Unitization and Pooling

Association of Lease and Title Analysts April 22, 2013 Houston, Texas Unitization and Pooling Lucas LaVoy Rebecca Seidl

Unit is one of the most confusing terms in oil & gas Can mean many different things Used interchangeably without explanation We will try to cover as many types of units as we can, explain where they came from, and how they differ Why do we care? 2

What is a Unit? 3

What is a Unit? Merriam-Webster: a single thing, person, or group that is a constituent of a whole an amount of a biologically active agent (as a drug or antigen) required to produce a specific result 4

Unit Urbandictionary.com: 5

Unit Urbandictionary.com: *(these definitions were neither relevant nor appropriate) 6

Unit Urbandictionary.com: *(these definitions were neither relevant nor appropriate) Collinsdictionary.com: a complete system, apparatus, or establishment that performs a specific function 7

The Rule of Capture Westmoreland & Cambria Natural Gas Co. v. Dewitt, 18 A. 724 [O]il, and still more strongly gas, may be classed by themselves, if the analogy be not too fanciful, as minerals ferae naturae. In common with animals, and unlike other minerals, they have the power and the tendency to escape without the volition of the owner. Their fugitive and wandering existence within the limits of a particular tract is uncertain. They belong to the owner of the land, and are part of it, so long as they are on or in it, and are subject to his control; but when they escape, and go into other land, or come under another's control, the title of the former owner is gone. If an adjoining, or even a distant, owner, drills his own land, and taps your gas, so that it comes into his well and under his control, it is no longer yours, but his. -Justice Mitchell, Pennsylvania Supreme Court, 1889 8

The Rule of Capture Actually developed from the English law relating to ownership of wild animals Rule of capture states you may extract as much as you want (except for waste) You may drain your neighbor without liability Creates the incentive to drill as much and as quickly as possible Each party will seek to extract maximum production quickly for fear of drainage 9

and predictable results ensue 10

and predictable results ensue 11

Boiler Avenue, Spindletop 1903 12

The Rule of Capture 13

and predictable results ensue Rampant wasteful drilling led to damage to reservoirs and precipitous price drops Particularly prominent in the East Texas Field, where production reached 1.1 million barrels in 24 hours on May 1, 1933. Prices hit $0.10/bbl. Railroad Commission attempted to limit production, but had limited power at the time Operators ignored the limits and filed numerous lawsuits against the RRC, tying its hands 14

This led to significant public and political pressure to effectively regulate waste. In April of that year, the Texas House passed a bill to create a stronger commission to regulate oil and gas Independent operators and their allies fiercly opposed this, even leading to fistfight in the Capitol building between representatives Burns (opposing) and Roeser (supporting) Burns lost the fistfight but won the debate; the bill failed in the Texas Senate. 15

Conservation Regulation Two main regulatory concepts emerged from this period: Density Proration RRC gained jurisdiction over oil & gas in 1919, and promulgated 38 original rules To address the crowding of wells and waste due to close spacing, RRC promulgated Rule 37: The very first spacing rule required only 150 feet to a lease line, and only 300 feet to the nearest well 16

Drilling Units This spacing limitation led to what we now know as Drilling Units Also known as the spacing unit Shows the RRC that there is sufficient unassigned acreage to satisfy the density rule for the field Could be special field rules for density, or statewide rules for density 17

Drilling Units Filed with the W-1 application for permit to drill 18

Drilling Units Plat to be attached for permit Describes unit on the ground But 19

Drilling Units In Texas this 40 acre Drilling Unit has: Zero effect on title Zero effect on royalty allocation Zero effect on well participation Zero effect on lease maintenance Purely regulatory concept 20

Drilling Units To re-cap: Drilling Unit is the result of the density regulations Avoids packed wells Does not, by itself, affect the quantity of oil that may be produced from any given well 21

