Oil and Gas Lawyer Blog
Every oil company lease form will contain a pooling clause, and the rights granted to the Lessee by that clause can significantly affect the economic and other rights of the Lessor under the lease. Every Lessor should therefore understand the concept of pooling.
The basic idea behind pooling is a good one, and its use can benefit both parties to the lease. In all states, laws and regulations have been adopted governing the spacing of wells – how many wells can be drilled in a field and how far apart they must be from each other and from the lease line on which the well is located. These regulations have been developed to prevent the drilling of unnecessary wells and to maximize the ultimate recovery of oil and gas from a field. The spacing rules — often called “field rules” — may differ from field to field, depending on whether the field produces gas or oil and on the geological characteristics of the reservoir. In Texas, the Texas Railroad Commission’s spacing rules require an oil company to have a minimum number of acres under lease and assigned to a well in order for the Commission to grant a permit to drill the well. The acreage assigned to the well is called a “proration unit” (not to be confused with a pooled unit). For most oil fields, the proration unit size is 40 acres. For gas wells, the proration unit size can range from 40 acres to 640 acres, depending on the field rules for that field. For horizontal wells, the amount of acreage that must be (or can be) assigned to a well generally depends on the length of the productive lateral. The longer the lateral the more acreage can be assigned to the well.
Where mineral ownership is divided into small tracts, it may not be possible for a Lessee to obtain a permit to drill a well unless it can somehow combine the small tracts into a larger tract for purposes of assigning a proration unit to the well. For example, if the proration unit size in a field is 160 acres but all of the tracts in the field are 40 acres or less, then the Lessee must combine several tracts into a single unit in order to drill a well. Also, the tract boundaries in a field may not fit the spacing pattern for a field. The best location to drill a well may be exactly on the boundary between two tracts. In such a case, the best solution is to combine all or parts of the two adjacent tracts to form a single unit. This combining of acreage is called pooling, and the units so created are called pooled units.
A lease pooling clause allows the Lessee to put all or parts of the leased premises into pooled units with other adjacent properties. The economic effect on the Lessor is that all Lessors of all of the leases included in the pooled unit will share in production from the pooled unit in proportion to the number of acres each lease contributes to the unit. For example, if the Lessee combines 60 acres from Lease A and 100 acres from Lease B to form a pooled unit, and if the royalty in Lease A is 1/5th and the royalty on Lease B is 1/4th, then:
Royalty Owner A will receive a royalty on unit production of 1/5th of 60/160, or 7.5%, and
Royalty Owner B will receive a royalty on unit production of 1/4th of 100/160, or 15.625%, and
The Lessee’s share of production will be 100% minus 7.5% minus 15.625%, or 76.875%.
The idea is that each royalty owner whose lease participates in the pooled unit will receive a fair share of royalties on production from the well, because the well will drain oil or gas from all of the tracts included in the pooled unit.
Problems arise in pooling where the interests of the Lessor and Lessee do not coincide. For example, most lease pooling clauses allow the Lessee to form pooled units for gas wells of up to 704 acres. If the wells in the field are only capable of draining 80 acres, then a well on a 704-acre pooled unit will not fairly allocate royalties among the tracts included in the pooled unit. But the Lessee has an incentive to create larger units, because production from the unit well will serve to keep all of the leases included in the unit in effect beyond their primary terms. So the Lessee’s incentive is to form units as large as possible, even though such units may not be in the Lessors’ best interest. In considering drafting issues related to pooling clauses, this inherent conflict of interest should be kept in mind.
— Is a pooling clause necessary?
The first question a landowner should ask in negotiating a lease is whether a pooling clause is necessary at all. If the leased premises will be 5,000 acres then there is no need to pool with other lands in order to develop wells on the property, and the pooling clause should be deleted. If the leased premises contain 80 acres, it may be appropriate to give the Lessee authority to pool for gas wells but not for oil wells.
One alternative is to leave the pooling clause in the lease but provide that the Lessor’s consent must be obtained to create a pooled unit. In that way, the Lessor can have the opportunity to judge the fairness of each pooled unit on its own merits.
