Considerations and Consequences of a Bankruptcy Filing in the Oil and Gas Industry

A Chapter 11 bankruptcy filing of an oil and gas company will likely have broad implications for a wide range of parties. Certain pervasive agreements in today’s oil and gas industry generate substantial, high-dollar controversies in an oil and gas company reorganization.

Because a debtor can assume or reject an unexpired lease or executory contract under §365(a) of the Bankruptcy Code, subject to a few exceptions and court approval, issues arise as to whether particular sorts of routine agreements in the oil and gas industry qualify as executory contracts as opposed to a vested property right. Once the executoriness of an agreement has been established, however, the decision to assume or reject an executory contract is left to the business judgment of the debtor. Mirant Corp. v. Potomac Electric Power Co. (In re Mirant Corp.), 378 F.3d 511, 524, n.5 (5th Cir. 2004). Counterparties to contracts with at-risk companies should plan ahead for what a debtor may do with their contract rights. In the oil and gas arena, contract type and governing law produce wildly different outcomes in a reorganization proceeding. We outline the bankruptcy implications for typical agreements in the oil and gas industry below.

Oil & Gas Leases

• Question of State Law: The question of whether an oil and gas lease constitutes an executory contract depends upon the treatment of the type of interest created under applicable state law, so the treatment of a particular oil and gas lease differs from state to state.
  • Texas: An oil and gas lease under Texas law is not an executory contract that a debtor may accept or reject in its bankruptcy proceeding. Bankruptcy courts examining Texas law have held that an oil and gas lease is not a contract, but instead is a conveyance of an ownership interest in real property. See Anadarko Petroleum Corp. v. Thompson, 94 S.W.3d 550, 554 (Tex. 2002).
  • Other States: The treatment of an oil and gas lease with respect to § 365 is not as well established in other jurisdictions.
    • Louisiana: Courts have not definitively decided whether an oil and gas lease is an executory contract subject to § 365. In Texaco Inc. v. Louisiana Land Exploration Co., 136 B.R. 658, 668 (M.D. La. 19992), the court held that the subject oil and gas lease was an executory contract upon the debtor's request to assume it, but in In re WRT Energy Corp., 202 B.R. 579, 583 (W.D. La. 1996), the bankruptcy court held the oil and gas mineral lease was not a lease or executory contract within the meaning of § 365.
    • North Dakota: The North Dakota bankruptcy court recently affirmed in Great Plains Royalty Corp. v. Earl Schwartz Co., No. 68-00039, 2015 Bankr. LEXIS 883, at * 52-54 (Bankr. N.D. March 18, 2015) that oil and gas leases are interests in real property in North Dakota, although it made no §365 determinations.
    • Ohio: Courts generally hold that an oil and gas lease is a license under Ohio law rather than a deed of conveyance, although there is contrary authority. Wellington Res. Group LLC v. Beck Energy Corp., 975 F. Supp. 2d 833, 838 (S.D. Ohio 2013) (holding that oil and gas leases are not "real estate" under Ohio law and instead create a license to enter upon the land for exploration and drilling for oil and gas lease).
    • Oklahoma: Similar to Texas law, under Oklahoma law, an oil and gas lease is a fee estate in real property. In re Heston Oil Co., 69 B.R. 34, 36 (N.D. Okla. 1986). Accordingly, § 365 does not apply to Oklahoma oil and gas leases. Id.
    • Pennsylvania: The Pennsylvania bankruptcy court in In re Powell, 482 B.R. 873, 878 (Bankr. M.D. Pa. 2012) held that no real property interest is conveyed in an oil and gas lease. The lessees objected to the debtor’s motion to reject, arguing that because the oil and gas lease was neither a lease nor an executory contract, it could not be rejected. Id. at 875. The Powell court observed that if production had occurred, such production would have vested the lessee with a fee simple determinable interest, and the executory nature of the lease would have terminated. Id. at 875-77. The Powell court did not outright decide whether § 365 applied because the oil and gas lease was executory, but instead held that even it if was, the debtor failed to demonstrate sufficient justification for rejection. Id. at 878.

Joint Operating Agreements

• Bankruptcy treatment: Courts hold that joint operating agreements are executory contracts subject to assumption or rejection by the debtor. In re Panaco, Inc.,No. 02-37811-H3-11, 2002 Bankr. LEXIS 2084 (Bankr. S.D. Tex. Dec. 10, 2002).
• Effect of Bankruptcy: Prior to assumption, an executory contract, including a JOA, is enforceable by the debtor and not against the debtor. In re El Paso Refinery L.P., 220 B.R. 37, 43 (Bankr. W.D. Tex. 1998). Thus, prior to assumption, the non-debtor party to the contract is obligated to perform its contractual obligations, although the debtor is not similarly obligated to perform. Id.
  • Timing for Assumption or Rejection: The Bankruptcy Code permits the Chapter 11 debtor-in-possession to assume or reject an executory contract at any time before confirmation of a plan of reorganization. See § 365(d)(2).
  • Compelling Debtor's Assumption or Rejection: Any counterparty to an executory contract or lease with the debtor, however, may request that the court order the debtor to decide whether to assume or reject within a specified period of time. See § 365(d)(4). In In re Panaco, Inc., the debtor was a non-operator of certain leases in the Gulf of Mexico. Panaco, Inc., 2002 Bankr. LEXIS 2084, at *2. The operator and another non-operating interest owner requested that the bankruptcy court compel the debtor to assume or reject the JOA, within a specific timeframe. Id. In granting the motion, the court remarked that the debtor was not current on its post-petition obligations under the JOA and had made no accrual for plugging and abandonment costs. Id. at *9-10. The court found that preventing further delay with respect to assumption or rejection was in the best interest of the estate, creditors, and prospective purchasers. Id.
• Rejection of JOA: If a debtor-operator rejects a JOA in its bankruptcy case, non-operators receive a general unsecured claim for damages under the JOA. See §§ 365(g)(1) & 502(g). Rejection of the JOA does not automatically terminate the JOA. Matter of Austin Development Company, 19 F.3d 1077 (5th Cir. 1994) (noting that rejection does not equate to termination).
• Assumption and Assignment of JOA: If a debtor wants to assume a JOA in its bankruptcy case, the debtor must cure any defaults under the JOA. See § 365(b)(1). In connection with a sale of the debtor's assets, the debtor may seek to assume and assign the JOA to a third-party purchaser. In such a circumstance, counterparties to the JOA can demand adequate assurance that the third-party purchaser has the ability to perform under the JOA prior to the court's approval of the sale transaction. See § 365(b)(1)(C).

