CHAPTER 5 PAYING WELL DETERMINATIONS AND PARTICIPATING AREAS

• Jurisdiction: United States

Federal Onshore Oil & Gas Pooling & Unitization - part 1
(Oct 2014)
CHAPTER 5
PAYING WELL DETERMINATIONS AND PARTICIPATING AREAS
Gregory R. Danielson
Sam Niebrugge
Davis Graham & Stubbs LLP
Denver, Colorado

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GREGORY R. DANIELSON is a partner with Davis Graham & Stubbs LLP in Denver, Colorado, For the last 25 years, Mr. Danielson has primarily represented oil and gas companies in the areas of exploration and production. He has extensive experience in the negotiation and preparation of purchase and sale agreements, various forms of exploration and marketing agreements, and preparation of all forms of title opinions, including drilling, division order, financing, and acquisition opinions. Mr. Danielson has represented oil and gas clients in administrative matters before the Colorado Oil and Gas Conservation Commission. He has also acted as Chapter 7 trustee in bankruptcy to liquidate a small independent oil and gas company and has generally represented clients in workouts and bankruptcy proceedings. Mr. Danielson is an active participant with the Rocky Mountain Mineral Law Foundation. He has served on the Board of Trustees and the Executive Committee for the Foundation and co-chaired Special Institute programs in 2002 (The Regulation and Development of Coalbed Methane) and 2004 (Development Issues & Conflicts in Modern Gas and Oil Plays). He also has been named in The Best Lawyers in America® for Energy, Natural Resources, and Oil & Gas Law. He has been a lecturer and author for various industry groups. Mr. Danielson is a past Chairman of the Natural Resources and Energy Law Section of the Colorado Bar Association. He received his J.D. from the University of Denver in 1983 and his B.S., magna cum laude, Phi Beta Kappa, from the University of Colorado in 1979.

SAM NIEBRUGGE is an associate attorney at Davis Graham & Stubbs, LLP in Denver, Colorado, in the firm's natural resources group. Mr. Niebrugge focuses primarily on transactional matters for the oil and gas and mining industries. His practice has involved drafting and negotiating development and exploration, joint operating, farmout, master services, and purchase and sale agreements, and various other agreements in the oil and gas and mining fields. He also has extensive experience preparing all forms of title opinions covering fee, state, and federal lands. Mr. Niebrugge received his J.D. from the University of Denver, Sturm College of Law and earned the Order of St. Ives, an honor awarded to graduates ranking in the top 10% of the graduating class. Mr. Niebrugge graduated from the University of Michigan, Ann Arbor, where he earned a Bachelor of Science in Engineering in mechanical engineering. He is a registered patent attorney. He has contributed significantly to the Rocky Mountain Mineral Law Foundation. He was the author of "Oil and Gas Law Jurisprudence: The Latest Jurisprudence, Legislation, and Regulation," 58 Rocky Mtn. Min. L. Inst. 2012; co-author of "Evaluating the Purchase and Sale Agreement in Light of Potential Royalty and Tax Claims," Rocky Mountain Mineral Law Foundation Journal, Volume 46, No. 1; and co-author of "Industry Agreements Affecting Record Title," Nuts and Bolts of Mineral Title Examination 15-1 (Rocky Mtn. Min. L. Fdn. 2012). He also served on several Foundation special institute committees and serves on the Young Professionals Committee. Mr. Niebrugge is a member of the Colorado Bar Association, the Denver Bar Association, the State Bar Association of North Dakota, and the Ohio State Bar Association.

I. Acknowledgement

The two primary topics for this paper have been presented at the Rocky Mountain Mineral Law Foundation's prior special institutes on pooling and unitization:

A. Paying Well Determinations.

Thomas W. Clawson, Paying Well Determinations, Federal Onshore Oil and Gas Pooling and Unitization 11-1 (Rocky Mtn. Min. L. Fdn. 2006),

Dante L. Zarlengo, The Making and Implementation of Paying Well Determinations in Federal Units, Onshore Pooling and Unitization 15-1 (Rocky Mtn. Min. L. Fdn. 1997), and

Dante L. Zarlengo, Paying Well Determinations in Federal Units: Capturing a Moving Target, Federal Onshore Oil and Gas Pooling and Unitization II 12-1 (Rocky Mtn. Min. L. Fdn. 1990).

