While new drilling and exploration activity in various parts of the U.S. remains quite strong, much of the booming new investment in the oil and gas sector in the past year or two has been focused in the midstream space.
Midstream refers to the building of pipelines and other infrastructure needed to transport oil, gas and other materials (such as brine water and fresh water) to/from new wellheads to end users and/or processors or suppliers of these materials. Many of these materials are now being moved by truck, barge or railcar, which in some instances may not be the most economical or safest method of transportation.
To date, most pipeline operators and other midstream participants have elected to build new capacity only after they have entered into binding long-term contracts with customers for an amount that justifies the planned investment in that new capacity. At the same time, exploration and production companies – and other customers of midstream service providers – are looking to enter into these contracts to gain access to and lock-in available capacity to move their products and materials to/from the wells or other facilities they are building. These contracts are also often viewed by financing sources of both midstream companies and their customers as critical elements in making proposed projects viable. Both parties are therefore critically dependent on these contracts to help drive the future success of their respective businesses.
For midstream companies and their customers, these contracts require careful thought and consideration. Items which might not be significant issues in a situation where the midstream assets have already been built become much more critical considerations in the “to be built” environment.
Aside from typical commercial terms (such as prices), other issues such as minimum quantity commitments, reservations of available capacity, and timing issues for bringing capacity online become critical. Each party needs to carefully consider what termination rights should be afforded to each party and when those rights may be exercisable. Contract terms must be constructed in light of the investments each party is making, and the planned time horizon for completing those investments. Allocation of risks between the parties must be carefully considered by both sides.
Each party will also want to carefully evaluate the creditworthiness of its proposed business partner and the business partner’s ability to deliver on its commitments on a timely basis. Failure of either party to honor its obligations could leave the other party in a “stranded” situation where it cannot realize a return of its investment because of the failure of the other party to honor its contractual commitments.
The negotiation of midstream transportation contracts, which might be relatively routine in normal circumstances, can become very complex and expose parties to dramatically increased levels of risk in the current environment of tremendous new investment by exploration and production companies, midstream service providers and other industry players.