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Published: 2008-03-26

Unitization



The terms "pooling" and "unitization" have tended to become words of special meaning, though the legal consequences are essentially the same, subject, of course, to the special contents of statutes which do somewhat vary the procedures and consequences of compulsory pooling from those in compulsory unitizations. But, though the legal consequences are much the same, and the case precedents largely interchangeable from one situation to the other, the physical results sought are quite different.

Pooling, whether resulting from multiple tracts joined together in a single lease by their owners, a voluntary consolidation among participating interests or royalty interests, or both, or a compulsory joining of all interests in a drilling and spacing unit entitled to only one well location, is unrelated to the oil pool as a natural physical entity. While such pooling reduces the number of competitive properties within a pool, the consequence is still competitive operations among the enlarged units to the extent permitted by conservation laws.

Unitization, on the other hand, is a deliberate effort to consolidate all, or a sufficiently high percentage of, the royalty and participating interests in a pool as will permit reservoir engineers to plan operation of the pool as the natural energy mechanism unit which it is. This means taking production at the locations and rates it is most efficient to take it, without disruption of the scheme by the legal rights inhering in competing properties. In the case of secondary, recovery and pressure maintenance units, it means injecting gas and fluids where these will most efficiently aid in expelling reservoir contents, again without the scheme being disrupted by property lines, or the withdrawal by a competing producer of the gases and fluids injected at great expense. To realize the significance of what is attempted it must be appreciated that an oil pool is a highly complex energy mechanism, capable of desirable and undesirable responses depending on how it is handled. The artificial property lines man has drawn upon these pools, coupled with the lessor-lessee rights and obligations arising from competitive production methods sanctioned or even required by law, make virtually impossible maximum ultimate recovery in the absence of unitization, and this is true even though a jurisdiction has otherwise excellent conservation regulations to limit the worst rule of capture competitive producing practices. The loss can be dramatic. Additionally, regulated competitive practices would entail a much larger investment in wells and lease equipment.

Voluntary poolings and unitizations derive from agreements among interested parties; hence there is no limitation upon their contents except possible contravention of public policy. As there usually are express statutory approval procedures in conservation statutes for voluntary unitizations, it may be said with great certainty that it is difficult to conceive a situation where public policy would be a limitation upon pooling and unitization for legitimate reservoir engineering purposes. Many jurisdictions authorize the competent authority to encourage or force unitizations for the benefit of the state. Unlike voluntary unitization, which can be but rarely is undertaken for exploratory purpose, compulsory unitization depends on a high level of knowledge of the physical characteristics of the pool to be unitized before a record can be made on which a conservation commission can act. This means there must be rather complete development or some real knowledge of the field. Unless unitization is implemented early in the life of a field, prior development (especially where conducted on a competitive basis) often results in inefficient operations and may lead to over development, as the owners seek to establish leverage in negotiating a larger share of the field or drain the field.

The Unitization Agreement

The normally operative sections of the unitization agreement create the unit, set forth its impact on the participating interests and avoid some legal traps for the unwary. Initially the agreement will provide that all of the parties have agreed to unitize their interests so that in the future the parties will be treated as if they had signed one lease covering all of the unitized area. A second provision usually attempts to conform all leases and other instruments that previously existed to the terms of the unitization agreement where authorized by the competent authority, specific language may also be included that allows unitized production to extend the production term of a concession. Normally included in this section is a provision expressing the parties' intent not to cross-convey any interests; this is because of the many problems that arise from treating the unitized interests as being cross-conveyed, e.g. approvals, preferential purchase rights and tax issues.

The provisions rejecting the cross-conveyance doctrine assumed importance in the United States when a participating interest owner claimed that it held ownership rights in a unitized gas field such that the unit operator, when it sold natural gas, was selling natural gas of the non-selling participating interest owner. Generally, the language of the unit operating agreement requires each participating interest owner to market its own share of production. These provisions tend to defeat claims that the unit operator has converted the non-selling party's gas where such party is unable or unwilling to sell its share of production. Such a result was reached in the U.S. case of Doheny v. Wexpro Co. Several non-selling parties to a unit operating agreement alleged that they were enticed to balance in cash where the unit operator was selling gas, but where they were either unwilling or unable to sell their share of the gas being produced by the unit. The court rejected their claim to balance in cash, following the widespread judicial preference to balance in kind unless the agreement or the equities dictate otherwise. The non-selling parties had claimed that they were tenants in common (common owners) with the unit operator which would entitle them to balance in cash. The court rejected the argument that the unit agreement's provision relating to allocation of production created a tenancy in common. The allocation of production provision merely related to determining each party's share, which would (under the agreement's express language) be separately disposed of by each party having the right to take in kind. Thus the parties to the unit agreement and unit operating agreement were deemed not to be tenants in common.

