Negotiating Financial and Surface Components of the Oil and Gas Lease

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1 Negotiating Financial and Surface Components of the Oil and Gas Lease The Negotiation of Any Oil and Gas Lease Begins with the Recall of the Nature and Purpose of an Oil and Gas Lease. In many states, and especially in New York State, oil and gas is considered fugitive, i.e. capable of migrating underground. Conventional oil and gas deposits derive from underground pools of oil and gas which allow anyone over the pool to drill a well into it and drain the oil and gas. The owner of the well has the right to drain the gas under his land even if the pool drains oil and gas from the neighbors property. This right to drain all the oil and gas in a pool even if the pool extends into neighboring properties is called The Rule of Capture. The rule has a long history in American real property law and has caused numerous problems including the wasting of economic resources, the loss of gas and oil which becomes unrecoverable from the ground, and the total absence of any correlative rights to a pro-rata share of the pool of oil and gas. It reduced the development of oil and gas to a race to see who could put the most wells on his property and drain the gas and oil the fastest. (Mostly oil however, as natural gas was once thought of as a nuisance and was vented or flared without saving it at all - another ugly consequence of the Rule of Capture. ) Today this rule is modified by Compulsory Integration (Forced Pooling) in which all landowners over the pool are entitled to a pro-rata interest in the oil and gas in the pool but only if they contribute to the cost of the well drilling and completion. All of this derives from the legal principal that, because oil and gas is fugitive, one cannot own it until one reduces it to possession on the surface of the ground. Anyone in the pool has the right to possess the oil and gas due to the Rule of Capture. Each landowner has the right to possess the oil and gas in the pool if he can recover it from the ground by drilling. In a sense, each landowner possess only the unique right to drill on his own land in an effort to try to tap the pool and drain off as much gas and oil as he can. To understand why a lease is the document of choice, one must know that a lease is the transfer of a right of possession in property. Once the oil and gas is removed from the ground it becomes the property of the person who has the right to possesses it. Therefore if an oil and gas company has a lease and the consequent right to drill and possess the oil and gas from the landowner, then the moment that the oil and gas company strikes oil or gas and brings it to the surface, that company is the owner of the gas and oil. For clarity, the person who owns the property is the landlord or lessor. The person who is granted the lease is the tenant or lessee. In the context of an oil and gas lease, the owner of the mineral rights (usually the landowner, but not always) will be the Lessor and the Oil and Gas Company will be the Lessee. It is the Lessee who has been granted the right to drill and possess the oil and gas. General and Specific Notions of Allocation of Risk.

2 In a Lease none of the economic risk should be allocated to the Lessor other than the risk that there is no recoverable oil or gas. The Lessor has surrendered all decision making powers to the operator in exchange for a contingent but formula based rate of economic return. The Lessor contributes his Natural Resource of oil and gas and expects the Lessee to have sufficient skill and acumen to perform competently, to accept and pay all the liabilities, and to exploit the resource to their mutual benefit, while not destroying the other natural resources of the Lessor (such as the water quality and quantity, the air quality, the soil quality, other subsurface deposits, and the use of the remaining unused surface). The Lessor s bargain is to be free of all liability other than to contribute the Natural Resource. In a Working Interest the parties negotiate the allocation of the risks and benefits. The Working Interest party has some say in operations and also receives a greater return on investment, if the well is successful, in exchange for a greater economic liability which is unpredictable and indeterminable. Notions and terms of a joint venture agreement or a Joint Operating Agreement should never be mixed with Lease notions. An examination of a lease should consider whether lease notions are honored by the language of the Lease. It is important to remember that no well can be drilled without a permit and that no permit can be granted without a unit being formed and approved by the Department of Environmental Conservation under Article 23 of the Environmental Conservation Law. See examples of unit maps below.

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4 Sketch of typical Overlap of Unit Map with Tax Map Parcels

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6 Conflicting Dynamic Tensions Complexity Precision High Cost of Administration Simplicity Broad Tolerances Low Cost of Administration PURPOSE OF COMPANY To make money with the least effort and least expenses. Extraction and sale of Landowner s resources. Oil and Gas Rights of Way Resale of Leases and interests therein Other products from the ground (helium etc) Use of surface rights Hedging LANDOWNER PURPOSE To make money from the landowner s own natural resources without losing the capacity and right to develop the other resources of the land, all while preserving the landowner s quality of life (human and natural environment, air, soil, and water and other energy or surface resources) and guarding against the frailties of all humans, such as error, mistake in judgment, incompetence, neglect, negligence, greed, spite, and fraud.

