CHAPTER 3 BEST MANAGEMENT PRACTICES--SECURING YOUR POSITION

• Jurisdiction: United States

Financial Distress in the Oil & Gas Industry
(Feb 2010)
CHAPTER 3
BEST MANAGEMENT PRACTICES--SECURING YOUR POSITION
Jeffrey S. Munoz
Nikita S. Taldykin
Vinson & Elkins
Houston, Texas

TABLE OF CONTENTS

I. Introduction

II. Choice of the Joint Operating Agreement

A. Introduction and Historical Background

B. Significant Improvements in the 1989 JOA

1. Expansion of the Collateral Package

2. Expansion of the Obligations Secured by the Liens

3. Imposition of Cross-Liens

4. Facilitation of Perfection and Enforcement of Liens and Security Interests

5. New Remedies

6. Other Revisions and Improvements in the 1989 JOA

C. Illegality of the "Removal of Operator in Bankruptcy" Provisions of the Model Form

D. Perfection of Liens and Security Interests under the Joint Operating Agreement

1. Perfection of Liens on Real Property

2. Perfection of Liens on Personal Property

3. Priority of Liens and Security Interests

III. Recording the Assignment and Bill of Sale

IV. Advance Payments

A. Letters of Credit, Cash Deposits, Surety Bonds and Guarantees

B. Escrow Arrangements

1. Escrow Arrangements Generally

2. Escrow Arrangements in Bankruptcy

C. Preventing Abuse by the Operator

V. Other Remedies

A. The Right of Setoff

1. The Right of Setoff Generally

2. Mutuality and In re SemCrude

B. The Right of Recoupment

C. The Right of Reclamation

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I. Introduction^*

For the better part of the last decade the oil and gas industry has experienced increased growth and interest from investors - the likes of which it had not experienced since the early days of Spindletop and the East Texas Field. The industry's expansion was due primarily to high commodity prices and new technologies that allowed oil and gas producers to extract hydrocarbons from areas that they had previously been unable to reach. Competition between producers to acquire oil and gas properties became intense. Producers feared that if they did not act quickly they may be locked out of the next great oil or gas field.

During this period, some producers did not always follow the best practices to ensure that they had fully protected their oil and gas investments. Many of these producers were new to the oil and gas industry and unfamiliar with the nature of the oil and gas interests that they were acquiring. In some instances, this failure to follow best practices was a result of a producer's increased acquisition activity and a lack of personnel resources necessary to fully address all of the issues that typically arise in an oil and gas investment. In other cases, some of these producers simply felt that because of a perceived stability in the industry, the high commodity price environment they were enjoying would last forever and their investment would not be at risk.

By the fall of 2008, however, commodity prices had begun their precipitous drop from the record highs reached during the summer of 2008 and the capital markets began to close for most new investment. The oil and gas industry began to slump like the rest of the general economy. Some of the oil and gas investments that had been made earlier in the decade began to unwind. Many oil and gas producers were not able to meet cash calls for drilling new wells. Even when an oil and gas property from an engineering and reserve standpoint remained a viable asset, because of the financial distress of the operator or another working interest owner, in some instances these assets were not able to be developed until the financial issues of the participants were sorted out.

In this paper, we will address some of the issues that oil and gas producers should take into consideration to perfect and protect their oil and gas investments vis a vis other working interest owners, operators, service providers and other parties with a potential interest in the oil and gas properties - particularly when certain parties investing in the oil and gas properties are experiencing (now or in the future) financial distress. Specifically, this paper will address the following topics: the importance of choosing the appropriate form of joint operating agreement to govern the relationship between co-owners in oil and gas properties; the timely filing of conveyances and other similar documents; perfecting security interests; how to protect your interests in connection with making advance payments to operators under joint operating or joint development agreements; the importance of having the ability to receive financial assurances from co-owners and

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the various forms which they can take; methods to prevent abuses by operators; and other remedies to protect an oil and gas investment.

