Timely Topics - Problem Solving for Oil and Gas Activities in Conservation Easements

Transcription

1 Third Symposium on Advanced Legal Topics in Land Conservation June 11-12, 2012 I Charleston, SC Timely Topics - Problem Solving for Oil and Gas Activities in Conservation Easements Bill Silberstein, Moderator Kaplan Kirsch & Rockwell LLP (CO) (303) I bsilberstein@kaplankirsch.com Cathy Howell, Senior Attorney The Nature Conservancy (TX) (512) I chowell@tnc.org

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3 A. As the U.S. continues to seek domestic sources of energy and as new technologies continue to emerge, oil and gas exploration and extraction will continue to grow and expand into new areas not previously subject to this type of development. This itself is creating the potential for economic boon for people, communities and industries that have never had the financial opportunities that are being presented now. B. Conservation lands (whether owned in fee or conservation easement) are not exempt from mineral development. Without debating whether current mineral extraction processes can be done safely, the purpose of this paper is to provide guidance in assessing the risk of potential oil and gas development and how to best minimize ecological impacts. C. Legal issues must be assessed based on the facts and circumstances of each situation and under the laws of the state where the property sits. Local oil and gas counsel is essential when dealing with requests for oil/gas exploration, leasing or development. Just saying "no" to mineral development is not an option in many circumstances, and even when it is, it might not provide the best conservation outcome in your situation. Best practice - develop a relationship now with local counsel so you'll be ready when the situation arises. PART I THE LEGAL BASICS I. Basic Oil/Gas Legal Concepts II. Mineral Issues in Donated Conservation Easements to Meet IRS Requirements Il l. Risk Assessment for O&G Leasing on Conservation Lands 1

4 1. BASIC OIL/GAS LEGAL CONCEPTS Although oil and gas laws vary by state, many of the concepts for assessing legal risks and potential strategies in dealing with leasing requests and other oil/gas activities are similar. A. Rule of Capture/Drainage - At its simplest, the rule of capture provides that a person owns all the minerals produced from a well bottomed in his mineral land, even if those minerals have migrated from (or been drained from) adjacent property. 1. It is largely a theory of non-liability for drainage. To protect against drainage, the adjacent mineral owner's options are to either "pool" with the producing mineral owner (discussed below) or drill his own offsetting well, which is inefficient and expensive. 2. As described further below, many states have mitigated the concerns of drainage through compulsory pooling statutes and well spacing requirements. 3. But the rule of capture and the need to protect against drainage are still relevant where these mitigating structures are not available, either in the state or in the specific situation. 4. Non-profit organizations in particular are obligated to protect their charitable assets, which would include any mineral assets they own that might get drained without compensation under the rule of capture. B. Severed Mineral Estates (by reservation, lease, deed, government reservation in original patent) - Minerals can be severed from the surface estate and conveyed separately from the land. Once severed, the mineral estate develops its own chain of title requiring its own distinct title examination to determine current owners. 1. Extent of Severed Minerals - Since an owner can only convey what it owns, the original severance document is significant in determining the extent of the severed rights, such as the types of minerals severed (e.g., are sand and gravel included?) and any restrictions that might be imposed (e.g., limits on the number of wells permitted on the land). as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 2 2

5 2. Silence - Where the severance document itself is silent, some states fill in the missing detail by statute or case law (e.g., states generally do not construe sand and gravel to be "other minerals" in a mineral conveyance unless the conveyance document expressly states otherwise). 3. Partial Divided/Undivided Mineral Interests - Just like land, minerals can be owned separately in distinct pieces or in undivided fractional interests. a. By its nature as a severed estate, mineral ownership follows a different chain of title than the surface estate. b. Within a single tract of land owned by a single surface owner, the minerals can be owned by multiple parties with multiple interests, each of whom typically have the independent right to conduct mineral activities on and under the land without the joinder or consent of the surface owner or any of the other mineral owners. c. For mineral owners of divided interests, this raises a concern of drainage. d. For mineral owners of undivided interests, their relationship is that of "co-tenants" and the leasing co-tenant must account and pay to the non-consenting co-tenants their proportionate share of profits (revenues minus costs) resulting from any production. e. [Note: Royalty owners and "non-executive" mineral owners do not have a right to lease the minerals. See discussion below on "executive rights" for consideration of who does and does not have a right to lease in certain circumstances.] 4. Surface Use - Of particular importance to the surface owner are the implied rights that are inherent in severed mineral estates, including implied rights to reasonable use of the surface (including use of water, timber removal). a. These rights generally include the right of ingress and egress, the right to select the locations of wells and facilities upon the property, the right to construct roads, tanks, pits, flow lines, conduct seismic, etc., as may be reasonably necessary to explore, develop, and transport as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 3 3