7 What is a Gas or Oil Production Company? What does the company do? 1. Acquire Oil and Gas leases. 2. Conduct Seismic Testing 3. Construct a wellsite with an access road 4. Explore for oil and gas 5. Drill well bores to find gas. 6. Complete the well by fracturing the rock to increase oil or gas flow rates. 7. Construct a pipeline from the well to the nearest common carrier transmission line. 8. Test, Measure, Market and Sell the gas. 9. Maintain the well and the pipelines 10. Plug and Abandon the Well 11. Reclaim and Restore the Lease Property Who does it for them? 1. Leasing Subcontracted to Landmen. 2. Seismic Subcontracted to Seismic testing company. 3. Wellsite construction and roads are subcontracted out. 4. Exploration and drilling subcontracted out to drilling companies. 5. Completion subcontracted out to Fracing company 6. Pipeline subcontracted out to Pipeline construction company. 7. Testing, measuring, Marketing and Sales are kept in house. 8. Well maintenance in house or subcontracted out. 9. Plugging and abandoning and reclamation and restoration are subcontracted out. What is the essential nature of many Oil and Gas Development Companies? 1. Oil and Gas Development Companies are essentially hybrid General Contractors with each company deciding how much of the work they want to keep in-house. 2. Keeping work in-house means high overhead for equipment, employees and building sites. 3. Subcontracting is therefore very common. 4. Conclusion: The persons to who you lease may not be the persons clearing your land, drilling the well, fracing the well, paying the royalty, or restoring the land. Therefore special legal conditions must be written into all leases to address this fundamental element of the industry. COMPANY ECONOMICS LANDOWNER ECONOMICS

8 Fixed or Determinable Expenses in: a. Acquisitions b. Production c. Marketing d. Construction and Restoration e. Plug and Abandon Acquisition Costs: Bonus Rental Royalty Delay Rental Renewal Fees Site Fees Pipeline Fees Production Drilling and Completion Royalty Formula Other Expenses - These are all company s risk Marketing Market in-house or outside contractor. Construction and Restoration Wellsite Access Pipeline Plug and Abandon Royalties, Rents, Site fees, etc. No Liability No Overhead Price Protection Benefit (Hedging & other innovations) Bankruptcies Buyer Defaults Spills Contamination and Cleanup Loss of volume of water, soil fertility, etc. Protection of other resources - Thermal, wind, subdivisions, etc. forest & farm Restoration Costs and Guarantees Surface Development of the Land Right to Mortgage Sale and Purchase of the Gas and Products

9 APPLICABLE PRINCIPLES: Allocation of Risk between the parties for the venture and its consequences. Express allocation of risk to landowner (in the words of the lease) Implicit allocation of risk to landowner (not in the words of the lease) Pragmatism Major Hurdles: Ideology Mistrust Lack of Company Competence Greed Do not assist the Operator in pursuing their vices by failing to have safe guards. People will cut corners when it comes to labor and expenses unless there is in place meaningful supervision. Industry Standards? 1. There is no such thing as industry standards when it comes to lease provisions, because to try to make them would be an anti-trust violation. 2. There is no such thing as industry standards in the standard for engineering and technology if it is not reasonable for the Landowner. If industry standards do not conflict with the landowner needs then if they are reasonable and we will accept them, not because they are industry standards, but because they happen to be reasonable to the landowners uses. The words industry standard has no meaning, as it changes with technology, time and the market. We went through this with the phoney standard royalty rate of 1/8th. Use of the Property: Always ask yourself why you own the land and what is your purpose in owning it. 1. Use of Surface

10 a. Siting of Well * size of site * placement of site * maintenance of site * closed loop drilling * recycling water * No waste injection * No disposal of cuttings on site * No disposal of anything on site * Baseline water testing * Strict Monitoring paid for by driller * Alternative fracturing methods such as Liquid Propane and cyrogenic nitrogen. b. Roads c. Pipelines: Pipeline Expert, specifications d. Equipment; e. Waste * pollution *disposal or keeping on site; f. Reclamation and Restoration; g. Storage; h. Release of Surface Rights around Improvements; i. Damage; * to remaining resources; * to improvements j. Soil and soil hydrology h. Spill management plan i. Storm water runoff plan j. fencing and hunting seasons 2. Use of Subsurface a. Waste b. Storage c. Damage to other resources d. Toxic pollution 3. Use of Resources: No venting or flaring, or use of water or gas or oil unless royalty paid on it. a. Water b. Gravel c. Timber d. Electricity e. Gas and Oil f. All other resources g. Permanent or temporary lose of resources

