CHAPTER 12 UNDERSTANDING STATE REGULATORY SCHEMES WHEN CONDUCTING DUE DILIGENCE

• Jurisdiction: United States

Due Diligence in Oil & Gas and Mining Transactions
(Sept 2018)
CHAPTER 12
UNDERSTANDING STATE REGULATORY SCHEMES WHEN CONDUCTING DUE DILIGENCE
Joseph C. Pierzchala
Welborn Sullivan Meck & Tooley, P.C.
Denver, CO
Geoffrey W. Storm
Welborn Sullivan Meck & Tooley, P.C.
Denver, CO

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JOSEPH C. PIERZCHALA is a shareholder at Welborn Sullivan Meck & Tooley, P.C., in Denver, CO. His practice focuses on representing oil and gas companies before the Colorado Oil and Gas Conservation Commission and business and individual clients in complex commercial and civil litigation before state and federal courts. Mr. Pierzchala has experience before the Commission involving establishment of drilling and spacing units, statutory pooling, well density, setback, surface issues, and enforcement matters. Mr. Pierzchala's litigation experience includes litigating and arbitrating a wide array of disputes involving oil & gas, mineral rights, real estate, corporate law, eminent domain, and securities. He was selected for inclusion in Colorado Super Lawyers "Rising Stars" List, 2014-2018. He received his J.D. from the University of Denver, where he was Staff Editor or the Denver University Law Review, and he received his B.A. in Political Science from Colorado State University.

GEOFFREY W. STORM is an associate in the Denver office of Welborn Sullivan Meck & Tooley. Mr. Storm's practice focuses on regulatory issues before the Colorado Oil & Gas Conservation Commission and oil & gas transactional matters. Prior to joining WSMT, Mr. Storm was a landman for Anadarko Petroleum Corporation. Mr. Storm is a graduate of the University of Oklahoma College of Law, where he served as an editor for the American Indian Law Review.

I. Introduction

In oil and gas acquisitions, the buyer's due diligence typically focuses on the seller's title. In any given transaction, the buyer will allocate significant resources to examining the seller-party's internal title opinions, contracts, well records, data sheets, and other internal materials to identify potential failures that may impair the asset. The buyer will usually devotes less attention to the applicable local, state and federal regulations that may govern an asset. Yet, the various levels of state, federal, and more modernly, local regulation may weigh heavily on an asset's value, and a potential buyer must identify all relevant regulations when conducting due diligence. A failure to do so exposes the buyer to risks that can undermine the buyer's expectations in the acquisition.

In modern oil and gas development, many oil and gas producing properties are governed entirely by state and federal regulatory instruments, rather than by private agreement. This paper will focus on how state regulatory bodies, particularly oil and gas conservation agencies and their procedures, can affect an oil and gas onshore asset. This paper will also point out relevant considerations for a potential buyer assessing potential working interest, non-operated interest, or mineral interest acquisition. The paper will lastly touch briefly on other regulatory issues related to permitting, bonding, and federal ownership that may alter the buyer's evaluation of a prospect.

II. Operatorship

Before discussing the specific ways that state, federal, and local regulation should be considered in due diligence, it is important to establish an important concept in modern oil and gas development: "Operatorship." "Operatorship," or "Secure Operatorship," refers to the emerging, strategic concept whereby an oil and gas operator seeks to secure control over the manner, timing, and scope of its development plan over its assets. Industry history has always dictated that one company has acted as the "Operator," or party that undertakes management of the physical oil and gas facilities for the joint benefit of numerous leasehold owners within a fixed area, and in the uber-competitive oil and gas industry, companies have always competed to operate just as they competed for leases, contracts, international bids, etc. Only recently, though, has the concept of "Operatorship," entered the industry lexicon. For instance, a search of scholarly, research databases will produce few returns for the term itself. So, what is the concept of Operatorship, where did this concept come from, and how long have operators taken this approach?

