By: TJ Poole (email@example.com)
Natural Gas midstream contracts are one of the most overlooked sources of structural value uplift and potential risk in a producer’s portfolio. At Mobius, we often come across contracts dating back decades that have been rolling without regard for a series of problems, a few of which are:
- Fees escalating year after year, and often at a rate significantly higher than inflation
- Pricing for residual gas and NGLs that are completely misaligned with current market conditions and with no TIK provisions
- Multiple contracts with the same midstream company, which are often redundant, causing administrative nightmares and data integrity issues.
The goal of renegotiating midstream contracts is to maximize value and flexibility for the producer while minimizing the risk of cash flow volatility and unilateral language that could disrupt business. All of this can be accomplished while aligning both the producer and midstream company’s long-term goals, strengthening the natural partnership between the two.
The first step of any renegotiation is understanding what you have. This involves an in-depth review and organization of your contract portfolio and plant statements, which allows you to evaluate where your commercial terms stand today relative to the initial contract language. Additionally, this allows a producer to diagram the physical flow and determine if more efficient pathing would bring realizations closer in line with current market conditions.
It is at this phase where proverbial low hanging fruit is identified. These include value enhancements such as:
- TIK rights for gas and liquids
- Inclusion of ethane rejection/recovery rights, at increased intervals
- Defined fuel rates
- Updated recovery rates
- Broadened scope of in-field gas use
- Removal or more favorable rate escalators (i.e. bi-directional at a minimum)
- Addition of preferable tax language
- Removal of meters that are no longer active and accumulating low volume fees
This period is also when errors in plant statements and invoices are unearthed. We have discovered everything from misallocations of fees to wells being completely unaccounted for. Not only do these issues need to be addressed, but dated mistakes by the midstream can also be leveraged in opening a contract renegotiation discussion.
Over the past year, we have seen midstream operators offering higher POP (percent of proceeds) to the producer in exchange for increased fixed fees, given the decline in their revenues during a low price environment. We are not opposed to such a trade, but only if all commercial terms of the contract are simultaneously considered. Commercial terms are the most conspicuous aspect of a midstream contract.
These include any direct influencer of value, such as fixed fees, variable costs, commodity purchase price, and POP.
Understanding how a mix of these components affects value, while combining in other potentially negotiable items such as fuel percentages, NGL recovery rates, or low volume fees adds a whole new layer of complexity to the analysis. None of these components should be evaluated in isolation. A proper scenario analysis should include all potential combinations of fees, POP, pricing components, terms, fuel percentages, NGL recovery rates, GPM rates (relevant when consolidating contracts), escalators, tiered rates, potential MVC liabilities and more. Additionally, this modeled impact must be applied to the producer’s production forecast and relevant up to date price curves. The output will show the value added or detracted on a per mcf basis by month for the duration of the proposed contract, as well a simplistic NPV comparison, for each scenario. In most cases the midstream company is doing this same analysis, as such independently and holistically calculating the impact on realized pricing is crucial in the negotiation process.
If commercial terms were the only aspect of a natural gas midstream contract, then the agreements would conceivably only be 3 to 4 pages long. Unfortunately, there are typically another 80 to 120 additional pages of potential risk warranting a closer review. Midstream companies will likely send the base contract over late in the process, hoping the producer gives it only a perfunctory review before forwarding it on to legal. Hidden in this stack of pages is language that potentially exposes the producer to both revenue risk and possible flow disruption. Phrases like “at the gatherer’s sole discretion” or “for any other reason that Gatherer deems uneconomic” are red flags. Often midstream contracts are littered with unilateral rights detrimental to the producer. A comprehensive contract renegotiation will push back against anything allowing the midstream counterparty to have the right to restructure pricing or curtail delivery due to “uneconomic conditions” or even terminate the contract for little to no reason. The ability to reasonably forecast revenue and fees, as well as flow assurance, should be a top priority of any contract discussion.
One last goal not to be overlooked is contract consolidation. After years of assets trading hands, a producer can find themselves with a complicated web of contracts which will cause administrative burdens not only for the internal team, but also for the midstream company. It can also lead to lower confidence in data integrity when reviewing plant statements. At times, we have found that a clear path to the renegotiation of burdensome agreements is approaching the midstream company to consolidate contracts. It is a mutually beneficial first step.
Still, producers often feel they are held captive by long term contract dedications or burdensome MVC obligations without the ability to renegotiate. Remember that while certain acreage may be dedicated, capital is not. The producer ultimately makes the decision regarding which assets decline and where growth is pursued. Midstream companies need capital allocation by their E&P clients, and in turn production growth to improve margins. Approaching agreements from this perspective establishes a mutually beneficial negotiation process. If a contract is uneconomical for you, it will become uneconomic for them as well.