11 List of Several Relevant Statutory Provisions Article 23 of the Environmental Conservation Law of the State of New York Definitions. As used in this article, unless the context otherwise requires: 1. "Buffer zone" means all that area outside and surrounding the underground gas storage reservoir which the department approves as appropriate to protect the integrity of the reservoir, no part of which shall be more than thirty-five hundred linear feet from the boundary thereof. 2. "Cavity" means an open or partially open space left after a salt has been solution mined. 3. "Commissioner" means the commissioner of environmental conservation. 4. "Department" means the department of environmental conservation. 5. "Fund" means the oil and gas fund as established in section eighty-three-a of the state finance law. 6. "Field" means the general area underlaid by one or more pools. 7. "Gas" means all natural, manufactured, mixed, and byproduct gas, and all other hydrocarbons not defined as oil in this section. 8. "Local agency" means any local agency, board, authority, school district, commission or governing body, including any county, city, town, village or other political subdivision of the state. 9. "Metered" means the physical measurement of gas by means acceptable to the department. 10. "Oil" means crude petroleum oil and all other hydrocarbons, regardless of gravity, that are produced at the wellhead in liquid form by ordinary production methods and that are not the result of condensation of gas. 11. "Owner" means the person who has the right to drill into and produce from a pool or a salt deposit and to appropriate the oil, gas or salt he produces either for himself or others, or for himself and others. 12. "Person" means and includes any natural person, corporation, association, partnership, receiver, trustee, executor, administrator, guardian, fiduciary, or other representative of any kind, and includes any department, agency or instrumentality of the state or any of its governmental subdivisions. 13. "Plug and abandon" means the plugging, replugging if necessary, and abandonment of a well bore including the placing of all bridges, plugs, and fluids therein and the restoration and reclamation of the surface in the immediate vicinity to a reasonable condition consistent with the adjacent terrain. 14. "Pool" means an underground reservoir containing a common accumulation of oil or gas or both; each zone of a structure which is completely separated from any other zone in the same structure is a pool. 15. "Producer" means the owner of a well or wells capable of producing oil, gas, or salt; or any salt or hydrocarbon mixture. 16. "Product" means any commodity made from oil or gas and includes refined crude oil, crude tops, topped crude, processed crude, processed

12 crude petroleum, residue from crude petroleum, cracking stock, uncracked fuel oil, fuel oil, treated crude oil, residuum, gas oil, casinghead gasoline, natural-gas gasoline, kerosene, benzine, wash oil, waste oil, blended gasoline, lubricating oil, blends or mixtures of oil with one or more liquid products or by-products derived from oil or gas, and blends or mixtures of two or more liquid products or by-products derived from oil or gas, whether herein enumerated or not. 17. "Reservoir" means any underground reservoir, natural or artificial cavern or geologic dome, sand or stratigraphic trap, whether or not previously occupied by or containing oil or gas. 18. "Salt" means sodium chloride, evaporite or other water soluble minerals, either in solution or as a solid or crystalline material in a pure state or as a mixture. 19. "Solution mining" means the dissolving of an underground salt by water to produce a brine for transport to another underground or surface location for sale, processing or storage. 20. "Waste" means a. Physical waste, as that term is generally understood in the oil and gas industry; b. The inefficient, excessive or improper use of, or the unnecessary dissipation of reservoir energy; c. The locating, spacing, drilling, equipping, operating, or producing of any oil or gas well or wells in a manner which causes or tends to cause reduction in the quantity of oil or gas ultimately recoverable from a pool under prudent and proper operations, or which causes or tends to cause unnecessary or excessive surface loss or destruction of oil or gas; d. The inefficient storing of oil or gas; and e. The flaring of gas produced from an oil or condensate well after the department has found that the use of the gas, on terms that are just and reasonable, is, or will be economically feasible within a reasonable time Declaration of policy. It is hereby declared to be in the public interest to regulate the development, production and utilization of natural resources of oil and gas in this state in such a manner as will prevent waste; to authorize and to provide for the operation and development of oil and gas properties in such a manner that a greater ultimate recovery of oil and gas may be had, and that the correlative rights of all owners and the rights of all persons including landowners and the general public may be fully protected, and to provide in similar fashion for the underground storage of gas, the solution mining of salt and geothermal, stratigraphic and brine disposal wells Administration of article. 1. Except to the extent that the administration of this article is specifically entrusted to other agencies or officers of the state by its provisions, such administration shall be by the department. Geological services for the department in connection with the administration of this article shall be provided by or in cooperation with the state geologist. Within appropriations therefor the department is authorized to employ such personnel as may be necessary for the administration of this article and may also employ

