By Denmon Sigler, Mark Bloom, Andrew Ketner, Bryan Uelk and Scott Shelton

Law360 (April 20, 2020, 6:09 PM EDT) --

Denmon Sigler

Mark Bloom

Andrew Ketner

Bryan Uelk

Scott Shelton

The oil and gas industry in Texas is currently facing a double whammy from the recent oil price shock and COVID-19 related demand reductions. While exploration and production operators in Texas are proactively taking self-help measures to reinforce their financial frameworks — reducing capital spending, operating expenses, overhead and dividends — the outlook remains highly uncertain.

Over the past month, operators have analyzed their material contracts to identify and evaluate particular threats and risks posed by the current crisis. A consistent theme to emerge is a recognition that financial distress across the industry may lead to a wave of nonoperated working interest owners entering bankruptcy, and a need for operators to understand the associated implications under their joint operating agreements, or JOAs.

Exploration and production companies across Texas typically develop their oil and gas leases cooperatively with other working interest owners through JOAs. The industry is, therefore, contractually interconnected.

It is not uncommon for a JOA to include several working interest owners of varying market capitalizations and credit ratings. This article will touch on a key strategic consideration for operators in Texas with respect to their nonoperated working interest partners that may be facing bankruptcy.

The JOA is typically an executory contract that may be rejected in bankruptcy.

The JOA acts as an operator's foundation upon which its development plans and economics are built — setting forth the rights, obligations and entitlements of the operator and nonoperators, allocating risk, and incentivizing participation in wells and operations, while penalizing nonparticipation.

Roles and responsibilities are clear for both operator and nonoperators alike. JOAs are heavily negotiated — and rightly so, as there is an expectation that these agreements will remain in place for many years.

When a nonoperator enters bankruptcy, this carefully laid foundation is put in jeopardy. Section 365 of the U.S. Bankruptcy Code permits a debtor in bankruptcy to assume — that is, keep — an executory contract, or reject it.

Under the traditional definition, an executory contract is an agreement with respect to which material performance (other than payment of money by the debtor) remains due on both sides.[1] More recently, courts and commentators have focused on a functional approach, whereby any contract deemed unduly burdensome to the debtor's estate is considered executory and therefore may be rejected in bankruptcy.[2]

Bankruptcy courts applying Texas law generally consider JOAs to be executory contracts.[3] Although assumption and rejection require bankruptcy court approval, courts will defer to a debtor's business judgment in determining which agreements the debtor wishes to assume or reject.

The business judgment rule is a deferential standard, making it difficult for the counterparty to prohibit rejection. Therefore, so long as a nonoperator debtor presents a rational business justification for rejecting a JOA, the operator has little recourse.

The practical and strategic significance of rejecting a JOA governed by Texas law is considerable. Due to the lack of widely used forced pooling regulations in Texas, the rejection of a JOA likely results in the nonoperator debtor becoming a co-tenant with the operator and other nonoperators.[4] Notwithstanding a nonoperator debtor's rejection, the other parties remain subject to the JOA.

In states with forced pooling statutes, the state's regulatory commission is authorized to "enter an order pooling all tracts and interests within a ... unit," which allows the operator to drill even without the cooperation of the nonoperators.[5] Texas operators are unable to rely on forced pooling to develop their oil and gas leases, and instead must cooperate with nonoperators by entering into JOAs and voluntary pooling agreements. The alternative in Texas is co-tenancy.

The threat of co-tenancy is that a potentially sizeable working interest share previously governed by the JOA will be outside the terms of the JOA following rejection — leaving the operator's future development plans, and most importantly, economics, at risk. Going from a JOA to co-tenancy is a fundamental change in the underlying bargain between the parties, largely due to the absence of nonconsent penalties.

