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(Reuters) - Sabine Oil & Gas Corp won an important court ruling on Tuesday that will allow the bankrupt energy producer to shed certain pipeline contracts, potentially exposing companies that transport and process gas to the crisis in the energy industry.
The ruling by New York's influential bankruptcy court is the first major test of whether Chapter 11 can be used to end a contract with companies in what is known as the midstream sector of the energy industry.
"The debtors have satisfied the standard for the rejection of the contracts," said Judge Shelley Chapman in Manhattan, who read the opinion from the bench.
Her decision can be appealed and is not binding. But it may encourage other struggling producers to follow suit at a time when scores of oil and gas companies are teetering on the brink of bankruptcy.
Shares of major pipeline operators fell on the ruling, with the Dow Jones index of pipeline operators ending down more than 5 percent.
Chapman's decision clears the way for Sabine to seek a new midstream operator to build a pipeline system in southern Texas to replace the existing one built by an affiliate of Cheniere Energy Inc. The company's lawyers have also said they may use the ruling to renegotiate with Cheniere.
Sabine said in court papers a new midstream operator would save it $35 million.
Advocates for the $500 billion midstream sector have argued that pipeline contracts are bankruptcy-proof because the energy producers have agreed to convey property rights over their natural gas to midstream operators.
The pipeline operators considered the contracts to contain covenants that "run with the land," and the operators compared them to a deed restriction that might limit the height of a building, and which binds future owners.
Chapman rejected that argument, although she said her finding on the covenants was non-binding for procedural reasons. Sabine's attorney said his client would follow her suggestions and put the issue back before the court.
"It's huge," said Heidi Sorvino, a bankruptcy attorney with LeClairRyan in New York. "This is going to have a domino effect on other industries."
The contracts often require energy producers to pay for pipeline capacity even if they do not use it. The contracts provided a way for pipeline operators to ensure they could recoup the $30 billion spent annually building infrastructure for the boom in shale energy.
Thanks in part to the contracts, investors have viewed the midstream operators as toll takers insulated from the volatility of energy prices. That stability has allowed the midstream operators to raise billions of dollars by organizing as high-yielding master limited partnerships, or MLPs.
But with energy prices down more than 60 percent from their 2014 peak, producers have cut their drilling and no longer need the pipeline capacity.
"These are the canaries in the coal mine for the MLP players," said a client note from Brean Capital LLC following the ruling. "This case will provide case law that can be used in other cases and will push MLPs to re-strike contracts ... setting up a very negative precedent, to state the obvious."
Shares of midstream energy companies added to losses after the decision, as a drop in oil prices on Tuesday also weighed broadly on energy stocks.
Shares of Williams Cos Inc closed down more than 9 percent after the ruling, while Kinder Morgan Inc was off 5.3 percent and Plains All American Pipeline LP fell 5.9 percent.
Already, Quicksilver Resources Inc filed papers in its bankruptcy to reject agreements with a unit of Crestwood Equity Partners. Magnum Hunter Resources Corp is seeking to reject a deal with an affiliate that is majority owned by Morgan Stanley.
A ruling on Quicksilver's request is expected later this month.
Reporting by Tom Hals in Wilmington, Delaware; additional reporting by Lewis Krauskopf Krauskopf and Rodrigo Campos in New York and Jim Christie in San Francisco; Editing by Dan Grebler