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More About “Allocation Wells”

Mike McElroy of the Austin firm McElroy, Sullivan, Miller, Weber & Olmstead, has written an article in the Section Report of the Oil, Gas & Energy Resources Law (Spring 2014), titled “Production Allocation: Looking for a Basis for Discrimination,” defending the practice of oil and gas operators’ drilling of “allocation wells.”  The term “allocation well” has come to be used by staff at the Texas Railroad Commission and by the industry to refer to a horizontal well that is drilled across lease lines without pooling the tracts on which the well is located.  Mike argues that the RRC has authority to issue allocation well permits and that a standard oil and gas lease, with or without a pooling clause, authorizes the lessee to drill allocation wells.

This firm represented the complaining party in the Klotzman case, in which we argued that the RRC has no authority to issue allocation well permits and that the drilling of an allocation well violates the terms of a typical oil and gas lease unless the lease expressly grants such authority.  So, below is a rebuttal to some of the points made by Mike McElroy in his article.

Mike says that “Lessors and their lawyers see horizontal drilling and production allocation as opportunities to amend (re-trade) old leases.”  The question that must be asked is, does the lease authorize the lessee to drill an allocation well? If the answer is no, then the lessee must obtain an amendment of the lease to drill the well. The lessor may bargain for consideration in exchange for granting the lessee the right to drill the well.  If the answer is yes, as Mike argues, then the lessee needs no agreement from the lessor to drill the well.

Mike agrees that a lease can prohibit a lessee from drilling an allocation well, and he quotes some provisions from recent leases that do just that.  Again, same question: would a lease that does not authorize, but does not expressly prohibit, the drilling of an allocation well grant the right to drill such a well?

An oil and gas lease requires the lessee to pay royalties on production from the leased premises or lands pooled therewith.  If a lessee drills an allocation well, it cannot comply with that obligation, because the lessee cannot determine how much of the production from the well is produced from the leased premises and how much is produced from the other tract(s) on which the wellbore is located. Mike’s answer is that the lessee should just make the best estimate that it can:

An operator who has finished drilling an allocation well should closely inspect all the data gathered during those operations to determine whether there is any data demonstrating that a part of the wellbore should be treated better or worse than every other part of the wellbore. In the absence of such data, the operator should treat each drill site tract consistently, allocating production in proportion to each drill site tract’s share of the open wellbore in the pay zone. … Unless clear evidence justifies a contrary position, an operator should treat all portions of a horizontal wellbore in the pay zone in a non-discriminatory manner, thereby ensuring each owner their fair share of their rights under Texas property law.

I doubt that royalty owners will be comforted by their lessee’s assurance that its allocation method is giving the lessee its “fair share” of production from the well, based on the lessee’s analysis of wellbore data.

Mike argues that by drilling an allocation well the lessee is not pooling the tracts across which the well is drilled. Pooling is a method of allocating production from a well by agreement among different tracts. While most pooling clauses provide that production will be allocated on an acreage basis, the parties could agree to any method of allocation, including the one Mike advocates, based on the length of the productive lateral on each separate tract. Allocation by a production sharing agreement usually follows this method. Whether the allocation is done by creation of a pooled unit authorized by the lease or by a production sharing agreement, the result is the same: the lessors and lessee have agreed on a method of allocating production of a well among separate leases. The only difference in the case of an allocation well is that the lessee is making the allocation without any agreement of the lessors, based on the lessee’s determination of what is “fair.”

Mike argues that the RRC has authority to issue allocation well permits — indeed, he says that the RRC has no authority to deny an allocation well permit.  The examiners in the Klotzman case disagreed with that conclusion. 2013-06-25 PFD EOG Klotzman (2).pdf  Although the Commissioners overruled the examiners, they did not provide any basis for their decision. No RRC rule authorizes the issuance of a permit for a well that crosses lease boundaries unless the lessee certifies that it has authority to pool the acreage to be crossed by the well. There are no RRC rules that even use the term “allocation well.” The absence of regulations prohibiting issuance of a permit does not authorize the RRC to grant a permit.

I’m sure the debate will continue until the courts rule on the issue. In the meantime, it’s nice to have someone like Mike to debate with.

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