CHAPTER 10 THE UNIT OPERATING AGREEMENT FOR FEDERAL EXPLORATORY UNITS

JurisdictionUnited States
Federal Onshore Oil & Gas Pooling & Unitization - part 1
(Oct 2014)

CHAPTER 10
THE UNIT OPERATING AGREEMENT FOR FEDERAL EXPLORATORY UNITS

Steven B. Richardson 1
Bryan Cave LLP
Denver, Colorado

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STEVEN B. RICHARDSON is a partner in the Denver office of Bryan Cave in its Energy and Natural Resources Client Service Group. He is active in project development, acquisition, financing and operations for renewable and conventional power projects including entity structuring, tax equity investment, site acquisition, and power purchase, interconnection, construction, and operational matters and project financing arrangements. He represents a wide range of oil and gas, mining and power companies, financial institutions and investors in energy and natural resource transactions and projects, including mergers and acquisitions and private equity investments in energy, exploration and development agreements, joint ventures, and other project development, financing and operational arrangements involving oil and gas projects on fee, federal, state and Indian lands throughout the U.S. He received his B.A., magna cum laude, in physics and mathematics from the University of Colorado in 1978 and his J.D., cum laude, from Harvard Law School in 1981. He is admitted to practice in Colorado. He has written papers for several Rocky Mountain Mineral Law Foundation special institutes, is a frequent speaker on oil and gas and energy topics, and teaches as an adjoint professor in the Global Energy Management Program at the University of Colorado Business School, Denver campus.

I. Introduction

It is important to understand the interplay between the unit agreement and the unit operating agreement because both agreements, taken together, constitute the unit arrangement and establish the contractual rights and obligations of the parties.

The provisions of the Mineral Leasing Act and the regulations relating to federal units generally apply to both proven and unproven areas. The vast majority of federal units have been formed for unproven areas2 and are referred to generally as exploratory units. A very brief overview of the unit agreement is presented below as background for understanding the interrelation of the unit agreement with the unit operating agreement.

The unit agreement prescribes the method of allocating production for purposes of determining royalties, overriding royalties, production payments and other non-cost bearing burdens. It does not address the allocation of costs or expenses (or the allocation of royalties and other lease burdens) among the working interest owners; those matters are covered by the unit operating agreement. The unit agreement sets forth the terms and conditions for the unit, which cannot be altered by the unit operating agreement, and the unit agreement controls with respect to any conflict between the provisions of the unit agreement and the unit operating agreement.

The Bureau of Land Management (the "BLM") does not prescribe any particular form of unit operating agreement and the working interest owners are generally free to use whatever form of unit operating agreement they prefer. In order to streamline the negotiation of the form of unit operating agreement among the working interest owners, the Rocky Mountain Oil and Gas Association compiled two suggested forms of unit operating agreements in the 1950s. Form 1--Rocky Mountain Unit Operating Agreement--Oil and Gas (Undivided Interest) (May 1954) ("RMOA--Form 1") is intended for "undivided interest" type units, i.e., units in which the working interest owners share of production and costs is fixed through the life of the unit and is not adjusted as participating areas are formed, expanded and contracted.

Form 2--Rocky Mountain Unit Operating Agreement--Oil and Gas (Divided Interest) (Feb. 1994) ("RMOA-Form 2") is for "divided interest" type units, i.e., units in which a working

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interest owner's share of production and costs is determined by its interests in the participating area and is adjusted as the participating area is revised.3

These forms are now distributed by the Rocky Mountain Mineral Law Foundation. These forms are used extensively as the operating agreement in connection with unit agreements for unproven areas in the Rocky Mountain states.4

There is no standard form of unit operating agreement for units formed for proven areas. The terms of such agreement are negotiated and allocation of costs and production is generally based on a complex formula that takes into consideration geological data and other factors.

II. Federal Exploratory Units and the Unit Agreement

Federal exploratory units are unlike any other units. Federal exploratory units typically contain thousands of acres of land and combine them to conduct exploration activities. A major distinction from other units is reflected in the title, that being "exploratory" -- almost all federal exploratory units are formed prior to discovery of oil or gas. Federal exploratory units provide for an initial test well and, if that well is successful, the parties drill additional exploratory and development wells. Because the lands included in a federal unit are typically so expansive, smaller units, or "participating areas" are established within the unit upon completion of wells. The lands covered by the participating area are intended to approximate the area capable of producing unitized substances in paying quantities. These participating areas can expand or contract as a result of additional operations. In addition, a federal exploratory unit may contain several participating areas covering different lands or different depths within the same lands.

The unit agreement, designed for exploration prospects containing significant amounts of federal acreage, is prescribed by federal regulations (the Model On-shore Unit Agreement for Unproven Areas contained in 43 C.F.R. § 3186.1 (September 18, 2014)) (the "Model Federal Unit Agreement"). Any changes to the form of the Model Federal Unit Agreement must be approved by the authorized officer of the BLM.

The Model Federal Unit Agreement sets forth how the royalty owners share production within the unit and the resulting participating areas. The Model Federal Unit Agreement does not, however, dictate how the working interest owners share production or the allocation of costs or the royalty burden associated therewith. The arrangement among the working interest owners is, therefore, left to the unit operating agreement which sets forth the working interest owners' duties and obligations and how the working interest owners will share in the production attributable to the working interests and the costs associated therewith.

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The Model Federal Unit Agreement requires the unit operator to drill at least one initial test well in the unit and, if this well is capable of producing unitized substances in paying quantities, an initial participating area is established. The working interest owners are required to continue drilling additional exploratory and development wells that may expand or contract the initial participating area, or create new participating areas, until the unitized area is fully developed. Many separate participating areas may exist within a single federal exploratory unit.

The Model Federal Unit Agreement dictates how royalty interest owners share in production from the expanding or contracting participating areas that are created. Royalty interest owners share unitized substances on an acreage basis in proportion to the number of acres each owns in the participating area. Each royalty interest owner's share of production from a participating area therefore changes as the participating area expands or contracts. The interests of the royalty owners are not affected by the form of unit operating agreement chosen by the working interest owners.

The Model Federal Unit Agreement imposes duties and obligations upon the working interest owners, requiring them to pay the royalty interest owners their respective shares of production and to bear the unit costs. The Model Federal Unit Agreement does not dictate how the working interest owners are to share their portion of the production as participating areas expand and contract, nor how to allocate unit costs and royalty burdens among themselves. Working interest owners must negotiate a unit operating agreement to define how their duties, obligations, costs, and production are shared and allocated.

III. Unit Operating Agreements

The unit operating agreement is entered into by the working interest owners who are committing their interests to the unit in conjunction with the execution of the unit agreement.5 Two copies of the unit operating agreement entered into with respect to the unitized lands are required to be filed in the proper BLM office before the unit agreement will be approved.6 The purpose of filing copies of the unit operating agreement is to demonstrate that the working interest owners have given the unit operator sufficient authority to conduct operations under the unit agreement and that the committed working interest owners have agreed upon the sharing of costs attributable to and production from the unit.

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Divided Type and Undivided Type Unit Operating Agreements

Unit operating agreements for federal exploratory units are commonly referred to as "undivided type" or "divided type" operating agreements. Under either type of operating agreement, royalty owners share only in production allocated to a participating area in which they have an interest. The differences between the two forms of operating agreements only affect the committed working interest owners.

Uncommitted Interests and Pre-Existing Operating Agreements

The BLM recognizes four categories with respect to the level of commitment of a particular tract to a unit:7

(i) "Fully committed," meaning that all interest owners (the...

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