Herein of "Production Sharing Agreements" and "Allocation Wells"


November 10, 2012

I have recently become aware of recent changes in Texas Railroad Commission policies regarding "production sharing agreements" and "allocation wells" that deserve some comment. Some background is necessary to understand these recent developments.

Over the last couple of years I have been asked to review and explain proposed "production sharing agreements" sent to royalty owners.  Operators in the Haynesville came up with the concept of production sharing agreements when they were faced with trying to drill wells in areas that were held by production from large pooled units producing from vertical Cotton Valley wells. The pooled units were not configured to allow for efficient drilling of Haynesville horizontal wells. Operators wanted to drill laterals crossing the boundaries of the pooled units, and apparently the pooled units covered the Haynesville depths as well as the Cotton Valley. So, they came up with the idea of production sharing agreements. The agreements provide that the royalty owners in the two existing units agree that production from the horizontal well will be "shared" between the two units based on the percentage of lateral length on each unit, and production allocated to each unit will be treated for lease and royalty payment purposes as if produced from the unit. Devon was a big proponent of these agreements. From the royalty owner's point of view, the agreements have advantages and disadvantages. The advantage is that the royalty owner will get royalties on production from a new well that might not be drilled unless a production sharing agreement is signed to allow drilling across lease or unit boundaries. The disadvantage is that production from one well serves to keep all of the leases in both units in effect for as long as it produces.

A well drilled across lease or unit boundaries pursuant to a production sharing agreement is referred to at the RRC as a "PSA" well, because the permit is granted based on the operator's assertion that it has production sharing agreements with royalty owners for allocation of production between or among tracts; or as an "allocation well," because production from the well is allocated to two or more separate leases or units. When operators began applying for drilling permits for these wells, there was discussion at the RRC about how to handle them, because they did not fit the standard model of pooled units. Eventually, the RRC staff adopted an informal, unwritten policy that, if the operator would represent in its permit application that it had production sharing agreements from at least 65% of the royalty owners in both units, the RRC would grant the permit. The RRC has created a new form, the "PSA-12" form, to replace the Form P-12 that operators must file to represent that they have the right to create a pooled unit. If the operator submits the PSA-12 form, the RRC grants a PSA well permit, based on its informal 65% joinder policy.

I have now learned that recently operators have asked the RRC to grant permits for allocation wells even if they don't have PSAs from 65% of the royalty owners - or even if they have no agreements from royalty owners. The RRC has granted some 40 such permits without requiring the operators to have PSAs with any of the royalty owners. Some of the permits granted for such "non-PSA" allocation wells contain the following disclaimer:

Commission Staff expresses no opinion as to whether a 100% ownership interest in each of the leases alone or in combination with a "production sharing agreement" confers the right to drill across lease/unit lines or whether a pooling agreement is also required. However, until that issue is directly addressed and ruled upon by a Texas court of competent jurisdiction it appears that a 100% interest in each of the leases and a production sharing agreement constitute a sufficient colorable claim to the right to drill a horizontal well as proposed to authorize the removal of the regulatory bar and the issuance of a drilling permit by the Commission, assuming the proposed well is in compliance with all other relevant Commission requirements. Issuance of the permit is not an endorsement or approval of the applicant's stated method of allocating production proceeds among component leases or units. All production must be reported to the Commission as production from the lease or pooled unit on which the wellhead is located and reported production volume must be determined by actual measurement of hydrocarbon volumes prior to leaving that tract and may not be based on allocation or estimation. Payment of royalties is a contractual matter between the lessor and lessee. Interpreting the leases and determining whether the proposed proceeds allocation comports with the relevant leases is not a matter within Commission jurisdiction but a matter for the parties to the lease and, if necessary, a Texas court of competent jurisdiction. The foregoing statements are not, and should not be construed as, a final opinion or decision of the Railroad Commission.

With this background, we now come to the most recent developments: EOG Resources filed an application to drill the Klotzman (Allocation) Well 1-H, in the Eagleville (Eagle Ford 2) Field, in DeWitt County. The proposed well would cross over two different oil and gas leases, neither of which authorizes the lessee to pool the leased premises with any other tract. The owners of the royalty in these two leases filed a protest to EOG's permit application. The protest stirred a discussion at the RRC and caused its staff to call an informal conference on the matter.  After that conference, the director of the Hearings Division of the RRC, Collin Lineberry, wrote a letter to the parties, which can be viewed here: Lineberry letter.pdf. Mr. Lineberry said that the royalty owners' assertions "cast sufficient doubt on the applicant's assertion of a good faith claim to preclude the administrative approval of the requested permit at this juncture." He concluded that, if either party wanted to request a hearing on the matter, he would "set an evidentiary hearing to allow both parties to present evidence and argument regarding whether, on the specific facts of this case, EOG has a sufficient good faith claim to authorize issuance of an RRC drilling permit for the proposed allocation well." A hearing has now been set for December 3.

To me, the RRC's issuance of permits for "allocation wells" without requiring the operator to obtain production sharing agreements or pooling agreements from royalty owners in the tracts crossed by the wellbore is in effect allowing operators to force-pool tracts.  Forced pooling in Texas is allowed only under limited circumstances and requires an application, notice to affected parties, and a hearing. Texas - unlike other producing states - has never given its regulatory body broad authority to force-pool tracts into drilling units. The RRC staff's "policy" of allowing such permits appears to have been adopted without any hearing and without consideration by the Commissioners themselves.  As evidenced by the comments quoted above from one of the allocation permits, the applicants appear to have convinced the Commission staff that the proper allocation of production between tracts on which an allocation well is drilled is a matter of private contract between the parties over which the RRC has no jurisdiction and does not affect its decision whether to grant the permit. This appears to me to be contrary to prior RRC policy and existing RRC rules regarding pooled units, which require the operator to assert in the permit that it has authority to pool the tracts included in the proposed drilling unit.

I expect that there will be further developments on this issue in the near future.