Perfection Pays in Oil and Gas Sales Contracts

Perfection Pays in Oil and Gas Sales Contracts

As bankruptcy fears continue in the oil and gas industry, sellers of downstream interests may hedge credit risks by ensuring their liens are senior to others.

April 06, 2018

In 2014, price shocks sent waves of financial distress throughout the oil and gas industry, as the price of crude oil plummeted from a high of $100.36/bbl in June to a low of $31.62/bbl by the beginning of February 2016.[1] This drop in prices hit many U.S. producers especially hard because a growing share of production in the country has been sourced from "unconventional" deposits with limited permeability, which involve higher production costs relative to traditional sources of petroleum.[2] Consequently, there is ongoing concern over bankruptcy in the industry.

Although prices have increased gradually since early 2016, the shock illustrates just one of the many threats to parties in an industry characterized by pervasive risk.[3][4] From natural disasters to human error, risk events may cause firms in the oil and gas industry to incur debilitating costs that render them insolvent. As a result, the threat of counterparty insolvency is often looming for parties to oil and gas contracts. 

Due to the omnipresent threat of counterparty insolvency, parties should actively manage counterparty credit risk. Long-term credit risk management in oil and gas contracts is challenging because production in some fields lasts many decades and a contract counterparty may change completely or suffer financial reverses. Accordingly, such long-term contracts should be written with the view that one's counterparty will seek to evade its debts and will be the subject of bankruptcy proceedings. 

One type of contractual relationship that may be threatened by bankruptcy proceedings is a sales contract for oil and gas production. When oil and gas production is sold on credit without a security agreement to secure the purchase price, the producer will bear significant risk of nonpayment if the purchaser declares bankruptcy as the producer will have a mere unsecured claim.[5] As a result, it is important for the seller to obtain an attached and perfected security interest – or some other right – in collateral to secure payment by purchasers.[6] This observation is important for both producers selling to first purchasers and first purchasers selling to downstream purchasers.

We examine how situations like this may occur and what sellers in several oil- and gas-producing states should consider before entering into a contract. 

The Sales Process

In practice, oil and gas production is frequently bought and sold by various parties before it reaches the end consumer. After producers extract the oil or gas, first purchasers typically buy the oil or gas at the wellhead from local tanks located on the leased premises, or at nearby market centers. First purchasers often – particularly in the case of oil – transport the products for temporary storage before reselling to downstream purchasers, such as refiners or commodities traders. Consequently, each party involved in the various transactions is paid on a different timeline, resulting in open balances between parties at different points of the process.

The timeline for payment under oil and gas sales contracts depends on the nature of the interests involved. Producers are customarily paid by first purchasers on either the 20th day or 25th day of each month for oil or gas produced in the previous calendar month. Thus, producers have essentially extended credit for 50 to 56 days of production.[7] First purchasers are then paid by downstream purchasers pursuant to the terms of their respective agreements. The multiple parties involved with the production and shipment of oil or gas results in competing interests.

Due to competing interests, sellers and lenders should timely perfect security interests or liens in the oil and gas sold to outrank other creditors who have interests in the same collateral. Although some of these interests are brought about by specific clauses in the contract, others may arise by operation of law.

State Statutes and Considerations

Following bankruptcies of Basin, Inc., Brio Petroleum, Inc., Compton Petroleum Corp., and Gratex Corp. in 1982, several states enacted statutory producers’ liens.[8]; Texas,[9] Oklahoma,[10] New Mexico,[11] Kansas,[12] and North Dakota[13] have enacted statutes that grant royalty owners, producers, and other oil and gas interest owners a statutory security lien to secure payment of the purchase price for that production.[14] Importantly, certain states allow these security interests to be treated as purchase money security interests (PMSI).[15] A PMSI is a security interest or claim on property that enables a lender or provider of goods on credit who provides financing for the acquisition of goods or equipment to obtain priority ranking ahead of other secured creditors.[16] Because the producer is the one actually furnishing the goods – in this case the oil or gas – it is logical that producer have a PMSI-like lien in such goods and the proceeds of their sale. Before a party may take advantage of the super priority of such producers’ liens, however, those liens must be made effective against third parties.

