Ken Irvin
David Kronenberg
Greg Kusel
Sidley Austin LLP
Washington, DC
Although bankruptcies involving large pipeline systems remain a rare event and such companies are generally well insulated from the market forces that routinely grip producers and other commodity-sensitive businesses, the Southcross Energy bankruptcy shows that certain corners of the midstream industry are susceptible to commodity price fluctuations and competition, and that size and diversification does not always guaranty solvency.
Southcross, an owner and operator of natural gas pipeline and processing systems, in early 2020 confirmed a Chapter 11 bankruptcy plan and is set to emerge from bankruptcy protection following a restructuring and sale of significant parts of its business. The case is notable because bankruptcies involving large, independent transportation and processing systems are relatively rare, as such companies often have a broad base of captive customers and the ability to raise transportation rates as needed to cover expenses. This favorable market position usually insulates midstream companies from the worst effects of depressed commodity prices.
Southcross’ business, however, was uniquely vulnerable to market forces that usually only affect producers, field operators, and local midstream operators, and its bankruptcy case stands as an example of what can occur when a midstream operator with elevated exposure to producers, inflexible transportation rates, and excessive debt, faces increased competition and a prolonged downturn in commodity prices.
Past pipeline bankruptcies
Although small intrastate pipelines and gathering systems are commonly the subject of bankruptcy proceedings, particularly when such businesses are integrated with the operations of an affiliated oil and gas producer, bankruptcies involving large intrastate pipelines or federally regulated interstate pipelines are quite rare. Before the Southcross case, the Columbia Gas case was the most high-profile example of a bankruptcy resulting from the insolvency of a large pipeline system. The circumstances that led to the Columbia Gas bankruptcy provide a good framework for understanding the midstream industry and the market dynamics that resulted in the Southcross bankruptcy decades later.
Columbia Gas
In 1991, Columbia Gas filed for bankruptcy protection in Delaware. At the time, Columbia operated one of the largest natural gas transmission systems in the US, stretching more than 18,900 miles across 16 states and the District of Columbia. One of the main reasons Columbia filed for bankruptcy protection was to reject take-or-pay contracts, which required it to purchase natural gas from producers at above-market prices.
Before the mid-1980s, companies such as Columbia principally operated as merchants that purchased natural gas from producers, bundled it with gas transmission services, and sold the bundled product to distribution companies or end users. To ensure a reliable supply of natural gas, Columbia and its competitors routinely entered into long-term take-or-pay contracts with gas producers that required the pipeline to purchase a minimum annual quantity of gas at fixed prices or, if it did not purchase such minimum quantity, make a deficiency payment to the applicable producer.
Such commitments by pipelines appeared prudent in the 1960s and 1970s, when a series of gas shortages throughout the US resulted from:
- Price controls that dampened exploration and production activity.
- Regulations that discouraged intrastate pipelines from interconnecting with the interstate pipeline network (in order to avoid regulation applicable to interstate pipelines under the Natural Gas Act of 1938), which prevented Gulf Coast gas from reaching undersupplied portions of the country.
Starting in the late 1970s, however, several regulatory changes transformed the natural gas industry and alleviated the undersupply problem, causing take-or-pay contracts eventually to become a costly burden to pipeline companies.
The first regulatory change was the passage of the Natural Gas Policy Act of 1978, which gradually allowed market forces to factor into wellhead prices for natural gas. As prices increased, pipelines continued to enter take-or-pay contracts to ensure steady supplies and protect against the gas shortages that had plagued the industry for years. Increased prices, however, spurred a surge of exploration and production eventually leading to oversupply in certain regions. Higher prices also prompted many large industrial end users to switch to cheaper energy alternatives, such as coal, which reduced demand for natural gas and exacerbated the oversupply.
Another notable regulatory change under the Natural Gas Policy Act of 1978 was that it allowed intrastate natural gas pipelines to transport natural gas in interstate commerce without subjecting them to regulation as interstate pipelines under the Natural Gas Act of 1938 if the transportation was on behalf of an interstate pipeline or a local distribution company served by an interstate pipeline. This facilitated widespread integration of the intrastate and interstate natural gas pipeline networks, allowing natural gas to flow from production areas to previously undersupplied regions. By the early 1980s, markets were well supplied nationwide, leading to a dramatic decline in wellhead prices for natural gas.
The next major regulatory change occurred in 1985, when the US Federal Energy Regulatory Commission (FERC) issued Order No. 436, which allowed pipelines on a voluntary basis to act as transporters of natural gas already purchased by customers, rather than exclusively as merchants that provided bundled natural gas and transmission services to customers. This new regulatory scheme, coupled with declining natural gas prices, created a problem for pipelines that had substantial take-or-pay obligations locked in at higher prices.
Instead of purchasing a bundled product tied to higher rates, customers could buy natural gas directly from producers at lower market rates and pay competitive transportation rates for delivery. As more and more customers purchased gas in this manner and avoided bundled services, pipelines were unable to meet minimum annual gas commitments in their take-or-pay contracts with producers, leaving them in the untenable position of making larger and larger deficiency payments to the applicable producers.
