CHAPTER 9 OIL & GAS MATERIAL AGREEMENTS AND UNRECORDED DOCUMENTS

• Jurisdiction: United States

Due Diligence in Oil and Gas Transactions
(May 2011)
CHAPTER 9
OIL & GAS MATERIAL AGREEMENTS AND UNRECORDED DOCUMENTS
Timothy C. Dowd
Elias, Books, Brown & Nelson, P.C.
Okahoma City, Oklahoma

TIMOTHY C. DOWD is with the firm of Elias, Books, Brown & Nelson in Oklahoma City. Mr. Dowd's primary area of practice is oil and gas law, including the rendering of title opinions, litigation and drafting and negotiation of industry contracts. Mr. Dowd has vast experience in oil and gas title examination, transactions and civil litigation representing oil and gas clients for over twenty-five years. Mr. Dowd has represented international and independent oil and gas companies and individuals. Additionally, Mr. Dowd has been a noted lecturer at over 100 seminars and CLE presentations. Mr. Dowd is a past President of the Oklahoma City Mineral Lawyers Society as well as past Chairman of the Oklahoma Bar Association Mineral Law Section. Mr. Dowd is also a member of the legal committee of Interstate Oil and Gas Compact Commission, the Advisory Counsel to the Marginal Well Commission of Oklahoma and the Oklahoma State University-Oklahoma City Advisory Committee for the Center for Environment and Energy. Mr. Dowd is also the author of the Chapter on Oil and Gas Titles in West Publishing Company's Oklahoma Real Estate Forms and Practice. Mr. Dowd has an "AV" Peer Review Rating by Martindale-Hubbell.

INTRODUCTION

When a buyer acquires oil and gas interests, unless an agreement is personal between the parties, or the buyer can invoke the protection of a bona fide purchaser, the Buyer will be subject to unrecorded agreements between the seller and third parties.

In the course of due diligence, the due diligence team should review the in-house records and documents of the Seller.

The in-house land files of a Seller may contain documents which could adversely affect the interests being sold.¹ For example, letters from lessors demanding a release of a lease or demanding action to cure a breach of implied covenant in a lease is something that the buyer would want to be aware of.² There may also be letters from working interest owners concerning adverse claims or operating agreement problems, such as improper elections or title failures.³ Claims of potential lien holders, which have not been filed, may also be found in the Seller's files.⁴ Discovery through due diligence will ensure that the Buyer is fully informed of the purchase he is making.

This paper addresses typical agreements and pitfalls that may await a Buyer in an oil and gas acquisition.

The first section examines Joint Operating Agreements, the second section addresses farmout and other related agreements, the third section discusses Area of Mutual Interest agreements, the fourth section addresses preferential rights to purchase, and, lastly, gas balancing agreements will be examined.

I. JOINT OPERATING AGREEMENTS

Joint operations are common in the oil and gas industry. When the interest in a property or group of properties is divided among more than one owner, the

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relationship between these co-owners is commonly governed by the AAPL Form 610 Model form Operating Agreement ("JOA"), which standardizes the recurring problem of how to unify, control and operate among the different participants in the project.⁵ A JOA provides for the development and operation of certain leasehold interests for the joint account of concurrent owners who share in the expense of drilling and operations in accordance with the terms of the agreement.⁶ It covers such diverse problems as the examination of title, the rendering of the property for ad valorem tax purposes, elections under the Internal Revenue Code, and the sale or transfer of any interest subject to the JOA.⁷ The JOA is an important document to be considered and reviewed by a potential purchaser of a producing oil and gas property.

The main functions of the JOA are pooling the parties' interest in the contract area, allocation of costs, expenses, and production within the contract area, the conduct of operations within the contract area, including the designation of the operator, and defining the respective rights, duties and responsibilities of the parties to each other and third parties.

Provisions of the JOA should be examined to determine if the proposed purchase would conflict with any of the terms of the agreement.

