Midstream operators, which until now had formed one of the most stable segments of the oil and gas value chain, are facing a new existential threat. The compounding pressures of plummeting demand and burgeoning supply have been hammering upstream companies, with an increasing number filing for Chapter 11 in 2020. In the process, the fee-based contracting mechanism that had been insulating midstream operators from the effects of commodity price changes has come under intense scrutiny in bankruptcy court.
The crux of the matter lies in whether judges find that the contracts are executory—meaning that unperformed obligations remain on both sides. Executory contracts, such as real estate or equipment leases, can be voided in bankruptcy proceedings. Thus far, the courts are finding most midstream contracts to be executory.
UNDERSTANDING THE IMPACT OF THE CONTRACTS
The contracting system under question first became popular during the booming 2000s and early 2010s, when commodity prices were much higher. At the time, such arrangements were simply what it took to get new production to market.
AlixPartners estimates that 80% of the industry’s contracts signed over the past 10 years are fee-based, meaning that the midstream operator is paid a fixed fee per amount of volume of oil or gas that flows through the pipeline. This presents volume risk if operators choose to reduce development activity in a dedicated area but insulates gathering, processing, and transportation (GP&T) companies. Many pipeliners further insulated their risk through other contracting mechanisms such as minimum volume commitments, time-based drilling commitments, long duration contracts, and limits on the exploration and production (E&P) operators’ ability to use other midstream providers in a specific area.
With the 2014 oil price crash and the gas collapse that preceded it, upstream companies began facing tremendous stress. Nonetheless, midstream companies continued to enjoy relative growth and more stable returns—until early 2020. A comparison of E&P, oilfield services and equipment (OFSE), and midstream segments from 2018 to December 2020 illustrates the relative midstream sector insulation (figure 1).
While the data is not encouraging for midstream management teams or their shareholders, companies are not wholly beholden to their E&P customers and court proceedings. There are several actions midstream companies can potentially pursue to minimize contract rejection risk:
- Develop market-driven negotiation positions
- Rethink contracting structures to manage risk
- Make imminent rejection and contingency plans
Download our Midstream operators can weather the E&P bankruptcy storm report to learn more.