The oil and gas industry is in the midst of a transition, with prices falling as supply outpaces current demand. With global economic weakness and growing competition from alternative energy sources, the expectation is for continued headwinds. Low prices have caused numerous producers to default on their indebtedness and many to seek financial restructuring, including filing for bankruptcy protection.

With the number of bankruptcy filings, courts are being faced with issues that may have long-term effects on upstream and downstream participants in the marketplace. The Bankruptcy Court for the Southern District of New York issued a ruling that could alter the contractual rights of producers and their midstream gatherers.

Sabine Oil & Gas LLC (Sabine) is an independent energy company engaged in the acquisition, production, exploration, and development of oil and natural gas within the United States. Sabine had Gathering Agreements with two midstream gatherers (Nordheim Eagle Ford Gathering, LLC [Nordheim] and HPIP Gonzales Holdings, LLC [HPIP]), who gather, treat, transport, and process oil and gas produced by Sabine before such products enter the commercial market. The Gathering Agreements required Sabine to dedicate to the performance of the respective agreements all of the natural resources produced from a designated area and to deliver the product to the respective counter-party. The agreements also provided Nordheim and HPIP each construct a gathering system of pipelines and treatment facilities in order to provide their midstream services.

Sabine filed for bankruptcy protection in July 2015. Shortly thereafter, Sabine filed a Motion to reject the Gathering Agreements. Section 365(a) of the Bankruptcy Code provides that a debtor may assume or reject executory contracts. In determining whether rejection is appropriate, courts generally defer to a debtor’s business judgment of whether the contract provides a net benefit or net burden to the estate.

Based on certain minimum payment obligations under the Gathering Agreements and the reduced production resulting from the market conditions, Sabine argued maintaining the Gathering Agreements would impose a considerable and unnecessary drain on their resources. Nordheim and HPIP objected, arguing Sabine’s dedication of the leases and the produced oil and gas products were covenants that run with the land and therefore, not subject to rejection under section 365(a) of the Bankruptcy Code.

The Bankruptcy Court noted if the covenants are deemed not to run with the land, Sabine would be able to negotiate with any party on new gas gathering agreements. If, however, the covenants were deemed to run with the land, Sabine would have to pursue alternative arrangements with Nordheim and HPIP on terms consistent with the covenants by which Sabine would remain bound. However, under either scenario, rejection of the agreements was a reasonable exercise of Sabine’s business judgment.

The Court then turned to the issue of whether the covenants did run with the land. The Court stressed the proper procedural path is to pursue an adversary proceeding for a full evaluation of the facts. Further, the Bankruptcy Court noted its findings were preliminary and not precedential. Despite these warnings and limitations, the court provided a detailed non-binding analysis finding, under Texas law, the covenants did not “fit into the traditional paradigm for horizontal privity of estate” nor did they “touch and concern” Sabine’s interest in or use of the land, because the Gathering Agreements dealt with the produced products, which under Texas law made the subject of the covenants personal property. The court concluded the covenants in the Gathering Agreement concerned the produced products (as opposed to the oil and gas which is still in the ground), which are personal property and not real property and, therefore, did not run with the land.

The Bankruptcy Court's decision was based on the facts as presented and analyzed under Texas law. The determination of whether covenants run with the land is fact intensive and analyzed under applicable state law. State laws vary on real property interests. 

Oil and gas contract parties face many unique issues in weaving their way through a bankruptcy process, and the language of the agreements, the facts, and the intersection of real estate and bankruptcy laws will play a large part in the reorganization process. The Bankruptcy Court for the Southern District of New York, in Sabine, highlighted the importance of a careful analysis of all facts and law in analyzing the rights of the parties in a bankruptcy scenario.