Some states provide for producers’ liens that are not automatically perfected and involve certain temporal limitations. For example, to perfect and maintain the New Mexico producer’s lien, the interest owners must file a Notice of Lien (similar to notices that are needed to perfect statutory mechanics liens) “after 15 days and within 45 days after payment is due by terms of agreement.”[17] The lien terminates if the notice is not timely filed. If timely filed, the lien expires one year after the date of the filing of the notice unless an action to enforce the lien is begun.[18]

North Dakota’s Oil and Gas Owner’s Lien Act[19] is similar to New Mexico’s. North Dakota’s Oil and Gas Owner’s Lien Act grants interest owners a continuing security interest in and lien on unpaid oil or gas until the purchase price has been paid to the interest owner.[20] To perfect the security interest on oil and gas, producers are required to file a UCC-1A in North Dakota’s central indexing system, record the lien in the real estate records in the county in which the well is located, and provide other interest owners with a copy of the notice of the lien by registered mail.[21] The security interest must be perfected within 90 days from the date of production, otherwise the security interest will not have priority over other security interests in the same oil or gas.[22]

Other states provide for producers’ liens that are “automatically” perfected.[23] For example, under the Texas producers’ lien statute, a security interest “is perfected automatically without the filing of a financing statement.”[24] Specifically, the statute provides that “if the interest of the secured party is evidenced by a deed, mineral deed, reservation in either, oil or gas lease, assignment, or any other such record recorded in the real property records of a county clerk, that record is effective as a filed financing statement.”[25]

Even in states that allow automatic perfection, producers may receive better treatment if they also file a UCC-1. For example, while the Texas producer’s lien is automatically perfected under the Texas statute,[26] the bankruptcy court for the District of Delaware held that a producer’s lien was subordinate to a contractual secured lender’s lien because the Texas producer had not filed a UCC-1 in the state of incorporation of the purchaser of the production before the contractual secured lender’s lien.[27] The lower priority resulted in the loss of approximately $57 million to the Texas owner’s interest in the oil and gas proceeds.[28] Thus, to ensure the best priority for the Texas producer’s lien, producers who are selling on credit should file a UCC-1 in the state of incorporation of the first purchaser of the production rather than rely solely on automatic perfection.[29]

A recent check of UCC records shows this is not being followed. But the lessons learned from bankruptcies of large purchasers such as Enron and Semcrude show that it needs to be done regardless of the size or reputation of the purchaser of production. A protective UCC preserving possibly millions of dollars in liens can be filed at a relatively nominal cost.[30]

Assuming that the security interest is timely perfected, then the security interest and lien takes priority over the rights of persons whose rights or claims arise afterward. But it may not take priority over the security interest and liens previously created and perfected.[31]

The Oklahoma legislature amended the producers’ lien statute in an attempt to ensure both automatic perfection and first priority to producer lienholders following the Semcrude decision.[32] The Oklahoma statute purports to grant producers an automatically perfected lien that has first priority over other competing Article 9 security interests even if the competing interests are first-in-time.[33]

The sole exception to this grant of priority is a permitted lien.[34] A “permitted lien” under the Oklahoma statute is a “validly perfected and enforceable lien created by statute or by rule or regulation of a governmental agency for storage or transportation charges … owed by a first purchaser in relation to oil or gas originally purchased under an agreement to sell.”[35] Thus, a permitted lien is a narrow exception to the otherwise broad superior priority granted in favor of first sellers of production by the Oklahoma producer’s lien statute. Although the Oklahoma legislature purportedly addressed the Semcrude problem, until courts decide the legislative fix worked, the better practice is to file a protective UCC-1.

Maintaining Priority Through Perfection

Perfecting producers’ liens should be on a marketing checklist because, when in bankruptcy, the failure to properly perfect producers’ liens in accordance with the specific jurisdiction’s statute poses a risk of significant loss to producers as a result of lower priority.[36] A producer’s inability to recover amounts owed because of lower priority and the ensuring lower recovery as an unsecured creditor is a real threat to an otherwise sound contractual relationship and is one of many risks that unprepared parties face as a result of a bankruptcy proceeding.

This article was adapted from the paper, “Minimizing Counterparty Bankruptcy Risk,” published in the Spring 2016 issue of the Louisiana Law Review

Authored by:

