September 19, 2018
Author: Michael S. Browning
Organization: Burleson LLP
What is an Allocation Well?
An Allocation Well is a Texas Railroad Commission designation for a proposed horizontal well for which the operator does not have a Production Sharing Agreement or at least sixty-five percent (65%) of the working interest owners and royalty interest owners signed up for each included oil and gas lease and unit. Drafting Production Sharing Agreements, 39th Annual Ernest E. Smith Oil, Gas and Mineral Law Institute, at 2, March 22, 2013, Robert D. Jowers and Mickey R. Olmstead.
Horizontal Wells.
The Texas Railroad Commission defines a horizontal drainhole well as “[a]ny well that is developed with one or more horizontal drainholes having a horizontal displacement of at least 100 feet.” 16 TEX. ADMIN CODE § 3.86(a)(4) (2000) (R.R. Comm’n of Tex., Horizontal Drainhole Wells). Horizontal drilling increases the exposure of the perforated (i.e. producing) portion of the wellbore by thousands of feet over a traditional vertical well. As such, the efficient gains in hydrocarbon extraction are exponential. In other words, as the amount of source rock exposed to the wellbore increases, production rates have skyrocketed from once hundreds of feet of productive formation exposed, to the thousands of feet of productive formation exposed today.
Horizontal drilling, coupled with the continued refinement of drilling and completion techniques, allows operators to achieve far greater hydrocarbon recovery from a given field, and to develop previously unproducible hydrocarbon reserves trapped in shale rock and other tight geologic formations. Further, as lateral lengths for each well continue to increase, operators may now access more of a particular formation through fewer surface locations, including the ability to access areas otherwise impossible to reach. Indeed, this past decade has seen an unprecedented boom in horizontal drilling in Texas and throughout the United States.
As with almost any new technological advancement, horizontal drilling presents its own unique set of legal and regulatory issues. To be sure, horizontal drilling has challenged the Texas Railroad Commission and the Texas Court system to apply and adapt traditional legal and regulatory concepts, which have been developed for over a century for vertical wells, to horizontal wells.
The Evolution of the Texas Railroad Commission Rules Leading to Allocation Wells.
Initially allowed as a means of maximizing production, the Texas Railroad Commission has issued permits based on Production Sharing Agreements. A Production Sharing Agreement (“PSA”) is an agreement between royalty, working and other mineral interest owners with interests in multiple pooled units and/or unpooled leases in which the parties agree to a method for allocating production from horizontal wells traversing these lands. See H. Phillip Whitworth & D. Davin McGinnis, Square Pegs, Round Holes: The Application and Evaluation of Traditional Legal and Regulatory Concepts for Horizontal Wells, 7 TEX. J. OIL, GAS & ENERGY L. 177, 210 (2011-2012).
A timeline of the evolution of the Texas Railroad Commission Rules leading to Allocation Wells is as follows:
1. In 1998 the Texas Railroad Commission first established a procedure for permitting vertical PSA wells drilled on or near lease-lines. Drafting Production Sharing Agreements, 39th Annual Ernest E. Smith Oil, Gas and Mineral Law Institute, at 4, March 22, 2013, Robert D. Jowers and Mickey R. Olmstead. [emphasis added].
2. In 2006 the Texas Railroad Commission established a procedure for permitting horizontal PSA wells. Id. [emphasis added].
3. In 2007 the Texas Railroad Commission Staff denied a permit for a PSA well because it had less than 100% of the royalty interest owners signed up. Devon Energy Production Co., LP then appealed that denial to the Commissioners, who granted the well permit and indicated that the Staff was authorized to permit similarly situated wells. Id.
4. In 2008 the Texas Railroad Commission Staff denied a permit for a PSA well that had less than ninety percent (90%) royalty interest signed up. Devon appealed the denial to the Commissioners. The Texas Railroad Commission approved any PSA well permit where each tract has at least sixty-five (65%) working interest and royalty interest signed up. Id.
5. In 2010, after the Texas Railroad Commission denied Devon’s proposed field rule language in Oil & Gas Docket No. 06-0262000 and Devon’s Motion for Rehearing was denied, Devon filed a well permit application for an Allocation Well, the Taylor-Abney-Obanion Allocation Well. On April 21, 2010, the Texas Railroad Commission’s Director of the Hearing Section, Mr. Colin Lineberry, notified Devon that based on the representations that Devon holds leases on each of the tracts crossed by the proposed wellbore and that there are no unleased interests within 330 feet of any point on the wellbore, the Texas Railroad Commission would process the Drilling Permit. See Oil & Gas Docket No. 02-0278952 the Proposal for Decision and Recommended Final Order in the Application of EOG Resources, Inc., Klotzman Lease (Allocation) Well No. 1H, Eagleville (Eagle Ford -2) Field, DeWitt County, Texas.
Despite no representation by Devon Energy that it had the agreement of at least sixty-five percent (65%) of the interest owners, the Texas Railroad Commission approved Devon’s Drilling Permit. Since that time, the Texas Railroad Commission has issued more than sixty (60) Allocation Well Permits, and has not required the previous minimum amount (sixty-five percent (65%)) of interest owners’ execution of Production Sharing Agreements.
