News & Insights

Energy Law Exchange

February 13, 2020

Moving Towards Alignment in Midstream Contracts (Part One)


In late 2017,[1] midstream services providers (each, a “Midstream Provider”) began in earnest to offer forms of additional upside compensation to oil and gas lessees/operators (each, an “Upstream Shipper”) in exchange for entering into long-term, dedicated-acreage services agreements (“Midstream Contract” or an “MSC”).[2]  The concept of additional upside awards began with and was developed under traditional gathering and processing agreements (“GPAs”), but it has since been applied to a range of Midstream Contract types, including NGL takeaway arrangements and produced-water disposal arrangements. It is now being tested again in negotiations over the “next wave” of new / revitalized types of oilfield service agreements—i.e., in power purchase, wet gas generation, and electrification arrangements and with physical waste disposal contracts. 

These quickly mutating forms have grabbed most of the headlines since they first took hold three years ago.  However, an equally significant (and maybe more important on a long-term basis) shift in midstream contracting has been simultaneously occurring during this period alongside the development of additional upside compensation models in the laboratory-like conditions that continue to prevail in high-risk / high-reward basins like northern Delaware that seems to have been mostly overlooked or ignored: the continuing and rapid evolution of traditional concepts contained in the gathering and processing agreement form.  Major, historic “base” structures that have held reasonably consistent for decades, including through the first few years of the shale revolution, have been revisited and, in many cases, significantly altered under new commercial regimes—prioritizing cash-flow optimization and price floor profitability.  This article will discuss the change generally and study one of the early structural changes in Midstream Contracts that seems to have emerged from this process; later articles will examine other, similar changes.

A. Right-Way Alignment Model

The primary goals of many upstream companies have shifted in recent years away from obtaining a core acreage position in an active shale basin and drilling one to two wells to prove up the rock in favor of the more fulsome commercial development of their acreage as a whole project, in order to create a business that will generate positive cash flow from existing and new production above a certain floor commodity price (“Price Floor”).  The process of proving cash flow down to a Price Floor does not necessarily require drilling up a significant portion of the acreage (although some additional wells are usually required); but it does typically require establishing a robust contractual infrastructure designed to provide / show two key aspects: (1) that the project has secured a long-term hydrocarbon takeaway route that is likely to achieve an agreed and predictable price (typically an index price, subject to a set differential), and (2) that the project has secured all midstream services necessary to produce and market hydrocarbons on a long-term basis for an agreed and predictable fee, preferably one that is designed to fluctuate with revenue (e.g., throughput-based fees; or even, in certain cases, adjustable pricing).

The unifying principle that seemed to have emerged in negotiations over long-term midstream agreements as operators seek to implement these cash-flow optimization principles is the need for counterparties to imaginatively and cooperatively restructure the traditional forms into a contract that is fair and balanced over its entire term.  Under this new “right-way alignment model” the parties negotiate the contract with the recognition that commodity price fluctuations will occur and seek to eliminate provisions that create one-way risk and/or encourage zero sum outcomes in favor of structures that incentivize cooperation and growth.  The Midstream Contract is designed with intention to create a partnership that: (1) encourages development while protecting the positive cash flow of the Upstream Shipper and (2) fairly allocates long-term upside in a success case while protecting the rate of return of the Midstream Provider, in each case down to a (modeled or express) Price Floor.  For the Upstream Shipper, development in this case means continuing to maintain and increase production and throughput for the entire term; while for the Midstream Provider, it means maintaining its systems and continuing to work to lower costs and increase efficiencies through upgrades / innovations after initial construction is complete, until the end of the term.  By encouraging throughput and revenue generation, the size of the entire pie that is available to the parties for allocation is increased; and by fairly allocating to each party its share of the pie, the parties are more likely to perform under the contract throughout its entire term and to the end and thereby avoid costly renegotiations and/or Sabine-type existential threats. 

Section B below discusses one of the specific structural changes the Midstream Contracts that we have seen emerge from this move towards right-way alignment in midstream contracting.

B. Reallocation of System Ownership (Transfer at High Pressure CDP)

Counterparties under gathering and processing agreements have begun to reassess the historical allocation of control over the low pressure gathering system connecting upstream operator’s individual wells (or well pads) in the field (“LP System”).  Under the traditional GPA, the Midstream Provider would be responsible for the build out of the LP System and would own and control the LP System for the term of the GPA and then after termination.  This arrangement was typically framed by Midstream Provider as a service that it provided at or just below cost for the convenience of the drilling-focused Upstream Shipper. 