6 minerals. b. Most states and courts recognize at least a reasonable amount of accommodation that the driller must provide to the existing surface uses of the landowner, particularly where reasonable alternatives are available to the driller. c. Some states require compensation be paid to the surface owner for these rights (ex., Oklahoma Surface Damages Act), while others do not so long as the surface use is reasonable. d. Regardless, drillers are often amenable to negotiations regarding surface use/compensation with the landowner to avoid conflict and potential litigation later, which is a crucial opportunity for the land trust to negotiate for the protections that it needs. C. Well-Spacing - Well-spacing generally refers to the permitted location of wells within a common reservoir. 1. Spacing - rules and requirements restrain the rule of capture by limiting the number of wells allowed in a given area. a. The goals of spacing are to prevent waste (ex. economic waste due to too many wells being drilled in a reservoir) and to protect correlative rights of each mineral owner to recover an equitable share from a common source. b. Spacing rules are generally set by statute or regulation in the state, although exceptions are often applied for by a driller and allowed by the governing state agency after notice and hearing. c. Typically, spacing rules will establish i. setback distances between a well and other points (such as ii. iii. buildings, residences, etc.), minimum distances between wells and boundaries, and amount of acreage required for a single well (ex. 40 acres). d. The spacing rules for a well depend on the mineral type produced and the depth of the well. The area designated to support a single well in as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 4 4

7 compliance with the spacing rules is called the "spacing unit." D. Pooling - Pooling is the grouping of multiple tracts or mineral interests together to form a single unit for purposes of exploring and producing minerals in compliance with applicable spacing rules. There are typically two types of pooling that a mineral owner will encounter: 1. Voluntary Pooling - In voluntary pooling, the mineral owner freely consents to have all or part of the leased acreage pooled with land from other leases. a. The pooled mineral owners will share in the royalties from a producing well based on their proportional mineral ownership within the spacing unit. b. The area from a lease that gets pooled into a spacing unit often will only include a portion of the acreage under the lease, and not the entire leased acreage. c. Yet, most pooling clauses in leases grant the driller the right to keep the entire lease alive by "production" if production is occurring anywhere within the pooled unit, even if the well is not on the leased acreage and even if only a small portion of the leased acreage is within the pooled unit. 2. Pugh - So it is prudent for the mineral owner to appropriately restrict the pooling clause, such as limiting the acreage to be pooled to only the minimum necessary for the drilling permit and inserting a Pugh clause. A Pugh clause provides that at the end of the primary term, the lease will terminate as to any non-producing acreage outside of a pooled unit. 3. Example: A owns 500 mineral acres in Whiteacre, and B owns 1000 mineral acres in Blackacre. Both A and B enter into oil and gas leases with Company X covering the entirety of their mineral acres, and both leases permit pooling. X creates a 160-acre spacing unit which includes 40 acres from Whiteacre and 120 acres from Blackacre. Well #1 is drilled in the unit on Blackacre and begins producing. No other well is drilled during the primary term on either tract. Whiteacre's lease does not contain a Pugh clause, and, therefore, after as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 5 5

8 the primary term, the lease will continue on the entire 500 acres for as long as Well #1 (located on Blackacre) is producing. Blackacre's lease does contain a Pugh clause, and therefore after the primary term, the lease will continue only as to the 120 acres in the spacing unit for as long as Well #1 is producing. The lease on the other 880 acres of Blackacre will terminate. W HITEACRE 500 acres BLACKACRE 1000 acres 160 Acre f.- Well #1 Spacing ~nl~ Whlteacre: I 4 0 pooled acre s 2 5% of spacing unit.\ Blackacre: 120 po oled acres 75% of spacing unit 4. Compulsory (or Forced) Pooling - Many states have compulsory pooling statutes wherein the mineral owner who does not voluntarily consent to pooling can be compelled to enter into a pooling arrangement to support a spacing unit. a. In this situation, the driller requests a pooling order from the state regulatory agency and due process is instituted (notice to nonconsenting mineral owners, opportunity to be heard). b. Laws vary greatly by state, but generally drillers are allowed to "forcepool" and extract minerals from a spacing unit if voluntary leases have been obtained for at least some of the unit area. c. Some states also allow the driller to recover an amount greater than his expenses from the non-consenting mineral owners' share of production as a penalty. as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 6 6

9 d. Yet at the same time, after the penalty has been paid, many states require the driller to pay to the non-consenting mineral owner the net profits from production (rather than just a royalty percent) attributed to the non-consenting mineral owner's share in the unit. e. About 39 states have forced pooling statutes. 5. Economics - Drilling a well is an expensive endeavor, costing millions of dollars per well, so the driller wants to ensure as high a return on his investment as possible. a. As a driller assesses leasing strategies, a main consideration is how much of the minerals he can obtain through voluntary leasing. If, for example, he can only obtain 60% of the minerals needed for a spacing unit and to obtain a drilling permit, then he may forego drilling entirely - even if compulsory pooling is available in the state. b. Costs of the compulsory pooling process, as well as reduced return to the driller for every force-pooled mineral owner, often create financial deterrents for the significant up-front investment that the driller has to make. c. Risks are even greater for exploratory wells when production is less certain. So, as a general matter, a driller is less inclined to force-pool or to even drill at all within a unit if it's an exploratory well and a significant amount of acreage is not under voluntary lease. E. Duty of Executive Rights Holder to Royalty Owner - The mineral estate is comprised of a bundle of rights, one of which is the right to receive royalties (eg, a fraction of gross production, such as 1/8) and another is the right to lease (the "executive rights"). 1. Royalties =- It is not uncommon for a royalty interest to be carved out of the mineral estate and held by a third party. By its nature, a royalty interest does not include the right to lease the minerals. Rather, the right to lease (the executive right) is generally held by the owner of the mineral interest from which the royalty interest was severed. Because the royalty owner has no as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 7 7

