CHAPTER 2 PROPERTY PROVISIONS OF THE OPERATING AGREEMENT
| Jurisdiction | United States |
(May 1990)
PROPERTY PROVISIONS OF THE OPERATING AGREEMENT
University of Houston Law Center
Houston, Texas
TABLE OF CONTENTS *
I. Introduction
II. Context and Characterization of the Operating Agreement
A. Context in Which Joint Operations are Advisable
B. Characterization of the Operating Agreement
III. Dedication of Properties to the Contract Area
A. Contents of Exhibit A
B. Description of the Contract or Unit Area
C. Specification of Burdens
IV. Transfers and Encumbrances
A. Implied Reciprocal Transfers
B. Transfers as Penalties
C. Operator's Liens
V. Restrictions on Transfers and Acquisitions
A. Waiver of Partition
B. Preferential Right to Purchase
C. Maintenance of Uniform Interests
D. Surrender of Leases
E. Abandonment of Wells and Reassignment Duties
VI. Distribution of Acquired Interests
A. Acreage and Cash Contributions
B. Area of Mutual Interest
C. Extension and Renewal of Leases
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VII. Failure of Title
A. Title Examination Requirements
B. Deletion of Provisions
VIII. Personal Property—Equipment and Production
A. Equipment and Materials
B. Production
C. Gas Balancing for Split-Stream Sales
D. Payment of Royalties
IX. Conclusion
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PROPERTY PROVISIONS OF THE OPERATING AGREEMENT
I. Introduction — The joint operation of mineral properties has always been a significant feature of the oil and gas industry. Whether oil and gas properties are pooled, unitized, or the subject of some form of concurrent ownership, the coordination necessary for joint operations has been typically achieved through the "operating agreement." The use of the instrument has become so widespread that the operating agreement is now considered by some, after the oil and gas lease, to be the most common instrument in the industry. See, Gulf Oil Corp. v. Southland Royalty Co., 478 S.W.2d 586, 594 (Tex. Civ. App. — El Paso 1972), aff'd, 496 S.W.2d 547 (Tex. 1973). Most analytical papers dealing with the instrument have focused on the crucial question of the nature of joint operations and the resulting relationship between the participants. This necessarily emphasizes functional aspects of the agreement which commit the various parties to participate in operations and share expenses for, and production from, joint operations. But other provisions of the operating agreement serve the supplemental role of adjusting the rights and duties of the parties outside the context of actual operations. These largely expand, limit and define the property interests of the parties, both within and outside the pool, unit, or lease to which the agreement applies. None of these property provisions can be considered inconsequential, but they are often overlooked in negotiations focused on accounting and procedural provisions.
For the successful and efficient conduct of joint operations, certain adjustments must be made in the rights and powers incident to the operational interests committed to the contract or unit area. Some of these changes are the result of express provisions, others can arise by implication. Certain modifications assist in structuring the transaction, while others ensure continuation of the "enterprise" for the duration of the joint operations. A few alterations are needed simply to provide guidance and certainty in future situations. By contrast, still others are needed to provide protection among the parties once there is a denial of fiduciary obligations.
A. No fixed term is established under the operating agreement. It is potentially a long-term venture binding all parties to prescribed procedures and obligations until the benefits derived from development of the contract area have lapsed. There are occasions in which the exercise of individual property rights could cause an early termination of the venture, complicate operations or take unfair advantage of mutual efforts. To ensure the viability and maintain the structural integrity of the venture throughout its term, provisions restricting rights to the transfer and acquisition of interests have become common features of the operating agreement. These include provisions relating to:
1. Waiver of partition.
2. Preferential right to purchase.
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3. Maintenance of uniform interest.