Nonconsent penalties typically range from 300% to 500% under a JOA, whereas they do not exist under Texas common law: "More often than not, an operator will refuse to drill a well with even a small uncommitted co-tenancy interest, due to the adverse impact it will have on its revenue."[6]

Importantly, a co-tenant has the right to drill and operate its own wells in the former JOA contract area without first obtaining the consent of the other co-tenants. This valuable right is subject only to the duty to account to the other co-tenants for their proportionate share of the value of the oil and gas produced, less the nondeveloping co-tenants' proportionate share of the drilling and operating expenses.[7]

It must be stressed that under co-tenancy, "a co-tenant must share the profits it reaps from production on the land with the other co-tenants, [but] it cannot force the other co-tenants to share in the risks. ... [I]f a co-tenant drills a dry hole, he does so at his own risk and without right to reimbursement from his co-tenant."[8]

Unlike a JOA, which allocates and incentivizes risk, co-tenancy may incentivize nonparticipation in some circumstances, due to the absence of nonconsent penalties under Texas common law. The intersection between contractual and regulatory compliance creates additional risk to the JOA operator facing co-tenancy. Regardless of which party drills, both the JOA operator and co-tenant must continue to comply with development obligations and restrictions under the terms of their applicable oil and gas leases and ancillary agreements.

Likewise, both parties must also continue to comply with regulatory restrictions relating to well spacing and density imposed by the Texas Railroad Commission. As such, a co-tenant could potentially undermine the JOA operator's ability to meet its contractual obligations by utilizing protest mechanisms under Texas Railroad Commission rules.

JOA operators should consider all levers at their disposal when faced with the co-tenancy risks discussed above. While each circumstance is unique, there may be factors at play between the parties that could benefit the JOA operator.

For example, the JOA operator and co-tenant may be parties to agreements that cannot be rejected in bankruptcy depending upon the applicable state law governing the agreements (e.g., certain oil and gas leases or certain midstream agreements) that contractually limit the co-tenant's ability to operate in the former JOA contract area.[9]

Similarly, the parties may jointly own interests in the same oil and gas leases, which incentivizes cooperation based on the parties' shared ownership. In this regard, it is incumbent upon the JOA operator to remain diligent and creatively think through ways in which it can exert pressure to drive a favorable outcome.

While no one can predict how long the current double whammy will persist, operators can proactively take steps to understand their rights and obligations under their JOAs in the event their nonoperator partners enter bankruptcy. Thinking through these nuanced issues takes time and careful planning as it is a fact-intensive, complex area, with significant strategic and legal considerations in play.

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Denmon Sigler and Mark Bloom are partners, and Andrew Ketner, Bryan Uelk and Scott Shelton are associates at Baker McKenzie.

Additional contributors included Baker McKenzie partners Luis Gomar and John Dodd.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] See Vern Countryman, Executory Contracts in Bankruptcy (Part I), 57 Minn. L. Rev. 439, 460 (1973).

[2] See John A. E. Pottow, A New Approach to Executory Contracts, 96 Tex. L. Rev. 1437 (2018).

[3] In re Wilson , 69 B.R. 960, 963 (Bankr. N.D. Tex. 1987) (parties had "continuing obligations under the operating agreements ... thus, the operating agreements are executory contracts"); In re Panaco Inc. , No. 02-37811-H3-11, 2002 Bankr. LEXIS 2084 (Bankr. S.D. Tex. Dec. 10, 2002) (joint operating agreements are executory contracts).

[4] McCurdy v. Harry L. Edwards Drilling Co. , 198 S.W.2d 609, 612 (Tex. App.—Galveston 1946, no writ). To be sure, the non-operator debtor in bankruptcy would argue its rejection of the JOA results in co-tenancy; however, this issue may be litigated between the JOA operator and nonoperator debtor.

[5] Gina S. Warren, Pooling Clauses and Statutes, 5 (2014) (available at https://scholarship.law.tamu.edu/facscholar/711) (last visited April 15, 2020).

[6] Caleb A. Fielder, Blood and Oil: Exploring Possible Remedies to Mineral Cotenancy Disputes in Texas, 50 TEX. TECH. L. REV. 173, 175-76 (2017).

[7] Wagner & Brown Ltd. v. Sheppard , 282 S.W.3d 419, 426 (Tex. 2008).

[8] Cimarex Energy Co. v. Anadarko Petroleum Corp. , 574 S.W.3d 73, 96 (Tex. App.—El Paso 2019, pet. filed).

[9] For example, certain oil and gas leases under Texas law are not executory contracts but instead represent an interest in real property. See Anadarko Petroleum Corp. v. Thompson , 94 S.W.3d 550, 554 (Tex. 2002).

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