By Omar Alaniz, Gary Johnson and Ramy Morad

Law360 (December 4, 2020, 6:42 PM EST) --

Omar Alaniz

Gary Johnson

Ramy Morad

As the COVID-19 pandemic continues, so too, does the distress inflicted upon upstream exploration and production companies.

To be sure, as of this writing, the price per barrel of West Texas Intermediate crude oil stands at approximately $45. In light of this low-price commodity environment, many exploration and production companies have commenced Chapter 11 bankruptcy proceedings, hoping to reorganize and restructure their balance sheets.

Section 365 of the Bankruptcy Code provides debtors a special opportunity to evaluate their executory contracts (i.e., contracts with respect to which the contracting parties have material obligations remaining) and determine which contracts are the most burdensome to the debtor's estate, which the debtor may thereafter seek to reject, and which contracts are beneficial, which the debtor may thereafter assume.

For decades, midstream companies that expended significant capital to construct gathering systems to service producers were comfortable that structuring the gas-gathering agreements with a covenant that runs with the land made the agreements impervious to a bankruptcy rejection.

But the increasing trend in exploration and production Chapter 11 cases is to seek rejection of the agreements that often contain out-of-market minimum volume commitments that were intended to cover the midstream companies' capital outlay.

The midstream companies' central legal defense is that the agreements containing covenants that run with the land create real property rights that are not susceptible to bankruptcy rejection. The covenant-running-with-the-land analysis is a state-specific inquiry, albeit one that is very similar across the various states.

The similarities in state law notwithstanding, bankruptcy courts across the country have yielded different interpretations when faced with the question whether a gas-gathering agreement that purports to run with the land may be rejected. A string of recent bankruptcy rulings has swung the pendulum the other way, evening the score set by the bankruptcy courts in In re: Alta Mesa Resources Inc. and In re: Badlands Energy Inc.[1]

In re: Extraction Oil & Gas Inc.

On Oct. 14, the U.S. Bankruptcy Court for the District of Delaware in three adversary proceedings[2] stemming from Extraction Oil & Gas Inc.'s Chapter 11 proceedings, held that Extraction's midstream agreements with Elevation Midstream LLC did not create covenants that run with land under Colorado law, and thus could be rejected by Extraction as executory contracts under Section 365 of the Bankruptcy Code.

In conducting its analysis, the Delaware bankruptcy court joined the U.S. Bankruptcy Court for the Southern District of New York's line of reasoning in Sabine Oil & Gas Corp. v. HPIP Gonzales Holdings LLC[3] and focused on the relationship of the various covenants contained in the gathering agreements and the debtor-producer's mineral estate.

In order for a covenant to run with the land under Colorado law, (1) the parties must intend to create a covenant that runs with the land; (2) the covenant must touch and concern the land; and (3) there must be privity of estate between the original covenanting parties at the time the covenant is created.[4] As to intent, the court found that certain of covenants were expressly intended to run with the land.[5]

To satisfy the touch-and-concern element, the court found that "the particular covenant intended to run with the land must closely relate to the estate in the real property with which it is intended to run (here, Extraction's mineral estate), its use, or enjoyment."[6] The court concluded that the only covenant that touched and concerned Extraction's mineral estate was a drilling commitment, which required Extraction to drill a certain number of wells into its mineral estate within a particular area within certain timeframes.[7]

According to the court:

The Drilling Commitment touches and concerns Extraction's mineral estates because it closely relates to the land by altering the parties' legal relationship thereto. … The Drilling Commitment directly affects the parties' physical use and enjoyment of the land because the obligation to drill a certain number of wells on a certain schedules affects Extraction's drilling and development of its mineral estates.[8]

In contrast to the drilling commitment, the other covenants at issue did not touch and concern the land because they bore no relationship to Extraction's mineral estate, and instead only concerned severed and produced minerals, which constitute personal property.

