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Produced Water Supersystems

H2O Midstream recently announced its acquisition of “produced water infrastructure” from Sabalo Energy in Howard County – 37 miles of pipeline, nine salt water disposal wells, four Ellenburger salt water disposal well permits, and other assets. This brings H2O Midstream’s produced water network up to a combined “supersystem” for handling produced water of up to 435,000 barrels per day, 190 total miles of pipeline, and 40,000 barrels per day of recycling capacity. The deal includes a 15-year “acreage dedication” of Sabalo’s leases to provide produced water gathering, disposal and recycling services to Sabalo. H2O Midstream is funded by EIV Capital and its institutional partners.

H2O is one of several companies trying to create supersystem produced-water handling systems in the Permian and the Eagle Ford. Like H2O’s deal with Sabalo, these acquisitions typically involve transferring produced water infrastructure assets to the company and dedication of the seller’s leases to the system – a commitment to pay an agreed amount to the company for produced water disposal services.

From landowners’ point of view, this development presents some interesting questions and challenges.

First, it has always been understood that groundwater is the property of the surface owner. This should include water that is contained in reservoirs that also include oil and gas – produced water. These new companies like H2O must have considered that issue, because the Texas Legislature in the last session passed House Bill 3246, amending Section 122.002 of the Natural Resources Code that deals with “fluid oil and gas waste,” which includes produced water. The effect of the amendment is to provide that, “unless otherwise expressly provided by an oil or gas lease, a surface use agreement, a contract, a bill of sale, or another legally binding document,” when produced water is “produced and used by or transferred to a person who takes possession of that waste for the purpose of treating the waste for a subsequent beneficial use, the waste is considered to be the property of the person who takes possession of it …” So if Sabalo Energy produces water and transfers it to H2O, it is “considered the property of” H2O. One might ask whether the legislature has the right to change ownership of groundwater after it has been produced.

Second, I expect that some of the assets Sabalo sold to H2O were built by Sabalo on their leases pursuant to rights granted to them as lessee of the leases. A lease typically allows the lessee to lay salt water lines and drill disposal wells as part of its producing operations. If those assets are transferred to H2O, does that give H2O the right to go on the lease and operate those water lines and disposal wells?

Third, the contract between Sabalo and H2O “dedicates” Sabalo’s leases to their contract. If that is legally possible, any assignee of Sabalo’s leases is bound by the contract to use H2O for disposal of produced water and pay the contract price. This could encumber the value of the wells on the lease, both for the working interest owner and the royalty owner. Can the lessee deduct these disposal costs from royalties under a typical oil and gas lease? Is this a post-production cost?

The issue of “dedication” of acreage to a contract has previously arisen with regard to gathering and processing agreements and whether the contract obligations can be rejected in a bankruptcy proceeding of the lessee. Chesapeake sold its gathering system in the Barnett Shale for a large sum, dedicating its wells to the system for gathering fees that were quite high – thereby inducing the buyer to pay a high price for the assets, having been assured of a guaranteed cash flow for its gathering services. When Chesapeake decided to sell its wells it had to “buy out” the gathering contract because its leases, burdened by the dedication to the gathering contract, had no value. But prior to the sale, Chesapeake was able to pass through a portion of the gathering costs to its royalty owners as a post-production cost.  A similar pattern could emerge with these produced water contract dedications.

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