10 right to lease, he is at the mercy of the decisions regarding leasing made by the executive rights holder. 2. Duties - As a consequence, the executive may owe duties to the nonexecutive that should be considered when making decisions regarding mineral development. In Texas, for example, the executive owes a duty of utmost fair dealing (described as fiduciary in nature) to the nonexecutive and must extract every benefit for the nonexecutive that it gets for itself. In some circumstances, the executive even has a duty to lease and may be liable to the non-executive for breach of duty if its refusal to lease is "arbitrary or motivated by self-interest to the non-executive's detriment." Lesley v. Veterans Land Board o/texas, No (Tex. Aug. 26, 2011). 3. Severed - If any part of the royalties have been severed from the mineral interest, the mineral interest owner should assess what, if any, duty he may have to the royalty owner, including any duty to lease. [Note that executive rights can also be severed from undivided mineral interests to be held by one or more of them, thereby creating an executive mineral interest and nonexecutive mineral interests.] F. Oil & Gas Lease - Typical components of the oil and gas lease include: 1. Lease Term - a. Primary Term - Typically 3-5 years. Some leases require that "delay rentals" be paid each year to keep the lease alive during the primary term unless a well is drilled. b. Paid-up leases - Wherein the amount paid at the execution of the lease maintains the lease for the full primary term without the need for additional payment. c. Secondary Term -- The secondary term extends the lease beyond the primary term by production. It is typically drafted something like: "This lease shall be for a term of XX years (the primary term) and for as long thereafter as oil and gas are being produced [in paying quantities] from said land or land with which it is pooled." as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 8 The 8

11 determination of production in paying quantities considers first whether production of oil or gas generates revenue in excess of operating expenses over a reasonable period of time (such as months). i. If so, then the lease continues. ii. 2. Payment Terms - If not, the second consideration is whether a reasonably prudent operator would continue operating the well for purposes of making a profit and not just for speculation (factors considered may include reservoir depletion, profitability of other wells in the area, commercial market for the resource, etc.). a. Bonus - The bonus payment is basically a signing bonus generally paid shortly after the lease is signed. It is usually based on an amount per acre. b. Royalty - Royalty payments are a percentage fee paid to the mineral owner (and other royalty owners, if any) based on gross production. Some states establish a minimum royalty payment (e.g., 12.5% in Pennsylvania), but higher amounts can be negotiated. c. Shut-In Royalties - Payments made to maintain a lease in effect where a well capable of production has been shut in, usually due to a lack of a market. Lease will specify amounts, but lessor should negotiate as high an amount as possible and also put a time limit on how long a well can be shut in before the lease terminates. 3. Pooling Clause - Pooling language either granting or prohibiting the right for the driller to pool the lease with other leases/land. If you grant the right to pool, be sure to insert a Pugh clause. See discussion above on "Pooling." 4. Limits to Secondary Term - These types of clauses prevent the driller from maintaining a large lease area with minimal drilling and production. Consequently, the dri ller will not offer these clauses, but should be inserted NOTICE: This paper and presentation are not intended to replace legal advice. and should not be relied upon as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 9 9

12 by the lessor as appropriate. a. Continuous development clause - requires the driller to drill additional wells within a certain amount of time, and failure to do so will terminate the lease as to all acreage except for the area around completed wells. b. Retained-acreage clause - specifies that a completed well will only hold a certain number of acres. c. Pugh clause - terminates the acreage that is not part of the producing pooled unit. S. Surface Use Restrictions / Conservation Restrictions - The lease might provide a minimal amount of surface protections, but most likely it will not. It will also not have provisions for minimizing ecological impact (such as noise, air emissions, groundwater protections, etc.). It will be up to the lessor to negotiate for them! G. Mortgages- 1. If land is subject to a mortgage, then prior to executing an oil/gas lease, the landowner should check her loan documents to ensure that the lease is not prohibited or does not require the lender's consent. In addition, most mortgages prohibit activities such as storing hazardous waste, which may be a part of the oil and gas lease. 2. Some mortgages directly address oil and gas leases entered into subsequent to the mortgage, and may specify that the lender is entitled to any payments made under the lease. 3. If land might be used as collateral for a loan, be aware that some lenders might not lend on property subject to an oil/gas lease. II. MINERAL ISSUES IN DONATED CONSERVATION EASEMENTS TO MEET IRS REQUIREMENTS There are many materials written on this topic, so the purpose here is to merely summarize the IRS requirements for addressing minerals in donated conservation as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 10 10