For example, with respect to Extraction's dedication covenant,[9] the court found that "the dedications and commitments do not touch and concern Extraction's mineral estates because the obligations and services for which they were made concern only personal property and do not closely relate to real property, specifically Extraction's mineral estates."[10]

Citing Sabine, the court noted that "[d]edications generally identify only particular produced minerals or produced water subject to, set apart for, pledged or committed to the parties' contractual obligations under midstream agreements."[11]

Similarly, Extraction's delivery covenant did not touch and concern Extraction's mineral estates because they only concerned produced minerals, and therefore only touched and concerned personal property.[12]

This focus on produced minerals, once again, echoes the sentiments of Sabine, in which the court held that "the triggers for the covenants at issue relate to the Products, not the land itself,"[13] before ultimately concluding that the covenants in the agreements under review did not run with the land.

As to the privity element, which requires that any covenant that allegedly runs with the land be accompanied by a contemporaneous conveyance of some interest in the land with which the covenant runs,[14] the Delaware court found privity of estate was not satisfied because the midstream agreements did not convey to Elevation any interest in Extraction's mineral estates.

Although Elevation contended that Extraction's conveyance of easements, rights-of-way and other surface rights satisfied the privity of estate requirement, the court found that, because the "surface estate and mineral estate, once severed, are separate and distinct estates in real property … [c]onveyances of easements or rights-of-way across the surface estate are interests in the surface estate that cannot satisfy the privity of estate respecting a mineral estate."[15]

The Extraction court's focus on the relationship of the covenants with the debtor-producer's mineral estate stands in contrast to the focus of the Alta Mesa and Badlands courts, which considered the relationship of the covenants with the debtor-producer's leasehold interests, and which ultimately held that the gathering agreements in question did contain covenants running with the land.

In Alta Mesa Holdings LP v. Kingfisher Midstream LLC, the U.S. Bankruptcy Court for the Southern District of Texas found that "[t]he Alta Mesa gathering agreements dedicate to Kingfisher the products of oil and gas leases, not the products of fee mineral estate. ... Unlike in Sabine, where the court focused its inquiry on a fee mineral estate, the relevant starting point here is Alta Mesa's leasehold interest."[16]

Similarly, the Badlands court found that:

The "Dedicated Reserves" under the GPA are interests in real property, not personal. ... "Dedicated Reserves" is defined broadly as "the interests of Producer in all Gas reserves in and under, and all Gas owned by Producer and produced or delivered from (i) the Leases and (ii) other lands within the AMI." ... Unlike the Sabine decision, the present dedication encompasses real property.[17]

Moreover, unlike the Extraction court, the Alta Mesa court recognized the significance of facilities obligations in its touch-and-concern analysis.

According to the Alta Mesa court:

The gathering system, which Kingfisher constructed in furtherance of the agreements, enhances the value of Alta Mesa's unproduced reserves. Because the gathering system enhances the value of the reserves themselves, not simply Alta Mesa's personal interest in the reserves, there is a logical connection between the covenant calling for the construction of the gathering system and the value of the reserves.[18]

In contrast, the Extraction court refused to afford any significance to Elevation's facilities obligation (i.e., its obligation to construct and operate the midstream facilities to service producer gas, oil and water) in its touch-and-concern analysis, instead noting that "the midstream facilities enable Elevation to provide the services it is obligated to provide to Extraction's personal property."[19]

Furthermore, whereas the Extraction court was unwilling to attach significance to the easements and rights-of-way granted by Extraction to Elevation, the Alta Mesa court found that:

In the context of an oil and gas lease the surface easement is integral to the lessee's ability to realize the value of its mineral reserves. ... The covenants granting Kingfisher surface easements directly burden Alta Mesa's interest in the reserves because they restrict Alta Mesa's use of the surface land for drilling or exploration.[20]

The difference in analysis between Extraction and Alta Mesa on this point is extreme and without a significant difference in the underlying state law at issue.