Farmout Agreements

• Bankruptcy Code Definition: A farmout agreement means a written agreement in which the owner of a right to drill, produce, or operate liquid or gaseous hydrocarbons on property (farmor) agrees or has agreed to transfer or assign all or a part of such right to another entity; and such other entity (farmee), as consideration, agrees to perform drilling, reworking, recompleting, testing, or similar or related operations, to develop or produce liquid or gaseous hydrocarbons on the property. See 11 U.S.C. § 101(21A).
• Treatment in Bankruptcy: If the farmout agreement has not been fully performed by both parties, courts generally treat the farmout agreement as an executory contract that the debtor may assume or reject under § 365. In re Texaco, Inc.,79 B.R. 560, 563 (Bankr. S.D.N.Y. 1987).
• Exclusion from the Bankruptcy Estate: Section 541(b)(4) excludes the earned portion of farmout agreements from the definition of "property of the estate," as long as the interest is in liquid or gaseous hydrocarbons transferred or agreed to be transferred. See Tow v. HBK Main St. Invs., L.P. (In re ATP Oil & Gas Corp.), No. 12-36187, 2015 Bankr. LEXIS 781, at *6 (Bankr. S.D. Tex. March 10, 2015). Because the interests that the debtor has already transferred or agreed to transfer are not considered "property of the estate," the debtor-farmor cannot reject the farmout agreement to invalidate a farmee's right to receive an assignment of its interest. The debtor may not defeat the farmee's right to an assignment simply because the farmee's interest is not of record.

Forward Contracts

• Bankruptcy Code Definition: A forward contract involves (other than a commodity contract) the purchase, sale, or transfer of a commodity with a maturity date more than two days after the date the contract is entered into. See § 101(25). In determining whether a "forward contract" exists, bankruptcy courts rely on contract terms specifying place of delivery, quantity, and price, with delivery occurring in the future, but not deferred forever. Some courts require a contract to have financial characteristics to qualify as a forward contract, but the Fifth Circuit rejected the argument that ordinary supply contracts cannot qualify as forward contracts. Lightfoot v. MXEnergy Elec., Inc. (In re MBS Mgmt. Servs.), 690 F.3d 352 (5th Cir. 2012). Additionally, to qualify as a "forward contract merchant," a party must be engaged in the trade to make a profit, and the practice of entering into forward contracts must be at least part of the party's business. See § 101(26).
• Treatment in Bankruptcy: The Bankruptcy Code provides several advantages to parties to a forward contract and forward contract merchants under various safe harbor provisions.
  • Preference and Avoidance Actions: Section 546(e) of the Bankruptcy Code prevents a debtor or trustee from avoiding and recovering preferential or constructively fraudulent transfers of "settlement payments related to forward contracts." The Bankruptcy Code defines "settlement payment" as a "preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement on account, a final settlement payment, a net settlement payment, or any other similar payment commonly used in the forward contract trade." See 11 U.S.C. § 101(51)(A). Notably, the Fifth Circuit has held that the term "settlement payment" should be interpreted broadly. Williams v. Morgan Stanley Capital Group (In re Olympic Natural Gas Co)., 294 F.3d 737, 742 (5th Cir. 2002).
  • Prevent Right to Setoff: Section 362(b)(6) provides that the automatic stay does not apply to a setoff by a commodity broker or forward contract merchant of any mutual debt and claim under or in connection with one or more forward contracts, including any master agreement, security agreement, or credit enhancement relating to or a part of the forward contract(s). GPR Holdings, L.L.C. v. Duke Energy Trading and Mktg, L.L.C (In re GPR Holdings), 316 B.R. 477 (Bankr. N.D. Tex. 2004).
  • Liquidation of Contract Upon Bankruptcy: Section 561 permits a forward contract merchant to liquidate a forward contract without bankruptcy court approval if the liquidation is based upon a contractual provision for default upon a counterparty filing bankruptcy when such right would otherwise be unenforceable against the debtor pursuant to § 365(e)(1). Section 556 explicitly exempts certain contracts, including forward contracts, from the reach of § 365(e)(1).

Understanding the foregoing Bankruptcy Code provisions and their likely application by courts can foster strategic planning useful in the event of the bankruptcy filing of a contractual counterparty. Taking proactive steps to determine the potential consequence of a bankruptcy filing in light of applicable law, and in particular, whether any revisions or adjustments should be made, may reduce exposure and yield a better end result in the bankruptcy proceedings. Such planning may well reveal itself later to be a stitch in time that saved nine.