Doheny also illustrates the wisdom of incorporating within unit operating agreements a gas balancing provision to deal with the likelihood that each owner will either be unable or unwilling to take in kind their allocated share of production on a regular basis -- where the unit operator is not selling the full gas stream for the unit owners. Especially as it relates to unit production of gas where the owners may be unable to store the production on-site, it is quite possible that not all owners will be able to sell their full share of production. Setting up the appropriate accounting methodology, providing a database for over and under production figures, limiting overproduction levels and limiting the time period in which to remedy an underproduced condition are all matters that need to be addressed. In addition, pricing mechanisms to deal with cash balancing, when and if authorized, should be agreed to rather than left to subsequent judicial determination at the culmination of the litigation process.

The effect of creating a unit may extend beyond the signatory parties. In the U.S. case of Tennessee Gas Pipeline Co. v. Lenape Resources Corp., a pipeline purchaser was attempting to limit its take-or-pay obligation by excluding, from the deliverability calculation, production from unit wells that were outside of the areas that had originally been dedicated to the contract. The court noted that under the terms of the gas purchase contract, Tennessee was obligated to take gas from the seller's leases as well as from areas which were unitized with the seller's leases. Thus, unit production, even if off of the original leases owned by the seller, would still constitute part of the deliverability calculation for determining the purchaser's take-or-pay obligation.

Care should be exercised to ensure selection of an appropriate choice of law provision. This is especially true where the unit straddles two jurisdictional boundaries and where the substantive and procedural laws are different within the boundaries of a particular unit. Again, the parties to a multi-jurisdictional unit agreement are better off deciding for themselves the appropriate choice of law, rather than having a court, expert or arbitrator(s) choose the applicable law after the matter has been instituted.

The participation formula is the heart of the unitization agreement. It is usually the most difficult problem to solve, but unitization is impossible until it is agreed upon by all of the affected parties concerned, especially the participating interest owners. The formula determines the portion of the unitized substances each participating party is to receive, and it is usually arrived at after long and laborious negotiation. The ideal solution would allocate production so that each participating interest owner's share of production from the unit would be in exact proportion to the value of the interest that each participating interest owner contributes to the unit. The relative value of each participating interest owner's contribution is not merely based on the amount of hydrocarbons that may underlay his or her estate. Therefore, value is determined not only by productive acre, feet of oil and gas in place, but also by such additional factors as location on the structure, amount of production already attained, number of existing wells and money invested in existing production facilities.

But the attainment of the ideal participation formula that exactly mirrors each participating interest owner's share of the value of the entire unit is impossible. The information concerning the reservoir is likely to be limited, even where there has been substantial primary development. Predictions of future reservoir behavior are also difficult to make and are subject to many variables, any of which might change each owner's proportionate share. External factors, such as market price of the hydrocarbons, also render an ideal participation formula impossible to achieve.

The formula, however imprecise it may be, is usually reached through the "give and take" of long and hard negotiation sessions between the participating interest owners. With the advent of computers, participating interest owners are capable of analyzing complex formulas in a short period of time to determine the effect of the proposed formulas on their individual interests. While, by definition, some participating interest owners will receive more than their proportionate value and some will receive less, even the losers on the formula finally chosen will become net winners, because overall production will hopefully be substantially increased over the levels that would have been achieved from non-unitized production. While the share is smaller, the pie becomes bigger and therefore a consensus is frequently reached voluntarily among the participating interest owners.

The process of developing a formula may vary from unit to unit. The engineers and geologists must have an important role, at least in the beginning of the process, because they are responsible for developing information about the characteristics of the reservoir. Since most reservoirs vary in thickness, pressure, porosity, and other factors, there can be considerable negotiations between the parties as to the data and projections used to develop the facts upon which the ultimate allocation decision is reached. The engineers and geologists try to determine the economic value that attaches to each of the leasehold estates that will be committed to the unit. Relative values are often the function of various factors: the two most important are the estimate of the total reserves in place and the source of the reservoir pressure combined with the location of the tract in relationship to the source of the pressure. Before one can arrive at any kind of allocation formula, the relative economic values for the entire unit must be evaluated in detail.

