CHAPTER 11 PAYING WELL DETERMINATIONS

• Jurisdiction: United States

Federal Onshore Oil and Gas Pooling and Unitization
(Nov 2006)
CHAPTER 11
PAYING WELL DETERMINATIONS
Thomas W. Clawson
Attorney
Van Cott, Bagley. Cornwall & McCarthy
Salt Lake City, Utah

THOMAS W. CLAWSON

Thomas W. Clawson is a shareholder in the Van Cott, Bagley, Cornwall & McCarthy law firm in Salt Lake City. His practice focuses on public lands and oil and gas matters, including the formation and defense of exploration and secondary recovery units. Tom practices before the Utah Board of Oil, Gas and Mining, the Interior Board of Land Appeals, the Utah State Engineer, Utah State Tax Commission, and Utah federal and state courts.

Tom received his J.D. from the University of Utah College of Law in 1990, where he was the Articles Editor of the Journal of Energy, Natural Resources and Environmental Law. Prior to attending law school, he worked as a geophysicist for Exxon Company, USA in Denver, Colorado, and Midland, Texas. Tom has undergraduate degrees from the University of Utah in geology and geophysics and currently serves on the Utah BLM Statewide Resource Advisory Council.

[T]he drilling requirements of section 9 of the unit agreement are an integral part of the unit agreement. Since the first goal of a unit agreement for an unproved area is to establish the existence or nonexistence of commercially recoverable deposits, the unit operator's obligation to drill both the initial well and subsequent wells is fulfilled only where a well is completed which is, indeed, commercial. Under section 9, the drilling of a well which might produce in paying quantities, but which would never recover drilling costs, simply would not establish the existence of a reservoir which was amenable to unit production. Therefore, for the purposes of section 9, defining paying quantities as including the costs of drilling is eminently reasonable. But the question whether a well is producing in paying quantities for the purpose of section 9 of the unit agreement (and for the purposes of section 20 of the unit agreement ...) is functionally discrete from the question whether the well is producing in paying quantities for the purposes of [the Mineral Leasing Act].¹

I. Introduction

In the context of a federal exploratory unit, a paying well determination is the decision by the authorized officer whether a well has discovered a commercial deposit of unitized substances beneath a portion of the unit area.² As the introductory quote succinctly states, demonstrating the existence of a commercial deposit is the parties' main goal under the unit agreement. Section 9 of the federal model onshore unit agreement for unproven areas published in the federal regulations (hereinafter the "Model Form")³ provides that a unit "paying well" is a well drilled within the unit area that discovers unitized substances that can be produced in paying quantities after the effective date of the agreement.⁴ "Paying quantities" is defined as "quantities sufficient to repay the costs of drilling, completing, and producing operations, with a reasonable profit."⁵ The authorized officer's paying well decision, accordingly, is based on the existence (or non-existence) of a number of economic factors and marks a significant milestone regarding the parties' legal rights. The initial determination that a well is capable of producing unitized substances in "paying quantities" as required by Section 9 satisfies an important condition that fulfills the unit operator's continuous drilling obligation, sets the clock running for unitized lands to be included in a

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participating area or face automatic elimination from the unit area, and triggers the agreement provisions regarding sharing proceeds from production from a participating area on a unit basis rather than a lease basis.⁶ Such wells are commonly referred to as "unit wells." Subsequent "paying well determinations" lead to the establishment of new participating areas or the revision of existing participating areas.⁷

The term "paying quantities" has more than one meaning in the context of administrating a federal exploratory unit, however. A well within the unit area may be capable of production in "paying quantities" on a lease basis (i.e., producing sufficient quantities of unitized substances to pay for the costs of operating and marketing) but not capable of producing quantities sufficient to pay for the well's drilling and completion costs.⁸ Such wells are known as "lease wells" or "Yates wells." By producing unitized substances in sufficient quantities to pay for the costs of operating and marketing, a "lease well" within the unit area can qualify as a "paying well" for purposes of extending all of the federal leases committed to the unit area. However, the well will not qualify as a "unit well" for purposes of satisfying the condition under Section 9 unless it can also recover the costs of drilling and completing.⁹ Once a participating area is established in accordance with Section 9, a "lease well" within a participating area will extend the terms of the leases within the participating area (even if all "unit wells" located within the participating area cease producing), and ultimately will determine the productive term of the unit agreement with respect to that participating area.¹⁰

