30 Oct A Primer on Gathering and Processing Agreements and Their Impact on Asset Value
This article originally published in North Houston Association of Professional Landmen’s Spring Newsletter
As oil is transported and processed through its value chain into its component products, it can be stored, trucked, railx`ed, or piped from one location to the next. Natural gas, on the other hand, can only be stored in huge underground salt domes that only exist in certain parts of the country. Consequentially, gas transportation requires a near-direct pathway from the producing wellhead to the end-user. It passes through hundreds of miles of gathering lines, treaters, dehydrators, compressors, processing plants, and fractionators. This infrastructure costs billions of dollars and disruption along any part of this system can severely impact profitability by curtailing production, shutting in both oil and gas from affected wells.
To manage this process, production companies negotiate complex gathering and processing agreements with midstream service providers. The contract itself is often the only tool that a producer has for asserting control over the value chain once production leaves their custody. Failure to properly understand these contracts can lead to higher than expected cost through unidentified fees, poor economic performance through reduced profit margins, or increased downtime.
This article will introduce dedication, which is one of the primary components of these agreements and also raises awareness of related key legal and commercial issues. It will also discuss how dedication relates to a land manager’s role in negotiating the purchase and sale of leases and gas production.
Dedication and Gas Production
Midstream companies invest substantial capital to construct the infrastructure needed to gather and process the producer’s gas. They recoup this cost and generate profit through guaranteed fees tied to the production itself for the life of the contract. This guarantee is called dedication and can be tied to certain wells, acreage, or production volume. An example of a dedication clause in a contract follows:
- Subject to the terms and conditions of this Contract and except as otherwise provided in this Contract, Producer hereby commits and dedicates exclusively to Processor all of the Committed Gas attributable to the Contractually Dedicated Area Interests for the term of this Contract for the purposes provided in this Contract. The commitment and dedication shall be deemed a covenant running with the Dedicated Area and shall be binding on the successors and assigns of Producer.
With a few notable exceptions (see In re Sabine Oil & Gas Corp., Bankr. S.D.N.Y. March 8, 2016), this language works with assignment language elsewhere in the agreement to ensure that any transfer of ownership of the dedicated well or acreage takes with it the terms of the agreement.
Most importantly, for the producer, this means that any purchase of a dedicated asset comes with (whether good or bad) the commercial rates, the terms of services, and the mechanical efficiency and reliability of the system. To understand how this may affect the performance of an asset, consider the following examples:
- To protect themselves from having to operate an unprofitable asset and filing for bankruptcy, midstream companies frequently use vague or overly broad “uneconomic” clauses to force a renegotiation of an offtake agreements’ commercial terms. The recent downturn forced these companies to enforce this language, drastically cutting into producer revenues. For example, in Bowers Oil & Gas, Inc. v. DCP Douglas, LLC (2012 WY 104), the court verified that DCP justifiably terminated a gathering and processing agreement. The court’s decision was based on the following provision that allowed either party to terminate if, in the terminating party’s sole opinion, the sale or purchase of the gas became unprofitable or uneconomical:
- “In the event the gas delivered hereunder at any point or points becomes insufficient in volume, quality, pressure or for any reason becomes, in the sole opinion of Buyer or Seller, unprofitable or uneconomical for Buyer to purchase or for Seller to sell, then Buyer or Seller shall have the right to terminate this Contract upon thirty (30) days written notice to the other party as to any or as to all such points.”
- Two producers operate in neighboring sections in Oklahoma and each section is dedicated to a different midstream service provider. One producer force pools the other, drills a well on their portion of the pooled acreage, and connects the well to their gatherer. Unless the contract is properly drafted, the second producer may be required to split connect the well to connect to their midstream provider or risk violating their agreement.
- My last example is not one for faint of heart and one that I hope no-one runs into after reading this article. Consider a situation where the sale of an asset comes with dozens of agreements, disclosed in the form of several dusty boxes (or more recently, hundreds of pages of illegible photocopies). Many of these are expired, however, one is a simple volumetric production payment, easily overlooked. This agreement promises to deliver 50% of the production from the wells in exchange for an upfront payment that was already paid to the predecessor. The result is an asset burdened with the equivalent of a 50% override, something that no amount of reservoir due diligence can overcome.
In summary, it is in the producer’s best interest to ensure that these agreements are fully reviewed and that all the future impact of the terms and conditions are identified. On a well by well basis, this is equally important on a small acquisition as a large one.
Dan Kennedy has spent the last 8 years negotiating oil and gas agreements, including 5 years focusing on midstream agreements at ConocoPhillips Company. He now works as an Oil & Gas, Corporate, and Intellectual Property Attorney at Kearney, McWilliams & Davis, PLLC. Call today!