In re: Chesapeake Energy Corp.

Adding an additional wrinkle into the fold, in In re: Chesapeake Energy Corp., the U.S. Bankruptcy Court for the Southern District of Texas recently considered whether a gas purchase agreement between Chesapeake and ETC Texas Pipeline Ltd. could be rejected as an executory contact under Section 365 of the Bankruptcy Code.[21]

In determining that the covenants contained in the gas purchase agreements did not run with the land, the court concluded that the intent element in the covenant running with the land analysis was not satisfied, notwithstanding a clear written expression by the parties that they intended for the obligation to sell specified quantities of gas to run with the land.

While the court acknowledged that an express statement of that intent, generally speaking, would establish the requisite intent for a covenant to run with the land, the court looked to other provisions of the gas purchase agreement and concluded that the requisite intent was lacking.

Specifically, the court noted that the formulaic monetary damages provision — and absence of equitable remedies such as specific performance and injunctive relief — underscored the personal, rather than real property, nature of ETC's rights under the contract.

The Chesapeake ruling also sheds some important light on whether a dedication covenant adequately touches and concern the land to which it relates. ETC contended that the dedication of all oil and gas produced from Chesapeake's leases touched and concerned the land.

The court disagreed, however, and noted that "[o]nly after gas is produced and becomes personal property does an obligation regarding the disposition of that gas arise."[22] Significantly, the court noted in a footnote that "[h]ad the agreement between the parties included a dedication of 'all of the Debtors' right, title and interest in and to the leases,' the court's analysis might have been profoundly different."[23]

Once again, by focusing on the mineral estate, rather than the debtor's leasehold interests, the court concluded that the agreement concerned only personal property, and not real property, and therefore did not create a covenant running with the land.

In re: Southland Royalty Co. LLC

More recently, on Nov. 13, the U.S. Bankruptcy Court for the District of Delaware issued a decision in an adversary proceeding in the In re: Southland Royalty Co. LLC case, where the court determined that Southland Royalty Co., an exploration and production operator with assets primarily in Wyoming, could reject a gas gathering agreement it had with Wamsutter LLC, a midstream service provider.[24]

Southland and Wamsutter were parties to two midstream agreements, the L60 and L63 agreements. After the parties entered into the L60 agreement, Southland enhanced its drilling program to include horizontal wells that required an expansion and update to the Wamsutter gathering system.

To accommodate this expansion and update, the parties entered into the L63 agreement. The area covered by the L63 agreement was located within the area covered by the L60 agreement, but it served different receipt points. Both agreements included minimum volume commitments, but the L63 agreement contained the more onerous of the two, with an estimated $863 million commitment.

Southland filed Chapter 11 on Jan. 27 after Wamsutter made a $6.9 million adequate assurance request on the cash-strained operator. Citibank is the debtor's sole secured lender with $540 million outstanding as of the bankruptcy. The bank agreed to a sale process that the debtor kicked off shortly after the filing.

However, the sale process came to a grinding halt when it became clear that Wamsutter would not renegotiate the gathering agreements' pricing to a level sufficient to attract binding bids from potential bidders, thereby dashing away the Chapter 11 parties' hope of a speedy sale.

Southland subsequently initiated an adversary proceeding against Wamsutter with a fairly straightforward strategy: Seek a declaration from the bankruptcy court that it could (1) reject the L63 agreement, (2) sell its assets free and clear of Wamsutter's interest under Section 363(f) of the Bankruptcy Code, and (3) novate all gathering and processing services to the L60 agreement.

The elements to create a real covenant under Wyoming law are similar to the elements in the state laws analyzed in Sabine, Badlands, Alta Mesa and Extraction: The parties must intend to create a real covenant, the covenant must touch and concern the land, and there must be privity of estate between the parties.[25]

The court found that the parties unquestionably intended for the dedication provision in the L63 agreement to run with the land. But, the court was unwilling to bootstrap the clear intent in the dedication provision to the remainder of the L63 agreement. The court also found that Southland's commitment to Wamsutter did not touch and concern the land.

