Wednesday, October 31, 2007

When An Agreement For A 640 Actually Means It Will Be A 1280

So, say a mineral owner (“MO”) executes a lease with an oil company (“OC”) that restricts the OC’s pooling authority to create a pool of not more than 640 acres, or in other words, restricting the OC to limit any spacing unit involving the lands to not more than 640 acres. Keep in mind that the state regs allow the creation of a 640 acre drilling unit for horizontal wells without any hearing, and any unit larger than 640 is considered an exception unit and requires a hearing. Then, say the OC requests that the NDIC create a 1280 acre drilling unit that includes the lands with the leases having the 640 acre pooling limitation, and the MO, citing the restrictive pooling provision in the lease, objects to the creation of the 1280 at the IC hearing. Oh, whatever shall the IC do in such a situation?

Well, that situation occurred at the IC hearings in September, and the IC said the lease provision was a m
atter between private parties. It said the proper venue for the dispute was the courts and not the IC, which has limited powers to regulate the orderly development of wells, etc., etc., etc., and not to resolve disputes between private parties. It then created the 1280 acre drilling unit. Now, it is apparently technically true as stated by the IC that the creation of a drilling unit (which was at issue here) does not actually effectuate the pooling of any interests, as that occurs when the IC creates a spacing unit after holding another hearing. But isn’t that like saying that a trespass only occurs after the trespasser chopped down your trees, as only at that later time was the trespass apparent?

As such, wasn’t the IC ignoring the practical effects of its order and the correlative rights of the MO who bargained for the restrictive pooling provision with the OC? In other words, by granting the order, the IC gave authority to the OC to drill a horizontal well across the 1280, and assuming the horizontal wellbore transverses both sections and is commercial, exactly how can a 640 acre spacing unit ever be created at a later time in such a situation? The answer is that it can’t, unless in the unlikely event the OC plugs back the lateral so that it does not extend beyond the hardline boundary for a 640 acre unit that contains the well site (and such a plug back order by the IC would inevitably lead to waste), or the IC deems the east or west halves of the two sections a 640 acre unit in the event the wellbore stays exclusively in the either half. However, I’m unaware that the IC has ever created a 640 acre spacing unit after a well was drilled on a 1280 drilling unit that was created for a single lateral.

Consequently, unless some bizarre series of events later occurred, the granting of the 1280 acre drilling unit effectively created a 1280 spacing unit. Thus, in a practical sense, the only stage in the regulatory process that the lease provision could prevent the creation of a 1280 spacing unit was at the initial hearing for the drilling unit.

So, it seems the only option for the MO after such an order is entered is to obtain an injunction to prevent the drilling of the well until the validity and effect of the lease provision can be determined by the courts. Now it should be noted that neither party may have standing, i.e., an actual “case or controversy,” to have a court hear the issue until after the IC issues an order either granting or denying the request for a 1280. But at bottom, the real and practical issue in this situation is whether the MO or the OC should have the burden of invoking a court’s review.

The IC could have found that the MO had an apparently valid lease provision (obviously an open question, although easily researched) that would be violated if it granted the OC’s request because a well transversing two sections cannot later be made into a 640 acre spacing unit, and accordingly, that it would deny the request because otherwise the correlative rights of the MO would be adversely affected. Then the OC, who is arguably attempting to breach a lease provision, would have the burden of going to court if it still wanted the 1280, instead of the MO having to go to court to rescind it after it already has been created.

My reading of this decision is that the IC is stating that it is the job of the courts to protect the correlative rights of the MO in this situation, rather than the job of the IC, although one of the primary duties of the IC’s O&G Division is to protect the correlative rights of all owners while regulating oil and gas development.

As it stands now, it appears that the MO must present evidence at the drilling unit hearing that the 1280 is not feasible on grounds independent of a contrary lease provision (geologic, economic reasons) in order to possibly prevent the creation of a 1280. In addition, shouldn’t the burden of proof be just a tab bit higher for the party seeking an exception to the rules, i.e., that the requesting party have a little higher burden in overcoming any objections to such a request in order to prevail? After all, there is a reason it is called an exception.

If the MO doesn’t seek an injunction and the well is drilled and later spaced at 1280, what damages does the MO have to prove in court? Well, that would be tricky, as the MO would have to present evidence of some difference in the amount of royalties between a 640 and the 1280. It’s likely that the breach of such a lease provision would be deemed a breach of a covenant and not a condition of the lease, the latter being a basis for terminating the lease, and the former being a basis for only collecting damages that resulted from the breach.

