The advent of the “Allocation Well” comes with a fresh legal challenge, where horizontal well royalties are concerned.
A new Railroad Commission phenomena has developed recently, despite obvious rulings to the contrary. The name? Allocation Wells. Operators that are diving into horizontal drilling may already know all they need to know, but for the rest, background is important.
Leases and production units that are held by vertical production are unlikely to be situated just right for a new horizontal well. In fact, a horizontal well is likely to cross more than one lease or existing pooled unit. As a way to maximize production, the Railroad Commission, since 1998, has issued permits based upon Production Sharing Agreements. These Agreements, signed by the interest owners, combine units or unpooled tracts and allocate production of the horizontal well based upon the length of the lateral under the tract. Since 2008, the Railroad Commission has issued such permits based upon the operator’s representation that at least 65 percent of the interest owners of each tract agreed.
The theory behind such permitting is that since the operator is Lessee on the tracts involved, Rule 37 notice and hearing requirements when the wellbore is within 467 feet of the lease line are waived, and the operator may obtain a permit to drill without pooling. The Railroad Commission permits these wells because Lessors on the tracts are adequately protected from drainage. If there are unsigned owners on the tracts, the operator must show that “(1) production is attributed with reasonable probability to each unit traversed by the well’s productive drainhole and (2) such production is paid to the lessors in compliance with the lessors’ royalty and pooling clauses.” Drafting Production Sharing Agreements, 39th Annual Ernest E. Smith Oil, Gas and Mineral Law Institute, March 22, 2013, Robert D. Jowers and Mickey R. Olmstead.
In 2010, the Railroad Commission changed the game. Colin K. Lineberry (a representative of the Railroad Commission) issued a letter to Devon Energy approving Devon Energy’s application for an Allocation Well, despite no representation by Devon Energy that it had the agreement of at least 65% of the interest owners. Since that time, the Railroad Commission has issued more than 60 Allocation Well permits, and has not required the previous minimum amount of interest owners’ execution of Production Sharing Agreements.
Operators applying for these Allocation Wells argue that it is well established Texas public policy to prevent waste, and to maximize the use of new technology. The operators point to a Texas Appellate Court case that seems to support the position that operators are entitled to cross lease lines without pooling the interests. The case, Browning Oil Company, Inc. v. Luecke, involved an operator that attempted to establish pooled units, and drilled horizontally. Unfortunately, he did not adhere to the pooling provisions in the lease, and the pooling was found to have failed. The royalty owners “claimed that because their tracts were not validly pooled, they were entitled to royalty on all production resulting from the two purported pooled units.” This is the “remedy appropriate to vertical wells,” which provides that “where pooling is not valid, a landowner with a wellbore drilled on his land receives the full royalty promised in his lease, and landowners with no wellbore receive nothing.” The operator argued that instead, the damages must be allocated based on the “wells that could be attributable to the [royalty owner’s] tracts.”
The Court held that “without valid pooled units, the leases do not and cannot award the [royalty owners] royalties on oil and gas produced from tracts they do not own.” Moreover, the Court held that the horizontal wells that crossed leases were to be viewed as “multiple drillsites on multiple tracts.” It declined to “apply legal principles appropriate to vertical wells that are so blatantly inappropriate to horizontal wells and would discourage the use of this promising technology.” The Court went on to say that “[t]he better remedy is to allow the offended lessors to recover royalties as specified in the lease, compelling a determination of what production can be attributed to their tracts with reasonable probability.” In reading the opinion, operators, (and presumably the Railroad Commission), take it to mean that pooling is unnecessary, as is even agreement from the interest owners, as long as production is attributed with reasonable probability.
As would be expected, mineral owners are up in arms about the issuance of Allocation Well permits. They argue that it amounts to forced pooling, which is not permitted in Texas without notice and a hearing. An answer may be found soon, however. In 2012, EOG Resources, Inc., applied for a permit to drill an Allocation Well that crossed leases in which it did not have the right to pool. The mineral owners protested the issuance of the permit, and a hearing was held in November 2012. As of yet, no determination has been issued. Operators, however, would be wise to lessen their risk of exposure to litigation initiated by interest owners by obtaining Production Sharing Agreements from as many of the interest owners as possible. Will that advice change if Allocation Well permitting continues to live on? No, it wouldn’t. Interest owners are still free to sue for wrongful payment of royalties, as well as any other claim they feel is appropriate, depending on the circumstances. Protect yourselves as much as possible, and get those agreements.