13 or secure the services of such engineering, technical and other consultants as it may require from time to time. 2. The provisions of this article shall supersede all local laws or ordinances relating to the regulation of the oil, gas and solution mining industries; but shall not supersede local government jurisdiction over local roads or the rights of local governments under the real property tax law. 3. a. The commissioner shall accept from municipalities requests for funds from the oil and gas fund to reimburse the municipality for costs incurred in repairing damages to municipal land or property. Such requests shall include such explanatory material and documentation as the commissioner may require. b. The commissioner and director of the budget, may recommend payment to the municipality to satisfy the request for reimbursement upon finding that: (1) The municipality has made a bona fide effort to seek relief and recover its costs from those deemed to be responsible and any other appropriate avenues, but has been unsuccessful; (2) The damage was a direct result of activities regulated under this article and that the amount of funds requested is reasonable in view of such damages; and (3) The costs were incurred after the effective date of this subdivision Well permits a. This section shall not apply to (1) wells drilled, deepened, plugged back or converted in oil fields or pools which were discovered, developed and operated prior to January first, nineteen hundred eighty-one, and (2) wells drilled, deepened, plugged back or converted in natural gas fields or pools which were discovered, developed and operated prior to January first, nineteen hundred ninety-five and which are not being extended. b. As used in titles five, seven and nine of this article, unless the context otherwise requires: (1) "Statewide spacing" means spacing units for gas or oil wells that are within ten percent of the following sizes, as applicable, unless another percentage is specifically stated: (i) For Medina gas pools at any depth, 40 acres with the wellbore within the target formation no less than 460 feet from any unit boundary, plus, if applicable, the number of additional acres necessary and sufficient to ensure that any horizontal wellbore within the target formation is not less than 460 feet from any unit boundary; (ii) For Onondaga reef or Oriskany gas pools at any depth, 160 acres with the wellbore within the target formation no less than 660 feet from any unit boundary, plus, if applicable, the number of additional acres necessary and sufficient to ensure that any horizontal wellbore within the target formation is not less than 660 feet from any unit boundary; (iii) For fault-bounded Trenton and/or Black River hydrothermal dolomite gas pools where the majority of the pool is between 4,000 and 8,000 feet deep, 320 acres with the proposed productive section of the wellbore within the target formation no less than one-half mile from any other well in another unit in the same pool and no less than 1,000 feet from any unit boundary that is not defined by a field-bounding fault but in no event less than 660 feet from any unit boundary; (iv) For fault-bounded Trenton and/or Black River hydrothermal dolomite gas pools where the majority of the pool is below 8,000 feet, within five percent of 640 acres with the proposed productive section of the wellbore within the target formation no less than one mile from any

14 other well in another unit in the same pool and no less than 1,500 feet from any unit boundary that is not defined by a field-bounding fault but in no event less than 660 feet from any unit boundary; (v) For shale gas pools at any depth, for a vertical well outside any existing spacing unit for the same formation, 40 acres with the wellbore within the target formation no less than 460 feet from any unit boundary; (vi) For shale gas pools at any depth, for a horizontal well outside any existing spacing unit for the same formation and with a written commitment from the well operator to drill infill wells pursuant to subdivision 4 of section of this title, with all horizontal infill wells in the unit to be drilled from a common well pad within three years of the date the first well in the unit commences drilling, notwithstanding the ten percent tolerance specified in this subparagraph, up to 640 acres with the initial horizontal wellbore or wellbores within the target formation approximately centered in the spacing unit and no wellbore in the target formation less than 330 feet from any unit boundary; (vii) For shale gas pools at any depth, for a horizontal well outside any existing spacing unit for the same formation and in the absence of a written commitment from the well operator to drill infill wells pursuant to subdivision 4 of section of this title, 40 acres with the wellbore within the target formation no less than 330 feet from any unit boundary plus the number of additional acres necessary and sufficient to ensure that the wellbore within the target formation is not less than 330 feet from any unit boundary; (viii) For all other gas pools where the majority of the pool is above the depth of 4,000 feet, 80 acres with the wellbore within the target formation no less than 460 feet from any unit boundary, plus, if applicable, the number of additional acres necessary and sufficient to ensure that any horizontal wellbore within the target formation is not less than 460 feet from any unit boundary; (ix) For all other gas pools where the majority of the pool is 4,000 to 6,000 feet deep, 160 acres with the wellbore within the target formation no less than 660 feet from any unit boundary, plus, if applicable, the number of additional acres necessary and sufficient to ensure that any horizontal wellbore within the target formation is not less than 660 feet from any unit boundary; (x) For all other gas pools where the majority of the pool is 6,000 to 8,000 feet deep, 320 acres with the wellbore within the target formation no less than 1,000 feet from any unit boundary, plus, if applicable, the number of additional acres necessary and sufficient to ensure that any horizontal wellbore within the target formation is not less than 1,000 feet from any unit boundary; (xi) For all other gas pools where the majority of the pool is below 8,000 feet, within five percent of 640 acres with the wellbore within the target formation no less than 1,500 feet from any unit boundary, plus, if applicable, the number of additional acres necessary and sufficient to ensure that any horizontal wellbore within the target formation is not less than 1,500 feet from any unit boundary; (xii) For oil pools in the Bass Island, Trenton, Black River, Onondaga reef or other oil-bearing reefs at any depth, 40 acres with the wellbore within the target formation no less than 460 feet from any unit boundary, plus, if applicable, the number of additional acres necessary