To reduce such massive liabilities, pipelines attempted to renegotiate their take-or-pay contracts en masse. In 1985, Columbia was one of the first major pipeline companies to enter into settlements to alleviate its take-or-pay contract overhang. Columbia, however, only settled contracts perceived to be a problem at the time and did not comprehensively address its portfolio of take-or-pay contracts, as other pipelines did. Accordingly, by 1991, as prices continued to decline and demand fell substantially following two unusually warm winters, Columbia filed for bankruptcy protection. Despite the difficult operating environment for all interstate natural gas pipelines at the time, Columbia appears to have been the only major pipeline company to seek bankruptcy protection.
In its Chapter 11 case, Columbia rejected more than 4,000 gas purchase contracts, leading to $13 billion in rejection damages claims against its bankruptcy estate. The contract rejections allowed Columbia to avoid hefty deficiency payments and focus on transporting and storing gas rather than marketing bundled gas products. Its operations were soon cash flow positive and Columbia began investing in upgrades to its pipeline system. In 1995, Columbia’s Chapter 11 plan was approved and creditors received more than $3.4 billion in satisfaction of their claims.
The Columbia bankruptcy was the result of unique regulatory and market changes. The forces that caused Columbia to file for bankruptcy protection are not applicable to today’s interstate natural gas pipelines, which provide transportation and storage services as a separate function from the role of gas marketer. In 1992, FERC Order No. 636 mandated this transition by requiring pipelines to separate their gas production and marketing operations from their transportation and storage services. Interstate pipeline companies underwent restructurings that moved their gas production and marketing operations into affiliated entities, which were prohibited from receiving preferential treatment with respect to transportation or storage services offered by their pipeline affiliates.
Interstate natural gas pipelines now act solely as transporters and storage providers, and thus are not party to take-or-pay contracts or similarly structured obligations that could endanger their financial solvency. Southcross and other intrastate pipelines and local gathering systems, however, remain subject to some of the same risks that imperiled Columbia Gas.
Recent midstream bankruptcies
In the last 5 years, low commodity prices have precipitated midstream bankruptcy filings. But nearly all the affected companies were local oil or gas gatherers or processors that entered bankruptcy largely due to the poor financial performance of their producer affiliates or connected producers.
The reason that most recent midstream bankruptcies involve oil and gas gathering companies is that such firms’ financial success is highly correlated to the performance of the oil and gas producers they serve. Companies that provide gathering services build the infrastructure needed to gather oil or gas from the various wells of a particular producer. In exchange for the investment required to build such a system, producers often agree to ship a minimum volume of gas through the system and dedicate the mineral interests and surrounding acreage to the midstream company, which is intended to provide the midstream company the exclusive right to gather the oil or gas on that property even if ownership of the property changes hands. These contracts essentially tie the midstream company’s financial success to the producer’s ability to profitably produce gas.
Because gas gathering systems are typically built to service a single producer’s wells, the midstream service company’s solvency is closely related to the performance of the applicable producer. This is in contrast to interstate pipelines or long-distance intrastate pipelines that operate independently and typically have a portfolio of dozens or hundreds of shippers, including gas producers, marketers, distribution utilities, and end users. In the case of Southcross, its operations, while large and diverse, were heavily exposed to producers and were subject to a regulatory framework that differs markedly from the regulatory framework that governs interstate pipelines.
Southcross business, regulatory framework
When Southcross filed for bankruptcy protection in April 2019, it owned numerous natural gas gathering systems, extensive intrastate pipelines, gas processing plants, a fractionation site, a treating system, and 20 compressor stations in Texas, Mississippi, and Alabama. Southcross also marketed natural gas and NGL to customers in the region.
The majority of Southcross’ pipeline transportation was governed by agreements under which it provided service at contract rates negotiated individually with each shipper. This contrasted with pipelines that provided service under a more traditional utility model that uses cost-of-service rates, which are set by a state or federal regulator and based on the pipeline’s cost of providing service plus a reasonable return on investment.
Southcross’ gathering activities were exempt from federal regulation under Section 1(b) of the Natural Gas Act but were subject to general state law prohibitions against discriminatory rates or terms of service. Southcross operated in states that employ a complaint-based approach to gathering regulation, meaning that Southcross negotiated rates and terms with shippers individually and if there was a dispute regarding rates or access to Southcross’ gathering system, shippers had the right to submit a complaint to the applicable regulator.
Most of Southcross’ intrastate pipeline activities were similarly regulated. In Texas, intrastate pipeline operators are permitted to negotiate rates on a customer-by-customer basis and such rates are subject to a complaint-based review process before the Railroad Commission of Texas. In Mississippi and Alabama, contracts may also be negotiated on a customer-specific basis, but must be approved by the applicable utility commission before commencing service. Under these regulatory schemes, Southcross had the flexibility to negotiate rates, but could not subsequently alter those rates without counterparty approval. This stands in contrast to cost-of-service rates that can often be increased as circumstances require following approval by the applicable regulator.