13 easements. If the donor owns any of the minerals in the subject land, then the requirements listed in Part A below will need to be met. If a third party owns any of the minerals, then Part B will also need to be met. Sample language for a conservation easement is attached as Exhibit A. A. Donor Landowner Owns Some or All the Minerals. 1. Prohibit surface mining - The conservation easement must expressly prohibit the extraction of minerals by surface mining. 26 USC 170(h)(5)(B)(i). a. Sand and gravel sites - If sand and gravel sites are needed on the property for non-commercial purposes, such as road maintenance, keep in mind Great Northern Nekoosa Corp. v. U.S., 38 ed. Cl. 645 (1997),97-2 USTC 50,591, Case No T filed Aug. 1, b. In that case, the tax deduction was disallowed where a conservation easement permitted sand and gravel sites for road maintenance because it ran afoul the prohibition on surface mining. c. The best practice is to exclude sand and gravel sites from the tax deductible conservation easement and create a separate non-deductible conservation easement covering these site areas. d. Other alternatives are possible but present potential deduction risks. 2. Restrict all other methods of mining -- If the conservation easement allows any other method of mining (such as oil and gas extraction), then those methods must be restricted and can have only "limited, localized impact on the real property but that are not irremediably destructive of significant conservation interests." Treas. Regs. at 1.170A-14(g)( 4)(i). a. In meeting this "limited/localized impact restriction," the Regulations state that a deduction will not be disallowed where mining facilities are concealed or compatible with existing topography and landscape, and where the surface is required to be restored to its original state. b. Oil and gas exploration and development can meet the limited/localized impact restriction with appropriate provisions in the conservation as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 11 11

14 easement. c. However, even if the mining activity meets the limited/localized impact restriction, it still must continue to meet the requirements of the conservation purpose (e.g., for an open space easement, the permitted mining activity, even if limited and localized, cannot destroy the required scenic view). 3. Best practice - Do not prohibit all mineral activity (other than surface mining), but rather restrict it as necessary and appropriate to meet the IRS "limited/localized impact restriction" and to protect the conservation targets, which might include provisions prohibiting any use of the surface and even the subsurface through a certain depth (ex feet). The restrictions can be significant, but a total prohibition creates challenges when extraction might legally occur anyway (due to severed mineral estate, compulsory pooling or drainage). B. Severed Mineral Estate. If the donor landowner does not own all of the minerals, then the following requirements will need to be met: 1. Negligible Probability of Surface Mining - The Internal Revenue Code expressly provides that the "surface mining prohibition" required in conservation easements can be met with respect to severed minerals so long as the donor can show that the probability of surface mining by the third party is so remote as to be negligible. 26 USC 170(h)(S)(8)(ii). This requirement is often met by the donor obtaining a geologist report (or "remoteness letter"). The donor must also show that the present owners of the minerals are not related to the surface owner. Treas. Reg A- 14(g)( 4 )(ii) (A) (2). 2. Limited/Localized Impact of Other Methods of Mining - Apart from surface mining, the donor will need to ensure that either: (a) the possibility of any mining by a third party is a remote future event (i.e., so remote as to be negligible under Treas. Reg A-14(g) (3)), or (b) any other method of mining by the third party meets the "limited/localized impact restriction" NOTICE: This paper and presentation are not intended to replace legal advice. and should not be relied upon as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 12 12

15 Ill. discussed in II.A.2 above. a. To meet (a), the donor can attempt to obtain a geologist report or "remoteness letter" determining that the probability of any type of mining (not just surface mining) is so remote as to be negligible. However, if a remoteness letter cannot be obtained because of oil/gas or other mining activity in the area, then the donor will need to meet (b) which is more difficult and potentially more expensive. b. To meet (b), all of the mineral owners (including anyone who has leased the minerals) will need to agree to the "limited/localized impact restriction." To accomplish this, the donor will need to (i) identify all of the mineral owners (including mineral lessees), which will entail a thorough mineral title examination, and (ii) obtain from each mineral owner a recordable instrument restricting his/her mineral interest with the "limited/localized impact restriction." RISK ASSESSMENT FOR O&G LEASING ON CONSERVATION LANDS In certain areas of the country, mineral owners are being offered Significant amounts to enter into oil and gas leases. Whether or not an oil/gas lease offer is on fee-owned land or conservation easement land, the following questions should be asked to assess whether the mineral activity can legally occur even if the landowner (as a mineral owner) refuses to sign a lease, and, if so, at what economic cost (to the driller and the landowner). A. Does the landowner own all of the minerals (including all the royalties) or only a portion? 1. Driller can usually provide the analysis of mineral ownership within the proposed drilling area. If not, consult your title policy or title examination when your interest was obtained. If neither the driller's analysis nor your own title information provide sufficient mineral title information, you may need to invest in obtaining a mineral title examination to assess whether any mineral interests have been severed and to what extent - particularly if your information conflicts with the driller's information. 2. Even if the landowner owns all of the minerals, minerals could still be as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 13 13

16 extracted if the state has a compulsory pooling statute. 3. If the landowner only owns a portion, the other mineral owners can typically lease without permission from the other mineral owners. 4. If there are outstanding royalty owners, does the landowner (as the executive rights holder) have a duty to the non-executives to lease under state law? Are there any non-executive mineral interest owners to whom the landowner owes a duty to lease? B. Does the state have a compulsory pooling" statute? If so: 1. What are the requirements (such as the minimum acreage that must be voluntarily leased)? 2. What is the timing and process (i.e., at what point is the mineral owner/landowner at risk of losing the ability to negotiate)? 3. What are the economic considerations for both the driller and the nonconsenting mineral owner? Is there a penalty to the mineral owner if forcepooled? Does the driller have to account for 100% of the net profits attributable to the force-pooled mineral owner after expenses and penalty? 4. Is the driller's leasing request for "exploratory" drilling or "development" drilling? Exploratory drilling carries greater risks of production. If the nonconsenting mineral owners make up a Significant part of the drilling unit, the driller may elect not to proceed in that drilling unit because the profit return is lower, particularly for exploratory drilling. C. What is the potential for drainage ifthe landowner does not lease? 1. Type of play (being the area of oil/gas accumulation within a geologic formation) is a factor - shale has low permeability so less concern of drainage. Sand play is highly permeable so greater concern of drainage. 2. For fee-owned lands - drainage raises the concern of protecting charitable assets for the land trust. D. Does the state have a "surface damage" compensation statute? 1. Some states require specific amounts be paid to the landowner for surface damages. as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 14 14

