In the higher commodity price environment of 2010 to 2014, upstream companies (E&Ps) either sold gathering systems to raise capital and/or incentivized midstream companies to construct assets for their benefit. This resulted in E&Ps agreeing to long-term contracts with minimum volume commitments, dedicated acreage and in some cases guaranteed cash flow.
Midstream ownership of gathering systems can be a win-win for both the midstream and E&P companies.
Operating the gathering system can be lucrative as the midstream company can market the infrastructure to multiple producers in the area and thereby expand the potential revenue stream from the system. E&Ps monetized assets by selling them to raise capital to infuse into their development plans.
Implications For E&Ps
Often when E&P companies sell gathering systems to midstream companies, the agreement contains certain guarantees such as minimum volume commitments, dedicated acreage and/or other contractual guarantees. Several E&P companies entered into such agreements in the higher commodity price environment when projected production resulting from active drilling programs substantially exceeded the minimum volume commitments or other guarantees. Therefore, E&P companies were not concerned with meeting their contractual obligations at the time.
During the depressed commodity price environment over the past two years, E&Ps have slashed capital spending and revised their drilling programs. Consequently, produced hydrocarbons are expected to be less than originally projected and as such, E&P companies now have a much lower probability of being able to meet their forecasted volume commitments.
In an acquisition context, the obligation arising from the minimum volume commitment likely will not make its way into the reserve report. As such, E&P companies looking to acquire producing properties should consider volume commitments when pricing the deal if the gathering assets are owned by a third party, and the accounting implications of such commitments.
Once an acquisition is closed, the acquiring company is required to allocate the purchase price to all assets and liabilities acquired at fair value under Accounting Standards Codification (“ASC”) 805, Business Combinations. Assuming the acquisition includes a gathering contract containing an obligation or above/below market contract, as described above, then the contract should be valued.
For example, assume the contract includes a minimum volume commitment and the expectation is the projected volumes (in the reserve report) will be less than the minimum. In this case, the present value of the projected shortfall is valued and recorded as a liability on the acquiring company’s balance sheet.
Similarly, if the properties acquired are subject to contractual gathering rates that are either above or below the market rate at the time of closing, an asset or liability (depending on whether the contractual rates are above or below market, respectively) is required to be recorded on the balance sheet to account for the off-market contract.
Once recorded on the balance sheet, the assets/liabilities are amortized and are evaluated periodically to determine if the carrying amount on the balance sheet requires adjustment pursuant to relevant GAAP. Additionally, SEC disclosure requirements related to contractual obligations should be considered for public companies.
Acquisitions of oil and gas properties have become more complex in situations where gathering systems are owned by a third party. Typically, the agreements were put in place in a higher commodity price environment where projected production well exceeded minimum volume commitments.
Given the decline in commodity prices over the last two years, projected volumes may no longer be expected to exceed minimum volume commitments. As such, agreements in place for gathering should receive consideration by prospective buyers of E&P properties, as they could have economic and accounting implications.
At a minimum, prospective buyers should consider the related contracts when developing a bid for the properties.