II. Choice of the Joint Operating Agreement

Choosing the form of a joint operating agreement is one of the most important decisions that the parties contemplating joint development of oil and gas properties will face. In addition to any applicable joint development agreement, the joint operating agreement will govern many operational aspects of hydrocarbon development, including drilling and development of the wells and the allocation of costs and expenses of hydrocarbon production among the parties. The joint operating agreement will also typically delineate the rights and obligations of the parties as the operator or a non-operator.

A. Introduction and Historical Background

The American Association of Professional Landmen ("AAPL") has been involved in the development of standardized joint operating agreements for the oil and gas industry for more than a half century. AAPL first developed its Model Form Operating Agreement for onshore operations in 1956 and then subsequently revised the document in 1977, 1982 and 1989. Currently, both the 1982 AAPL Model Form Operating Agreement (the "1982 JOA")¹ and the 1989 AAPL Model Form Operating Agreement (the "1989 JOA")² are widely used by the oil and gas industry for onshore operations. As such, parties contemplating joint development of oil and gas properties are likely to pick either the 1982 JOA or the 1989 JOA as the starting point for their negotiations. For this reason, it is important for the parties to understand the differences between the 1982 JOA and the 1989 JOA in order to choose a form that provides the most protections in times of financial distress in the energy industry.

Before the "oil crash" of the mid-1980s, the oil and gas industry conducted joint operations guided primarily by industry custom and practice and frequently in a spirit of reasonableness, rather than by the express terms of any joint operating agreement.³ The inconsistencies between the industry custom and practice, on the one hand, and the express terms of the written agreement, on the other hand, were largely ignored. The "oil crash" of the mid-1980s highlighted many shortcomings of the 1982 JOA. These shortcomings, combined with a shift in the industry's attitude away from the "wild west" mentality, brought about the development of a form joint operating agreement that more thoroughly addressed the rights and obligations of the parties - the 1989 JOA.⁴

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Although it is widely accepted that the 1989 JOA is more successful than the 1982 JOA in balancing the rights and obligations of the operator and the non-operator, the general resistance toward a "new form," combined with the fact that several provisions of the 1982 JOA unilaterally favor the operator, have caused some players in the oil and gas industry to remain loyal to the 1982 JOA.

B. Significant Improvements in the 1989 JOA

Article VII.B. of the 1982 JOA addressed the non-operator's payment defaults and liens granted by the non-operator to the operator. The 1989 JOA revised Article VII.B. of the 1982 JOA and (1) expanded the scope of the collateral package, (2) expanded the obligations secured by liens and security interests granted by the parties, (3) imposed cross-liens on each party's collateral package and (4) facilitated the process of perfection and enforcement of liens and security interests. The 1989 JOA also expanded the remedies available to the operator and the non-operator. The revision to Article VII.B. and the expansion of remedies available to the parties to the joint operating agreement are among the most significant improvements to the 1982 JOA. During the last period of significant financial distress, many operators found themselves inadequately collateralized and unable to collect fully from the non-operators. As a result, the businesses of many small operators failed. For this reason, a party engaged in oil and gas operations under a joint operating agreement and concerned with the financial stability of its co-interest owners would be wise to insist on the language and concepts of the 1989 JOA.

1. Expansion of the Collateral Package

The 1989 JOA expanded the description of the collateral package in the 1982 JOA to include, among other things, leasehold interests, working interests, operating rights, royalty and overriding royalty interests (including after-acquired interests), as-extracted oil and gas, equipment, accounts, contract rights, inventory, general intangibles and proceeds and products of the above.⁵ The expanded collateral package in the 1989 JOA offers significantly better protection to a party whose counterparty is experiencing financial distress than the protection offered by the 1982 JOA.

2. Expansion of the Obligations Secured by the Liens

The 1989 JOA expanded the obligations secured by liens and security interests granted by the parties to all of the obligations of the parties under the joint operating agreement and not just the payment obligations as provided in the 1982 JOA.⁶ The obligations secured by the liens and security interests under the 1989 JOA specifically include, among other things, payment of expenses, interest and fees, the proper disbursement of all monies paid under the joint operating agreement, the...