The origin of this idea appears rooted in the increasing interrelation of the oil and gas industry with the finance and private equity sectors. In 2008, oil prices exceeded $140/bbl.¹ High commodity prices opened access to credit across the industry, spawning a boom in exploration and development activity in emerging onshore basins.² Since then, oil prices have fluctuated, but

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private equity has remained entrenched in oil and gas financing.³ However, the oil and gas business model has changed dramatically. In the past, growing companies required access to capital in order to finance their initial drilling programs. Now, new companies focus their capital to secure an asset that can be marketed over a short cycle, and established operators seek to secure operatorship and establish proven undeveloped reserves.

In the oil patch, the "Operator" of an asset has significant control over the asset - the Operator has broad discretion over the timing and manner of an asset's development. Whereas nonoperating interests are like minority and noncontrolling interests, operated interests are basically controlling interests, and this has altered the market's evaluation of a company's asset.⁴ The Operator can therefore manage risks, control expenses, and leverage control over its interests more capably than a non-operator. As a result, "[o]perating interests can be more valuable than nonoperating interests in fields where significant development activities are required (since the operator has the exclusive right to control the exploration activities and pace)."⁵ As a result, secured operated assets often generate significantly more interest from potential operator-buyers than unsecured non-operated assets, and more oil and gas companies have consequently made Operatorship a corporate priority. Per example, the term "secure operatorship" now frequently appears in the investment materials of public companies,⁶ appears in contract clauses,⁷ and is discussed widely amongst those engage in the oil and gas business.⁸

III. State Regulation and Operatorship

The U.S. onshore horizontal plays that have developed in the past 15 years are, primarily, "resource plays." Generally, resource plays are understood as an oil and gas accumulations with boundaries not constrained within well-defined geologic configurations (such as a folded or faulted reservoir, or trap), but rather by the extent of an expansive, mature source rock, that may extend

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over an entire region.⁹ Due to the size and relative consistency of these plays, emerging companies have invested a greater percentage of their initial capital into building a portfolio, rather supporting a drilling program to "prove" a prospective asset.¹⁰ As an emerging company builds its leasehold position, it is incentivized to simultaneously secure operatorship over that position for the reasons discussed above.

Historically, an emerging oil and gas player would secure the rights to drill, develop and explore by pursuing agreements with other companies that had large asset portfolios, but limited time and resources to develop those assets.¹¹ This model is still prevalent, but more companies now acquire rights to drill and operate through regulatory mechanisms available under state conservation agencies. As a result, regulatory activity has grown, as companies attempt secure to an operated foothold in crowded, established basins.¹² A company purchasing an asset with intent to operate must understand the regulatory conditions that control Operatorship, whether its path to operate the asset is secure, and what regulatory threats may exist to challenge or overturn its path to operate.¹³

Colorado

In Colorado, Operatorship is gained and controlled by acquiring a Form 2 Application for Permit-to-Drill, or "APD."¹⁴ However, the default Colorado well location rules require that any well drilled to a target greater than 2,500' in depth¹⁵ must be located no closer than six hundred

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feet from any lease line, and no closer than 1,200 feet from any other producible or drilling oil and gas well within the same common source of supply.¹⁶ Thus, in modern horizontal drilling, the COGCC must establish a drilling and spacing unit which will regulate the density and location of a horizontal pad or set of pads. Any owner with a right to drill pursuant to a lease, mineral right, or contract may file an application to establish a unit.¹⁷ In fact, the COGCC has established drilling and spacing units over the objection of an owner of a 50% working interest within the proposed unit area.¹⁸

Operators frequently establish drilling and spacing units, but the unit itself does not confer operatorship upon the applicant.¹⁹ Rather, Colorado is a "Race to the Permit" State, meaning that when two competing APDs are filed before the Commission, the permit filed prior-in-time will have preference.²⁰ Whereas the Commission has suggested that in the future, competing permits may be resolved by taking into account other considerations in excess of "first-in-time," to date the COGCC has not applied these standards when resolving competing APDs.²¹ Once approved, the Colorado Oil and Gas Conservation Commission ("COGCC") will not approve APDs filed by other operators that directly compete with an approved APD, and a Form 2 is valid for 2 years from the date of approval.²²

Wyoming

Like Colorado, Operatorship in Wyoming is gained by filing an APD.²³ Wyoming has also implemented a "first to file," where the first APD filed for an area will be approved, and...