CHAPTER 1 TRANSACTIONAL EVOLUTION OF OPERATING AGREEMENTS IN THE OIL AND GAS INDUSTRY
| Jurisdiction | United States |
(Dec 2007)
TRANSACTIONAL EVOLUTION OF OPERATING AGREEMENTS IN THE OIL AND GAS INDUSTRY
Professor of Law
Director, Washburn Business and Transactional Law Center
Washburn University School of Law
Topeka, Kansas
DAVID E. PIERCE
David E. Pierce is a professor at Washburn University School of Law in Topeka, Kansas where he teaches Oil & Gas Law, Advanced Oil & Gas Law, Contracts, Property, Transactional Drafting, and Business Associations. He is also the Director of the Law School's Business and Transactional Law Center. Prior to entering law teaching Professor Pierce was an in-house oil and gas attorney for Shell Oil Company in Houston, Texas and before that he engaged in the private practice of law in Neodesha, Kansas. He has also worked Of Counsel with the Tulsa-based law firm of Gable & Gotwals and with the Kansas City-based law firm of Shughart Thomson & Kilroy.
Professor Pierce has a B.A. from Pittsburg State University, a J.D. from Washburn University School of Law, and a Masters of Law (LL.M.- Energy Law) from the University of Utah College of Law. Professor Pierce is the author of the Kansas Oil and Gas Handbook, a co-author of Cases and Materials on Oil and Gas Law, a revision and upkeep co-author of Kuntz on the Law of Oil and Gas, a co-author of Hemingway Oil and Gas Law and Taxation, and an editor of the Oil and Gas Reporter.
CONTENTS
I. INTRODUCTION
II. THE PROPERTY DIMENSION OF OIL AND GAS OWNERSHIP
A. Common Law Cotenancy
1. Fiduciary Obligations?
2. Special Accounting Principles?
3. Partition
B. Rule of Capture, Ownership, and Correlative Rights
C. Conservation Regulation
III. THE CONTRACTUAL DIMENSION OF OIL AND GAS OWNERSHIP
A. Freedom of Contract
B. The Evolution of Contracts to Govern Joint Operations
1. 1956 to the Present
a. Onshore Operations
b. Offshore Operations
c. International Operations
2. Before 1956
3. Field-Wide Development
4. Promotion
IV. INTERSECTION OF PROPERTY AND CONTRACT: RELATIONSHIPS
A. Deliberate Relationships
B. Remedial Relationships
1. Asserted by a Party
2. Asserted by a Non-Party
V. CONCLUSION
"I know of no other agreement in use in the petroleum industry, or any other industry for that matter, that can be compared to the Operating Agreement from the standpoint of frequency of use and the multitude of complicated situations and eventualities it is required to anticipate in its provisions."1
I. INTRODUCTION
Mineral development requires coordination whenever more than one party possesses development rights in a targeted property. To provide the necessary coordination the transactional response has been the joint operating agreement ("JOA"). When more than one party has the right to drill on a tract of land, there must be some mechanism to avoid wasteful competition for scarce resources, such as a drilling permit.2 Even when the issuance of multiple drilling permits is permissible,3 it will often be more efficient to have all interested parties participate in the first well before deciding to proceed with a second well. The JOA contractually coordinates development of lands encompassed by the "contract area" the parties designate. When coordination is required for a larger block of properties covering an entire oil and gas reservoir, the developing parties will enter into a "unit" operating agreement ("UOA").
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Whether the operation is governed by a JOA or UOA, the agreements are designed to accomplish the same goals: (1) define the initial operations in which all parties having development rights will participate;4 (2) provide a mechanism for conducting subsequent operations to develop and maintain production from the contract area; (3) provide for the day-to-day management of the properties by a designated "operator"; (4) define the rights and duties between the "operator" and the "nonoperators"; and (5) define the rights and duties between the parties to the agreement and those who are not parties to the agreement.5
This article examines the legal contexts in which joint operations take place by focusing on the property and contract dimensions of the joint development relationship. These legal contexts
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will be considered in conjunction with the various "standard" operating agreement forms that have evolved through the years. The foundational legal context for joint operations is the "property" dimension which defines each party's oil and gas ownership rights and obligations.
