Oil and Gas Investor: Midstream’s Survival—Bloody, but Unbowed

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[Editor's note: A version of this story appears in the July 2021 issue of Oil and Gas Investor magazine. Subscribe to the magazine here.]

The pandemic fired away relentlessly at the oil and gas industry, shredding demand for transportation fuel and forcing retreats in staffing, rig counts and investor interest. The upstream sector was particularly shell-shocked, with Haynes and Boone LLP reporting that 54 E&Ps filed for Chapter 11 bankruptcy protection from the start of 2020 through first-quarter 2021, accounting for debt of more than $53 billion.

By contrast, only eight midstream companies filed for Chapter 11 during that time, with collective debt of less than $700 million. So, is it time for high-fives yet? How about a victory lap? Did the sector dodge a bullet?

“No,” said Ethan Bellamy, principal at BP Capital in Dallas. “I would say the best example of what the midstream has gone through would be the Chesapeake-Williams omnibus agreement.”

The deal is an example of what Bellamy calls “blend and extend.” Sometimes, survival is not just about being the fittest but about figuring out how to get by in tough circumstances.

Blend and extend

Chesapeake Energy Corp. is one of those “too big to fail” entities—maybe not for the government but arguably for midstream providers. Only a company that had known enormous success could end up filing for bankruptcy with an astonishing $11.8 billion in debt. The total was more than double that of the second-largest 2020 E&P bankruptcy, Ultra Petroleum Corp.

After Chesapeake Energy filed in June, it proceeded to follow a restructuring plan that would eventually allow it to shed $7 billion in debt while returning to natural gas production and away from aggressive bets on crude oil. It also went to work with pipeline giant The Williams Cos. Inc., on finding a way to survive the present and prosper in the future.

“Generally speaking, in almost every case, midstream is an essential service for the upstream,” Bellamy said. “Depending on the amount of leverage or how core that is, the midstream may be able to continue at the same rate if there aren’t any other options to the upstream, or they can blend and extend and take a lower rate but for longer or add on some other ancillary businesses.”

Williams chose the latter. By late November, the two parties reached a deal in which Williams would take over some of Chesapeake’s assets in exchange for lower gas gathering fees. In return, Chesapeake promised to not reject transportation service agreements (TSAs) with Williams in the Eagle Ford, Marcellus or Midcontinent shales. Chesapeake also agreed to long-term gas supply commitments for Williams’ Transco Regional Energy Access Pipeline, which is expected to be in service in the Northeast in time for the 2023-2024 winter heating season.

The producer emerged from bankruptcy protection in February under the control of its lenders. The company had shed assets and a hefty share of its previous workforce. In April, it also pulled its name off the side of Chesapeake Energy Arena, home to the NBA’s Oklahoma City Thunder. Chesapeake was chastened, but back in the game and valued at about $5.1 billion.

Williams’ approach led to a solution that worked for both sides and, while it might appear that a company with a market capitalization of $28.5 billion in mid-April had the upper hand, that advantage could evaporate in bankruptcy court.

“The unfortunate part of it is, the way the case law has developed, some of these midstream contracts, if they weren’t structured properly, they could be shed fairly easily in a Chapter 11 by rejecting the agreements,” said Randall Rios, senior counsel for the Husch Blackwell law firm. “If you reject a midstream agreement, then the midstreamer is left with an unsecured claim for rejection damages. In the cases back in 2015 to 2016, all of the restructurings were just deleveraging the balance sheets. They really weren’t dealing with trade creditors and things of that nature. The restructurings we’ve seen now, everybody’s suffering.”

Tim Million, also senior counsel at Husch Blackwell, likes the idea of getting ahead of the issue.

“If a midstreamer is approached early on by a counterparty that claims they have problems and need to restructure their agreement, the midstreamer should seriously consider taking the opportunity to work something out with the counterparty prior to a bankruptcy filing,” Million said. “There’s a chance that they can reach a deal out of court, which might result in a better deal than if there is a (Chapter) 11 filing and the contract is rejected.”

However, “blend and extend” has not fit into every situation in the pandemic era.

Calling in the Feds

West to east and east to west, the bidirectional Rockies Express Pipeline (REX) can transport as much as 4.4 billion cubic feet per day of natural gas to Midwest markets from gas fields in the Powder River Basin and Denver-Julesberg Basin in the Rockies, and the Marcellus and Utica shale plays in Appalachia. The 36-inch and 42-inch pipes traverse 1,700 miles beneath Wyoming, Colorado, Nebraska, Kansas, Missouri, Illinois, Indiana and Ohio.

But not South Texas. And yet, that’s where REX (in a metaphorical sense) has been diverted—to U.S. Bankruptcy Court of the Southern District of Texas. The pipeline’s owners, Tallgrass Energy LP (75%) and Phillips 66 Co. (25%) may be holding steady through the pandemic’s economic travails, but its upstream counterparty, Gulfport Energy Corp., is not. It filed for Chapter 11 bankruptcy protection in November, declaring an estimated $2.5 billion in liabilities as of the end of third-quarter 2020.

Prior to the filing, Gulfport Energy’s struggles were not a secret. The company was stuck with assets it had purchased in Oklahoma’s SCOOP play and, despite efficiency gains and the completion of seven wells in the Utica Shale last summer, its net debt increased in 2020 and liquidity declined. “The outlook continues to look challenging,” Simmons Energy assessed politely last summer.

In anticipation of the filing, REX petitioned the federal government for help. In September, the pipeline asked the Federal Energy Regulatory Commission (FERC) to assert that it, along with the bankruptcy court, had jurisdiction over TSAs with Gulfport if the E&P were to file for Chapter 11. FERC agreed and in late October, just days before Gulfport Energy filed for Chapter 11, found that canceling the TSAs would not be in the public interest.