17 2. In some instances, this could be a tool for negotiating ecologic protections. E. For a donated conservation easement, what IRS issues might come into play, particularly if the easement prohibits mineral extraction but the risk of extraction occurring anyway is present? 1. Is an amendment to the conservation easement an option? (Consider that CE amendments must be reported to the IRS by the land trust on Form 990, and the IRS has not been a fan of amendments.) Should the land trust be compensated for the amendment? 2. Consider private benefit in any outcome. 3. What is the best conservation outcome to negotiate with the driller? Is this even an option? 4. Consider an IRS letter ruling? Lands PART II MITIGATING ECOLOGICAL THREATS OF OIL/GAS ACTIVITIES ON CONSERVATION LANDS IV. Hydraulic Fracturing V. Ecological Threats to Conservation Lands of Oil/Gas Activities VI. Mitigating Ecological Threats of Oil/Gas Activities on Conservation IV. HYDRAULIC FRACTURING Hydraulic fracturing (aka "fracking") is a process for extracting natural gas from shale. Water, sand and chemicals (the "frack fluid") are injected into a well under high pressure that creates fractures in the rock formation and releases the natural gas. Current extraction methods combine vertical drilling with horizontal drilling. This method has allowed for production in areas that have never before been part of energy production, and at the same time have brought new attention to the risks involved not only in fracking but in all oil/gas production - disturbance and fragmentation, etc. contamination of groundwater, air emissions, surface See attached Exhibit B for a map of shale plays in North America (as of 5/2011) and Exhibit as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 15 15

18 .G for a schematic of the vertical and horizontal drilling in fracking. Proponents of fracking believe that this method will ultimately make the U.S. self-sufficient by opening up new areas for production, while others argue that the long-term supply has been grossly over-estimated and its durability will quickly play out. But regardless of which side you're on, there's no doubt that fracking has changed the energy debate. The US Environmental Protection Agency (EPA) is undergoing studies of fracking and is poised to enact regulations covering water use, emissions, chemical disclosures, wastewater discharges and underground injection. Although this paper is not addressing policy or regulation, you should keep an eye on these areas and expect to see changes in reporting and standards, such as in the Toxic Substances Control Act, Clean Air Act, Clean Energy Standards, etc. v. ECOLOGICAL THREATS TO CONSERVATION LANDS OF OIL/GAS ACTIVITIES The ecological threats associated with oil and gas activities, including fracking, can be categorized as follows: A. Freshwater 1. Large volumes of water usage for fracking (millions of gallons of water required per well) 2. Contamination due to: a. Casing failures b. Blowouts/spills c. Wastewater disposals - wastewater includes salinity, NORM, frack fluid/chemicals d. Open pit leaks e. Faulty gathering lines (largely unregulated) 8. Surface Disturbance/Fragmentation 1. Infrastructure, including well pads, access roads, utility corridors, pipelines 2. Erosion C. Air Emissions 1. Methane leaks (greenhouse gas emission) as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 16 16

19 2. Emissions due to normal operations, routine maintenance, evaporation (smogforming volatile organic compounds VOCs) D. Noise 1. Drilling operations 2. Pumps at well site 3. Road traffic E. Other 1. Threats to livestock and wildlife from open pits 2. Potential earthquakes by way of deep well injection of wastewater (ex. Ohio, Arkansas) 3. Flaring disturbances (light, heat) 4. Incomplete/insufficient remediation 5. Introduction of invasive species 6. Financial insolvency/reputation of driller resulting in shoddy operations VI. MITIGATING ECOLOGICAL THREATS OF OIL/GAS ACTIVITIES ON CONSERVATION LANDS 1. Technical Provisions - Attached as Exhibit D is a table of the types of protections for minimizing the above threats that should be considered for conservation easements, surface use agreements and in oil/gas leases. Also check with the state agency in charge of mineral leasing for provisions it employs for state leases that might helpful in your situation. Other resources include (the "Environmentally Friendly Drilling Systems Program" of the Houston Advanced Research Center) and (Intermountain Oil and Gas BMP Project). 2. Baselines - Before any oil/gas activity occurs on your conservation land (or even on neighboring lands), conduct a baseline of the condition of the property, including water quality testing and wildlife surveys if possible. This will provide important evidence of potential causal relationship if groundwater contamination or other conservation impacts occur. NOTICE : This paper and presentation are not intended to replace legal advice, and should not be relied upon as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 17 17