An even tricker situation is presented when there are multiple working interest owners in the proposed unit, and the OC that agreed to the restrictive pooling clause is not the same OC as is requesting the creation of the 1280. Does this “secondary” OC have any duty to abide by, or have its rights limited by, the terms of an agreement to which it wasn’t a party? Too many issues are raised there to be addressed here.

Now, it should be noted that the case last month involved special circumstances. The southern sections in the standup units to be created, which didn’t have the restrictive lease clauses, were entirely under the waters of Lake Sakajawea and over a half mile from shore. The northern sections that had the lease restrictions, however, had some terra firma available. Therefore, the only practical way to reach the offshore sections was to drill a long lateral through the sections that had the lease clause. Although that case involved peculiar circumstances, it doesn’t mean that the IC’s determination would have been any different in a "normal" case, since the legal principles involved are the same.

In any event, the apparent violation of a lease provision should be a factor that the IC considers when determining the size of a drilling or spacing unit, especially when the violation adversely effects a party’s correlative rights. Apparently the IC feels it shouldn’t be a factor.

I have yet to see any persuasive evidence that a single long lateral adequately drains the entire width of a 1280 acre unit. Some companies are saying they need a 1280 for a single well because such a well drains the entire unit, but then say, but hey, if it’s a good well, we will drill another well on the unit. And for some reason the IC buys it. There is only one thing here that we know for sure - - there will be one well on the unit. So therefore, why doesn’t the IC start with the premise that there will be only one well and create a 640, and then a create a second 640 when and if a second well is planned.

I find it especially ironic that the IC doesn’t want to get involved in private lease matters regarding a restrictive pooling clause, and yet everyone knows the unspoken motive for the 1280 requests is so the companies can tie up a lot of leases by drilling a single well. Doesn’t the IC consider it to be getting involved in private lease matters when it creates larger units than necessary and thus allows leases to be held by production when they should otherwise expire if a second well isn’t drilled?


Anonymous said...

I've read your entry twice, it's beginning to sink in. Somewhat confusing for those of us not in the industry. I appreciate the explanation for those of us who don't have the expertise. Does this entry have anything to do with your 10/23 entry regarding EOG and the request for 1280 spacing in sections 2 & 3 of 152 N 90 W, where there is in place 640 with two producing wells? I'm a royalty owner there and am wondering about the ramifications of EOG's request.

Teegue said...

It appears that EOG is going to continue to drill on 640s in their current area of activity anyway. They are planning a pilot project to try putting a second well on the 640s and see how that works. I don't know what the 1280 is all about, except that it may be targeting the Sanish Sand, which is a separate zone in the Bakken than what is currently producing in the field.

Good luck with your interests in the area!

roccojoco said...

I think the savvy mineral owner worried about this scenario should fight back and include a strong default clause whereby the lease can be terminated at the option of the lessor if the restrictive pooling provisions are violated. Stick in a mediation or arbitration clause if you are worried about judicial ascertainment. Get creative and give those provisions some bite! If these provisions are not acceptable to the lessee, hold out and demand a 25% landowners royalty. If the OC refuses and goes the compulsory pooling route, execute a highly favorable lease to yourself or acquaintance. At this stage of the game you’ll have no problem selling this lease to the OC or a competitor wanting to get in under a spacing unit.

Teegue said...

Good points rocco, but I'll play devil's advocate. I'm not sure a default clause will actually hold up in court, especially if the company requesting the unit is not the company with with a restrictive clause, and mediation doesn't have a great track record for looking out for the little guy. I just don't think this event is something that the law recognizes as requiring a forfeiture,as spacing units are ultimately set by the IC, and not the lessee.

As for compulsory pooling, recently a company at such a hearing was offering the unleased owners 100/acre and 1/6, and that was it. And this wasn't out in the boonies somewhere, but in a currently active area (don't recall exactly where). If that's what's going to happen, it's better to stay unleased than execute a lease to a strawman as the risk penalty for not participating in the well costs for mineral owners is costs plus 50% more, whereas it's costs plus 200% more for working interests. If the well is in a marginal area, it may be a long time before the costs, now yet the risk penalty, is paid for.

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