Scenarios for Allocation Well Use and the Applicable Case Law Pertaining to Production Allocation in Allocation Wells. There are several scenarios in which an operator might need to utilize an Allocation Well or utilize a production allocation method as one would use for an Allocation Well, to wit:
A. An operator, who owns 100% of the working interest in two (2) or more adjacent tracts, desires to drill a horizontal well traversing and producing from each tract but the underlying oil and gas leases covering these tracts do not allow for pooling.
B. An operator, who owns 100% of the working interest in two (2) or more adjacent tracts, desires to drill a horizontal well traversing and producing from each tract but the pooling provisions of one or more of the underlying oil and gas leases covering these tracts has been maximized.
C. An operator who owns 100% of the working interest in two (2) or more adjacent tracts, desires to drill a horizontal well traversing and producing from each tract but one or more of these tracts contains an unleased/unpooled undivided mineral interest owner.
D. An operator who owns 100% of the working interest in two (2) or more adjacent tracts, desires to drill a horizontal well traversing and producing from each tract but one or more of these tracts contains an unratified non-executive interest owner.
E. An operator who owns 100% of the working interest in two (2) of three (3) tracts adjacent tracts, desires to drill a horizontal well traversing and producing from each tract but in the third tract such operator owns only a 50% working interest while the reaming 50% is owned by another operator whose interest is not pooled.
Unfortunately, there is scant legal authority to rely upon. One case which supports the position that operators are entitled to cross lease lines without pooling the interests involved (“allocating”) and provides some guidance as to an operators obligations to allocate production is Browning Oil Co. v. Luecke, 38 S.W.3d 625 (Tex. App. —Austin 2000, pet. denied).
In Luecke, the operator drilled two (2) horizontal wells that traversed tracts owned by the Lueckes, as well as several other tracts, and then purported to pool the Lueckes’ lands into Units that failed to comply with the Lueckes’ oil and gas lease anti-dilution clauses. The Lueckes contended that such pooling was ineffective as to them, thereby entitling them to royalties based upon all the production from the first well and royalties based on all the production from the second well. Id.
The Luecke Court concluded that even though the reasonably prudent operator standard would support the Units formed, this implied covenant doctrine could not override the express provisions of the Lueckes’ oil and gas leases, thereby rendering the pooled units ineffective as to the Lueckes' lands. The Luecke Court further ruled that the Lueckes’ damages were not the royalties they would have received from a Unit complying with the pooling provisions, as the trial court had instructed. The Luecke Court declined to apply legal principles appropriate to vertical wells that are inappropriate to horizontal wells and would discourage the use of horizontal drilling. Instead, Luecke Court ruled that the Lueckes were entitled to royalties on the production that can be attributed to their tracts with reasonable probability. Id.
A few of the relevant holdings from Browning Oil Co. v. Luecke are as follows:
I. Each tract traversed by the horizontal wellbore is a drillsite tract, and each production point on the
wellbore is a drillsite. Browning Oil Co. v. Luecke at 634.
II. The measurable portion of a horizontal well lies between the initial penetration point and the terminus point. Id at 635.
III. If a horizontal drainhole traverses and is producing from a tract with an unpooled/unleased interest owner, and such interest is not validly pooled, such unpooled interest owner is entitled to a share of production that can be attributed to their tract with reasonable probability. Id at 647. [emphasis added].
Procedurally, the Austin Court of Appeals remanded the Luecke case back to the trial court for a new trial on damages consistent with the Austin Court of Appeals’ Opinion. Thereafter, the parties settled the case. As such, the Luecke Opinion failed to address:
A. What is “reasonable probability”?
B. Who has burden of proof?
C. What is the measure of damages if “reasonable probability” cannot be ascertained?
Possible Allocation Calculation Methods.
With respect to the question of “What is the best methodology to satisfy the ‘reasonable probability’ standard set forth in Browning Oil Co. v. Luecke?”, the short answer is that no one really knows. There are several calculation methods each with their own positive and negative attributes, a few examples are listed below, to wit:
1. Surface Acreage Basis: simply calculating the production attributable to a given tract based on the quantum of acreage of such tract divided by the total surface acreage of a “Production Unit”.
Positives: (a) known calculation method (same method utilized for most pooled units); (b) simple calculations; and (c) maintains the same standard of measurement (acreage) so that ownership totals will equal 100%.
Negatives: (a) would require expert testimony to a scientific level of exactness confirming that the entire reservoir under such tract is homogenous and isotropic, which is probably not achievable; (b) most likely fails to comply with the ruling in Browning Oil Co. v. Luecke; (c) most likely method to be attacked as “forced pooling”.
2. Productive Horizontal Drainhole Length: by definition productive horizontal drainhole length is the horizontal length of the wellbore path that begins at the first take point and runs along the surveyed wellbore path to the last take point. Calculations utilizing this method would consist of the numerator being the length (in feet) of the productive horizontal drainhole traversing the tract in question with the denominator being the total length (in feet) of productive horizontal drainhole. See Drafting Production Sharing Agreements, 39th Annual Ernest E. Smith Oil, Gas and Mineral Law Institute, at 10, March 22, 2013, Robert D. Jowers and Mickey R. Olmstead.