Meanwhile, back in 1933 22

Limitations on Production Spacing and density rules (Rules 37 and 38 in Texas) alone were not working They remained difficult to enforce, many exceptions Many tracts were so small they would be un-drillable 23

Limitations on Production Small Operators objected, in court & in the legislature Wanted equal access to the reservoir, regardless of acreage Commission granted thousands of exceptions, hoping to avoid a showdown 24

Limitations on Production One Texas example was the Hendrick field in Winkler County So many spacing exceptions granted that the field began to water out and price plummeted 17,000 of the 24,269 wells in the East Texas Field drilled before 1938 were exception wells $100,000,000 per year wasted on drilling unnecessary wells Needed a second component to regulation 25

Limitations on Production Texas has used different systems for limiting overall production of oil and gas One concept is Maximum Efficient Rate of production. MER is the maximum rate a particular oilfield will produce that will not damage the field Used where there is high demand for certain field production. E.g., during WWII, or the 1970 s energy crisis Under MER, a field receives a maximum field-wide allowable, which is then distributed to the wells based on various formulae (i.e., it is prorated among the wells) 26

Limitations on Production The second production limitation concept is Market Demand prorationing This is used when there is not a supply crisis Looks at the market demand for oil & gas and attempts to provide price stability Since 1973, market demand factor has been set at 100% This means that most fields may produce at 100% of their maximum allowable 27

Proration Rules Wells within a field have a limit on how much they may produce (their allowable ) The proration unit is the acreage assigned to a well for determining the well s production allowable (Rule 38(a)(3)). Some field rules allocate production based on productive surface acres Some fields allocable allowables based only on well deliverability and/or well count. There are less-common variants as well. 28

Proration Rules Interestingly, for virtually all fields in Texas, gas allowables are all suspended. Therefore, no proration units for gas If there are no applicable field rules, and Statewide Rules apply, proration units are unnecessary Instead, Rule 45 allocates production based on a yardstick according to the depth of the reservoir Furthermore, if the field rules use deliverability, well count, or something other than acreage for the oil allowable, proration units are unnecessary 29

Proration Units IF the field uses productive acreage allocation, then acreage is assigned to a well s proration unit on the form P-15 Accompanied by a certification that the acreage claimed is productive 30

Proration Units This 40-acre proration unit: May be different land than the drilling unit Has zero effect on title Has zero effect on allocation of royalties 31

Proration Units Potential for confusion: Contracting parties may use proration unit to describe land Even where there is no acreage allocation for allowables, and hence no proration unit 32

Pooled Units Back to the small tract problem None of these tracts large enough to drill a well under 40-acre spacing 33

Pooled Units Operator files a P-12 with RRC, designating all 4 lease tracts as a pooled unit Now the Operator has 40 acres on which to drill the well Operator can also assign 40 acres to the well to get the allowable 34

Pooled Units If operator does nothing more than file this P-12: Operator has enough acreage to drill on the 40-acre pooled unit The well is on Baker s tract Baker gets his royalty share of 100% of production Able Lease Baker Lease Charlie Lease Dog Lease 35

Pooled Units If operator does nothing more than file this P-12: Able, Charlie and Dog get nothing No well can be drilled on Able, Charlie or Dog tracts Not enough acreage remains Able Lease Baker Lease Charlie Lease Dog Lease 36

Pooled Units If operator does nothing more than file this P-12: But, assume all 4 primary terms end on the same day At end of primary terms: Baker has production, so his lease is HBP Able Lease Baker Lease Charlie Lease Dog Lease 37

Pooled Units If operator does nothing more than file this P-12: But, assume all 4 primary terms end on the same day At end of primary terms: Baker has production, so his lease is HBP Able, Charlie and Dog Leases terminate for no production Able Lease Charlie Lease Baker Lease Dog Lease 38

Pooled Units Filing the P-12 does not, by itself, affect title RRC normally has no jurisdiction over title or property rights Filing the P-12 does not allocate royalties among the separate tracts 39