20 3. Remain Vigilant - Even if you have strong surface protections in your lease or conservation easement, the terms are only as good as the monitoring and enforcement behind them. Also, if a well is only producing marginally, then the driller will spend less time/energy/money managing and maintaining it. Consider contracting with an environmental monitor who is familiar with oil/gas drilling and production to oversee the activities to ensure proper compliance. Require the payment of a monitoring fee by the driller in the lease or surface use agreement. Also, do not necessarily rely on the state agency to vigorously enforce its regulations - the extent of agency oversight and enforcement varies greatly by state. 4. Educate Yourself - Educate yourself on the information and materials maintained at the state's oil/gas commission. Many have materials publicly available online regarding wells, spacing, permits, production, spills, etc. Also check out the resources at the end of this paper. 5. Naturally Occurring Radioactive Materials (NORM) - NORM has long been known to be encountered in oil and gas operations. The geology containing the oil and gas contains other elements including radioactive materials such as radium and uranium. These materials can become concentrated in the extraction process and brought to the surface. Levels are typically very low and not a cause for alarm. However, the best practice is to not allow yourself or your staff to spend extensive amounts of time around the mineral operations or handle the materials. From the Texas Railroad Commission site: "Workers employed in the area of cutting and reaming oilfield pipe, removing solids from tanks and pits, and refurbishing gas processing equipment may be exposed to particles containing levels of alphaemitting radionuclides that could pose health risks if inhaled or ingested." as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 18 18

21 PART III CASE STUDY DISCUSSION Case Study: An existing Conservation Easement covering 2000 acres expressly prohibits any exploration, development or extraction of minerals from the surface or subsurface of the protected property. The mineral ownership of the 2000 acres is as follows: a. Tract A (500 acres) - Landowner (LO) owns all the minerals. b. Tract 8 (250 acres) - LO owns all of the minerals, subject to a 1/32 royalty interest held by Royalty Owner (RO). e. Tract C (7 50 acres) - LO owns '/2 of the minerals, and Third Party (TP) owns 112 of the minerals. d. Tract D (500 acres) - LO does not own any of the minerals. Mineral Owner owns all of the minerals. LO has been presented with an offer to lease LO's minerals in Parcels A. 8 and C, for a bonus payment of $2000/acre on 1125 net mineral acres ($2,250,000), plus 1/8 royalty. The driller has agreed not to use any of the surface of the property overlying the LO's minerals. LO proceeds to sign the lease and collect the bonus. NOTICE : This paper and presentation are not intended to replace legal advice, and should not be relied upon as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 19 19

22 Tract A 500 acres LO = 100% minerals Tract D 500 acres LO = 0 minerals MO = 100% minerals Tract B 250 acres LO ~ 100% minerals, less RO ~ 1/32 rovaltv Tract C 750 acres LO ~ 50% minerals TP = 50% minerals Questions for Discussion: 1. Is the mere signing of the lease a violation of the conservation easement? 2. Has a violation of the conservation easement occurred in Tracts A and 8 since LO owns the entire mineral estate and no surface occupancy is allowed? Is the RO's interest relevant in the analysis of whether a violation has occurred? a. Assume the state does not have compulsory pooling. b. What if the state does have compulsory pooling? 3. In Tract C where LO only owns 50% of the minerals, has a violation occurred since TP can lease the minerals? Does it matter if the other mineral owners have or have not already leased their minerals? as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 20 20

23 Resources: (the "Environmentally Friendly Drilling Systems Program" of the Houston Advanced Research Center) (a registry of wells across the U.S., including chemical disclosures and water consumption) (Intermountain Oil and Gas BMP Project). (Rocky Mountain Mineral Law Foundation) CRAIG R. CARVER & CHRISTOPHER M. KAMPER, CONSERVING LANDS WITH SEVERED MINERAL INTERESTS (a guide for conservation organizations funded by Colorado Conservation Trust and The Nature Conservancy of Colorado), Carver Kirchhoff Schwarz McNab & Bailey, LLC, Sout Street, Ste. 1700, Denver, CO ERNEST E. SMITH & JACQUELINE LANG WEAVER, TEXAS LAW OF OIL AND GAS (3 volumes, 2nd ed., LEXIS Law Pub., 1998 and 2009 update) as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 21 21

24 EXHIBIT A EXAMPLE LANGUAGE IN CONSERVATION EASEMENT Mineral Extraction. There shall be no exploration, development, production, extraction, or transportation of oil, gas or other mineral substances (whether such other mineral substances be part of the mineral estate or part of the surface estate) on, from, or across the Property ("Mineral Activities") except in accordance with this section; provided, however, that this section does not apply to water, which is addressed elsewhere in this Conservation Easement. A. No Surface Mining. Mineral Activities shall not be conducted by any surface mining methods [add if appropriate: (including, without limitation, the removal of gravel, sand or caliche)]. Surface mining is strictly prohibited. B. Oil & Gas Mineral Activities. Further, there shall be no Mineral Activities on the Property, except for oil and gas (together with such other liquid or gaseous hydrocarbons, sulphur, and substances as are necessarily produced through the wellbore with and incidental to the production of oil or gas from wells producing from the Property) ("Oil & Gas Mineral Activities"); provided, however, that such Oil & Gas Mineral Activities above shall not include the installation or operation of any amine or other hydrogen sulfide or sulphur treatment or removal facilities, gas processing facilities, refining facilities, or cathodic protection facilities, all of which facilities are strictly prohibited on the Property. All Oil & Gas Mineral Activities shall be subject to the following: 1. Oil & Gas Mineral Activities may be accomplished only by methods that will have a limited and localized impact on, and not significantly impair or interfere with, the Conservation Values and the purposes of this easement. as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 22 22