In March, Gulfport appealed FERC’s decision in the Fifth U.S. Court of Appeals, arguing that the commission did not have jurisdiction, and its findings interfered with the E&P’s bankruptcy filing.

“It’s kind of a hot litigation issue currently,” Million said. “FERC had taken the position that they can’t just unilaterally be rejected in a bankruptcy case without their input, their approval, as well. They’re asserting that they have co-jurisdiction with the bankruptcy court.”

The type of proactive stance taken by REX as a non-bankrupt counterparty is an understandable action, according to a Dallas-based lawyer with extensive experience in oil and gas bankruptcies.

“Any time that you see bankruptcy coming and you’re the non-bankrupt counterparty, you’re considering, ‘How can I better posture my position so as not to be so much at the mercy of the special bankruptcy powers?’” the lawyer, who wished to remain anonymous, said. “When you’re the non-bankruptcy party, the bankruptcy powers seems to favor the debtor and to disfavor you. That’s going to be your position or your perception if you’re that non-bankrupt counterparty.”

The maneuverings, he said, are akin to a chess match.

“A pipeline company doesn’t want to lose available production,” he said. “They want to keep their pipe full, and they want to keep their product moving. But they have to protect themselves from what they think are the variables and, from their posture, the other party going into bankruptcy can seem to put them at risk. You’re always going to be trying to play a couple of moves ahead on the chessboard.”

That can mean keeping a close eye on a troubled counterparty.

“If the midstream company is a creditor or a counterparty to an entity that goes in, the only thing you can do, really, is manage your credit risk as best [as you can] and not let somebody get too far ahead of you in terms of dollars that they owe you,” Rios said. “To the extent that the midstreamers under their contracts have the ability to demand adequate assurance of future performance or anything of that nature, certainly, keep those remedies available and on the table. To the extent that they can demand security like letters of credit and things of that nature, they should evaluate those alternatives, as well.”

But while devising chess-like moves to gain advantages around bankruptcy proceedings might exist in the domain of big companies like Williams, Chesapeake, Gulfport, Tallgrass and Phillips 66, small independents might face tougher odds.

Water: Finding a way

Water, for example, is an essential midstream service. It has historically been volatile because it’s been based on revenue from skim oil, Bellamy said, referring to the practice of skimming oil off the water and reselling the oil. Revenue now is more likely to come off a per-barrel fee, he said, but operators have grown more skilled at not leaving oil in the water.

“I think the biggest issue now with water is leverage at private equity,” Bellamy said. “A lot of these private entities were levered up with the expectation that there was going to be continued growth at 2018 to 2019 levels.”

Last year, of course, shut that down and even with expected recovery throughout 2021, it will likely take years to return to pre-pandemic levels. So the question remains: How levered are these private entities in the water assets segment?

“That’s still a business that, if 2020 hadn’t happened, we probably would have had three or four water company IPOs and those haven’t occurred,” he said. “So I think it’s a question of what the private equity firms that backed them choose to do.”

So, can a pure water provider succeed in this environment? This time, Bellamy answered with a definitive “yes” … then he added a “but.”

“The key to successful midstream is scope, scale and integration,” Bellamy said. “You want to touch a molecule as many times as you can, you want to offer more rather than fewer services to a customer. You want to bundle services together when you can. If you can handle two or three streams from a customer, that is a better service offering.”

It depends, though, on the situation. How has the company differentiated its offerings? How competitive is the market?

“There’s no reason a stand-alone water company can’t work,” he said. “That’s clearly a huge business with so much produced water to handle. Ultimately, I think it would be best for water businesses to run alongside other gathering and processing businesses so you can have a master service agreement with an E&P and handle all of their needs.”

From the Dallas lawyer’s perspective, water companies will ultimately make it because their work constitutes an industry imperative.

“If you’re doing fracking, there’s a certain amount of water that has to be within a certain degree of salinization to be used in the production,” he said. “It just has to be there. Can the water people make it? Is there a way where that industry can make it? The answer is: We have to find that way.”

Slow, steady, sigh of relief

A criticism of the concept of bankruptcy protection, the lawyer mused, is that it sometimes keeps weak players hobbling along in the game, thus impeding the progress of reaching equilibrium.

“I don’t know if that’s always true,” he said. “But I’m saying that’s a frequent criticism.”

If the sector has not experienced a pandemic shakeout, that may owe to the body blows endured in the last downcycle in 2015 to 2016. Perhaps that is why 2020’s bullet only grazed the sector.

“In midstream, we saw some problems in 2015 and 2016 after the original OPEC Halloween massacre event took out some weak hands,” Bellamy said. “Then we saw very few midstream bankruptcies in this cycle because some weak hands had already been washed out and just because the businesses are more resilient.”

Not that doubts did not break the surface. Last year at this time, Rios detected fear among midstreamers.

“Some of the midstream companies that we work with, there were layoffs and things of that nature,” he said. “This year, things seem to be calmer than they were last year and things seem to be a little more optimistic, but I don’t know that anybody’s looking to do anything new right now.”

Million agreed, noting that many are just trying to ride out the downturn.

“They’re trying to hold steady, and are not currently very aggressive with respect to new deals or projects,” he said.

And with a slow but steady recovery expected later this year, a sigh of relief might even be warranted at this stage.

“The general threat on the industry is behind us with $60 oil and a constructive outlook for natural gas,” Bellamy said. “Midstream fundamentals tend to lag the market so while we’re not totally out of the woods, the worst is behind us. And in general, the midstream performed admirably. We did not see an extraordinary amount of pain and going concern risk from negative oil prices, and I think it suggests that the midstream has some investment merits that are worthy of consideration.”