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Midstream Contracts Rejected in Bankruptcy, How Does this Impact MLPs?

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Midstream Master Limited Partnerships should be designed to generate a  base level of operating cash flows in return for making infrastructure available to producers.  If a midstream company intends to develop new gathering or pipeline systems, they require that producers commit to future use of the infrastructure, ensuring a level of return on their investment over a considerable period of time.  In the case where a Master Limited Partnership acquires existing assets from either a Sponsor, via dropdown, or by way of a market purchase, the assets are purchased assuming a base level of cash flows.  Without the cash flows, the EBITDA multiple on such acquisitions would be significantly lower than those which have occurred over the past 5 years.   Prior to the crude crash, the industry has coined and marketed these base cash flows as  Fixed Fee, Take or Pay, and Minimum Volume commitments, suggesting that they are low risk cash flows. Over the past year, MLP investors have learned that these contracts are not as "guaranteed" as often suggested, but to date have not regarded these agreements as easily terminated.  MLP management teams have been adamant about the staying power of these agreements, if a producer were to enter bankruptcy.  During the Q4 earnings calls, most MLPs outlined their counter party exposure to risky producers, but assumed that all of the revenue would not be at risk if they all petitioned for bankruptcy.  However, there are two cases winding their way through the court system which may impact these base line cash flows assumptions, specifically related to the obligations of the producer if they declare bankruptcy, and either operate or sell the assets thereafter.

 

Earlier this year on July 15th, Sabine Oil and Gas filed a petition for relief under Chapter 11 and in doing so, filed a motion to reject the 10 year dedicated acreage gas and condensate gathering contracts, governed by Texas law,  in place with Nordheim Eagle Ford Gathering LLC, a subsidiary of Cheniere Energy .  Sabine also petitioned to reject their Production Gathering, Treating and Processing agreement with HPIP as well as a Water and Acid Handling agreement in place since May 2014.  The Debtors argued that the company is no longer able to produce the necessary volumes required by the agreements, and the deficiency payments would impose a considerable and unnecessary drain on resources, indicating that new gathering agreements could be contracted at much lower rates. Through September 2015, Sabine paid $2.7MM in deficiency payments related to their gathering agreements, on roughly $26MM of total gathering fees recording through the same period.  HPIP and Nordheim argued that the gathering agreements run with the land, and are not subject to rejection  On Tuesday, Judge Chapman ruled that the midstream contracts could be rejected on the basis that the Debtors did not reject the contracts out of bad faith, whim, or caprice,  meaning there would be no obligations of future payments.  The Judge did not determine that the gathering agreements do not run with the land per se, but suggested that argument was outside the scope of the motion, although the Court did provide a non binding opinion.

 

The second  case is related to the proposed sale of acreage from the bankrupt Quicksilver Resources to Bluestone Natural Resources.  What is being contested is whether the dedicated gas processing and transportation agreements between Crestwood and Quicksilver can be terminated upon the sale of the acreage, a condition which Bluestone has placed on completing the $245MM transaction.  Crestwood's position is that the gathering agreements are connected to the land, regardless of ownership, arguing that they otherwise would not have paid $741MM for the Quicksilver Gas Services pipelines on October 1, 2010.  Being the largest producer on the network, Crestwood's position is that the gathering system's value is predicated upon the acreage for which is was developed.   Bluestone's position is that the $65MM paid for gathering, processing and transportation through September 30, 2016 is above the prevailing market rates, despite the fact that Quicksilver recorded a $454MM gain when they sold the pipelines to Crestwood, as well as renegotiated the rates up to 65% lower in July 2014.  Below are Quicksilver's rates and future volume commitments (excluding compression agreements in place with CSI Compressco as disclosed in their most recent 10k

 

 

 

The company previously opted not to pay gathering fees for their Canadian Horn River acreage, which resulted in termination of service prior to any proposed acreage sale, which may be a key factor in the Bluestone transaction, as noted by Judge Silverstein:

 

 

QRCI did not pay an uneconomic Canadian gathering and processing commitment, which included significant unused firm capacity, due in late February 2015.. In early March 2015, the third-party service provider issued a demand letter regarding the missed payment and suspended service resulting in our Horn River Asset production being shut-in.  Further, a termination notice was issued by the third-party service provider effective March 19, 2015.  We continue to explore alternative to gather and process our Horn River Asset production; however, we may not be able to find economic alternatives in the near-term, or at all, and production may remain shut-in.