United States

No case has held state approval of a proposed unit to be necessary. What is accomplished by approval is express statutory immunity from state antitrust laws. No means for obtaining comparable immunity from the federal antitrust laws exists, but it can be said with fair certainty, based on a major federal antitrust case which resulted in a closely negotiated consent decree (and in which the federal government never urged per se illegality from production limitations related to conservation practice) that production limiting agreements among the participating parties in a unit created for the purpose of enhancing ultimate recovery, and even protecting their correlative rights, do not trench upon the federal antitrust laws.

Depending as they do on the infinite range of agreements which can be reached, voluntary unitization agreements can grow enormously complex, presenting most difficult problems of construction. This is particularly true where more than one pool is involved in the unit, an uncommon but not unusual situation.

Compulsory poolings and unitizations derive from application of the police power of the state to prevent waste and protect correlative rights. The constitutionality of such statutes now is not open to doubt. Typically, a compulsory pooling statute calls for the forcible integration and consequent sharing in production from a drilling and spacing unit, in which but one well will be permitted, upon application of a party owning participating interests in the unit. The state commission orders entered vary widely, many providing the alternative of proportionate contributions to costs of drilling or for a non-consenting participating interest owner to be carried, subject to payout in favor of the drilling party, but with drilling at the drilling party's risk. Others provide alternatives such as contribution of share of costs or submitting to a forced sale of the non-consent participating interest at a price set by a government agency if sharing is not elected.

A few carrying alternatives (paying for another party in consideration of obtaining some premium for assuming the cost and risk associated with the operation) deal with the risk aspect by requiring the drilling party to carry, the non-drilling participating interest owner, but with an incentive percentage over and above actual drilling and completion costs to be recovered in addition to actual costs before the non-drilling party participates. Royalties are also unitized in the United States, sometimes voluntarily and sometimes by order of the state authorities after obtaining a legally specified percentage of these interest holders. Lease burdens such as overriding royalties and production payments should be the burden of the participating interest owner for whose account the drilling takes place whether he is the drilling party of a carried participating interest owner, unless the compulsory pooling order provides otherwise and are generally not entitled for vote for or against the creating of a unit.

As a practical matter compulsory unitization originates with a participating party or a group of participating parties interested in unitizing a pool or field. These parties then develop a unit agreement and unit operating agreement essentially the same as the documentation found in a voluntary unit. Then, in advance of going to the appropriate government agency, they seek approval of at least the requisite percentage of participating interest and royalty owners needed to comply with statutory requirements, after which the matter is presented to the government agency. There a record of testimony, particularly including the expert testimony of geologists and reservoir engineers, is made on the basis of which the government agency renders its decision and issues an order (a ruling).

In all states, under the somewhat standardized statutory procedures, there must be approval of required percentages of both the participating interest and royalty interest ownerships. In some states, notably Arkansas and Louisiana, the proponents must present the requisite percentage of approvals at the time of hearing, in effect putting these government agencies in the position of affirming or denying, but unable to change the unitization as agreed and presented. In other states, notably Oklahoma, the government agency orders the unitization plan on the basis of the hearing record made after which a period of time is provided in which the assent of the requisite percentage of ownership must be obtained if it is to go into effect. Here, the government agency is not limited by the proposals presented it. Apportionment of production according to a participation formula, appointment of a unit operator and an operators' committee, provision for turnover of equipment to the unit with appropriate financial adjustment accountings and provision for contributions by participating interest owners to the costs of operating the unit are the more important matters covered by the orders made.

It has been suggested there is an obligation upon lessees to pool or unitize in appropriate circumstances. Case developments appear to be the contrary. Cases have supported the view that it is an unreasonable burden upon a participating interest owner to compel him to seek pooling and unitization with other owners over who he has no control and whose interests may be radically different from his own. On the other hand, a participating interest owner presented with a fair plan of pooling or unitization which would be beneficial to him and his lessor (the owner of the subsoil who grants the right to explore and produce oil and gas and who retains a royalty interest) well might be expected to accept or support it. The area is not likely to be productive of much bona fide litigation, so for participating interest owners to maximize profits, they will support pooling and unitization in situations where the financial benefits are sufficiently clear.

Australia

The laws in Australia provide that a holder of a production license may from time to time voluntarily enter into a unit development agreement.

Moreover, the Joint Authority (competent government authority) may on its own motion or motion of (a) a license holder or (b) a person who is lawfully entitled to carry on operations for recovery of petroleum in an area outside the adjacent area that includes a part of a particular petroleum pool that enters into the adjacent area, direct any licensee whose license area includes any part of the pool to enter into a unitization agreement within a certain time period.