15 and sufficient to ensure that any horizontal wellbore within the target formation is not less than 460 feet from any unit boundary; and (xiii) For all other oil pools at any depth, the wellbore within the target formation shall be no less than 165 feet from any lease boundary. Wells completed under a well permit issued pursuant to clause (xii) or (xiii) of this subparagraph that do not produce oil may not commence production of natural gas prior to modification of the spacing unit pursuant to applicable provisions of this title. (2) "Well operator" means the applicant for a permit to drill, deepen, plug back or convert a well subject to this title and titles 7 and 9 of this article, or the actual operator of the well if the well is not operated by the original applicant. (3) "Permit" or "well permit" means a permit to drill, deepen, plug back or convert a well for production of oil or gas. 2. Every person who applies for a permit to drill an oil or gas well or deepen or plug back a well to a different pool after the effective date of this section, notwithstanding prior orders, shall control through fee ownership, voluntary agreement, or integration pursuant to section or of this article no less than sixty percent of the acreage within the proposed spacing unit for such well and shall provide the department with: a. A map in a format specified by the department depicting the proposed spacing unit for the well, the surface and bottom hole locations of the well, the location of the wellbore in the target formation, the location of any field-bounding faults within the proposed spacing unit, the acreage of the proposed spacing unit, and the boundaries of each tract wholly or partially within the proposed spacing unit as may be evidenced by tax identification numbers; and b. A demonstration that the applicant controls the oil or gas rights, as applicable, in the target formation to be penetrated by the wellbore, provided that, if the applicant does not control such oil or gas rights, the department shall issue a permit that is conditional upon the applicant completing the integration process required by section of this article before the applicant can exercise the right to drill, deepen, plug back or convert under the permit. 3. In furtherance of the policy objectives of this article, the department shall take all actions required by it under this title and titles 7 and 9 of this article as expeditiously as possible Well spacing in oil and natural gas pools and fields Spacing orders are not required for wells drilled, deepened, plugged back or converted in oil fields or pools which were discovered, developed and operated prior to January first, nineteen hundred eighty-one. Spacing orders are not required for wells drilled, deepened, plugged back or converted in natural gas fields or pools, which were discovered, developed and operated prior to January first, nineteen hundred ninety-five and which are not being extended. 2. The department shall issue a permit to drill, deepen, plug back or convert a well, if the proposed spacing unit submitted to the department pursuant to paragraph a of subdivision 2 of section of this title conforms to statewide spacing and is of approximately uniform shape with other spacing units within the same field or pool, and abuts other spacing units in the same pool, unless sufficient distance remains between units for another unit to be developed. Prior to issuing any

16 such permit, the department shall publish a notice of intent to issue a well permit in the environmental notice bulletin, which shall include information concerning the spacing unit associated with the well. 3. a. If the proposed spacing unit does not meet the requirements described in subdivision two of this section, the department shall determine if the proposed spacing unit satisfies the policy objectives of section of this article. b. If the department determines the proposed spacing unit meets the policy objectives of section of this article, the department shall issue a notice of intent to issue a permit and spacing order. The well operator shall cause such notice to be published in a form and manner prescribed by the department. If the notice of intent relates to a proposed spacing unit that is not of a uniform size and shape with other spacing units for the field or pool, the department shall, if necessary, make such adjustment of the allowable production from the well to be drilled thereon so that the owners in the spacing unit receive their just and equitable shares of the production from the pool. Any such adjustment of the allowables shall be included in the notice of intent to issue a permit and spacing order. c. Any comments regarding a notice of intent to issue a permit and spacing order must be received by the department within thirty days of the date of the notice of intent and must meet the substantive and significant requirement for establishing an issue for adjudication. Any challenge to a spacing unit must contain (i) a description and a map of the proposed alternative spacing unit; (ii) a technical justification of the proposed alternative spacing unit, which shall include a description and analysis of the scientific data intended by the owner to support its proposed spacing unit configuration; and (iii) the name, address and experience of any expert witness proposed to support the proposed alternative spacing unit configuration. The department may request the owner challenging the spacing unit to present its scientific data to the department. d. The department shall determine whether substantive and significant issues have been raised. If the department receives no comments or if the comments do not raise a substantive and significant issue, the department shall issue the permit and the final spacing order. If the department determines that substantive and significant issues have been raised in a timely manner, the department shall schedule an adjudicatory hearing. 4. The department may issue permits to drill infill wells on a reasonably uniform pattern within the spacing unit after an integration order has been issued, if required, and only if it determines that drilling infill wells is necessary to satisfy the policy objectives of section of this article. The distances from the unit boundaries set forth in paragraph b of subdivision 1 of section of this title shall apply to any infill wells. For purposes of this section, new lateral wellbores drilled from the original wellbore in the unit are not considered infill wells if they are drilled prior to the first product sales from the original surface location. In a spacing unit established pursuant to clause (vi) of subparagraph 1 of paragraph b of subdivision 1 of section of this title, infill wells shall be deemed necessary, and the number of infill wells required to satisfy the policy objectives of section of this article must be drilled within three years of the date the first well in the unit commences drilling.