II. THE PROPERTY DIMENSION OF OIL AND GAS OWNERSHIP
Before considering the impact of contract law on a JOA, the parties' base ownership rights must be defined in the things that are the object of the JOA. This means a property law analysis must be applied before the contract law analysis. Once the rights and obligations arising from property law are identified, it will be easier to identify how such base property rights have been, or need to be, affirmed, negated, or redefined by the JOA. The first inquiry will be whether the parties to the JOA are common law cotenants.
A. Common Law Cotenancy
Occasionally some or all of the parties to a JOA will be common law cotenants. This occurs when the parties lease from owners of undivided mineral interests in the same tract of land. In those cases the relational status of the lessors will transfer to their lessees.6 It also occurs when a lessee assigns an undivided interest in a lease they own and creates the relational status in the first instance.7
Frequently the parties will not be common law cotenants. For example, each party may own interests in different leases, covering differing tracts of land, which comprise the contract area or pooled area. This will almost always be the case with unit operations and other situations where the "contract area" includes a large block of acreage instead of merely a drill site or offsetting drill sites.
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Often there will be a mix of relationships. Parties to a JOA or UOA may be common law cotenants as to some of the lands within the unit, pooled, or contract areas, but as to other lands they will not have a cotenant relationship. Does this mean the rights of the parties to the JOA or UOA will vary depending upon the parties' property-based relationships? More precisely, is there a difference between lessees who hold their leases as common law cotenants as opposed to lessees who lack a cotenant relationship? If the answer to this question is anything but an unequivocal "no," the parties' contractual agreements should seek to equalize the status of all parties to the JOA or UOA, regardless of their common law cotenant status.8
There are at least three important areas where common law cotenant status can impact the rights of the parties.9 First, cotenants enjoy a loosely defined "fiduciary" relationship under some circumstances. Second, cotenants have common law accounting rights that may run counter to the business goals of the parties to a JOA or UOA. Third, cotenants have a right to end the cotenancy relationship through partition.
1. Fiduciary Obligations?
Although many cases can be found which make the broad statement that cotenants owe fiduciary obligations to one another,10 a fiduciary relationship has in fact been found to exist only in very limited circumstances. These circumstances include when one cotenant purchases the entire property at foreclosure11 or one cotenant receives funds to which the other cotenants are entitled to
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a proportionate share.12 The major problem in this area is determining when other cotenant activities might be subject to fiduciary principles.
Professor Kuntz begins his analysis of the issue with the proposition that a mere cotenancy relationship, absent special circumstances, is not a fiduciary relationship.13 Dicta in many cases suggest the cotenant relationship is fiduciary.14 However, closer analysis reveals that courts do not evaluate cotenancy issues applying general fiduciary principles.15 The broader dicta nevertheless creates uncertainty regarding when fiduciary concepts might be successfully applied to a situation.
2. Special Accounting Principles?
If the parties are common law cotenants, a majority of jurisdictions allow one cotenant to develop the oil and gas even over the objection of other cotenants.16 The non-developing cotenants are carried in the development, generally on a well-by-well basis, with the developing cotenant obligated to account for any net revenue realized from their efforts to obtain production from a well.17 The right to payment arises once revenue from a well exceeds the reasonable development
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and operation costs associated with the well.18 Normally this "timing" issue for the distribution of net revenue does not create a problem.
When there are disproportionate takes from a gas well resulting in gas imbalances between the owners in the well, disputes can arise over how the parties should be brought back into balance.19 Gas balancing may be a product of agreement, statute, or the application of judicial principles when the parties have not addressed the issue.20 The cotenancy relationship offers a property-based argument that each cotenant is entitled to their share of net production revenue currently as opposed to some future balancing upon well depletion or through future disproportionate takes.21 The same argument can be made by the producing cotenant that all other cotenants must currently accept their share of the net revenue as opposed to asserting a right to some sort of delayed balancing remedy. This approach differs from the various "balancing" remedies courts have employed to address disproportionate takes.22
3. Partition
One of the basic rights of all cotenants is the right to end the cotenancy through partition.23 Although in some states the right may be limited to prevent "fraud or...
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