If the licensee does not enter into the unitization agreement as directed within the specified period, or if the unitization agreement is entered into but an application for approval thereof under Section 81 of the Petroleum (Submerged Lands) Act of 1967 is not submitted, the Joint Authority may require the filing of a scheme for or in relation to the unit.

Any time after the scheme is submitted, the Joint Authority may submit directions to the licensee "as the Joint Authority thinks necessary for the purpose of securing the more effective recovery of petroleum from the pool." Directions can be amended and supplemented as the Joint Authority sees fit from time to time. The licensee has the right to confer with the Joint Authority before directions are issued by the Joint Authority. Directions may also include directions as to the rate at which petroleum is to be recovered.

Section 81 states that all assignments of existing tide are subject to approval by the Joint Authority. This section applies to unit agreements.

United Kingdom

The state secretary, with charge over the oil and gas industry is empowered to require unitization where he is satisfied that a field lies within a licensed area and an area comprised by another license and considers that it is in the national interest, in order to secure the maximum ultimate recovery of petroleum and to avoid unnecessary competitive drilling, that the field should be unitized.

Generally speaking, UK unitization statutes require that an approved plan of compulsory unitization include the following items: (a) a description of the unit area, (b) a statement in reasonable detail of the operations contemplated, (c) a plan for allocating to the separately owned tracts in the unit the oil and gas produced therefrom, (d) provisions concerning the financing and allocation of costs incurred, (e) provisions for carrying or financing a person who elects to be carried or financed, (f) a statement of procedures for and the basis upon which wells, equipment and other properties of the lessees are to be taken over, (g) provisions for supervision and control and for voting by owners of interests included in the unit, (h) the time when the plan shall become effective and operations shall commence, (i) the time when, the conditions under which and the methods by which a plan may be terminated and (j) such other provisions that are appropriate.

Brazil

Article 27 of the Brazilian Petroleum Law states that "in case of fields extending over adjoining blocks, operated by other concessionaires, the parties involved shall agree on the splitting of production. In case of non-agreement within the maximum period fixed by the Agencia Nacianal do Petro'leo (ANP), the latter shall, based on an arbiter's award, determine how the rights to the blocks and the obligations shall be equitably appropriated, based on applicable general legal principles." Brazilian law, therefore, requires parties to form units, and, where the parties cannot come to an agreement amongst themselves with respect thereto, the matter is referred to an arbitrator for resolution.

In addition, the Third Round Concession Agreement contains provisions which deal with the formation of units. Under paragraphs 12.1.1 and 12.1.2 thereof, whenever a discovery is made outside of a concession area either (a) ANP will notify all other relevant concessionaires with the purpose of having all parties execute a unitization agreement or (b) ANP (until a concessionaire is engaged for the relevant blocks) will negotiate a unitization agreement with the relevant concessionaire in the event the discovery is located in an area where there is no concessionaire.

Paragraph 12.2 of the Third Round Concession Agreement sets forth the contents of the unitization agreement: (a) description of the unitized area, (b) identification of the operator, (c) participation percentages of participants, (d) plan of development, (e) payment of participations, and (f) all other items typically covered in a unitization agreement based on best practices in the oil and gas industry. ANP may permit an operator from an adjacent area to undertake evaluation activities with the approval of all interested parties.

If requested ANP may, but is not required to, act as mediator with respect to the negotiation of the unitization agreement. If a concessionaire enters into a unitization agreement, ANP shall have 60 days from the receipt of the executed agreement in which to request amendments which ANP deems advisable. No response from ANP is deemed to be approval. If ANP requests amendments, the concessionaire and the other interested parties shall have 60 days from the date the request was made to submit to ANP appropriate modifications. After a unitization agreement becomes effective and has been approved, all further amendments are subject to the consent of ANP.

An operator of a unitized field must hold a minimum participation of 15 percent contrasted to a 30 percent requirement for non-unitized fields.

Conclusion

To enable pools that straddle multiple concessions (host government contracts) to be efficiently developed and produced, states have or are enacting legislation that encourages and, in some instances, mandates the creation of units. This state action must be balanced against the rights of individual concession owners to freely operate their property (whether this be a direct interest in the oil and gas or a contract right to develop and produce the oil and gas). Outside the United States and the United Kingdom, unitization is a relatively new phenomenon, and the rules are just now beginning to coalesce. The interplay between government rules and the conflict associated with the negotiation of unit sharing arrangements among the various participating parties in multiple concessions makes for some complicated arrangements that involve, among other factors: subsurface geotechnical and engineering, surface engineering, construction and operations, economics, market predictions, negotiations and drafting.