Southland had dominion over its unproduced gas reserves and unfettered control over its exploration, drilling and production activity. Southland's produced gas was the only property directly benefited and burdened by the L63, which once severed, is personal property. The court reasoned that "[a]t bottom, the L63 is a contract for Wamsutter's services in the [dedication area] so that Southland can monetize its production."[26]

The court also disposed of Wamsutter's argument concerning the privity of the estate requirement, determining that Southland's easement conveyances were of surface rights, not of an interest in the mineral estate.

The court also held that Southland could sell its assets free and clear of Wamsutter's interest. Wyoming law permits a mortgagee like Southland's lender to foreclose and extinguish later-created real property covenants. Thus, Wamsutter's interest could be sold free and clear under Section 363(f)(1) of the Bankruptcy Code, which permits free and clear sales when nonbankruptcy law permits the property to be sold free and clear.

The court also held that Section 363(f)(5) — permitting free and clear sales when the entity could be compelled to accept a money satisfaction — applied because Wyoming law gives broad discretion to a court to select appropriate remedies to enforce covenants. Importantly, the court noted that the L63 agreement does not exclude monetary damages as a remedy to address breaches.

Southland won the rejection battle, but not the war. U.S. Bankruptcy Judge Karen Owens denied Southland's request to sever the minimum volume commitment from the gathering agreement.

The agreement's structure and language convinced Judge Owens that the minimum volume commitments was intertwined with the gathering and processing services. Wamsutter's witnesses testified that the minimum volume commitments was part-and-parcel with Wamsutter's agreement to expend significant capital to construct the gathering system.

Judge Owens also held that Southland could not flow gas serviced by the L63 agreement under the overlapping L60 agreement. Wamsutter persuaded the court that the agreements dealt with different receipt points, which is supported by the interplay between the two gathering agreements as well as their structure.

Ultimately, the court declined Southland's request to force Wamsutter to accept gas through the L60 notwithstanding the L63 rejection.

Concluding Thoughts

The dissimilarities in state substantive touch-and-concern law and in the factual circumstances attendant to the cases do not seem to be driving the disparate outcomes of these midstream agreement decisions.

The courts seem not to have landed on a common analytical threshold for determining what constitutes a real property interest; some applying very rigorous standards and scrutiny and placing very little value on the contemporaneous intent of the contracting parties and others using less rigorous standards and scrutiny and placing a much higher value on contemporaneous intent.

Because the factual circumstances of these cases arise out of a common set of industry dynamics, they are all very similar and their relatively minor factual differences do not appear to be outcome-determinative. Indeed, one is left with the impression that these bankruptcy courts might reach different outcomes applying the same state's touch-and-concern law to an identical set of facts.

Until some of these midstream agreement cases advance to federal circuit or the U.S. Supreme Court, there is going to be continuing uncertainty about whether midstream agreements create real property interests and how parties may structure them to assure themselves of a more certain outcome under Section 365 analysis.

One additional practical consideration comes into focus from Southland.

Although a single decision certainly does not create a trend, Judge Owens' refusal to allow the producer to remove the economically desirable aspects of a rejected midstream agreement and then to push them into another midstream agreement with the same counterparty that the debtor had determined not to reject means that in making rejection determinations, the producer needs to do an all-or-nothing analysis because the courts simply may not go for a "have your cake and eat it too" approach.

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Omar J. Alaniz and Gary C. Johnson are partners, and Ramy A. Morad is an associate, at Reed Smith LLP.

Reed Smith partners Michael Cooley and Keith Aurzada contributed to this article.