In practice however, numerous drags against long-term parity under the GPA would emerge again and again under this framework—the most pervasive being the damage it does to the viability of the Upstream Shipper’s release rights as a remedy.  In most dedication-based GPAs (especially those without a minimum volume commitment or other type of demand payment obligation), the Upstream Shipper’s main remedy for Midstream Provider’s non-performance is the right for Upstream Shipper to obtain a temporary or permanent release of its hydrocarbon from the dedication, with the intent being that Upstream Shipper would deliver the hydrocarbons to an alternative Midstream Provider.  However, in the case where Upstream Shipper does not own, or otherwise does not have rights to control, the LP System in its own field, these release rights can be (and usually are) illusory in practice as the current Midstream Provider is not obligated and/or commercially incentivized to permit third party interconnections to an LP System that it owns / controls, and an alternative Midstream Provider is unlikely to build a duplicate LP System to service temporary releases. 

Under a structure where the Upstream Shipper does own its LP System, it is more likely to have the ability to establish economic, standby interconnections with one or more alternative Midstream Providers, which it can then use to flow gas under temporary release rights if and when it gets curtailed under its primary GPA.  Ownership of its own LP System also provides an Upstream Shipper with leverage-parity in negotiations with its current Midstream Provider in situations where performance has deteriorated to the point that it is entitled to a permanent release under the GPA, by creating a more level playing field, where potential alternative Midstream Providers do not have to factor the time and cost of rebuilding the existing LP System into bids to replace the current Midstream Provider / GPA.  Where this parity does not exist, the current Midstream Provider has significant leverage to require Upstream Shipper to continue to accept poor performance / non-economic terms rather than exercise the remedy that it bargained for under the GPA.  Other problems with the traditional ownership allocation structure include: (1) a tendency to create windfall profits in favor of Midstream Provider during the later part of the primary term / extension periods of the GPA when a relatively high “gathering fee” designed to permit Midstream Shipper to recoup its capital outlay to build the LP System plus earn an IRR target continues to be charged long after the Midstream Shipper has recouped and earned these amounts and (2) a tendency towards lack of incentives for either party to maintain and/or upgrade the LP System where Midstream Provider is incentivized to allocate new capital towards new customer build-outs and expansion projects to its high pressure / processing system and Upstream Shipper is reluctant to spend money to improve a third party asset.

The set of potential solutions to issues arising from the traditional LP System ownership structure are set out in items 1-5 below. 

