Why Pipelines Could Soon Feel The Next Devastating Phase Of The Oil Bust

Post written by

Cliff Vrielink and David Kronenberg

Attorney Vrielink is Co-Leader of Sidley Austin LLP's Global Energy practice in Houston. Kronenberg is an Associate.

This article is more than 2 years old.

How a landmark bankruptcy proceeding could enable troubled oil and gas producers to break their contracts with pipeline operators--and deal devastating blows to the midstream sector and MLP investors. 







As the midstream industry braced itself for more adverse rulings, many companies in the sector began examining their gathering contracts and asking how certain highly technical provisions in such contracts would be treated in light of Sabine.  They also wanted to know what the law in their state says about the relevant property issues.  And critically, they wanted to know whether their counterparties may file for bankruptcy protection, and if so, what leverage the midstream company may have.

The ripple effects of the Sabine ruling also extended to the financial industry, as lenders and equity investors began examining the exposure of midstream companies they had invested in, and financial analysts attempted to quantify (and arbitrage) this previously unappreciated risk.

Amid the tumult, some commentators called for calm, emphasizing that the Sabine ruling had little precedential value given that it was issued on a non-binding basis for procedural reasons.  In fact, in recognition of the non-binding nature of her ruling, Judge Chapman encouraged Sabine and the midstream companies to reach a consensual resolution of their dispute, rather than undertake the procedural steps required for a final, binding ruling on the matter.  She also warned these midstream companies that she was unlikely to change her mind if the issue came before her again.

Against this backdrop, the parties in the Quicksilver and Magnum Hunter cases unexpectedly settled their respective gas gathering disputes, meaning that another ruling potentially adverse to the midstream industry would not be issued in these proceedings.  However, the parties in Sabine were unable to reach a similar resolution and are now pressing forward with litigation calling for Judge Chapman to issue a final, binding ruling on the matter.

This is a risky gambit by the midstream companies given Judge Chapman’s clear inclinations.  Nevertheless, they are continuing to fight, and it is not hard to see why.  The initial ruling in Sabine turned on a number of technical points, and a closer look at the Texas property law at issue reveals strong arguments in favor of the midstream companies.  It also reveals a more nuanced picture of the risks posed by this case to the midstream industry in general.

The first property law issue that took center stage in the case was the “touch and concern requirement,” which provides that a valid real covenant should affect the nature, quality, or value of the property or property interests at issue. In her initial ruling, Judge Chapman held that because minerals extracted from the ground cease to be real property under Texas law, the right to gather and process such extracted minerals was not a right that touched and concerned the land.

However, in recently filed motions, the midstream companies cited for the first time various Texas state law cases that directly counter this conclusion.  These cases hold that in determining whether a covenant involving a mineral touches and concerns the land, one should look to where the mineral is located at the time of contracting.  If, for example, the contract involves yet-to-be-produced gas, such underground gas is a form of real property at that moment and any covenant regarding such mineral is a real covenant that runs with the land.

It is hard to know if this argument will persuade Judge Chapman to move off of her initial conclusion on the issue, but it certainly lays the groundwork in the event a final ruling by Judge Chapman is appealed to a higher court.

It also emphasizes that even though Sabine is a federal bankruptcy case, the “touch and concern” issue is governed by Texas state law.  No matter what Judge Chapman or any other federal judge decides, the true arbiters on the proper interpretation of Texas law are Texas state courts and ultimately the Supreme Court of Texas, which can clearly delineate Texas state law on the issue if given the opportunity in another case.

The other property concept that Judge Chapman’s initial ruling examined was whether Sabine was in “horizontal privity of estate” with each of the midstream companies involved.  Under this concept, a real covenant is not valid unless it is created simultaneously with the conveyance of a recognized property right.  Because there was no such conveyance in Sabine, in Judge Chapman’s view, the parties were not in horizontal privity, so the dedications in the contracts did not create real covenants that run with the land.

Judge Chapman’s analysis appears simple enough, and if upheld, may doom most of these contracts since they typically are not executed in connection with a conveyance of real property.  This could have severe, adverse consequences for the midstream industry since the integrity of long term contracts is critical to support the financing required to build the relevant infrastructure.

Although this sounds concerning, others argue that Judge Chapman may have it wrong and that horizontal privity may no longer be a requirement for the creation of a real covenant in Texas.  The Supreme Court of Texas has never expressly sanctioned the horizontal privity requirement, and lower state court decisions are not in accord regarding the issue.  Also, in 2000, the American Law Institute proposed in its influential Restatement (Third) of Property that courts eliminate any requirement for horizontal privity in the context of real covenants because it “serves no necessary purpose and simply acts as a trap for the poorly represented.”

In her initial ruling, Judge Chapman imposed the horizontal privity requirement because she was not presented with any “governing authority” in Texas that had explicitly rejected the requirement.  Unfortunately for the midstream companies in Sabine, their latest motions do not contain any such smoking gun.  Rather, they note that in recent years many “Texas courts  [have] consistently analyze[d] whether covenants run with the land without considering horizontal privity,” meaning, by implication, that horizontal privity is no longer a requirement under Texas law.

It remains to be seen whether this will be enough to convince Judge Chapman.  But even if it is not, any final ruling by Judge Chapman holding that horizontal privity remains a requirement under Texas law will rest on sands that can quickly shift.  As noted earlier, the Supreme Court of Texas courts has the final say on the proper interpretation of Texas law.  So, if it has the opportunity to rule on this issue in another case and explicitly states that horizontal privity is no longer a requirement for a real covenant under Texas law, bankruptcy courts would have to respect such precedent when considering the issue under Texas law.  Further, in other cases, Texas law may not apply at all and another state’s jurisprudence may govern such issues.

This all demonstrates that no matter how Judge Chapman ultimately rules, the Sabine case is merely the opening salvo in a legal conflict between producers and midstream companies that will play out in bankruptcy courts, federal appellate courts, state courts and possibly legislatures across the country over the coming months and years.  While Sabine has thrown much of the industry off guard, it is far from clear whether this ruling will unwind the synergy between producers and midstream companies that facilitated the infrastructure build required to bring shale oil and gas to markets.  Instead, it could be nothing more than a victory for a single producer that will become an anomaly as soon as state courts or legislatures clarify the underlying legal principles.

For now, midstream companies, their lenders and their investors are monitoring the Sabine proceeding with trepidation and trying to gauge the effect and application of various arcane legal principles on their contracts.  But, as the analysis above demonstrates, all is not lost for such parties, and those that are active and creative can help forge a path through the legal thicket.