A paying well determination is fundamentally a technical decision.¹¹ The proponent will be required to make an evidentiary showing that the well is capable of producing in paying quantities, whether on a unit basis or lease basis. The proponent will have to establish the existence of several relevant factors demonstrating the economic viability of the well and the nature of the deposit of unitized substances.¹² The Bureau of Land Management ("BLM"), the authorized officer under the unit agreement and regulations,¹³ will make its determination based on the evidence presented by the proponent as well as other information presented by other parties or independently gathered by the BLM. Careful preparation of the evidence and adherence to existing guidelines regarding what constitutes the "best" evidence of paying quantities will help persuade the authorized officer (and perhaps the IBLA on appeal) to decide whether a well is a paying well.

The "paying quantities" language under Section 9 of the Model Form does not fit all circumstances that arise with respect to unit operations. Coalbed methane units present special problems regarding paying well determinations. Due to the delay in gas production while de-watering operations are ongoing, the decision whether a commercial deposit of

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unitized substances has been discovered in the coalbed methane unit context is more difficult.¹⁴ The Model Form, however, is a proposed form of unit agreement; its provisions are negotiable and modifications are authorized.¹⁵ Accordingly, some coalbed methane units are formed under unit agreements containing a form of Section 9 expressly modified from the Model Form to provide a method for making paying well determinations in the context of coalbed methane operations.¹⁶

This paper first discusses in a general way the statutory and contractual framework of unit agreements and, in particular, the paying well requirement under Section 9 of the Model Form. The contractual consequences of a paying well determination are recognized and the factors involved in the determination are identified and discussed. "Unit well" and so-called "Yates well" (or lease well) determinations are distinguished. The paper then discusses the problems associated with paying well determinations and coalbed methane units and the solutions the BLM has adopted to address those problems. The paper does not discuss in detail the statutory or regulatory bases for unitization of federal leases or the full framework of the Model Form.¹⁷

II. Background and Framework of Federal Units and Unit Agreements

A. Congressional and Statutory Intent

Section 17 of the Mineral Leasing Act, as amended, authorizes the Secretary of the Interior to approve cooperative and unit plans involving federal oil and gas leases so long as the plans serve the purpose of conserving the natural resources of the pool, field, or area involved and are necessary or advisable in the public interest.¹⁸ The Model Form is a part of the regulations promulgated to implement Section 17.¹⁹ The historic background and development regarding the unitization of federal leases is covered by other papers as a part of this Institute and will not be repeated here.²⁰ Suffice it to say that authorizing the unitization

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of federal leases was Congress's answer to the chaos of the oil and gas industry in the 1920s and 1930s that resulted, at least in part, from the widespread adoption of the rule of capture.²¹ The rule lead to over-drilling, which in turn caused the loss of reservoir pressure, damage to the reservoir, and decreased ultimate recovery of oil and gas.²² Unitization seeks the orderly development of the pool. As Professor Kramer has observed:

The effect of unitized operations is to eliminate the internal property lines within the unit area so that the engineers and geologists can determine where, when and how to drill the wells needed to most effectively and efficiently drain the reservoir.²³

Thus, by authorizing the unitization of federal leases, Congress sought to encourage the orderly development of federal minerals and the public lands.²⁴

B. The Parties' Intent

Unit agreements are contracts between the affected parties and the United States government.²⁵ Dante Zarlengo previously authored two papers on the topic of paying well determinations as part of the Rocky Mountain Mineral Law Foundation's prior pooling and unitization special institutes.²⁶ Both papers did an excellent job of presenting this topic and raising interesting issues, and this paper relies heavily on the previous author's organization and analysis. In discussing the interplay between...