May 26, 2020
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Last month, West Texas Intermediate crude dropped below $0.00 for the first time in history after weeks of low global oil demand as a result of the novel Coronavirus (COVID-19) pandemic and the Saudi Arabia-Russia price war. Many upstream and midstream oil and gas companies are currently faced with the lack of, or limited, offtake capability and disappearing crude oil storage capacity, which has these companies evaluating the impact of shutting in wells or pipelines.
For so long as this historically low oil demand persists, both upstream and midstream companies face the risk that they, or their counterparties, will default under their midstream contracts. Upstream producers primarily need to identify whether their contracts have minimum volume commitments or other take-or-pay obligations that may be difficult to meet in the current environment, especially if some of their production is shut-in, and conversely whether they could be relieved of performance obligations—including acreage dedications—if midstream counterparties fail to accept any produced volumes. Midstream companies likewise need to identify whether they are contractually obligated to accept hydrocarbons into their system even if they have no downstream delivery options or to deliver hydrocarbons downstream even if producers have stopped delivering, whether they are at risk of releasing dedicated acreage if they fail to accept volumes, and if they have the ability to demand adequate assurance of performance from their upstream customers.
Force majeure provisions, found in most midstream contracts, excuse a party from performing its obligations under the contract, without liability, if the failure to perform is due to circumstances outside of the party’s control. Typical events or circumstances covered include acts of God, war, labor shortages, and government interferences. Epidemics and pandemics are sometimes, but not typically, explicitly listed. If neither epidemics nor pandemics nor the effects of the COVID-19 pandemic (e.g., negative crude oil prices, lack of storage capacity, lack of offtake capability) are enumerated in the force majeure provision, the general “catch-all” language in the provision (e.g., “any other cause beyond the reasonable control of the parties”) may still excuse performance.
The interpretation of a force majeure provision’s catch-all language varies state to state. In Texas, a party must first generally establish (i) that the incident in question falls into the scope of the catch-all language and (ii) that the event in question was not foreseeable by the parties at the time they entered into the contract. For older contracts, it is unlikely that a court would conclude that the COVID-19 pandemic, or the resulting circumstances, were foreseeable at the time those contracts were executed; however, the closer in time that the execution date of the contract is to the outbreak of the pandemic, the more likely it is that a court may determine such circumstances were foreseeable at the time the parties entered into the contract. Regardless, parties seeking to rely on force majeure relief should be prepared to demonstrate that the COVID-19 pandemic, and the resulting circumstances, were not foreseeable at the time the parties entered into the contract and that the nature of the COVID-19 pandemic, and particularly the extent of its impact, has been unique and unpredictable. After establishing that COVID-19 or the effects of the pandemic constitute force majeure events under the contract, a party must also show a nexus between the force majeure event and the party’s inability to perform (i.e., that the force majeure event is the “cause” of the inability to perform). For example, available storage for crude oil was decreasing prior to the COVID-19 pandemic, so parties should be prepared to demonstrate that the current lack of capacity is actually a result of the pandemic, rather than a factor that was already in effect.
In the end, whether the COVID-19 pandemic or resulting events constitute force majeure will be determined based on the specific language of the contract and the specific events alleged to be force majeure. Parties who may benefit from claiming force majeure should prepare by taking the following actions:
In the absence of an express force majeure provision, parties in most states, including Texas, can turn to common law affirmative defenses, such as the doctrine of “impossibility,” which may allow a party to be excused from performance of contractual obligations if its performance is rendered impracticable or impossible due to supervening circumstances. The doctrine requires that non-occurrence of the event was a basic assumption on which the contract was made. In order to assert this affirmative defense, 3 the supervening circumstance (i) must not have been foreseeable and (ii) must not have been caused by the party asserting such defense. Because performance must be rendered impracticable or impossible, the presence of alternative solutions, even if not economical, weakens this affirmative defense. For example, a party considering this affirmative defense due to the absence of a buyer or lack of storage capacity would need to show whether these circumstances make performance truly impossible or only more difficult or less economical.
Importantly, a finding of impossibility could result in the complete termination of the underlying contract. Additionally, the inclusion of a force majeure clause in a contract may preclude the parties from asserting an “impossibility” defense.
Minimum volume commitments require an upstream producer/shipper to deliver a specified volume of hydrocarbons (gas, oil, NGLs, or other products) to a midstream system, measured on a quarterly or annual period. If the upstream company delivers less than the minimum volume commitment, it must pay a deficiency fee for shortfall volumes.
The drastic drop in oil prices and lack of storage capacity is causing many upstream companies to consider shutting in wells, which may result in their inability to meet minimum volume commitments. As discussed above, force majeure provisions may excuse an upstream company from performance, and whether a provision also provides relief from making deficiency payments for failing to satisfy the minimum volume commitment will turn on whether it excludes the obligation to make payments from the protections given to the party claiming force majeure. Midstream companies looking to collect deficiency payments will need to look to credit support and other protective provisions in their agreements.
Many midstream agreements entitle the party (or parties) receiving payment under the agreement to demand adequate assurance of performance (i.e., credit support) from the payor to secure future payments. If the payor party fails to deliver “adequate assurance of performance,” the payee party can generally suspend performance or, eventually, terminate the contract. Forms of adequate assurance typically include letters of credit, guarantees from a creditworthy entity, security interests in assets, prepayments, and security deposits.
Midstream and upstream companies alike should be prepared to demand, or alternatively to provide, adequate assurance of performance. When to demand adequate assurance, and whether and in what form to provide it, are strategically important decisions. Certain forms of credit support, such as letters of credit or posted cash collateral, generally provide accessible and viable forms of security, notwithstanding a counterparty bankruptcy filing, so long as such credit support was sought and established before the bankruptcy filing. Likewise, a guaranty may be an actionable source of recovery, provided that the guarantor has not also filed for bankruptcy relief.
Midstream contracts also often contain dedications, in which the upstream company commits all production from specified acreage to delivery under the midstream contract. Acreage dedications are usually binding on all assignees of the contract, except potentially in the event of a rejection of the contract in a bankruptcy. Please see our discussion of the treatment of midstream contracts in producer bankruptcies.
Under most dedication provisions the upstream company is typically entitled to a temporary release from the dedication if the midstream company cannot take volumes for any reason, including force majeure. In addition, if a temporary release continues for an extended period, the acreage could be permanently released from dedication under the contract. When the permanent release covers all dedicated acreage, this is tantamount to a termination of the contract for economic purposes, particularly for the midstream company.
As the effects of the COVID-19 pandemic continue to suppress crude oil demand, upstream and midstream companies can look to provisions in their midstream contracts—including force majeure, minimum volume commitments, adequate assurance of performance, and dedications—for both remedies and relief. While certain common law doctrines may also apply, the available tools and defenses will turn primarily on the contractual language and the specific circumstances surrounding a party’s performance (or inability to perform).