17 5. For wells permitted prior to the effective date of this section where a spacing order is required but has not been issued, the department shall issue a notice of intent to issue a spacing order. The well operator shall cause such notice to be published in a form and manner prescribed by the department. The department may issue an order without a hearing if the proposed spacing unit complies with the requirements of subdivision two of this section and no substantive and significant objections to the boundaries of the proposed spacing unit are received within thirty days after publication of the notice by the well operator. If the department determines that substantive and significant issues have been raised in a timely manner, the department shall schedule an adjudicatory hearing. 6. Unless it is extinguished pursuant to subdivision seven of this section, a spacing unit established by the department shall be binding upon all persons and their heirs, successors and assigns. Upon good cause shown, an order establishing a spacing unit or a spacing unit which conforms to statewide spacing may be modified by the department without conducting a hearing if a finding has been made that no facts are in dispute after all affected persons have been provided a reasonable opportunity to comment. In a spacing unit established pursuant to clause (vi) of subparagraph 1 of paragraph b of subdivision 1 of section of this title, failure to drill infill wells pursuant to subdivision 4 of this section shall constitute good cause for the department to initiate a modification of the spacing unit. If necessary, upon issuance of an order which changes unit boundaries, the well operator shall adjust the accounts for owners within the original and modified units to reflect the modified boundary. Any participation by new owners and any adjustment of revenue or royalties resulting from participation by new owners shall be on a prospective basis only. If the initial risk penalty phase pursuant to title 9 of this article is in effect, any new owner added to the unit may elect to be integrated as a participating owner, a non-participating owner or an integrated royalty owner as defined by title 9 of this article. Full well costs shall be assessed against new participating owners and non-participating owners and included in the risk penalty calculation. If the initial risk penalty phase has concluded, any new owner added to the spacing unit may elect to be integrated as a participating owner or an integrated royalty owner on a prospective basis only. 7. Upon the expiration of a well permit or the plugging and abandonment of all wells in a spacing unit, the spacing unit shall be extinguished. Upon extinguishment, all lands within such spacing unit shall be eligible for inclusion in subsequent spacing units. 8. The department, without considering correlative rights, may grant a permit to those entities described in paragraphs b and c of subdivision 3 of section of this article for the purposes of natural gas development if the department determines, after notice and hearing, that the natural gas resource would not be developed by any other entity within twelve months of the close of the hearing record. In the event that the department shall not receive timely notice of appearance prior to the scheduled date of hearing, it may dispense with such hearing. In making its determination the department shall require that the entity described in paragraphs b and c of subdivision 3 of section of this article submit a finding made by such entity that such drilling is likely to be economically sound, and that the entity in question utilize

18 the resource for its exclusive use when granting such a permit Compulsory integration and unitization in oil and natural gas 1 pools and fields. 1. Compulsory integration and unitization in oil pools and fields and in natural gas pools and fields shall be subject to the provisions of this section with subdivision 3 to be specifically applicable to integration within individual spacing units, and subdivisions 4 through 12 to be specifically applicable to unit operation of an entire pool or part thereof. 2. The department shall not make any order requiring the integration of interests in any spacing unit or requiring the development or operation of any field, pool or part thereof as a unit unless it finds, after detailed study and analysis, notice and hearing, that the integration of interests in spacing units, under conditions then existing in this state, or in the field or pool to be affected, is necessary to carry out the policy provisions of section of this article. 3. In the absence of voluntary integration as permitted by section of this article and after finding as required by subdivision 2 of this section, the department shall make an order integrating all tracts or interests in the spacing unit for development and operation. Each such integration order shall be upon terms and conditions that are just and reasonable and subject to the following: a. As used in this section or otherwise in this article, to the extent applicable to oil and gas wells: (1) "Integrated non-participating owner" or "non-participating owner" means an owner who elects to reimburse the well operator, out of production proceeds, for such owner's proportionate share of the actual well costs of the initial well in a spacing unit and be subject to a risk penalty, and complies with all of the requirements for integration, including the terms of integration, as specified in an order of integration issued pursuant to the compulsory integration provisions of this section. The non-participating owner shall receive the full share of production attributable to such owner's proportionate interest in the spacing unit following the recoupment by the well operator of the owner's proportionate share of the actual well costs plus a risk penalty of two hundred percent of the share of the actual well costs allocable to such owner. In the case of a leased tract, a royalty shall be deducted from the non-participating owner's share of production, which shall not be subject to charges or costs, but shall be separately calculated and paid to the non-participating owner on behalf of the royalty owner as follows: (i) During the recovery of the actual well costs, 1/16 or 6.25%, (ii) During the recovery of the first 100% of the risk penalty, 3/32 or 9.38%, (iii) During the recovery of the second 100% of the risk penalty, the lowest royalty fraction set forth in an existing lease in the unit, but no less than 1/8 or 12.5%. Nothing in this subparagraph relieves any lessee of its obligation to pay, from the commencement of production, any remaining royalty and overriding royalty owed under the terms of its lease. (2) "Integrated participating owner" or "participating owner" means an