[A] Designation of Operator

One purpose of a JOA is the appointment of an entity to be responsible for all operations in the contract area. That entity or individual is designated as the operator. The operator is given "full control" over all operations. There is a misconception among some buyers that if they are buying from the operator, then they will automatically acquire the right to operate the purchased properties. However, this only happens when the Seller owns the entire working interest in the purchased properties.⁸ If the Seller owns only an undivided interest, even if it is the majority interest, it is necessary to review the provisions of the operating agreement to determine if the operations can or will be acquired.⁹

The right to operate is predicated in part on the operator's ownership of an interest in the contract area. The right is extinguished upon the sale of the contract area and, therefore, cannot be assigned.¹⁰

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Unless modified, the party who acquires the majority of votes is selected as the operator. The 1989 Model Form requires an affirmative vote of non-operators owning a majority interest, as shown on Exhibit "A" with JOA.¹¹ The 1982 Model Form anticipates three or more parties to the agreement. It requires the affirmative vote of two or more non-operators. If the AAPL Model Form Operating Agreement is not used, it is possible that the operating agreement utilized does not contain provisions detailing successorship to the operator.¹² Older operating agreements may not contain any provisions regarding the succession of the operator. It then becomes a matter of negotiation with the other working interest owners to determine who will succeed as operator once the operator has sold his interests.¹³

[B] In-Kind Provisions

An in-kind provision in a JOA, governed by Article VI.G. of the 1989 agreement, requires that each party take his natural gas in-kind and separately dispose of his proportionate share produced from the contract acreage.¹⁴ The provision states that if any party fails to so take, the terms of the gas balancing agreement, which is discussed below, will automatically become effective.¹⁵ Primarily the major and larger independent oil companies utilize this provision, because they have the ability to market their share of production separately.¹⁶ An in-kind provision also serves to maintain a non-corporate status between the parties for federal income tax purposes.¹⁷ If the operator had a duty to dispose of his non-operators' gas, the entities would be classified and taxed as one corporate entity.

Under the JOA, if the non-operator fails to take its share of production in kind, the operator has the right, but not the obligation, to purchase and sell the non-operator's share of production for the account of the non-operator.¹⁸ Any purchase or sale by the operator shall be for a period of no more than a year.¹⁹

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The JOA states that the purchase and sale of the non-operator's production by the operator is always subject to the non-operator's exercise of their right to take in-kind at any time.²⁰ As the operator is not obligated to sell the gas, a non-operator Buyer should become knowledgeable of any wells where the operator is selling the Seller's gas, as the sales relationship could be terminated.²¹

[C] Non-Consent Provisions

Non-consent operations under a JOA can result in a party not being entitled to proceeds of production from a particular well because he did not agree to bear the costs, drilling, reworking or other remedial operations.²² In almost all situations, non-consent status is not reflected in the county clerk's records.

Typically, the penalty for not participating in the drilling, reworking or other operations is that the non-consenting party does not share in the revenues from the successful well until the consenting parties have recovered a penalty ranging from 100 percent to 600 percent of the operation.²³ There is no difference in the treatment of the expense from non-productive wells.²⁴ The parties that elect to participate in ventures that become dry holes completely bear the cost.²⁵

There is the possibility that the Seller went non-consent or that the Seller has committed to bear a greater share of costs than indicated from record title.²⁶ The Purchase and Sale Agreement should undertake to identify any well in the transaction in which either the Seller or any other working interest owner has gone non-consent.²⁷

Furthermore, non-consent operations may result in the Seller receiving a greater interest in production then he is normally entitled. A review of the revenue or working interest deck may show that the Seller owns a greater interest than what is shown from an examination of the county clerk's records. One frequent reason for the discrepancy in the decimal number is the Seller's acquisition of a non-consent interest. If the Buyer is assuming that this interest is perpetual, the Buyer will be unpleasantly surprised when the non-consent payout occurs.

Unfortunately, there isn't a typical or easy way to determine the nonconsent interest acquired by a party. Many times, it is a function of 1) reviewing the proposal letters from the operator regarding the nonconsent

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interest and 2) a review of the election letters and a determination of who did not respond to the nonconsent proposals. After the review, follow-up conversations with the operator's accountant may be necessary to determine the number of wells not in full pay status.

[D] Maintenance of Uniform Interest

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