Published on:

Production Sharing Agreements

A client recently asked me whether he should sign a production sharing agreement. I replied that this is not an easy question to answer.TexasBarToday_TopTen_Badge_Small

First, the nomenclature.  These terms are not defined anywhere and their usage is not always consistent, but here’s what I mean when I use these terms:

Allocation Well. A horizontal well drilled across two or more lease lines without creating a pooled unit including the leases. Because no provision of the leases dictates how production will be shared among the leases, production must be “allocated” among the leases.

Production Sharing Well. An allocation well for which production sharing agreements have been obtained from royalty owners in tracts crossed by the well.

Production Sharing Agreement. An agreement between the lessee and lessor as to how production will be shared among leases crossed by a production sharing well. Most (but not all) production sharing agreements provide for allocation based on the percentage of the “productive lateral” crossing each lease. The productive lateral is measured from the first to last “take point” in a horizontal well. A take point is a perforation in the well – a hole in the well’s casing – through which production flows from the formation into the well.

Originally, the Texas Railroad Commission would issue a horizontal well permit for an allocation well only if the operator represented that it had production sharing agreements from at least 65% in interest of the royalty owners in each tract crossed by the well. Such a well is called a production sharing well, or PSA well. A few years ago, the RRC decided that it could issue permits for allocation wells without requiring the operator to obtain production sharing agreements from any of the royalty owners.

There is heated debate whether oil and gas leases authorize the drilling of allocation wells. The issue has been addressed in at least four legal proceedings. Three of those were settled before any court ruling was obtained. The fourth is a landowner challenge to the RRC’s issuance of an allocation well permit to Devon. The RRC has refused to hear the landowner’s challenge to the permit, and the landowner is preparing to appeal that ruling. Our firm represents the landowner in that proceeding.  Oil and Gas Docket No. 08-0305330, Complaint of Monroe Properties, Inc., et al. that Devon Energy Production Co., L.P. Does Not Have A Good Faith Claim to Operate the N I Helped 120 (Alloc) Lease, Well No. 6H, Phantom (Wolfcamp) Field, Ward County Texas.

Some operators will not drill allocation wells without first obtaining production sharing agreements from at least some royalty owners. Other operators will send production sharing agreements to royalty owners but will drill the well whether or not royalty owners sign them. At least one operator’s practice is to stand on its right to drill such wells and not request production sharing agreements. Often royalty owners will receive a production sharing agreement after an allocation well has been drilled.

I counsel clients to consider a request for a production sharing agreement the same as a request to agree to a pooled unit. In Texas a lessee has no right to pool the leased premises with other lands unless the lease grants such authority or the lessor separately agrees to the pooled unit. A production sharing agreement serves the same purpose: it authorizes the drilling of the allocation well and sets out the agreement for how production is to be allocated among the tracts from which the well produces.

The major difference between a pooling agreement and a production sharing agreement is in how production is allocated. In a pooling agreement, production is almost always allocated among the tracts included in the unit based on each tract’s percentage of the total acres in the unit. Participation in the pool does not depend on the location of the well. In a production sharing agreement, production is generally allocated based on lateral length, and only those tracts crossed by the wellbore are allocated a share of production from the well.

So should one sign a production sharing agreement?  In answering that question, the lessor should consider the following questions:

  • Is the allocation method fair under the circumstances? Are there local conditions that would cause one to question the assumption that production from the wellbore will be evenly distributed among the take points in the well? Is the lateral of the well located close to a lease boundary line?
  • Will production from the well maintain the lease in effect as to all of the leased premises? Many oil and gas leases contain Pugh clauses limiting the acreage that can be held under lease to the portion of the leased premises included in the pooled unit. Should a similar provision be included in a production sharing agreement?
  • Does the lease contain a retained acreage clause? If so, how much of the leased premises will be “retained acreage” for the production sharing well? Should that be addressed in the production sharing agreement?

As with any request for a lease amendment, the lessor should also consider whether the lessee’s request for a production sharing agreement is an opportunity to address other problems with the lease.  If the lessor is also the surface owner, are there issues with the lessee’s surface use that should be negotiated? Does the lease allow deduction of post-production costs? All such considerations should be open to negotiation. Unfortunately, because the RRC will issue permits for allocation wells without requiring the operator to have any production sharing agreements, many operators refuse to consider any such negotiations.

Contact Information