Jan. 10, 2020
2020 is shaping up to be a year of “capital discipline” for the exploration and production companies in the gas sector, and especially in the Marcellus/Utica basins. One of the larger producers in the region, Southwestern Energy, indicated that its capital investment will be limited to cash flow, based on strip pricing at the time it sets the plan. In response to questions about that methodology, the CEO made it clear that if the price of the commodities reaches a point where the company cannot meet this rigorous economic threshold, it will then stop all capital developments. Similarly, Chesapeake Energy indicated that because it would not be investing significant capital in 2020, its gas production would decline, even though it anticipates holding its production in the Marcellus level compared to 2019.
Today, we look at the risks to gathering companies and interstate pipelines associated with three conditions: production cuts, expiring contracts and bankruptcy. Notably, the Marcellus region began production just about a decade ago and so it has the potential to experience all three risks if low gas prices and lack of takeaway capacity continue. As discussed below, the risks differ depending on the tenor of the contracts, the type of commitment made, the credit assurance granted by the producer and whether the producer has a “most favored nations” clause. That’s a lot to consider. This will be the first of several Insights on this topic, with future Insights diving into the data to dissect the potential impact that could be caused by particular producer reductions.
The Amount of Capacity at Stake
In the chart below, we set forth the total interstate pipeline capacity held by six of the larger producers in the Marcellus/Utica region -- Antero Resources, Chesapeake Energy, Cabot Oil and Gas, Southwestern Energy, EQT and Range Resources.
The first thing to note is just the overall total of the capacity. While not all of that capacity is dedicated to the Marcellus/Utica region, the vast majority of it is. So, the pipelines that are in that region have a substantial exposure to these six producers. The next thing to note is that over the next five years, approximately 33% of the contracts will reach the end of their initial term which, if not renewed, would reduce the contracted capacity from just over 23 Bcf/day to just under 16 Bcf/day. If production stays flat or slows substantially, the contracts for this capacity may not be renewed. The first big risk to understand when assessing a pipeline or gathering company’s exposure is the tenor of the contracts that the pipeline or gathering company has with exploration and production companies.
Risks to Gathering Companies
Gathering companies install pipelines to each gas well and gather the production from a wide area to a single point where it can be processed and then delivered into the interstate pipeline system. These companies are not regulated by FERC and many are not economically regulated at the state level either. This means that there is limited transparency into the contracts that they have with the production companies, and it also means that the contracts are more open to market conditions because there is no obligation to treat customers equally. Gathering companies have at least three ways to protect themselves from adverse business decisions by the producers: acreage dedications, volume commitments and credit assurances. We discuss each of these separately because they have different risks associated with them.
First, gathering companies may demand an acreage dedication, which essentially means that the producer is obligated to use the gathering company’s system for all gas produced in a defined area, but there is no minimum commitment. Prior to 2015, many gathering companies used acreage dedications as their primary commitment from the producer. The perceived benefit of acreage dedications was that the commitment would follow any sale of the gas leases to a new purchaser and would survive any bankruptcy filing by the production company.
That perception changed beginning in 2015, when the U.S. Bankruptcy Court for the Southern District of New York determined that an acreage dedication, at least under Texas law, was not a property interest and therefore could be voided by a bankrupt producer. This case, which concerned the Sabine Oil & Gas Corporation, was appealed to the Second Circuit which affirmed the lower courts’ rulings in mid-2018.
While a Second Circuit decision is only binding in the states covered by that circuit, namely Connecticut, New York and Vermont, its decisions have much more impact with respect to bankruptcy cases. Over the last decade more than 80% of all business bankruptcies were filed in either New York or Delaware. That is because the debtor, which in cases involving acreage dedications would be the producer, has substantial discretion as to where to file for bankruptcy. This means that even though the acreage dedication agreement may be governed by Texas law, as it was in Sabine, or Pennsylvania law as it may be for Marcellus gathering companies, the producer may choose to file in New York. Consequently, it would be the New York Bankruptcy Court, the New York District Court and the Second Circuit on appeal, that would determine the effectiveness of the acreage dedication.
This creates two risks for acreage dedications. First, because there is no minimum commitment if a producer reduces its drilling program, its production would fall and so would the gathering company’s revenue. Second, if the producer ultimately files for bankruptcy, at least in New York, or elsewhere in the Second Circuit, it is likely that the acreage dedication itself could be voided, which could lead to a complete loss of revenue or, more likely, substantially reduced revenue after renegotiation of the contract.
In place of or in addition to the acreage dedication, gathering companies can demand from the producer a minimum volume commitment. Such a commitment is better than the acreage dedication in that, outside of bankruptcy, such a commitment would not be impacted by a reduction in the actual production of gas. The bankruptcy risk for a volume commitment in bankruptcy, however, is greater than for an acreage dedication, because there is almost no possibility of arguing that such a volume commitment is a property interest in a particular parcel of land and so such a commitment can almost certainly be voided if the producer files for bankruptcy.
In addition to either of the above commitments, a gathering company may have secured some form of credit assurance, either in the form of a letter of credit or a cash deposit. The major benefit of such assurance is that following a bankruptcy by the producer, the gathering company should be able to access the funds to compensate it for any loss arising from the failure of the producer to comply with the commitments made. However, it is unlikely that such assurance could be accessed to compensate a gathering company for the loss sustained under an acreage dedication arising from a reduction in output because there has been no breach of the commitment.
Interstate Pipeline Risks
We recently discussed the bankruptcy risks applicable to interstate pipelines in Chesapeake Energy Stock Tumbles - - Assessing Bankruptcy Risk for Pipelines , and the risks are very similar to the gathering company risks described above, but for the fact that the interstate pipelines do not use the acreage dedication concept. Also, the use of a firm transportation contract is essentially the same as a volume commitment because the shipper must pay the reservation fee whether it uses the capacity or not.
In our prior discussion, however, we did not discuss two other risks to the interstate pipeline, one of which may also apply to a gathering company.
First, some interstate pipelines enter into negotiated rate firm transportation agreements that have a very small reservation rate and put almost all of the revenue in the commodity rate. Under the typical cost-based tariff, almost all of the costs are recovered in the reservation rate and just variable costs are recovered in the commodity rate. So, a typical ratio is like that found in Columbia Gas Transmission’s tariff, where the reservation charge is approximately $0.19/dth/day and the commodity charge is approximately $0.01/dth of actual usage. If the pipeline deviates substantially from the typical ratio in its tariff and puts more emphasis on the commodity charge, it can be exposed to a greater risk of a revenue reduction arising from the producer simply reducing its production.
One other provision that can be found in both pipeline and gathering contracts is a most favored nations clause. Such clauses typically protect a shipper from being charged a higher rate than other similarly situated shippers. If a producer files for bankruptcy and the pipeline or gathering company has other shippers who have most favored nations clauses, the pipeline or gathering company may feel constrained by those most favored nations clauses from offering a reduced rate to the bankrupt producer because such a reduced rate could trigger the most favored nations clauses in other shipper contracts. This may leave a pipeline or gathering company with the difficult choice of simply taking back the capacity from the bankrupt producer or exposing itself to reduced revenue from other contracts. Such most favored nations clauses could lead to the impact from a bankruptcy of a producer being greater than would otherwise be expected if there were no such clauses.
We will be providing an example of these ripple effects in a future Insights , but in the meantime, if there is a particular pipeline or producer that you would like us to assess for you, please let us know.