Positives: (a) in the author’s experience, the most utilized calculation method thereby moving closer to an “industry standard”; (b) comes closest to complying with the ruling in Browning Oil Co. v. Luecke; and (c) appears to be a fair and reasonable method of allocation, assuming supported by geological evidence. Id.
Negatives: (a) whether this calculation method establishes “reasonable probability” necessitates expert testimony that the reservoir under such tract is “reasonably” homogenous and isotropic along the wellbore so each foot of wellbore can be expected to produce as much as any other foot of wellbore; and (b) utilizes different standards of measurement (number of feet v. acreage) so that ownership totals will not equal 100%.
3. Number of Perforations Along the Productive Horizontal Drainhole Length: this method of calculation is essentially the same as the “Productive Horizontal Drainhole Length” method listed as No. 2 above but incorporates the number of perforations along the portion of the wellbore under a given tract instead of using the number of feet the wellbore traverses under such tract. Here the numerator would be the number of perforations along the productive horizontal drainhole traversing the tract in question with the denominator being the total number of perforations along the total length of the productive horizontal drainhole.
Positives: (a) likely a more accurate measure of the production attributable to a given tract than the “Productive Horizontal Drainhole Length” method; (b) also appears to be a fair and reasonable method of allocation, assuming supported by geological evidence (uniformity of the quality of perforations); and (c) appears to also satisfy the ruling in Browning Oil Co.
v. Luecke.
Negatives: (a) whether this calculation method establishes “reasonable probability” necessitates expert testimony that the perforations along the productive horizontal drainhole under a given tract are “reasonably” uniform so that each perforation can be expected to produce as much as any other perforation along the total length of the productive horizontal drainhole; (b) utilizes different standards of measurement (number of perforations v. acreage) so that ownership totals will not equal 100%.
Confusion of Goods.
As previously mentioned, the Luecke Opinion failed to address: (A) What is “reasonable probability?”; (B) Who has burden of proof?; and (C) What is the measure of damages if “reasonable probability” cannot be ascertained? Indeed, the Lueckes, Browning Oil, and the Court did not raise the issue of commingling. Further, the author is unaware of any
Texas appellate court case in which a Confusion of Goods argument was made in the context of a lessor challenging the allocation method of the lessee.
The Doctrine of Confusion of Goods (commingling) provides that where goods of a similar nature and value owned by different parties are commingled so that a proper division among the owners as to their preexisting rights cannot be made the burden is on the one commingling the goods to properly identify the aliquot share of each owner; thus, if goods are so confused as to render the mixture incapable of proper division according to the pre-existing rights of the parties, the loss must fall on the one who occasioned the mixture. Humble Oil & Refining v. West, 508 S.W.2d 812, 818 (Tex. 1974). [emphasis added].
To meet this burden, the commingling party would have to show by a preponderance of the evidence and with reasonable certainty the amount of oil and gas produced from each of the tract penetrated by the horizontal wellbore. See Exxon Corp. v. West, 543 S.W.2d 667, 673 (Tex. Civ. App. —Houston [1st Dist.] 1976, writ ref’d n.r.e., cert. denied 434 U.S. 875); Humble Oil & Refining v. West, 508 S.W.2d 812, 819 (Tex. 1974). [emphasis added]. Failure to meet this burden would result in the owner in each of the separate tracts will be entitled to receive their ownership share in production from the total oil and gas produced from the well. Mooers v. Richardson Petro. Co., 204 S.W.2d 606, 608 (1947).
Since the burden of proof shifts to the operator after proof by the tract owners of their ownership in an unpooled tract together with proof that they did not consent to the commingling of production in the horizontal wellbore, an important question to ask is whether the computation of the production allocable to each tract is capable of being established with reasonable certainty. See George A. Snell, III, Pooling Issues – From A to Horizontal, San Antonio Association of Professional Landmen, at 24, (March 12, 2012). [emphasis added].
While the Luecke Opinion did not address the Doctrine of Confusion of Goods, the Luecke Court did reject the Lueckes’ claims to recovery based on the doctrine utilized for vertical wells drilled on invalidly formed units. This doctrine entitles the lessors of the well site royalties on the full production from the well, rather than a share of production proportionate to the amount of acreage their tract has contributed to the Unit in which such tract is located.
The Luecke Court opined:
“…we recognize the immense benefits that have accompanied the advent of horizontal drilling, including the reduction of waste and the more efficient recovery of hydrocarbons. Draconian punitive damages for a lessee's failure to comply with applicable pooling provisions could result in the curtailment of horizontal drilling. We decline 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 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.” Browning Oil Co. v. Luecke at 647. [emphasis added].
The rejection by the Luecke Court to apply traditional doctrines to measure damages suggests, but is by no means conclusive, that Texas Courts are willing consider the public policy implications of a given remedy. Therefore, it is possible, but again, not certain, that a Confusion of Goods argument would not be successful.