25 The person conducting any Oil & Gas Mineral Activities shall at all times use best efforts and practices to prevent damage or impairment of natural values and shall restore any area damaged to its original condition. All facilities relating to any Oil & Gas Mineral Activities must be concealed or otherwise located so as to be compatible with existing topography and landscape to the greatest extent practical. 2. Without limitation of the foregoing, [Insert any special limitations, such as no activity (including drilling, pipelines, roads, etc.) in sensitive areas, no more than 1 well site on the property (but which may contain multiple wells), timing of activities to avoid nesting/migration periods, etc.]. 3. Grantee must be given written notice of any actual or proposed Oil & Gas Mineral Activities at least forty-five (45) days prior to entering into any contract or lease, and, if no such contract or lease, prior to beginning any work. Grantor shall, prior to entering into any contract or lease (or prior to beginning any work if there is no contract or lease), consult with Grantee and incorporate conditions or restrictions as Grantee may reasonably determine are required in order to prevent a significant impairment or interference with the Conservation Values (such as limiting the number and location of wells, facilities, roads, pipelines, etc.). 4. Any and all subsequent mineral contracts, mineral conveyances, and mineral leases shall be bound by the provisions hereof. [OR, IF GRANTOR OWNS THE MINERALS & SLANT DRILLING IS REQUIRED: B. No Surface Use. Grantor has the right and retains its interests in all oil, gas and other mineral substances (whether such other mineral substances be part of the mineral estate or part of the surface estate) in and under the Property; provided, however, it is understood and agreed by Grantor and Grantee that, in conducting any Mineral NOTICE : This paper and presentation are not intended to replace legal advice, and should not be relied upon as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 23 23

26 Activities on the Property, Grantor shall not use or occupy any portion of the surface estate of the Property and shall not place any facilities, fixtures, equipment, building, structures, pipelines, rights of way or personal property of any kind or nature whatsoever on the surface of the Property or in the subsurface within the depth interval of 1000 feet below the surface of the Property or on or in any portion thereof. Grantor agrees that any and all Mineral Activities shall be strictly on a "nodrill" basis, except for directional or horizontal drilling below said subsurface interval from a surface location off the Property, and on a "no-operations" basis, and, accordingly, Grantor hereby waives any rights whatsoever to the use of the surface and said subsurface interval of the Property in connection with any Mineral Activities on the Property. Notwithstanding anything above to the contrary, Grantor shall not be prohibited to conduct exploratory activities that are non-invasive and do not otherwise damage or negatively impact the watersheds or aquifer. To the extent Grantor elects to explore for or otherwise extract or exploit any oil, gas or other minerals in or under the Property from a surface location off the Property, Grantor shall use its best efforts to minimize any damage or other negative impact on the watersheds or aquifer by such activity. [Even though no facilities will be allowed on the Property, still consider adding provisions to protect the Property's conservation values that could be adversely impacted by the mineral activities that are extracting minerals from under the Property, such as: restricting noise, requiring green completions, minimizing incidence of oil spills migrating to the Property by requiring all tanks to be bermed, etc.] [INSERT IF ANY MINERALS ARE OWNED BY THIRD PARTIES: C. Third-Party Minerals. In the event all or part of the oil, gas or other mineral substances (whether such other mineral substances be part of the mineral estate or part of the surface estate) are owned by third parties as of the date of the grant of this Conservation Easement, the following provisions shall apply to such third party oil, gas and other mineral substances to the extent this Conservation Easement is as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 24 24

27 deemed subordinated (by law or otherwise) to such oil, gas and other mineral substances ownership rights: 1. Grantor shall notify Grantee of any mineral exploration, development or other mineral activity proposed to occur on the Property by any such third parties (or their lessees) immediately upon becoming aware of such proposed activity. Grantee is granted the right (but not the obligation) to negotiate and join as a party in any surface use agreement or other agreement that may be negotiated with such third parties or their lessees for the protection of the Conservation Values. 2. Whenever such third party owners are required by applicable law or pursuant to any existing or future contract, conveyance or lease to obtain any consent from Grantor with respect to any access to, operation on, physical alteration of, or improvement to the Property, Grantor shall, prior to giving any such consent, notify and consult with Grantee and use its best efforts to incorporate the above conditions or restrictions on such consent or as Grantee may reasonably determine are required in order to prevent a significant impairment or interference with the Conservation Values. In the event Grantor at any time becomes the owner of any of such third party ownership rights, then such rights shall be deemed immediately subject to this Conservation Easement (including without limitation, paragraphs A and 8 of this section), and any and all subsequent Mineral Activities, contracts, conveyances and leases of or relating to such ownership rights shall be bound by the provisions of this easement.] as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 25 25

