Midstream Contracts: Joined at the Pipe

[Editor's note: A version of this story appears in the July 2020 edition of Oil and Gas Investor. Subscribe to the magazine here.]

Because recent events have decreased demand for crude oil, forced shut-ins of oil producing wells and reduced drilling activity, the energy industry’s focus has turned back to natural gas. As oil wells are being shut in, volumes of rich associated gas are declining as well. Moreover, a decrease in drilling activity means normal decline is not being replaced with new volumes of rich gas, thus creating dilemmas for producers and midstream operators.

Producers are now focused on finding every available revenue stream, including scrutinizing their existing midstream commercial contracts. Relief with lower fee levels for gathering, processing, compression and other midstream services is being sought out. As lower oil prices appear to be in the cards for at least the near term, any increases in gas revenue ease producer pain.

Midstream operators also face a major hurdle: declining volume throughput. With the transition over the last 20 years from legacy allocated percentage of proceeds (POP) contracts to fixed fuel and recovery fee-based contracts, gathering and processing inlet volume levels have become the largest variable for most midstream operators’ bottom lines. Moving away from commodity price exposure has flattened the risk curve for operators and afforded them other means of achieving slices of margin.

Under pro forma fixed fuel and recovery fee-based contracts, several items can affect margin levels:

• Fees for gathering, treating, compression, marketing and processing;
• Fee levels based on volume levels;
• Fees for low-volume receipt points;
• The delta between actual NGL plant recoveries and the “fixed” contractual levels;
• The delta between actual field fuel and “fixed” contractual fuel charges;
• The delta between actual plant/recompression fuel and “fixed” fuel charges;
• The delta between actual lost and unaccounted for gas (L&U) and “fixed” L&U;
• The delta between actual residue gas pricing and “fixed” contractual price;
• The delta between actual NGL transportation and fractionation (T&F) rates and “fixed” contractual T&F rates;
• Any fees or capital recovery under volume throughput commitments (VTCs);
• Any fees for various levels of service for gathering or processing capacity (firm versus interruptible); and
• Plant tailgate imbalance fees for producers taking their products in-kind for marketing.

Volume throughput language

In this environment, producers’ risks do not only lie in decreasing gas revenue due to lower volumes; those companies that are subject to contractual VTCs could face additional challenges.

Some midstream commercial contracts contain VTCs whereby producers agree to deliver guaranteed volumes over a period of time, and producers that fail to meet the VTC are subject to penalties in the form of increased fee rates or cash payments to the midstream entity based on the level of volume shortfall.

VTC language has been prevalent in recent times when midstream operators have outlaid capital for greenfield or extended gathering and/or processing assets upfront in newly developed areas.

“Despite the hurdles each side faces, potential reasons exist to come to the table through contract renegotiations, with each party holding different advantages.”

As the shale revolution unfolded, producers realized they needed a connection ready to go for their flush gas production. Without that, the larger flush volumes could be wasted, and their frac time could be delayed. VTC language ensured a return on capital employed for the midstream operator in exchange for the installation and commissioning of new facilities in a timely manner (many times before wells were completed) for the benefit of the producer.

Now, producers with VTC contracts are beginning to stare down the possibility of further deterioration of their gas revenue stream if faced with increased midstream service fees and/or a cash payment due to volume shortfalls in the VTC contract language.

Midstream companies, on the other hand, have some hard decisions to make on the VTC issue:

• Do they persist on the higher fees or cash payments if due now?
• If so, could this accelerate some producers into bankruptcy?
• If inflexible, could this affect dealings in the future with this producer?
• Is there a possibility of a producer claiming force majeure?
• Could there be potential litigation or arbitration involved?
• Could a regulatory body step in?
• If the producer goes into bankruptcy, is there a risk the court throws out the contract?
• If the producer is given an extension or the terms are renegotiated, what does that do to the return on the capital that has been deployed by the midstream company? 

Legacy production and contracts

Producers with older vertical wells and legacy contracts face different hurdles. With the decline in gas and NGL prices since 2015, both POP contracts and fee-based contracts have deteriorated net wellhead gas prices. Since POP contracts are based on producers receiving only a percentage of value for their attributable residue gas and NGL products’ value, the net effect has been much lower netback pricing.

In addition, as the overall value chain is lower, net back pricing is further diminished by ancillary fees for items such as low volume meter charges. In some fee-based contracts in certain basins, these fees have actually resulted in some gas having a negative value at the wellhead. As gathering systems age and legacy wells require lower system pressures to produce, compression fuel and system loss tend to increase, exacerbating the issue of gas not getting to market.

Renegotiations: possibilities and conclusions

Since both sides of the table have hurdles in this environment, what do they have to gain or lose to come together for renegotiation?

Producers are after price relief. They also want to continue to benefit from the same level of gathering and processing service regardless of whether they are producing significant volumes from horizontal wells or lower, steady amounts of gas from legacy verticals.

Midstream operators want to continue generating margins that afford them cover for their operating expenses while making a return on their capital. During “normal” times, these parties work in harmony as new wells are drilled, decline curves are flattened and more private and public money is invested into drilling activity and midstream infrastructure buildouts.

Despite the hurdles each side faces, potential reasons exist to come to the table through contract renegotiations, with each party holding different advantages.

Producers have two major advantages: term and dedication. Midstream companies are built on revenue streams and on the security of their gas supplies. Long-term gas supply contracts enable a midstream operator to focus on operational efficiencies, business development and technological innovation. Also, larger acreage dedications under midstream contracts bring future value, and while the original producer under contract may not develop all its acreage, there is an excellent chance that successors will.

For producers offering term extension and expanded acreage dedications, midstream operators could offer:

• VTC time extension and/or lowering VTC shortfall fees/capital payback;
• Fee tables based on volumes for incentives;
• Waived or renegotiated low volume meter fees to keep legacy gas moving;
• A transition to actual fuel on fixed fuel contracts for a period of time;
• Options for actual or fixed product recoveries; and
• Expanded producer rights for take-in-kind gas and NGL.

Willingness to renegotiate now will go a long way for both parties, producers and midstream operators, to survive and even thrive once again. This reality will not change between the two parties: Producers need their midstream services as much as midstream operators need the gas supply and the security that it will be there long term.

Steve Reese is celebrating his 40th year in the energy business. He is the founder and CEO of Reese Energy Consulting Inc., Reese Energy Training Inc. and the publisher of the Reese Midstream Report with offices in Edmond, Tulsa and Houston. The Reese family of companies specialize in energy commercial contracts, midstream engineering and operations, energy contract and midstream field auditing, due diligence, and energy research and project planning. He can be reached at sreese@coxinet.net.