  1. System Ownership. Reallocation of system ownership / control under the GPA, so that  Upstream Shipper (not Midstream Provider) owns and controls the LP System in its own field.  The Upstream Shipper agrees to assume the primary cost responsibility for constructing and maintaining the system; while Midstream Provider agrees to construct, own, and operate the high-pressure processing system downstream (“HP System”), consisting of one or more initial central delivery points (each, a “CDP”) that will provide hub-type interconnections with the LP System at location(s) at or nearby Upstream Shipper’s acreage within the dedication area, along with any necessary compression, treating, high-pressure gathering and transport and/or processing facilities that may be required to provide the applicable services under the GPA.  The Midstream Provider assumes responsibility for establishing (constructing) and maintaining the actual interconnection facilities between the LP System and the HP System at each CDP and for providing any contract services that may be necessary at such location.  Under a gas services Midstream Contract these services will typically include metering and testing, and the compression required to move Upstream Shipper’s gas onto the HP System; while under an oil services Midstream Contract they are likely to include metering and testing services, and may also include storage and/or some form of stabilization services.  
  2. Construction of LP System. Upstream Shipper is required to build out the LP System to keep pace with its development.  Upstream Shipper may build the LP System itself (or have a third party contractor build it); but Upstream Shipper also retains an option to elect to require Midstream Provider to perform the actual construction of (and/or obtain the materials, secure the right of way for, etc.) one or more discrete segments of the LP System, as an additional service under the contract.  Where Midstream Provider does construct a segment of the LP System in accordance with this option, Upstream Shipper agrees to pay Midstream Provider an amount equivalent to the Midstream Provider’s total costs associated with the work under an agreed AFE (actual third party costs, together with agreed overhead), plus, as negotiated, an additional incentive amount.  In most cases where an additional incentive amount is agreed, it will be calculated as a flat percentage of, or an amount necessary generate a particular internal rate of return on, the agreed total cost reimbursement amount for the applicable segment construction, but it may also be a pre-agreed charge pegged to some relevant aspect of the project, such as an adjustable dollar amount pegged to the length of new gathering lines that need to be constructed.  In any case, in order to incentivize timely completion of any applicable new segment project constructed by Midstream Provider, the additional incentive amount that may be earned by Midstream Provider for the project is made subject to an adjustable downward reduction that is triggered if the Midstream Provider fails to complete construction of the project by certain pre-set target dates pegged to the original Upstream Shipper construction notice, with the amount of the downward adjustment increasing the longer after the original target completion deadline that the project is completed.  Upstream Shipper also retains step-in rights for each new segment project conducted by Midstream Provider, pursuant to which Upstream Shipper can elect to take over the project at cost where Midstream Provider fails to complete the project by a certain outside date (also pegged to the original shipper construction notice), and/or fails to meet certain project milestones, like obtaining ROW, etc. by certain outside project dates, so that Upstream Shipper does not have to wait until the outside completion deadline is missed for a project that is clearly behind schedule. 
  3. Cost Reimbursement. In the case where Upstream Shipper elects to require Midstream Provider to construct a segment of the LP System on its behalf, Upstream Shipper may also negotiate and obtain the option to elect the method pursuant to which it reimburses and pays to Midstream Provider the costs associated with the project and the applicable additional incentive amount.  The default option will typically be for Upstream Shipper to fund reimbursement of costs on an as-incurred (immediate) basis (for example, a setup where operating expenses, everyday costs and administrative overhead are reimbursed monthly in arrears; while major third party capital expenditures may be prepaid one month in advance and/or by Upstream Shipper directly to the supplier), with the additional incentive amount paid in the invoice delivered upon completion.  However, Upstream Shipper may be able to achieve material benefits by retaining the option to amortize the total amount owed, as applicable, through an incremental increase to the gathering fee for throughput at the corresponding CDP that remains in effect over a certain period (of months or years) until the amount is paid in full.  This second type of payment structure may be easier for Upstream Shipper to finance and/or it may provide royalty and accounting benefits, where permissible.  In exchange for agreeing to provide Upstream Shipper with this type of cost-reimbursement amortization option, a Midstream Provider will usually require the ability to require reimbursement / credit protections under the Midstream Contract, in the event that this option is exercised.  One relatively straightforward structure that provides this protection is setting an outside date by which, if Midstream Provider has not been reimbursed in full through revenue from the incremental increase to the gathering fee for the entire amount owed to it for an LP System construction project (i.e., reimbursable costs plus additional incentive amount), the Upstream Shipper must pay the difference in a lump sum fee due under the next month’s invoice; then, at or prior to start of the applicable construction project, if Upstream Shipper cannot show that it is a creditworthy counterparty, Midstream Provider may require that Upstream Shipper provide a guarantee of such lump sum payment obligation from a creditworthy affiliate or otherwise provide alternate credit support of the obligation.  An ancillary benefit of the credit support provided by an Upstream Shipper in this case (i.e., in support of the ultimate reimbursement of costs for a project) is to provide support in the event that Midstream Provider intends to seek financing to build the project. 
  4. Downside – Loss of Revenue. The clear downside of reallocating ownership of the LP Gathering System to the Upstream Shipper is the elimination of (or significant reduction to) the “gathering services” provided by Midstream Provider, and the revenue associated with such services, including the potential for material profits from gathering fees during the back-half of the contract, as discussed above, and “hidden” revenue from fixed / system-allocated FL&U rates.  In large part, eliminating these types of revenues is the intent behind the change under the right-way allocation model, in cases where parties have determined that gathering services under a Midstream Provider- owned LP System model would be likely to misalign the parties over time and impair overall value, for the reasons discussed in the lead paragraphs to this section.  This loss of revenue can also be mitigated to an extent through adjustments made by the parties to opportunities for Midstream Provider to earn additional incentive amounts for constructing the LP System on behalf of the upstream operator, including by requiring that Upstream Provider first offer the opportunity to build the LP System to the Midstream Provider or by otherwise adjusting the methodology by which additional incentive amounts are calculated.  
  5. Downside – Post-Sabine Risk. This author does not personally subscribe to most of the post-Sabine list of terrors around the risk of Midstream Contracts being rejected in bankruptcy; but it would be unreasonable to deny that the risk of losing a valuable contract has increased following the decision.  So it should be noted that moving the custody-transfer / system-ownership boundary from the wellhead to a CDP under the allocation system proposed here could be interpreted as increasing Sabine-type downside risk, by: (1) potentially making it less likely that a court would rule that the contract “touches and concerns” the subject lands, by moving the Midstream Provider footprint further away from the Upstream Shipper’s real property (i.e., the Midstream Provider will not own and control an LP System built on ROW obtained from lease rights under Upstream Shipper’s oil and gas leases, and the HP System that is owned by Midstream Provider may not actually [literally] touch those lands at all); while simultaneously (2) removing an important piece (some may say the most important piece) of leverage held by the Midstream Provider in the renegotiation of a Midstream Contract that is under threat of a Sabine-type rejection in bankruptcy, where the Upstream Shipper’s ability to find an alternative Midstream Provider at a reasonable / competitive cost is no longer limited by the original Midstream Provider continuing to own the LP System that is installed and in place.  Of course, removing leverage that causes market distortion / prevents the efficient remarketing of throughput when an Upstream Shipper is entitled to do so under bargained for temporary or permanent release is one of the main reasons behind the new allocation structure proposed here, so Item 2 probably needs to go.  However, certain Sabine-fixes may still be effective, esp. the more real types – see discussion in our next article on this topic, which will follow next month. 

 

[1] Bur early examples during the current cycle can be found as far back as 2014. 

[2]  Including cash payments, cash performance bonuses, preferred equity and synthetic equity upside.  See “The New Midstream Transactions”, by Peter Hays, published in the July 2018 K&S Energy Newsletter; republished in The Energy Law Advisor; Midstream Business (December 1, 2018).

Related
Energy