Mitchell E. Ayer
Attorney – Thompson & Knight LLP

  1. Crude Oil, NASDAQ.
  2. Ed Crooks, “US Shale Industry Braced for Bankruptcy,” Financial Times, September 6, 2016; see also Jennifer Cruz, Peter W. Smith, and Sara Stanely, “The Marcellus Shale Gas Boom in Pennsylvania: Employment and Wage Trends,” U.S. Bureau of Statistics Monthly Labor Report, February 2014; “Information on Shale Resources, Development, and Environmental and Public Health Risks,” GAO-12-732, September 5, 2012.
  3. Crude Oil, NASDAQ.
  4. See generally Roberta Bigliani, “Reducing Risks in Oil and Gas Operations,” IDC Energy Insights, EMC Corp., May 2013.
  5. See id. § 506(a)(1).
  6. A perfected security interest is one in which a creditor’s lien on that interest is secured. Secured claims are senior in priority to unsecured claims.
  7. For example, SemCrude filed bankruptcy on the 20th day of the month to maximize its cash, which resulted in maximum losses to its sellers.
  8. See generally Terry I. Cross, “Oil and Gas Product Liens-Statutory Security Interests for Producers and Royalty Owners under the Statutes of Kansas, New Mexico, Oklahoma, Texas and Wyoming,” 50 Consumer Fin. L. Q. REP. 418 (1996).
  9. TEX. BUS. & COMM. CODE § 9.343 (West 2011).
  10. OKLA. STAT. ANN. tit. 52, §§ 549.1, 549.3 (West 2011).
  11. N.M. STAT. ANN. §§ 48-9-1, 48-9-3 (West 2003).
  12. KAN. STAT. ANN. § 84-9-339a (West 2008). Interest owners in Kansas are required to file an “affidavit of production” in the register of deeds of the county where oil and gas is produced to perfect security interest. Id. § 84-9-339a(b). Like Texas, the security interest in and lien on produced oil and gas is treated as a PMSI for purposes of determining priority relative to other Article 9 security interests. Id. § 84-9-339a(h).
  13. N.D. CENT. CODE ANN. § 35-37-02 (West 2008).
  14. Mississippi grants a lien to royalty owners to secure the payment of the royalty proceeds. See MISS. CODE ANN. § 53-3-41 (West 2014). Unlike the other liens, however, a producer who is not also a royalty owner would not be protected. Id.
  15. See supra notes 16, 19.
  16. TEX. BUS. & COM. CODE ANN. § 9.103 (West 2011).
  17. N.M. STAT. ANN. § 48-9-5 (West 2003).
  18. Id.
  19. N.D. CENT. CODE ANN. §§ 35-37-01 to 06 (West 2008 & Supp. 2015).
  20. Id.§ 35-37-02.
  21. Id.§ 35-37-04.
  22. Id.
  23. See TEX. BUS. & COM. CODE ANN. § 9.343.
  24. TEX. BUS. & COM. CODE ANN. § 9.343(b).
  25. Id.
  26. Id.
  27. Arrow Oil & Gas, Inc. v. SemCrude, L.P. (In re SemCrude, L.P.), 407 B.R. 112, 132 (Bankr. D. Del. 2009). This SemCrude decision has been criticized, on the basis that Tex. UCC §9.343 is more in the nature of a statutory lien like a mechanic and material’s lien than a consensual security interest found in the UCC. The placement of this provision in the UCC rather than the Property Code should not be the outcome determinative. Rhett Campbell, “A Survey of Oil & Gas Bankruptcy Issues,” Texas Journal of Oil, Gas, and Energy Law, Volume 5, 265, 293, 2009.  
  28. Id. Victor Chiu & Penelope Christophorou, Presentation, “Joint Meeting of the UCC Committee and the Commercial Finance Committee,” August 1, 2009.
  29. Note that filing a protective UCC might not guarantee the producer is senior to a lender. Because the producers’ lien was a nonstandard UCC provision and no UCC-1 was filed, the court did not need to address the issue of priority based on date of filing which might give the bank another argument if it filed first. If a producer does not file a UCC, however, if the court adopts the SemCrude rationale, the secured lender will win. As long as there is any question, the better practice is to file a protective UCC.
  30. For example, in Delaware, Capitol Services charges $125 to file a UCC-1, plus cost of any paralegal time, and a state charge of $2 per page in excess of four pages. If same purchaser is in multiple states with statutory liens, it can file one UCC for multiple states.
  31. N.D. CENT. CODE ANN. § 35-37-01 (West 2008).
  32. See Sahar Jooshani, “There’s a New Act in Town: How the Oklahoma Oil and Gas Owners’ Lien Act of 2010 Strengthens the Position of Oklahoma Interest Owners,” Oklahoma Law Review, Volume 65, 133, 142, 2012, The Texas legislature did not address the Semcrude problem.
  33. OKLA. STAT. ANN. tit. 52 §§ 549.4, 549.7 (West 2011).
  34. Id.
  35. Id. § 549.2(11)(b).
  36. For the importance of checklists in every business endeavor, this author recommend the very interesting, best-selling book, Atul Gawande, A Checklist Manifesto: How to Get Things Right, Picador, 2011.