19 owner who elects to participate in the initial well in a spacing unit, pays all costs associated with participation and complies with all of the requirements for participation, including the terms of integration, specified in an order of integration issued pursuant to the compulsory integration provisions of this section. (3) "Integrated royalty owner" means an owner who has either elected to be an integrated royalty owner or who does not elect to become either a participating owner or a non-participating owner. The integrated royalty owner shall receive a royalty equal to the lowest royalty in an existing lease in the spacing unit, but no less than one-eighth. The integrated royalty owner shall have no obligation to the well operator or any other owner for any charges, taxes or fees associated with the operation of the oil or gas well and, notwithstanding any other law to the contrary, shall not be liable by reason of the owner's status as an integrated royalty owner for any claims for personal injury or property damage suffered by any person relating to the drilling and operation of the well. (4) "Risk penalty" means the percentage applied to well costs to reimburse the well operator for the risk involved with the exploration for and development of a well or the percentage applied to other costs that are subject to recoupment and a risk penalty, as provided herein. At any time during a risk penalty phase, an owner subject to a risk penalty may pay to the well operator the full amount subject to recoupment by the well operator, to terminate the risk penalty phase and be eligible for other opportunities for participation as provided herein. (5) "Well costs" means the costs incurred or estimated to be incurred by the well operator in relation to the drilling, completion, and the installation of surface equipment, other than as described in item E of clause (ii) of subparagraph 1 of paragraph c of this subdivision, including, without limitation, surveying, drill site preparation, leasing of surface rights and access roads pertinent to the drill site, construction of access roads, permitting, drilling, stimulation, testing, well logging, drilling insurance, plugging and abandonment of the well, environmental mitigation costs associated with drilling and any other costs associated with the foregoing that the operator has incurred or anticipates incurring, including a reasonable charge for supervision of the foregoing activities. b. If upon issuance of a well permit by the department, the well operator does not control all owners within the spacing unit, either through lease or voluntary agreement, the department shall schedule an integration hearing. c. The well operator shall, no later than thirty days prior to the date of the integration hearing scheduled by the department, provide actual notice of the hearing to all uncontrolled owners wholly or partially within the spacing unit and shall provide notice by publication in a form and manner prescribed by the department. Prior to or contemporaneously with such notice, the well operator shall provide to the department the well operator's estimate of those well costs that the owners electing to participate shall be required to pay to the well operator prior to or at the integration hearing based on each owner's proportionate share of such costs and a list of each tract wholly or partially within the spacing unit, the acreage attributable thereto, the percentage interest of the total spacing unit of each tract, an

20 indication of whether the tract is controlled by the well operator and the names and addresses of the uncontrolled owners. If applicable, such list shall also identify each tract where the owners remain unknown or cannot be located after diligent efforts by the well operator. To the extent an owner cannot be determined after diligent efforts by the well operator and such owner is integrated as an integrated royalty owner, the well operator shall hold the royalty percentage payable to such integrated royalty owner in an interest bearing account for such integrated royalty owner until the owner is located or the property is deemed abandoned, whichever comes first. (1) The notice of hearing to each uncontrolled owner shall be made in a form prescribed by the department, and shall include: (i) An election form, as prescribed by the department, granting the uncontrolled owner the right to elect to be integrated into the spacing unit as an integrated participating owner, an integrated non-participating owner or an integrated royalty owner. Such form shall set forth the well operator's good faith estimate of those well costs which the owners electing to be integrated as participating owners will be responsible for paying to the well operator prior to conclusion of the integration hearing, based on each owner's proportionate share of such costs, and confirm that if an uncontrolled owner does not make a timely election and does not timely comply with all of the requirements to be either a participating owner or a non-participating owner, that such uncontrolled owner shall be integrated into the spacing unit as an integrated royalty owner. (ii) A copy of the proposed order of integration, which shall include the proposed terms of integration applicable to integrated participating owners and integrated non-participating owners. The proposed order of integration shall include the following terms in addition to any applicable risk penalty: A. The owner shall be liable for its proportionate share of all costs and expenses, including taxes, and claims of third parties related to the well, operations thereon and in conjunction therewith, and shall be entitled to its proportionate share of all benefits therefrom. If an owner's share of production is subject to a risk penalty, the well operator shall establish a risk penalty account for such owner and all costs, expenses and benefits attributable to such owner shall be reflected in the penalty account; B. The well operator shall hold any funds paid by the owner or recouped through the risk penalty attributable to the plugging and abandonment costs of the well, as estimated prior to the drilling of the well, in an interest bearing account until such funds are required and utilized for such purpose; C. The owner shall be liable for and shall indemnify all other persons participating in the development of the well, whether participating owners, non-participating owners or otherwise, including the well operator, from and against all claims arising out of the owner's non-payment of rentals, royalties and other payments or burdens on the oil and gas rights that such owner contributes to the spacing unit and from and against all claims associated with the loss or failure of title to the oil and gas rights the owner contributes to the spacing unit; D. The well operator shall have a first lien on the production of the owner to pay any outstanding costs, expenses or claims and the well operator shall be entitled to withhold and retain for the purposes of

21 set off any revenue or production owed or due to the owner under an order of integration. Nothing in this paragraph shall affect the well operator's right to collect any outstanding amounts incurred nor the right of any fee owner of oil and gas interests to collect any amounts owed under the terms of any lease from such owner. The exercise of any remedy shall not preclude the well operator from seeking any other remedies available under the law; E. Whether or not the owner is subject to a risk penalty, the well operator shall submit to the owner a written authority for expenditure of the estimated costs associated with the construction of any facilities not included in well costs beyond the surface equipment at the wellhead to the first point of interconnection with other facilities that commingle production from a group of wells that includes the well, including, but not limited to, pipe, compression, processing, treating, dehydrating or separating equipment, fixtures, related buildings and other equipment. The owner shall have thirty days to elect to participate and pay its proportionate share of such estimated cost, the failure of which shall be deemed to be an election by the owner not to participate. If the owner elects not to participate or is deemed to have elected not to participate, the well operator shall be entitled to retain for its own account all of the owner's share of production from the well until the well operator has recouped from the net proceeds of the owner's share of production the owner's share of the actual costs of the facilities, plus a risk penalty of one hundred percent of such costs. Any such amounts shall be added to the risk penalty account for such owner; F. If the owner is not subject to a risk penalty, the owner shall have the right to take its share of gas or oil production in kind and shall be responsible for its transportation and marketing arrangements downstream of the facilities constructed pursuant to item E of this clause. The owner's election to take in kind must be conveyed to the well operator no later than fourteen days prior to first production from the well or upon seventy-five days written notice to well operator at any time following first production from the well subject to the expiration of any existing contracts; G. If the owner is not subject to a risk penalty and does not take its share of gas or oil production in kind, the well operator shall market the owner's share of production from the well ratably with its own share of production from the well for the account of the owner. The well operator shall pay the owner based on the price received by the well operator for production in the general area less (I) the owner's proportionate share of all costs incurred by the well operator for transporting, treating, processing, or otherwise making the production marketable, and (II) a marketing fee not to exceed five percent of the sales price of the production; H. The well operator shall be entitled to propose and conduct a subsequent operation on a well, meaning any reworking, sidetracking, deepening, re-completing or plugging back of the well or the drilling of a lateral or an infill well in the formation for which the unit was created. Owners shall be provided with a written authorization for expenditure of the estimated costs of the subsequent operation. An owner shall not be entitled to participate in a subsequent operation as long as the owner is in a risk penalty phase. If a subsequent operation is proposed while an owner is in a risk penalty phase, the owner's

22 proportionate share of the actual cost of the subsequent operation plus two hundred percent of such actual costs shall be added to the risk penalty account for such owner. The owner not in a risk penalty phase shall have thirty days to elect and pay its proportionate share of the estimated costs, unless a drilling rig is on location, in which event notice of a subsequent operation may be given by telephone and the owner shall have forty-eight hours, exclusive of Saturday, Sunday and legal holidays, to make an election and thirty days to pay the owner's proportionate share of costs. The failure of any such owner to elect and pay in a timely manner shall be deemed an election by the owner not to participate in the subsequent operation. If such owner elects or is deemed to have elected not to participate in the subsequent operation, the well operator shall be entitled to retain all of the owner's proportionate share of production from the well until the well operator has recouped the proportionate share of the actual costs of the subsequent operation attributable to such owner, plus two hundred percent of such actual costs; I. The well operator, on behalf of the owner, shall be entitled to conduct all acts associated with the well and necessary facilities related thereto, including without limitation: conducting title examination and curative work on the tracts included in the spacing unit; arranging for contract services or employees of the well operator, at the customary salaries, wages and benefits of such employees, to oversee the operation and maintenance of the well and the facilities in the production unit associated with the well; arranging for and maintaining required financial security for well bonds and insurance; discharging litigation, claims of third parties and disputing tax assessments; developing and implementing emergency responses and dealing with catastrophic events; and arranging for the storage, transporting and disposal of produced water, by-products or refuse associated with production and maintenance facilities; and J. Other terms may be included in the order of integration if the department determines such terms are reasonably required to further the policy objectives of section of this article. (2) Within twenty-one days of receiving notice of the integration hearing, each uncontrolled owner shall provide to the well operator and the department its election as to whether it chooses to be integrated as a participating owner, a non-participating owner or an integrated royalty owner. Failure of an uncontrolled owner to elect to be integrated as a participating owner, a non-participating owner or an integrated royalty owner and to pay the amount specified in the notice by the date of the hearing, or to make any election, shall result in the owner being integrated as an integrated royalty owner. Nothing contained in this section shall preclude any person from entering into a lease or other voluntary agreement at any time prior to the hearing. d. If substantive and significant issues are raised during the integration hearing, the department shall schedule an adjudicatory hearing. e. If no substantive and significant issues are raised at the hearing, the department shall issue a final order of integration confirming the status of all uncontrolled owners in the spacing unit as participating owners, non-participating owners or integrated royalty owners; the terms of integration; the acreage attributable to each owner and the proportion such acreage bears to the entire spacing unit; and the