Pooling clauses should also be seen from the Lessee’s point of view. A company may have to assemble hundreds of leases from owners of multiple tracts with multiple mineral interest owners in order to assemble a drillable prospect. It may not be reasonable to expect the company to obtain consent from all of those royalty owners every time it wants to form a pooled unit. The law implies an obligation on the Lessee to form pooled units in good faith, taking into account the interests of both parties. In most cases, pooled units benefit all parties by allowing for an efficient development of the mineral resource.
— The “Pugh” Clause
A pooling clause has a consequence that many Lessors may not realize. Suppose that a lease covers 320 acres, and that the Lessee exercises its right under the lease to create a pooled unit containing 20 acres of the leased premises and 620 acres of an adjacent tract. So 20/620ths of production from the unit will be allocated to the 320-acre lease for royalty purposes. The pooling clause provides that production from a pooled unit will be considered production from the leased premises for purposes of maintaining the lease in effect beyond its primary term. So inclusion of 20 acres of the 320-acre lease has the effect of keeping the lease in effect beyond its primary term as to the entire 320-acre tract, even though only 20 acres of the tract was included in the pooled unit.
To avoid this result, the Lessor commonly insists on inclusion of a “Pugh clause.” This clause provides that production from a pooled unit in which less than all of the leased premises is included will maintain the lease beyond its primary term only as to the part of the leased premises included in the pooled unit. In the example given above, if the lease contained a Pugh clause then the lease would expire at the end of it primary term as to all of the 320 acres except for the 20 acres included in the pooled unit, unless the Lessee established production from the non-pooled acreage.
— Other Restrictions on Pooling
Depending on the circumstances, the Lessor may want to negotiate other restrictions on pooling. For example, if the lease contains 40 acres, consider requiring that all of the leased premises must be included in any pooled unit. Consider restrictions on the size of the pooled unit depending on the depth or field in which the well is completed. If all of the wells in the area are producing from a field in which the proration unit size is 160 acres, why grant the Lessee the right to create 640-acre units for gas wells? Effective negotiation of pooling restrictions requires a knowledge of the spacing rules in effect in the area of the leased premises.
— Limitations on Size
Standard pooling clauses may often say that pooled units can be created with the number of acres “permitted by applicable field rules.” Field rules are not a good measure of how large pooled units should be. Field rules are written by counsel for operators to maximize the acreage that can be held by pooling. Field rules do not approximate the amount of acreage that can be drained by a well. So a pooling clause should not reference field rules, but should set the maximum size of pooled units. For vertical wells the maximum size of pooled units may vary depending on the depth of the producing zone. The deeper the zone, the larger the permitted pooled units. For horizontal wells in shale formations, the size of pooled unit should depend on the length of the productive lateral, from first to last “take point.” The standard used by the Texas General Land Office is based on a formula: A = L x .032, where A is the maximum number of acres for the pooled unit and L is the length in feet of the productive lateral. So a pooled unit for a well with a productive lateral of 5,000 feet could encompass up to 160 acres (5000 times .032 = 160).
— Allocation Wells
A recent phenomenon in Texas has caused much discussion among oil and gas practitioners – the drilling of wells that have come to be known as “allocation wells.” The term refers to a horizontal well that is drilled across two or more separately leased tracts without pooling those tracts, or a well drilled across two or more existing pooled units. Sometimes the operator of the well will ask the royalty owners in the tracts crossed by the well to sign an agreement on how production from the well will be allocated among the tracts crossed by the well – usually called a Production Allocation Agreement or Production Sharing Agreement. But some operators will drill an allocation well without getting agreement from the royalty owners affected by the well, and will simply propose a division of royalties among the tracts by sending a division order after the well has started producing.
There are many unknown questions about allocation wells, including the very basic issue of whether an oil and gas lease authorizes the drilling of such a well. To avoid such controversies, an oil and gas lease can clearly provide that no allocation well may be drilled on the lease without the consent of the Lessor. The State of Texas has recently added such a provision to its Relinquishment Act lease form. If a royalty owner is asked to sign a Production Sharing Agreement she should understand the consequences of doing so and how such an agreement affects the other provisions of her oil and gas lease.