 

 

Judge Silverstein indicated she will do her best to render a decision by the March 31st deadline for Bluestone to complete their purchase of the Quicksilver assets.  A decision which allows the gathering agreements to be terminated will likely be a key factor in the sale of future acreage by struggling producers.

 

So what should MLP Investors make of these judgments?   It is certainly not good news, as it enables producer to negotiate with a stronger hand prior to bankruptcy, where the producer has viable options to replace their midstream providers.  Creditors will also be more weary of extending capital and the market will demand higher rates on current and future debt issuance. Certainly midstream companies will be modifying their future agreements to address this issue, but for the moment, there is some MLP asset exposure to near insolvent producers, who constitute a small percentage of diversified midstream cash flows.  Williams, which has significant exposure to Chesapeake by way of their Access Midstream acquisition a few years ago, outlined their view on the topic below:

 

"And so here’s how we think about the risk. First of all, we have long term dedications with strong contractual conveyances of interest in unproduced gas. We like our argument that we hold a current real estate in unproduced gas and that our covenants running with the land not subject to the rejection in bankruptcy. We certainly are following current bankruptcy cases like Sabine where the general question is at issue. But people should understand that the ultimate outcome in individual cases will turn on specific facts and circumstances."

 

"Regardless, even if the court were to rule we don’t have such legal rights, our gathering lines are physically connected to Chesapeake’s wellheads and pads. And we provide a very critical service, conditioning and connecting Chesapeake’s production to points where they can then choose the best markets for long haul transportation alternatives. In exchange for the dedication of production, we invested capital to build gathering lines that are uniquely positioned to serve Chesapeake’s well. So all these systems were built out specifically for their needs and generally at their direction as to the size and scale that they needed to be able to produce volumes on a projected basis."

 

"In most cases, there are no other gathering lines nearby because these are big contiguous areas and, again, these systems were built specifically for their production. And in many cases, our pipelines have been built on populated places such as beneath the city of Fort Worth. And it would be very costly for others to replicate our gathering lines. And the rates of return that we generate from these investments and assets are very typical for a midstream provider."

 

"Likewise, our gathering lines have been in place for some time, and thus, the reserves behind them are now partially produced. To continue to produce such gas, Chesapeake and its creditors, if that ever came to that, would want and need to utilize our gathering lines to deliver gas to the markets. So such gathering lines are just very distinguishable from long haul transportation service because the intra and interstate pipeline initiate service after the gas is already pulled at marketable points, producers then have many options to receive cash for their products other than transportation on any one particular interstate pipeline."

 

"If it did come to a bankruptcy, a producer can argue that it can reject certain types of contracts. And we believe gathering contracts such as ours are not the type of contract that would be rejected. But even if the gathering contract were allowed to be rejected, a producer and its creditors will continue to need the gathering service to be able to produce gas and create revenue. If a producer rejects the gathering contract in a bankruptcy, the gatherer will no longer be obligated to provide the gathering service."

 

"Furthermore, rejection of a contract is all or nothing. Therefore, the analysis of the risk of any producer’s bankruptcy is best analyzed contract by contract and really understanding that the particulars of the services being provided and how unique those services are that are being provided."

 

MLP Management teams will now be pressed to provide greater transparency of their agreements and counter-parties, as likely will be finding their producer "partners" a little more emboldened with their concession requests.   MLPData will provide updates to the Quicksilver case, and any other additional disclosures related to the midstream contract rejections or re-negotiations.

 

 

 

 

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