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] Alta Mesa Holdings, LP v. Kingfisher Midstream, LLC (In re Alta Mesa Res., Inc.), 613 B.R. 90 (Bankr. S.D. Tex. 2019); Monarch Midstream, LLC v. Badlands Prod. Co. (In re Badlands Energy, Inc.), 608 B.R. 854 (Bankr. D. Colo. 2019).

[2] See, Extraction Oil & Gas, Inc. v. Elevation Midstream, LLC  (In re Extraction Oil & Gas, Inc.), 2020 Bankr. LEXIS 2855, Adv. Proc. No. 20-50839 (Bankr. D. Del. Oct. 14, 2020);Extraction Oil & Gas, Inc. v. Platte River Midstream, LLC (In re Extraction Oil & Gas, Inc.), 2020 Bankr. LEXIS 2853, Adv. Pro. No. 20-50833 (Bankr. D. Del. Oct. 14, 2020); Extraction Oil & Gas, Inc. v. Grand Mesa Pipeline, LLC  (In re Extraction Oil & Gas, Inc.), 2020 Bankr. LEXIS 2854, Adv. Pro. No. 20-50816 (Bankr. D. Del. Oct. 14, 2020).

While Chief Judge Sontchi issued three separate Findings of Fact and Conclusions of Law, the facts and conclusions across all three rulings are substantially similar. However, because the ruling in Extraction Oil & Gas, Inc. v. Elevation Midstream, LLC contains the Court's most in-depth discussion of the issues presented in these proceedings, the discussion contained herein is in reference to that specific ruling.

[3] Sabine Oil & Gas Corp. v. HPIP Gonzales Holdings, LLC (In re Sabine Oil & Gas Corp.), 550 B.R. 59 (Bankr. S.D.N.Y. 2016).

[4] Extraction Oil & Gas, Inc. v. Elevation Midstream, LLC, 2020 Bankr. LEXIS 2855 *43 (Bankr. D. Del. Oct. 14, 2020).

[5] Only the covenants pertaining to dedication and delivery were expressly stated to run with the land. Id. at *46.

[6] Id. at *63 (internal citations omitted).

[7] Id. at *70.

[8] Id. at *69-70.

[9] The "dedication covenant" refers to Extraction's dedication and commitment of its mineral interests to the performance of gathering services provided by Elevation.

[10] Id. at *73.

[11] Id. at *75 (comparing In re Sabine Oil & Gas Corp., 550 B.R. 59, 81 (S.D.N.Y. 2016), aff'd, 567 B.R. 869 (S.D.N.Y. 2017), aff'd, 734 Fed. Appx. 64 (2d Cir. 2018).

[12] Id. at *81. The "delivery covenant" required Extraction to deliver 100% of the minerals produced from its "Dedicated Interests" to the midstream service provider at specific "Delivery Points."

[13] In re Sabine Oil & Gas Corp., 550 B.R. at 81 (S.D.N.Y. 2016).

[14] Extraction Oil & Gas, Inc., 2020 Bankr. LEXIS 2855 at *53-54.

[15] Id.at *56.

[16] See, Alta Mesa Holdings, LP, 613 B.R. at 103 (internal citations omitted).

[17] See, Monarch Midstream, LLC, 608 B.R. at 869.

[18] See, Alta Mesa Holdings, LP, 613 B.R. 90 at 104 (internal citations omitted).

[19] See, Extraction Oil & Gas, Inc., 2020 Bankr. LEXIS 2855 at *86.

[20] See, Alta Mesa Holdings, LP, 613 B.R. 90 at 104.

[21] In re Chesapeake Energy Corporation , No. 20-33233, 2020 Bankr. LEXIS 3022 (Bankr. S.D. Tex. 2020).

[22] Id. at *24.

[23] Id. at n. 5.

[24] Southland Royalty Co. LLC v. Wamsutter LLC (In re Southland Royalty Co. LLC), No. 20-50551, 2020 Bankr. LEXIS 3185 (Bankr. D. Del. 2020).

[25] Id. at *25.

[26] Id., at *33.

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