Last week, a news article spiked fear that Chesapeake Energy (NYSE: CHK) was set to file for bankruptcy. While any imminent bankruptcy plans were immediately denied by the company, the midstream sector experienced an extreme sell-off in the wake of this fear. It appears this high profile bankruptcy candidate renewed investor anxiety over the fate of midstream assets if producer bankruptcies begin to multiply. In this discussion, we provide some general guidelines of what investors can expect when producer customers go through bankruptcy.
As a preface, consider that the primary goal of bankruptcy is to preserve as much value as possible for the lenders. So, during bankruptcy, in the vast majority of cases, the oil and natural gas stream will continue to flow from wellheads, “critical vendors” and service providers will continue to provide services and drilling and development operations will often continue. The lenders—the new owners of these assets—are best served by keeping the assets in good operating health.
Importantly, every bankruptcy situation is unique and is specific to its own set of circumstances. How midstream contracts are ultimately treated through a bankruptcy process will vary by each individual case and this discussion is meant to provide our understanding of the range of outcomes that generally result.
Keep, Reject or Renegotiate
Often, midstream fee levels or commitments will not face any challenge during bankruptcy, particularly for producing assets. However, during the bankruptcy process a producer customer has the ability to request that certain contracts with service providers and other third parties, midstream or otherwise, be rejected. If granted by the courts, the producer customer then has the ability to pursue alternative arrangements with other parties. Though, unless those midstream agreements are significantly different than what the producer believes to be the current market for such services, there is little to gain from challenging those contracts.
Therefore, midstream contracts most at risk for rejection by bankruptcy courts are those where the producer customer is paying above-market rates or is perhaps subject to some other onerous term, such as underwater minimum revenue or volume commitments (MVC). Conversely, contracts with the best chance for survival are generally those that both (i) charge service fees in-line with market rates and (ii) are deemed “critical vendors” (if not in the legal sense, at least “critical” to the producer in getting its oil and natural gas stream from the wellhead to market).
MVCs are a common feature found in midstream contracts, and we estimate that the majority of midstream customers have throughput levels that exceed their MVCs. However, there are some instances where producers are underwater on certain MVC contracts tied to specific basins. In general, if actual production is well below the MVC levels, then those MVCs have a greater chance of being altered in bankruptcy. In cases where the MVC commitment is rejected in bankruptcy, then the midstream company would be able to file a damage claim that would sit alongside other creditors to eventually seek a recovery.
Also, a producer and its midstream provider may voluntarily renegotiate agreements before or after a bankruptcy proceeding has been initiated. In fact, there have been instances of voluntary renegotiations over the past couple months, which have generally provided a neutral outcome to the midstream provider but which allowed the producer greater flexibility through the transition of commitments from one system to another.
Midstream Value Chain Position
An important factor in how midstream services and contracts are treated during a producer bankruptcy process is where along the midstream logistics chain the assets sit. Generally, the closer the assets are to the wellhead, the stickier the contract attached to those assets.
For example, gathering pipelines are tied into a wellhead and volumes from these wells are essentially captive. Building out a new competing system would likely be financially and operationally prohibitive. As such, contracts for assets close to the wellhead would generally have the greatest chance to be considered critical vendors and ultimately be upheld by the courts.
Farther away from the wellhead, options for long-haul transport or processing can sometime increase as connectivity to competing midstream assets may exist. As such, if the incumbent midstream commitments are above prevailing market rates, or represent underwater volume commitments, then those contracts are at greater risk for rejection in bankruptcy courts. Again, a rejected contract does not preclude the midstream provider and producer customer from executing a new agreement but, post rejection, the new agreement would likely result in cost and throughput concessions.
Notably, long-haul, or interstate, natural gas pipeline assets are FERC (Federal Energy Regulatory Commission) regulated and may have regulatory means to provide a reasonable opportunity to recover costs and earn a profit. In addition, interstate crude oil and refined product pipelines also often benefit from features (i.e., cost-of-service contracts, tariff escalators, etc.) that help insulate them from producer revenue and/or volume volatility, whether by bankruptcy or otherwise.
OFI SteelPath Approach
Contractual agreements, counterparty credit risk, and customer concentration are important considerations in our investment approach. Though company disclosure and details on these items are often limited, we do attempt to identify where bankruptcy risks exist and attempt to quantify potential impacts under distressed scenarios. Regardless, we note that producer bankruptcy headline risks can dominate sentiment and stock price performance in the short-term while the bankruptcy process slowly proceeds in the real world, with any conclusive rulings or negotiated agreements potentially not finalized and disclosed for months or quarters.
Generally, we feel only a few names carry significant risk in this regard. For the few that we believe may, we have attempted to account for this potential risk in a sober and realistic fashion and believe our portfolios are positioned accordingly. Though, regardless of the ultimate outcome of any contract challenge in bankruptcy, credit ratings pressure-related customer bankruptcy risk may also force management teams to take action that could impact unit pricing.
Notably, we believe rating agency actions of late have appeared overly reactionary and currently consider credit rating agency fickleness as likely a greater risk than any potential outcome from a bankruptcy challenge to midstream operator contracts.
The Big Picture
In thinking about the potential impact of producer bankruptcies on the midstream industry, it is also important to take a step back and consider the broader oil and gas picture. The U.S. is home to some of the most prolific oil and natural gas resources in the world. As the current global crude oil supply and demand imbalance is corrected, oil prices will have to improve enough to encourage supply growth once again as global demand is expected to continue to steadily increase. The U.S. shale basins stand amongst the best positioned to meet this demand growth as the U.S. shale resource is low risk, able to respond quickly, and, after significant efficiency and cost improvements, is amongst the most economic basins on the globe.
Therefore, despite what may happen above ground – bankruptcies, mergers, acquisitions, asset sales – such actions only impact ownership of the resource and do not impact the quality of the resource or the ultimate production of that resource. We believe that the market disruptions of today will prove transitory but that over the longer term North American midstream assets will benefit materially from U.S. shale development.
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Investing in MLPs involves additional risks as compared to the risks of investing in common stock, including risks related to cash flow, dilution and voting rights. Energy infrastructure companies are subject to risks specific to the industry such as fluctuations in commodity prices, reduced volumes of natural gas or other energy commodities, environmental hazards, changes in the macroeconomic or the regulatory environment or extreme weather. MLPs may trade less frequently than larger companies due to their smaller capitalizations which may result in erratic price movement or difficulty in buying or selling.
These views represent the opinions of OppenheimerFunds and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.