherrill said, midstream companies should have started the renegotiation push as soon as the judge indicated in a Feb. 2 hearing that she was inclined to side with Sabine.

“The leverage against the midstream companies has already gotten worse,” Sherrill said.

Sabine is represented by Jonathan S. Henes, James H.M. Sprayregen, Paul M. Basta, Christopher Marcus, Gabor Balassa, Ryan B. Bennett, A. Katrine Jakola and Whitney L. Becker of Kirkland & Ellis LLP.

The creditors committee is represented by Keith Wofford, D. Ross Martin and Mark R. Somerstein of Ropes & Gray LLP.

Nordheim is represented by William A. Wood III, Jason G. Cohen and Robert G. Burns of Bracewell LLP.

HPIP is represented by Keith A. Simon, Jeffrey S. Munoz and Annemarie V. Reilly of Latham & Watkins LLP.

The case is Sabine Oil & Gas Corp., case number 1:15-bk-11835, in the U.S. Bankruptcy Court for the Southern District of New York.