Several of Southcross’ intrastate pipelines transported gas for interstate pipelines in a manner that subjected them to FERC jurisdiction and a cost-of-service rate-setting regime. The application of a more flexible regulatory cost structure for this portion of Southcross’ business, however, was not enough to prevent Southcross’ overall slide into bankruptcy.
Bankruptcy filing
Southcross offered a variety of midstream services on a scale larger than most gathering systems and local operators. It seems, however, to have suffered a fate similar to many of its smaller peers. In Mississippi and Alabama, Southcross’ infrastructure was interconnected with producers that were unable to generate profits in a low commodity-cost environment. Falling demand for gathering services appears to have led to decreased throughput for Southcross’ other services in the region.
Southcross’ Texas operations traditionally served the Eagle Ford shale, which enjoyed steady production levels leading up to the bankruptcy case. But the destination of produced volumes changed dramatically. Rather than using Southcross’ pipeline system to ship gas further into the mainland, producers increasingly used various cross-border pipelines to export gas to Mexico. Mexico’s demand for natural gas was so strong that exports from the Eagle Ford to Mexico tripled from 2013 to 2018, reaching 3.5 bcfd.
Table 1 shows a more than 30% decline in use of Southcross’ pipeline systems in the relevant regions from 2014 to 2018, assuming a 1 to 1 conversion ratio for MMbtu to Mcf.
Average processing per day at two plants for which Southcross consistently reported processed gas during the period also declined dramatically, down more than 29% from the 5-year high reached in 2015.
The lack of demand for its transportation and processing services in Texas and the falling creditworthiness of its customers in Mississippi and Alabama, coupled with the noted regulatory limitations, meant that Southcross could not raise rates in a manner that would ensure its solvency. This, along with an excessive debt burden, resulted in acute liquidity issues that necessitated the April 2019 bankruptcy filing.
Southcross bankruptcy
Southcross filed for bankruptcy protection with the aim of selling substantially all of its assets in a court-supervised auction process. In the initial June 13, 2019 notice of sale, the bid deadline was scheduled for July 24, 2019, followed by a possible auction on Sept. 3, 2019, and ultimately a sale hearing on Sept. 18, 2019. Southcross’ assets were divided into two groups: one included assets in Mississippi and Alabama, the other included Southcross’ Corpus Christi pipeline network in Texas.
At the time, Southcross anticipated a robust sale process with numerous bidders. But apart from stalking-horse bids on the Mississippi and Alabama assets from Magnolia Infrastructure Holdings and on the Texas assets from Kinder Morgan Tejas Pipeline, other potential bidders expressed a reluctance to acquire Southcross’ assets due to ongoing litigation by the company against certain non-debtor parent and affiliate entities involving breach of contract and fraudulent transfer claims.
Southcross and its advisors determined that resolving such disputes would improve the marketability of its assets and maximize recoveries for creditors. Accordingly, the sale process was temporarily adjourned while Southcross sought to settle the claims. On Sept. 17, 2019, Southcross filed a motion seeking approval of a settlement that provided for the non-debtor defendants to transfer $22.5 million in cash and certain operating assets to Southcross. The settlement was approved Sept. 25, 2019.
The operating assets that Southcross received in connection with the settlement were offered for sale as a third group of assets known as the G&P Assets and the sale process was restarted. In mid-October 2019, however, Southcross announced that it did not receive any additional qualified bids for the three groups of assets. Accordingly, the Mississippi and Alabama assets and Corpus Christi pipeline in Texas were sold to the respective stalking-horse bidders, while the G&P Assets were largely retained by Southcross, which was restructured according to its Chapter 11 plan.
The authors
Ken Irvin ([email protected]) is co-leader of Sidley Austin LLP’s global energy practice, representing clients on a variety of regulatory, enforcement, compliance, and transactional matters involving the US wholesale electricity and natural gas markets. Irvin earned a BS (1987) in electrical engineering from Clarkson University, Potsdam, NY, and his JD (1992) from Syracuse University College of Law.
David Kronenberg ([email protected]) is a counsel in Sidley’s energy group, representing energy companies, financial institutions, and private equity firms in matters involving the structure and negotiation of physical and financial commodities transactions, enforcement of energy contracts and other creditor rights issues in Chapter 11 proceedings and related litigation, and application of the bankruptcy code’s safe harbors, among others. Before joining Sidley, Kronenberg worked for an international energy firm where he was involved in the restructuring or liquidation of various energy companies, insurance companies, and financial services firms. He earned his BA (2004) at Washington University, St. Louis, Mo., and his JD (2007) at Brooklyn Law School.
Greg Kusel ([email protected]) is an associate in Sidley’s energy and mergers and acquisitions practice groups, advising clients on energy-related matters with a focus on natural gas marketing and pipeline transportation capacity. Before joining Sidley, Kusel worked for nearly 6 years at the US Federal Energy Regulatory Commission’s office of energy market regulation. He earned his BA (2008) at Ball State University, Muncie, Ind., and his JD (2013) at The Catholic University of America, Columbus School of Law, Washington, DC.
