What’s a sure way to destroy untold millions of dollars of energy infrastructure value built in reliance on the promise of reimbursement for huge capital investments necessary to move a producer’s product to market for the next 20 years or more?

Here’s another one: What’s a helpful way to effect the goal of bankruptcy reorganization, to give a bankrupt energy producer and its shareholders a fresh start by shedding burdensome contracts?

The answer to both questions: Allow a bankrupt energy producer to reject, as in walk away from with no remorse, gas gathering, processing and transportation agreements.

This is the hot issue

Can the E&P debtor reject, under Section 365 of the Bankruptcy Code, what is in today’s environment an above-market agreement?

The typical contract dedicates the producer’s oil and gas interests and associated acreage to its midstream counterparty.  These dedications assure that the producer and everyone who follows will be bound by the original bargain. Midstream companies invest billions of dollars to develop the infrastructure necessary to gather, process, and transport oil and gas for their E&P counterparty-producer.

A significant right of a debtor is to reject burdensome executory contracts. Upon rejection, the debtor no longer can be compelled to perform, leaving the counterparty with a breach of contract claim, which generally an unsecured claim worth very little. Bankruptcy courts apply a business judgment standard to the debtor’s decision, and generally do not consider the effect on the counterparty.

The legal question

From the midstream company‘s point of view: Dedications of producers’ underlying mineral interests are covenants running with the land that are real property interests and therefore, cannot be rejected in bankruptcy.

From the debtor’s point of view: The gathering and processing agreements are executory commercial services agreements and only affect personal property interests – oil and gas that has already been severed from the land.

How it will be resolved

Reconciling the issue requires examination of state law. At least in Texas, courts have not been asked to determine whether a producer’s dedication of reserves is a real property interest or a commercial agreement. Bankruptcy courts are left to speculate how a state court would rule on this issue.

What does it mean for the future?

The resolution could have a far-reaching effect on the structural and financial underpinnings of both midstream and E&P companies. If these agreements can be shed, the sanctity of thousands of bargained-for contracts is in jeopardy, investor confidence in midstream companies will be shaken, and the cost of capital and thus the price producers would have to pay for gathering and processing services, will increase.

On the other hand, saddling a bankrupt producer with an above-market contract would limit its ability to restructure.

Bragging on Gray Reed

In the Quicksilver bankruptcy, see the objection by Crestwood Midstream Partners to the debtor’s motion to reject a gathering, processing and transportation agreement. Kudos to Gray Reed lawyers Philip Jordan, Lydia Webb, Jonathan Hyman and James Ormiston.

Our musical interlude: A message from litigants to judges everywhere.