Pooled Units The Pooled Units we all know and love are created by contract (i.e., by the oil & gas lease) The pooling clause in the Leases would have allowed: Able, Charlie and Dog to share in production, and That production would have been deemed to have occurred on all their tracts, making them HBP 40

Pooled Units Example: Lessee, at its option, is hereby given the right and power to pool or combine the acreage covered by this lease or any portion thereof as to oil and gas, or either of them, with any other land, lease or leases in the immediate vicinity. Lessee shall file for record in the appropriate records of the county in which the leased premises are situated an instrument describing and designating the pooled acreage as a pooled unit In the event of operations for drilling on or production of oil or gas from any part of a pooled unit which includes all or a portion of the land covered by this lease. such operations shall be considered as operations for drilling on or production of oil or gas from land covered by this lease whether or not the well or wells be located on the premises covered by this lease 41

Pooled Units Traditionally, the tracts participate in production from the well proportionate to their acreage Royalty owners get paid on the basis of their tract participation in the pooled unit Production from Baker now holds Able, Charlie and Dog Leases 25% 25% Able Lease Baker Lease 25% 25% Charlie Lease Dog Lease 42

Pooled Units Alternative tract participation formulas now becoming common Particularly for horizontal development and in leases with sophisticated landowners Often there are restrictions on the ability to pool: Example: If my tract is pooled with other tracts, at least 50% of the resulting pooled unit must be my lands. 43

The Same Unit A pooled unit may also be the same land as a drilling unit and a proration unit The plat looks identical for each They do not have to be the same land 44

Differences between the units For example: Operator has four adjacent leases This field has 40- acre spacing Field has 80-acre proration units 45

Differences between the units Operator drills a well on the 40 acre lease 40 acre drilling unit No pooling is needed 46

Differences between the units Operator wants the larger allowable, so files an 80 acre proration unit, using the 3 west leases 47

Differences between the units Operator wants to hold more acreage, so creates a 160- acre pooled unit Files the P-12 Files in the County Courthouse 48

Pugh Clause The Pugh Clause modifies the pooling clause 3,000 acre lease Provides that operations or production from the pooled unit will not preserve the whole lease 500 acre Gas Unit (pooled) 49

Pugh Clause In other words, such operations or production will only preserve that portion of the lease which covers land in the pooled unit 3,000 acre lease 200 acres HBP 500 acre Gas Unit (pooled) 50

Pugh Clause Severs the unpooled acreage from the pooled acreage To keep the lease in force on the unpooled acreage, the lessee must pay delay rentals or drill a well Can be vertical or horizontal 500 acre Gas Unit (pooled) 200 acres HBP 51

Quiz: Which of these is the Pugh Clause? A: if, after the expiration of the primary term, Lessee fails to conduct drilling operations for more than 180 days between the completion of one well and the spudding of the next well this Lease shall terminate except as to a Unit being the number of acres surrounding each producing well required to obtain the full monthly production allowable B: each horizontal well producing on the leased premises, or on lands pooled or unitized therewith, shall hold only the acres out of this lease (or such pooled or unitized acreage) as is located within a rectangle measured 500 feet on each side of the horizontal wellbore within the correlative interval and 500 feet from the penetration point and terminus of such wellbore in a direction perpendicular to the path of the well... 52

Answer: None of the above These are Continuous Development / Released Acreage Clauses. These clauses require sequential drilling operations to keep the lease alive after the primary term ( Continuous Development ) The units around the producing wells, that survive the expiration of the primary term and the end of Continuous Development, are the Production Units 53

Continuous Development/Released Acreage The lessee should have a reasonable time to develop the leased premises 3,000 acre lease 500 acre Gas Unit (pooled) 54

Continuous Development/Released Acreage Designate a specified tract (a "production unit") around each well then producing on the leased premises 480 acre Production Unit 500 acre Gas Unit (pooled) 55