28 EXHIBIT B as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 26 26

29 cia Muskwa-Otter Park, 'Evie-Klua MUlkwa OtterPl/'k '\,; '\.. \~ '\ i ' r'" C.,... d.,.. Group ~ ~,,'" North American shale plays (as of May 2011) " ~akke UtI.. + Tuscaloosa Haynesville- Bossier Source: u.s. Energy Inrormallon A dm inistration based on dala from vari ous published studies. Ca nada and Mexico plays rrom ARI. Up dated: May 9, ~ 7l' Frederick Horton Brook ; 8Iuff _ N A Current shale plays Stacked plays -- Sha ll owest I youngest -- Interm ediate depth I age - - Deepest I oldest * Mixed shale & chalk play "'* Mixed shale & limestone play _.. Mix ed shale & tight dolostonesiltstone-sandstone play.. Prospective shale plays Basins Miles ;l~ I - r I Q WI C Q:I :I:: >< '" "t'- ON o.q) " I:lJ) '0 C1l.9:! 0.. 'E.c '" ~ o '0 " "3 0.c: '" '0-0 '"".. > '" '" u '".. ':; '0 '" "'-5'" '" II bjl,_ 2": ~ ~ '" N" c...,.. N '" 0 8(9 '0 ~ '0,_ "'-5'" ".. ~ '" 0. >,.S 0 ~ U 0 ".. u '0. '" '" 0 " ~.9.:!l ~.c: ~ '" ~ ~ 0.. '" '" bjl 0... '0 '" >.. "'" u 0 '" 0.,_ > '" '" '" 0. ".:!l ~.c: E- 1: o. W E u 8 E= 0 Z '" '" t'- N

30 bo 0: '>' <t: Vi to " 0.> M M ro 0.<: Vl N,...:i E E- 0 t.t.l J:: z 0: ",' 0.>.>:: 0.> bo 13 0: ~ ~ to ro.<: E u... ~ ~ 0.>... 0: 0.> t.t.l 0: t.t.l '" to U '0; c '" 0 0.> ~ E <t: 0.> 0.> u > (;::: "0 Vl ""' 0 0 6:a > 0 ~ 0: "0 t.t.l 0: 4-..<: 0 u... 0.> 0: E- O.> E t to 0-0.> 0 0 ~ (Not to scale) Municipal Water Well: < 1,000 ft. Additional steel casings and cemen1 to protect groundwater Protective Steel casing Approximate distance -- from surface: 6,000 feet Steel casing lines the well and is cemented in place to prevent any communication up the wellbore as the fracturing job is pumped orthe well is produced. Shallow formations holding fresh waterthat may be useful for farming or public consumption are separated from the fractured shale by thousands of feet of rock. ~ I :c X t.t.l;,,00 on C-O.> " bo "'".~ 0.. to 0:;.,.....c ~ 0 " "5 "'" 0..c: on "'". "'" "'" oj.,... ~ u.s:., on... "'"..c: II 00 '" , - _ u N '" '" ' C-,...., 0... N S@ ~.,..c: "'" 00 "... "'" 2:l s..... " C- 0 ~ u 0., u " '"... '0.. " 0 ~ -3.;!l ~ '"..c: " ~ ~ 0., on., C- '"... "'" '" '"., " > 0... u.,., > C-... on C- on., ".....c:..c:., E-... C- tii E u 0 u E= 0 '" on Z '" 00 N

31 STRATEGIES FOR MINIMIZING ECOLOGICAL THREATS FROM OIL/GAS ACTIVITIES Note: This table is merely a starting point for considering the types of ecological threats during oil/gas activities, their causes, and potential strategies for addressing them in an oil/gas lease, surface use agreement, management plan or even in a conservation easement. It is not intended to be comprehensive. In addition, technological advances are proceeding at record pace so new strategies are constantly appearing and should be considered. ECOLOGICAL THREAT Water Usage PROPOSED STRATEGIES TO MINIMIZE THREAT Limit or prohibit water use from the property. Explore alternatives to using freshwater, including waterless fracking (an emerging technology, though may not necessarily be safer) (Chesapeake carbon dioxide foam, using 1/10 of normal amount of water; New York landowners requiring use of liquid propane) Groundwater Contamination (from spills and waste) Require: - all tanks be in impermeable bermed enclosures. - well pad to be wholly contained in earthen berm or other appropriate containment structure - all liquid and solid waste be removed to an appropriate disposal facility - all containment areas to be constantly maintained and periodically pumped clear of fluids and rainwater to minimize long-term soil contamination Attempt to require frac fluids be non-toxic, and require disclosure of chemicals. as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 29 29

32 Where pipelines cross streams, consider having pipeline bored and cased sufficiently underneath the stream (unless that would be more detrimental). Groundwater Contamination (from faulty casing) Ensure sufficiency of well-casing and wellbore integrity. Retain independent third party to ensure driller properly installs casing. Determine depth of water table to determine depth of vertical casing necessary. Install and cement a sufficient amount of casing from the base of the water table to the ground surface. Require cement formulation that minimizes shrinkage. Waste Management and Disposal Require all wastewater and materials to be disposed of off-site to an appropriate disposal facility. Open Pits Prohibit any burying of liquid or solid wastes onsite. Prohibit open pits. Require closed-loop containment system (pitless system with storage tanks that separate liquids and solids). Maximizes amount of recycled drilling fluid and reduces waste. Wastes transferred offsite for disposal at injection wells or waste disposal facilities. Require storage tanks to be in impermeable bermed enclosures. If any pits are necessary, require 2 layers of liners, a leak detection system between liner layers, fences to keep out wildlife, nets or other devices to keep birds out. Surface Disturbance/ If necessary and appropriate, prohibit any surface use for activities. NOTICE: This paper and presentation are not mtended to replace legal advice, and should not be relied upon as a comprehensive coverage of this topic. Copyright 2012, all rights reserved. Page 30 30