Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

How's your knowledge of covenant law?

Well, you likely aren't alone. In a bench decision last month in the U.S. bankruptcy court in New York, the Honorable Shelley C. Chapman wrote of covenant law as being an "unspeakable quagmire." As if to emphasize this, she felt compelled to give a brief history lesson touching upon an English case from 1583.

It's all a long way from Texas in 2016, to be sure. But right now this is the hottest, and murkiest, topic in the U.S. oil and gas business.

The central issue is this: Can bankrupt exploration and production companies tear up the contracts they have signed with pipeline companies? On Wednesday evening, investors got another clue.

Crestwood Equity Partners, a pipeline company, reached a settlement with BlueStone Natural Resources. The latter is buying some natural-gas-producing assets in Texas' Barnett shale from now-bankrupt Quicksilver Resources, which had been contesting the contracts it had signed earlier with Crestwood. Rather than continue the fight in court, Crestwood and BlueStone essentially renegotiated a new, 10-year contract.

On the face of it, this is a setback for the pipeline and master limited partnership sectors. Previously regarded as utility-like investments, these stocks have been battered as their exposure to the commodity cycle has been unveiled. Now, it seems, even their contracts are malleable. Judge Chapman's decision, pertaining to a similar situation involving Sabine Oil & Gas, was only preliminary. But she concluded that those contracts weren't as rock-solid as portrayed. The Alerian MLP Index sank 6 percent that day.

Judged
Alerian MLP Index
Source: Bloomberg

In contrast, the latest ruling hasn't had much impact: The index fell Thursday, but only in line with the broader market, while Crestwood actually jumped.

There is no doubt these developments are negative for pipeline companies in one respect: Contracts aren't necessarily set in stone. That is even the case with covenants that "run with the land," supposedly giving pipeline operators who have invested in infrastructure serving a particular area protection against being treated like any other creditor in bankruptcy court.

This is partly because there is little precedent. In the last protracted energy downturn, in the 1980s, most pipelines were part of integrated companies rather than separate businesses, and no one had an interest in suing themselves. It also reflects differences in how each state treats these covenants and even the arcane notion of when oil and gas changes from being real estate to personal property -- in Texas, it happens when you take it out of the ground, a key point in the Sabine decision. Bear in mind, also, that decisions in one bankruptcy court aren't binding on any others. "Quagmire" indeed.

Equally, though, the same quagmire means investors can't simply extrapolate these decisions across the entire industry. For example, there is intense focus on what might happen with Chesapeake Energy's contracts with Williams Partners if the struggling E&P firm eventually files for Chapter 11. Yet, as Lawrence Gelber and David Karp, partners at law firm Schulte Roth & Zabel, pointed out in a recent report, the language in several of Chesapeake's agreements with Williams specify reserves being "in place." That could mean they get treated, differently, as real property, which in theory makes the contract harder to overturn.

The element of doubt is a problem for pipeline stocks, but given how battered the sector is already, it is arguably largely priced in anyway. Crestwood rose Thursday morning precisely because the settlement provides some clarity on its specific situation. And the stock is still down 95 percent from its peak.

Crestfallen
Source: Bloomberg

What the Crestwood settlement also illustrates is the sheer symbiosis of E&P companies and their pipeline provider. Oil and gas isn't worth anything if you can't get it to market; and, equally, money invested in pipelines is wasted if there's nothing running through them. Hence, Crestwood's willingness to cut fees to get the production switched back on and committed through several years, until a hoped-for recovery in commodity prices.

Given this doctrine of mutually assured destruction, more future cases will probably end in settlements rather than judgments. As Gelber at Schulte Roth & Zabel puts it:

Chapter 11 isn't only about litigation; it's also a venue for parties to cut a deal.

To put all this in a broader context, these negotiations are really just another part of the process of taking out the inflation built up in the commodity boom, much of it fueled by cheap credit. This has happened already with regards to E&P firms canceling or repricing contracts with oilfield services firms and, more straightforwardly, slashing headcount.

The contracts with pipeline operators present some legal complexities, but ultimately some will have to be repriced for a different environment if both parties are to have a viable way forward. That presents extra risk to investors in some MLPs but not a blanket bombing of the entire sector, especially with the Alerian yielding 9 percent already. Its fortunes are tied far more closely to the oil price than anything else right now.

Barrel Rolling
The Alerian MLP Index's correlation coefficient with oil has jumped (1.0 indicates perfect correlation)
Source: Bloomberg
Note: Data indicate rolling 90-day correlation.

Indeed, perhaps it is oil bulls who ought to be just as concerned with these pipeline contracts. One argument supporting a recovery in prices is the prospect of chaos in the shale fields as E&P firms go bankrupt. A more orderly renegotiation, even if drawn out, offers less scope for disruption of supply and, importantly, would continue the process of resetting the industry's cost structure even lower. That would tend to undermine prices, not boost them. If there's a quagmire in the oil business, everyone's stuck in it.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net