Continuous Development/Released Acreage One 480 acre Production Unit HBP A Second Unit consisting of Acreage HBP from the Pooled Unit 480 acre Production Unit Acreage HBP 500 acre Gas Unit (pooled) 56

Continuous Development Continued After the designation of production units, production from each production unit will maintain the lease in effect only as to the lands included within that production unit. In effect, each production unit becomes a separate lease for lease maintenance purposes. 57

Possible Problems Take care to be clear when referring to any unit: what type of unit are you really talking about? For example: Oil & Gas Lease At the expiration of the primary term this lease shall terminate except for the acreage within the proration unit for each well then producing oil or gas If these are oil wells, and there is no acreage allocation in the field rules for oil, arguably the lease is terminated except for the producing wellbores 58

Possible Problems Net Profits Interest Conveyance: The Net Profits Interest shall cover and apply to the Subject Wells, and also to the acreage within the unit for each such Subject Well. Farmout Agreement: If Farmee should drill and complete a producing well Farmee shall earn the acreage out of the lease associated with such well in the records of the Railroad Commission of Texas 59

Forced Pooled Unit-Texas Mineral Interest Pooling Act Precluded in most major fields (i.e., Permian Basin, the East Texas Field) RRC cannot compel based on its own motion Fair & Reasonable Offer Muscle-in Provision Lease A Lease B Lease E Lease C Lease D 60

In Oklahoma Favors forced pooling Represents the Majority View Pool all of the interests in the drilling unit Name one of the interest owners as operator Three options: Participate, Be Carried with Penalty or Lease Lease A Lease B Lease E Lease C Lease D 61

Unitization Unitization refers to a slightly different concept than pooling Both involve combined multiple tracts to be operated together Pooling is about complying with density regulations and assigning acreage for allowables Unitization is about operating a common source of supply, for maximum efficiency 62

Unitization Here, the entire field can become the Unit, sometimes thousands of acres Many states allow parties seek compulsory unitization where they can show it will benefit the field Texas is the only major producing state that does not allow this. Texas Units are voluntary 63

Secondary Recovery Units Today, units (in Texas) are encountered in fields for secondary recovery operations 64

Secondary Recovery Units Generally the parties will enter into a Unit Agreement (including the royalty owners) Provides for the sharing of costs and allocating production to various unit tracts May designate one party to operate the new Unit, or may provide for coordinated operations Approval of the Unit provides for immunity to some tort actions 65

Secondary Recovery Units There will be an approval process at the RRC, usually not contested (normally a large majority of stakeholders sign the agreement) An approved Unit provides for limited immunity to antitrust actions 66

Secondary Recovery Units Usually the Unit Agreement will provide that all leases in the unit will be HBP from production anywhere in the Unit. Usually provides for specified participation factors for the individual tracts in the unit These may be acreage based, but likely will take into account geological advantages as well RRC approval of the Unit does NOT bind stakeholders (WI owners or royalty owners) that have not signed it Those parties may still sue for tort damages, although their burden of proof will be more difficult These parties leases are not kept alive by Unit production 67

Federal Units Where a large portion of the lands for a reservoir are federally owned lands, a federal unit is often used Most important type of federal unit is the Exploratory Unit Can be huge (20,000+ acres) Administered by various federal agencies (often the BLM) 68

Federal Units A federal exploratory unit is a contract between the United States and participating parties for joint exploration and development There is a statutory form of unit agreement The federal agency (varies by jurisdiction) will generally require some large majority of interest owners agree to the proposal, before the agency will approve it Provides for lease maintenance by unit operations/production, although terms are considerably more complex than private unit agreements Usually there will be a Unit Operating Agreement as well, negotiated separately 69

ANY QUESTIONS? 70

ANY QUESTIONS? Lucas.LaVoy@tklaw.com Rebecca.Seidl@tklaw.com www.tklaw.com 71