Recent technological innovations and advancements in drilling and completion techniques have led to an unprecedented expansion of natural gas production by large and midsize exploration and production companies. This expansion created competition for wild cat acreage as well as producing properties, putting lessors and co-owners (the “non-operators”) at a distinct advantage in negotiating the terms of leases, farmout agreements and joint operating agreements (“JOAs”).

Due to the increased production of gas – and the resulting decline in gas prices – operators are now facing liquidity constraints as they labor to sustain cash flow from lower priced production and maintain lease acreage positions until gas prices increase. Lower gas prices are also triggering lower reserve valuations used in determining borrowing base limits in the working capital facilities of gas companies. A reduced borrowing base may result in the working capital lenders requiring a principal paydown and may limit future borrowings. As a result, some operators are unable to meet their obligations to working capital lenders and other creditors and may resort to seeking protection under chapter 11 of the Bankruptcy Code. When an operator files chapter 11, every aspect of its business is impacted and non-operators should understand the rules of the game to protect their interests.

Non-operators are likely to encounter several issues when an operator files for bankruptcy:

• The automatic stay. The automatic stay in bankruptcy has important consequences on contractual relationships with a bankrupt operator. First, the automatic stay prevents operation of certain contractual provisions triggered by the bankruptcy of the operator, e.g., standard JOA language which provides that the operator shall be deemed to have resigned upon filing of bankruptcy (‘ipso facto’ clauses). Second, the stay may prohibit non-operators from exercising remedies under a JOA, e.g., to enforce liens on the operator’s share of production or terminate the agreement without bankruptcy court approval. Third, the automatic stay will prohibit non-operators from offsetting amounts owed the operator (such as joint interest billings) against amounts owed the non-operator (royalty payments) without bankruptcy court approval. In certain situations, a non-operator may seek to lift the automatic stay to exercise its rights, including set-off under the JOA.
• Treatment of JOAs in Bankruptcy. The Bankruptcy Code allows an operator to assume or reject certain executory contracts. JOAs are generally considered to be executory contracts that may be assumed or rejected. If the JOA is rejected, the non-operators are given an unsecured claim for the damages under the agreement. Rejection of a JOA does not automatically terminate the JOA – which would require the parties to operate the lease as tenants-in-common – and there may be proactive steps that can be taken to avoid or reduce the consequences of rejection of a contract. If the JOA is assumed, the operator must cure all defaults under the contract. Finally, a JOA can be assumed and assigned to a third party under certain circumstances in connection with a sale of the operator’s assets. Importantly, a non-operator may demand adequate assurance of the assignee’s ability to perform under the JOA before the assignment may be approved by the bankruptcy court.
• Treatment of Oil and Gas Leases. In many cases, operators in bankruptcy will seek to sell their interests in oil and gas leases. Most leases, however, include provisions that prohibit an assignment of the lease without the lessor’s consent. While these provisions are generally unenforceable under the Bankruptcy Code’s executory contract provisions for assumption and assignment, most oil and gas leases are not considered to be executory contracts that can be assumed or rejected in a bankruptcy case. Instead, most jurisdictions consider oil and gas leases to be real property interests (though this is an open issue in several significant jurisdictions such as Louisiana, Kansas and federal offshore oil and gas leases). In jurisdictions where oil and gas leases constitute a real property interest and are not executory contracts, operators are unable to rely on the assumption and assignment provisions to avoid anti-assignment and lessor consent provisions.
• Royalty Payments. When an operator files bankruptcy with royalty obligations based on pre-bankruptcy production, the royalty owner will generally be treated as an unsecured creditor in the operator’s bankruptcy case though certain states (such as Texas) allow non-operators to assert a lien for the non-payment of royalties. If the operator intends to continue operating post-bankruptcy, it must pay royalties on production after the bankruptcy filing and may request authority from the bankruptcy court to pay outstanding royalties to avoid forfeiting potentially valuable leases.
• Plugging and Abandonment. Non-operators may be faced with some contingent liability for plugging and abandonment obligations (“P&A”) to restore the land to its pre-drilling condition. Generally, the operator is primarily liable for the costs, then the co-owners, and ultimately any predecessor owners. Because an operator in chapter 11 may seek to either transfer or cease operations on a lease, it is important for non-operators to ensure that the P&A costs are satisfied by the operator or assumed by any successor.

Every bankruptcy case is unique. Each affected oil and gas lease and JOA must be evaluated independently and in the context of the operator’s bankruptcy case. If the operator is reorganizing and has obtained sufficient funding, there may be very minimal impact on the non-operators. On the other hand, if the operator is selling certain assets or liquidating its entire business, the non-operators may be significantly impacted by either a new operator or by the termination of a lease or JOA. Non-operators should seek professional advice and legal counsel to ensure that their rights are protected in any bankruptcy case of an operator with whom they do business.

For more information concerning this issue, please contact: