Oil and Gas Committee Newsletter Vol. 2, No. 1 May 2014 NOTE FROM THE CHAIR Keith B. Hall Dear Readers, This is the inaugural issue of the ABA SEER Oil and Gas Committee Newsletter under the leadership of Kerry Kilburn, our new Vice Chair Newsletter. I thank Kerry for agreeing to serve as Vice Chair Newsletter. I also thank the other individuals who have volunteered to help with the newsletter or with some other Oil and Gas Committee activity. If you have not yet volunteered, but would like to help with the newsletter, programs, social media, the Web site, or some other committee activity, let us know. We will be happy to get you involved. Keith B. Hall ABA SEER Oil and Gas Chair Director of Mineral Law Institute Campanile Charities Professor of Energy Law LSU Law Center Visit the committee webpage: www.ambar.org/environcommittees Oil and Gas Committee, May 2014 A FORM FOR ALL DIRECTIONS: A.A.P.L. S NEW 1989 HORIZONTAL WELL JOA Michael H. Cooper, Austin Elam, and Kim Mai In 1956, the American Association of Professional Landmen (A.A.P.L.) published the first version of its model form Joint Operating Agreement (JOA), which it later revised in 1977, 1982, and 1989 (the A.A.P.L. form ). Since that initial publication, the oil and gas industry has universally adopted the A.A.P.L. form as its standard JOA. The industry has also since adopted horizontal drilling and development as a popular method to recover hydrocarbons. The technique and associated technologies have led to booming exploration and development in areas like the Eagle Ford and Barnett Shale formations in Texas, the Bakken formation in North Dakota, and the Marcellus and Utica Shale formations in the northeast United States. Although horizontal drilling technology continues to move at a breakneck pace, traditional oil and gas contracts, including the A.A.P.L. form, struggle to keep up. As the use of horizontal drilling and hydraulic fracturing became increasingly common, parties began incorporating into Article XVI of the A.A.P.L. s 1989 Form 610 JOA (the 1989 JOA ) provisions to address horizontal-specific issues related to horizontal wells that were not contemplated by the 1989 JOA. In 2013, the trend prompted the A.A.P.L. to update its 1989 JOA to address operational issues associated continued on page 3 1
Oil and Gas Committee Newsletter Vol. 2, No. 1, May 2014 Kerry Kilburn, Editor In this issue: Note from the Chair Keith B. Hall... 1 A Form for All Directions: A.A.P.L. s New 1989 Horizontal Well JOA Michael H. Cooper, Austin Elam, and Kim Mai... 1 Texas Offset Well Provisions Jordan B. Chester... 5 AMERICAN BAR ASSOCIATION SECTION OF ENVIRONMENT, ENERGY, AND RESOURCES CALENDAR OF SECTION EVENTS May 29, 2014 Key Environmental Issues in US EPA Region 2 Primary Sponsor: New York State Bar Association Columbia Law School New York, NY June 4-6, 2014 32nd Annual Water Law Conference The Red Rock Resort Las Vegas, NV June 24, 2014 Bankruptcy Considerations for the Oil and Gas Industry Live Webinar Primary Sponsor: Section of Litigation Copyright 2014. American Bar Association. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Send requests to Manager, Copyrights and Licensing, at the ABA, by way of www.americanbar.org/reprint. August 7-12, 2014 ABA Annual Meeting Sheraton Boston Hotel Boston, MA October 8-11, 2014 22nd Fall Conference Trump National Doral Miami Miami, FL Any opinions expressed are those of the contributors and shall not be construed to represent the policies of the American Bar Association or the Section of Environment, Energy, and Resources. For full details, please visit www.ambar.org/environcalendar 2 Oil and Gas Committee, May 2014
continued from page 1 with horizontal drilling. This paper highlights and discusses the significance of the revisions. The revised form is anticipated to be published in the near future for use in drilling horizontal wells. If the parties desire only to drill vertical wells, the 1989 JOA without the horizontal well revisions may be better suited. The terms that are capitalized below are defined terms in the new A.A.P.L. No. 610-1989 (Horz.) Joint Operating Agreement (the 1989 JOA (Horz.) ). Form Updates Definitions The 1989 JOA (Horz.) has added, revised, and supplemented several definitions to account for horizontal well drilling. For example, the term Deepen has been supplemented to account for the possible drilling of a horizontal well and, as a result, rules governing the Deepening of a well will cover the horizontal extension of a horizontal wellbore. Drilling and Development The location for an Initial Well is the surface and bottom hole of the Lateral(s). The language is important in the context of horizontal wells where the distance between the surface and bottom hole of the lateral can be thousands of feet. Subsequent Operations Under the 1989 JOA, drilling proposals must include an Authority for Expenditure. The 1989 JOA (Horz.) adds a checklist of items that should be included in a proposal for the drilling of a Horizontal Well. First, the proposal must state it is for a Horizontal Well. Next, it must specify the following: Total Measured Depth Surface and Bottom Hole Locations Horizontal Distances/Displacement Utilization and Scheduling of Rigs Stimulation Operations, Staging, and Sizing. Oil and Gas Committee, May 2014 Spudder Rigs A new section has been added to address the reality of two drilling rigs potentially used or required by horizontal drilling Spudder Rigs and Horizontal Rigs (Article VI.B.9.). If the operator desires to extend the time period between the Spudder Rig and the Horizontal Rig Move-On Period, the operator may extend that timeline for X number of days, or beyond those days, by affirmative vote of X percentage of Consenting Parties. If the initial Horizontal Well proposal does not provide for a Spudder Rig to be utilized, the Operator may elect to utilize a Spudder Rig upon affirmative vote of X percentage of the Consenting Parties. If a horizontal rig has not commenced operations within the Horizontal Rig Move-On Period, and the Consenting Parties have not extended the deadline (as set forth in the second paragraph of this section), the Operator is required to re-propose the well. If only a lesser number of Interest Owners elect to continue participation in the well, the then Operator will reimburse the previous Consenting Parties for unused funds, and the Consenting Parties are required to reimburse the parties who consented to the previous proposal for such prior party s costs incurred. Multi-well Pads Multiple horizontal wells are frequently drilled from the same pad location. If multiple wells are drilled or proposed from a single pad or location, the costs of such single pad shall be allocated, and reallocated, among all of the Consenting Parties of each of the wells on such pad. Presumably, if a party consented to a prior well, but declined to consent to a new well proposal, that party would be reimbursed for its well pad costs to the extent such party s proportionate ownership interest in the pad was reduced by the new well. Well Completion The Consenting Parties to a horizontal well do not have the option to decline to participate in a Completion attempt and Option No. 1 of Article VI.C.1. is now 3
mandatory for all horizontal well proposals. If Option No. 1 is not deleted or revised in some manner, the effective result is that the Completion is agreed to at the time of the initial well proposal. This change is consistent with the fact that once the wellbore has penetrated the objective formation and begins to deviate from a vertical orientation, the drilling of the horizontal segment of the wellbore is both a drilling and completion operation. Data that might be gathered and evaluated for a casing point election in a vertical well is customarily already available at the time the decision is made to deviate from the vertical portion of a horizontal well. Consequently, horizontal wells are generally drilled as completed wells. Where it is contemplated that a horizontal well will be perforated and some form of stimulus performed, there is generally no identifiable point for a casing point election to be made. Less than 100 Percent Participation in 1989 JOA (Horz.) If the Operator elects to proceed with drilling operations without 100 percent of the working interest owners having signed the 1989 JOA (Horz.), there are now two options the parties may select. One option, and formerly the only option, is for the Operator to indemnify the Non-Operators for all costs incurred in the well operation that would have been charged to the Non-Operators if all of the interest owners joined the 1989 JOA (Horz.). The other option is for the Operator to advise all parties of the total interest of the parties who have executed the 1989 JOA (Horz.). Each party joining the 1989 JOA (Horz.) then has the right to (1) limit its participation in that well to its interest shown on Exhibit A (as opposed to its aggregate participation interest in the well proposal) or (2) carry a portion of the interest of the non-executing party. The Operator must carry the interest of any nonexecuting party that is not otherwise carried by a Consenting Party. Other Provisions As the 1989 JOA enters its fourth decade of use, most practitioners are accustomed to seeing (often numerous) additions to Article XVI. Some of the most common additions are now included in the updated 1989 JOA (Horz.). The provisions of Article XVI now expressly control over any other article of the 1989 JOA (Horz.). The Operator is given the right to cease drilling a horizontal well if the horizontal well has reached its objective depth and, more importantly, to a distance or Displacement that a reasonably prudent operator would deem further drilling is not justified or required. The Operator may also conduct operations at a variance from the operations outlined in an approved AFE proposal, in Operator s discretion as a reasonably prudent operator. With respect to both of these additions, it would be important for the Non- Operators to consider what level of control the Operator should maintain over the distance and length of the horizontal leg of the well. Priority of Operations is now included by default in Article XVI (1) testing, coring, or logging; (2) complete drilling operations of proposed Laterals; (3) extend or Deepen a Lateral; (4) kick out and drill an additional Lateral in the same formation; (5) plug back the well to another formation or zone; (6) sidetrack; and (7) plug and abandon the well. The Operator also has the ability to not conduct a contemplated operation if a reasonably prudent operator would not do the same, for fear of placing the hole in jeopardy or losing the hole prior to Completion. Conclusion A.A.P.L. anticipates release of the 1989 JOA (Horz.) to the general public in the next few weeks. As horizontal drilling and hydraulic fracturing continue to play a large role in oil and gas development, we understand that some relatively minor revisions in addition to those previously available for review will appear in the final version. We will review those revisions when they are available. If those revisions are significant, we will provide additional comment. Operator and non-operators should continue to monitor closely, and consult with their counsel regarding, the provisions in operating agreements for horizontal wells. Kim Mai is a member of the Energy Practice Group at Haynes and Boone, LLP. Her practice is focused on transactions in the financial and energy 4 Oil and Gas Committee, May 2014
industries. She represents lenders and borrowers in secured reserved-base credit facilities, and has negotiated a variety of transactions, including ISDA master agreements and schedules and oil and gas purchase and sale agreements. As a member of the Energy Practice Group at Haynes and Boone, Austin Elam maintains a broad transactional energy practice that includes energy finance and the acquisition, development, and disposition of oil and gas properties. He has represented lenders and borrowers in secured reserve-based financings, project development and project finance, and negotiated oil and gas purchase and sale agreements, farm-out agreements and a variety of other transactions ranging from gas gathering agreements to ISDA Master Agreements and Schedules. Michael H. Cooper, a member of the Energy Practice Group at Haynes and Boone, LLP, possesses significant experience in all aspects of representation of energy companies and investors (foreign and domestic) in the energy industry, ranging from day-to-day operational and title matters to significant farm-out and participation and development projects and major acquisition and disposition transactions for clients involved in the E&P and midstream sectors. The vast majority of his current practice is devoted to transactions in the highly regulated oil and gas industry, including the securities and tax aspects of those transactions. TEXAS OFFSET WELL PROVISIONS Jordan B. Chester Over the course of the last hundred years, Texas oil and gas leases have included language intended to protect a lessor s land from drainage of hydrocarbons caused by operations on adjacent lands. These clauses, referred to as offset well provisions, obligate a lessee to protect the leased premises from drainage, which occurs when oil migrates from under one lease to the wellbore of a producing well on an adjacent lease. Protecting the leased premises from drainage is an implied duty of a lessee, even if an offset well provision is not written in a lease. Adding an offset well provision to a lease places this obligation in writing and can provide for more specific requiremen ts concerning the duty to drill. An example of standard offset well language is as follows: In the event a well or wells producing oil or gas in paying quantities should be brought in on adjacent land and draining the leased premises, Lessee agrees to adequately protect the oil and gas under the leased premises from drainage. Including an offset well provision in a lease places an obligation on a lessee to be aware of operations on adjacent lands. If another operator drills a well close to the leased premises boundary lines even at a legal location, an offset well provision becomes relevant, and a lessee must determine whether or not to drill an offset well. To fully understand a lessee s obligation to drill an offset well, one must understand the ramifications of not drilling an offset well and how Texas courts have ruled on this issue in the past. Further, when evaluating the need for drilling an offset well, a lessee must consider its implied covenant to protect correlative rights and prevent waste. With the development of horizontal drilling practices and the complexity of offset well provisions in modern leases, courts should continue to implement and uphold current jurisprudence. Vertical Wells: Substantial Drainage and the Reasonably Prudent Operator www.ambar.org/annual Even though the lessee is under the obligation to protect the leased premises from drainage, Texas Oil and Gas Committee, May 2014 5
courts, when analyzing offset well provisions with vertical wells, have placed the burden upon the lessor to prove that the lessee breached its duty. The lessor must prove that (1) substantial drainage occurred on the leased premises from an adjacent land or lease and (2) that a reasonably prudent operator would have acted to prevent the substantial drainage from the lessor s land by drilling an offset well. Amoco Prod. Co. v. Alexander, 622 S.W.2d 563 (Tex. 1981). Because the reasonably prudent operator standard includes an independent requirement that drainage be substantial, the reasonably prudent operator standard has become the determining factor in whether or not the lessee committed an offset well provision breach. Good v. TXO Production Corp., 763 S.W.2d 59 (Tex. App. 1988). The test for determining if a lessee has a duty to drill offset wells is what a reasonably prudent operator would do when drainage occurs. A lessee is not required to drill an offset well when an operator could not drill it, equip it, and produce the oil therefrom at a reasonable profit to himself. Chapman v. Sohio Petroleum Co., 297 S.W.2d 885 (Tex. 1956). The following jury instruction describes the nature of the reasonably prudent operator standard as it applies to the offset well obligation: [A] duty arises only if a reasonably prudent operator with knowledge of the risks involved would protect from such drainage by drilling a well and also unless [sic] a reasonably prudent operator would have a reasonable expectation of producing gas and condensate in paying quantities. The term paying quantities as used in this charge, means production of gas and condensate in such quantities as would give the operator a reasonable profit after deducting the costs of drilling, completing, operating, taxes, and marketing. Good v. TXO Production Corp., 763 S.W.2d 59, 60 (Tex. App. 1988). The reasonably prudent operator standard allows for the lessee to evaluate the lessor s interest, as well as its own, when determining whether or not to drill an offset well. Even if substantial drainage occurs on the leased premises, an obligation to drill an offset well might not be triggered if the offset well would not be profitable. Texas courts have yet to establish a firm standard for proving profitability, leaving the question to be answered on a case-by-case basis. Without a firm standard for proving profitability, it appears that a lessor has an uphill battle in proving a lessee breached the offset well obligation. Horizontal Drilling and the Future of Offset Provisions Over the past several years, offset well provisions have become more detailed and more complex. Today, it is not uncommon for an offset well provision to give a lessee different options when faced with a producing well or wells on adjacent land or leases. These options include (1) commencing operations for an offset well (the standard obligation); (2) paying a lessor a compensatory royalty in an amount based on production from the well located on the adjacent lands or leases; and (3) releasing the land which offsets the producing well on the adjacent land or leases. Along with these options, some new offset well provisions include deemed drainage language, which lessens the substantial drainage standard for a lessee. With new intricacies arising daily, today s offset well provisions are more complex than ever before. Based on advances in drilling technology, courts will soon turn their focus toward evaluating offset well provisions relating to drainage from horizontal wells. Courts will evaluate several factors, including the amount of drainage from the take points of a horizontal well, to determine whether or not to implement new jurisprudence. Though Texas courts have yet to break ground on this issue, courts should continue to implement the reasonably prudent operator standard. Parties should also consider alternatives, such as pooling, when evaluating complex offset well provisions. Taking advantage of an alternative lease provision, such as pooling, may eliminate unnecessary offset wells being drilled, protecting correlative rights, and preventing waste. Jordan B. Chester is an associate at the Kilburn Law Firm, PLLC, in Houston. Credit goes to Brandon L. Rutledge and William H. Rice for their help on this article. 6 Oil and Gas Committee, May 2014