B. Participating Areas.

Thomas S. Reese, P. Jaye Rippley & Rin Karns, Participating Areas, Federal Onshore Oil and Gas Pooling and Unitization 12-1 (Rocky Mtn. Min. L. Fdn. 2006),

Laura Lindley, The Life Cycle of a Federal Unit, Onshore Oil and Gas Pooling and Unitization, 14-1 (Rocky Mtn. Min. L. Fdn. 1997), and

Laura Lindley, Participating Areas, Federal Onshore Oil and Gas Pooling and Unitization II 12-1 (Rocky Mtn. Min. L. Fdn. 1990).

This paper may be considered a fourth edition of the prior presentations.¹ Our goal has been to update these papers and attempt to add to the previous scholarship on these topics.

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II. Introduction²

The first goal of a federal exploratory unit is to establish the existence of commercially recoverable deposits. Under the terms of a federal exploratory unit, an authorized officer will make a "paying well determination" as to whether a unit well has discovered a commercial deposit. Under Section 9 of the federal model onshore unit agreement for unproven areas published in the federal regulations (the "Model Unit Agreement"), a paying well determination satisfies obligations of the unit operator to drill a unit obligation well, starts the clock running for lands to be included in a participation area and triggers the provisions of the unit agreement requiring the sharing of proceeds of production from a participating area on a unit basis rather than a lease basis.

The first part of this Paper will focus on the paying well determination, and we will examine how the concept of "producing oil and gas in paying quantities" means one thing for purposes of the habendum clause of federal oil and gas leases that are committed to a federal exploratory unit and something entirely different for purposes of establishing a participating area under the Model Unit Agreement. We will also consider paying well formulas.

The second part of this Paper will focus on the participating areas. We will discuss formation, revisions, consolidation and termination of PAs. We will also cover some of the challenges faced by the lessee in trying to pay royalties correctly in light of the changing boundaries of a PA.

III. Paving Weil Determinations³

A. Unit Agreement

The Model Unit Agreement is a contractual agreement between affected parties and the United States of America.⁴ Under the Model Unit Agreement, working interest owners of fee (leased or unleased), federal, state, and leases issued by the Bureau of Indian Affairs come together for the orderly development of federal lands.⁵ The parties to the Model Unit Agreement initially establish a unit area, which is the land logically subject to exploration and/or development.⁶ Parties enter into the Model Unit Agreement because they believe unit operations will be the most efficient means of development.⁷ Once federal oil and gas leases⁸ have been

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committed to the Model Unit Agreement, production in paying quantities on any of the leases committed to the Model Unit Agreement will serve to extend the terms of every federal oil and gas lease committed to the Model Unit Agreement so long as the leases haven't already expired by their terms and the leases remain subject to the Model Unit Agreement and the Model Unit Agreement remains in effect.⁹

Subject to certain savings clauses contained in the Model Unit Agreement, the Model Unit Agreement will terminate (and the unit area will contract) at the end of five years after the effective date of the initial participating area as to all lands not then within a participating area.¹⁰ Accordingly, the operator's overarching goal of the Model Unit Agreement is to establish one or more participating areas so as to define the ultimate size (after expansion or contraction) of the unit area under the Model Unit Agreement. Additionally, the larger the participating areas the greater number of leasehold acres that may be maintained in effect under the terms of the Model Unit Agreement.

Under Section 2(a) of the Model Unit Agreement, the initial size of the unit area is that which is set forth on Exhibit A to the Model Unit Agreement when all necessary parties execute the Model Unit Agreement.¹¹ Under Section 2(e) of the Model Unit Agreement, and subject to a 90-day continuous drilling clause in that section, the unit area will automatically contract to the participating areas on the fifth anniversary of the effective date of the initial participating area.¹²

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Even with the 90-day continuous drilling clause, the unit area will automatically contract to the participating areas on the tenth anniversary of the effective date of the initial participating area, and, after that date, the operator may not rely on the continuous drilling clause.¹³

In order to establish participating areas, the operator must meet certain drilling commitments. Section 9 of the Model Unit Agreement requires the operator to commence an adequate test well at a BLM agreed-upon location within six months of the effective date of the Model Unit Agreement.

If the operator drills a test well that satisfies the depth requirements within the first six months of the effective date of the Model Unit Agreement but the test well is not capable of producing unitized substances in paying quantities, the operator must either continue to drill additional wells every six months until the operator completes a well that is capable of producing quantities or voluntarily terminate the unit agreement. If the operator fails to drill the additional wells, the Model Unit Agreement will automatically terminate.

Once the operator has drilled a well that the operator believes is capable of producing unitized substances...