Third Circuit Rejects Oil Producers’ Security Interest Arguments In Midstream Provider’s Bankruptcy Proceeding

On July 19, the U.S. Court of Appeals for the Third Circuit decided an important case involving oil and gas producers, intermediaries, and the ultimate purchasers of the oil and gas. The case, a bankruptcy matter, is In re: SemCrude, LP, et al.

The appellants, many oil and gas producers located in Texas, Oklahoma and Kansas, sold their product to SemCrude, L.P. (SemCrude), a “midstream” oil and gas service provider, who then sold oil to and traded oil futures with downstream oil purchasers. SemCrude’s unsuccessful futures trading activities cause the company to become insolvent and enter into bankruptcy. However, the producers had taken no steps to protect themselves in case SemCrude went bankrupt in contrast to the downstream purchasers. As a result, when SemCrude filed for bankruptcy, the downstream purchasers were paid in full, and more than a thousand producers were unpaid.

The producers argued that, apart from the U.S. Bankruptcy Code, local laws nevertheless provided them with appropriate security interests in the oil they produced, but the Court of Appeals rejected this line of argument. The Court of Appeals concluded by observing that while Texas, Oklahoma, and Kansas have passed laws that protect those whose produce oil in their states, those protections do not reach downstream purchasers.

The oil industry operates through sales on credit. It involves thousands of producers and those producers represent countless interest owners who have fractionalized interests at the well. Downstream purchasers have no contact with these producers and do not even know who they are…The effect of any opinion form us upholding the producers’ positions would be chaos. The industry thus uses the Conoco warranty that this oil is sold free and clear of any liens because it is a hard-to-trace, liquid asset that flows throughout the country.

In sum, if any producer of oil tries to sell it subject to a security interest or implied trust that flows endlessly down the  stream of commerce, it will be unsold. The Producers’ contention that a lien or trust follows oil from their wells to the gas pump does not make sense for this type of market.  The effect of any opinion from us upholding the Producers’ positions would be chaos.

Ultimately, the Court of Appeals affirmed what it described as “the superbly reasoned rulings of both the Bankruptcy and District Courts.”