4. Surrender of leases.
5. Abandonment of wells and reassignment duties.
6. Subsequently created interests.
B. Another set of provisions grants each party the right to obtain an ownership proportionate to its initial interest in the contract area in any property subsequently acquired by another party to the operating agreement. These provisions are intended to ensure a fair distribution of any benefits derived from the joint investment of the parties and the information and data obtained from joint operations. In this sense, the agreement imposes obligations similar to those found in fiduciary relationships to prevent one party from gaining an undue advantage over another who has placed trust and confidence in their association. These provisions include clauses on:
1. Acreage and cash contributions.
2. Area of mutual interest, sometimes added to the operating agreement as a supplemental provision.
3. Extension and renewal of leases.
C. Regardless of whether the parties are co-tenants or contractually share production from the lands contributed to the contract area, participants are mutually dependent on the validity of one another's title. If a party's ownership is inaccurate, the venture's share of production declines and the cost of operations becomes disproportionately high if the owner of the outstanding interest cannot be enticed to joint the joint operations. If the failed title pertains to the drillsite, the error can result in trespass. For these reasons, the operating agreement must address the failure of title issue.
Beyond these real property provisions, there are also provisions affecting personal property such as equipment, rights in production and and royalty obligations.
Unfortunately, few cases interpret these provisions in the context of the operating agreement. The legal analyst is often forced to rely on the construction of similar provisions used in settings unrelated to the joint operation of the petroleum interests, after adjusting such interpretations to reflect the unique purpose of the provision in the petroleum industry. Interpretation is further complicated by divergent characterizations of the operating agreement by different courts as an instrument creating a joint venture or effecting a cross-conveyance of property rights, both of which are expressly denied by the instrument itself. As a consequence, provisions intended to apply to separately owned real property interests must be applied to patterns of ownership not contemplated by the structure of the agreement. Interpretation and understanding of the property provisions in the operating
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agreement, then, must be based largely on both the specific function intended for the provision within the joint enterprise and the proper application of that function within the co-tenancy or joint venture imposed by judicial decisions.
The aim of this paper is to review the various provisions typically included in the operating agreement which affect the property interests of the parties. It is hoped that this review will contribute to the general understanding and appreciation of this crucial instrument in the petroleum industry.
As with the oil and gas lease, there is no "standard operating agreement." Specific provisions vary to allow for the peculiar needs of the parties to the instrument and special concerns inherent in the immediate transaction. Nevertheless, there is considerable similarity in the basic provisions of most operating agreements. This results in large part from the development of model forms of the instrument which have received widespread acceptance in the industry. The model form operating agreement promulgated by the American Association of Petroleum Landmen, designated A.A.P.L. Form 610, is generally perceived to be the most popular form in current use when private properties are involved. To take advantage of the more widely recognized provisions employed in this form, most references in this paper will be to that instrument, and in particular to A.A.P.L. Form 610-1982. Changes appearing in the new 1989 version of the form will be cited where relevant. The comments in the paper, however, are equally applicable in most instances to the same provisions as they appear in other forms.
II. Context and Characterization of the Operating Agreement — To fully comprehend the purpose and effect of many provisions in the operating agreement, it is necessary to understand the contexts in which the agreement may be used and the nature of the relationships it creates between the parties to the joint operations. In simple terms, the operating agreement is a contractual arrangement between two or more parties for the joint development and operation of mineral properties. See, e.g., Universal Consolidated Oil Co. v. Los Angeles, 202 Cal. App.2d 771, ______, 21 Cal. Rptr. 61, 68 (1962); Transcontinental Gas Pipeline Corp. v. State Oil & Gas Board, 457 So.2d 1298, 1309 n.6 (Miss. 1984), rev'd on other grounds, 474 U.S. 409 (1986).
A. Context in Which Joint Operations are Advisable — This coordination is necessitated by a diversity of ownership of operating rights in the area to be developed. Such diversity of ownership, and the consequent need for joint efforts, can arise in any of three contexts.
1. The first exists where there is concurrent ownership of operating rights in a single tract of sufficient size and configuration to permit drilling and production activities under applicable conservation regulations, but where, nevertheless, there is a desire to conduct joint operations for practical or legal reasons.
...a. Minority rule — In some
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