In this day of shale plays, we are seeing high bonus and royalties being offered by oil companies for oil and gas leases. However, just because your neighbor received $5,000 or more per acre as bonus and 1/4 royalty for a lease does not necessarily mean you will receive the same. Nevertheless, mineral owners will often hold out for better bonus or royalty and find themselves unleased when drilling begins. Below are some things to consider before holding out for more and going unleased.
Drillsite v. Non-Drillsite Tract
In Texas, an unleased mineral owner ("UMO") does not always share in production from a unit well in which the UMO's tract is pooled. To be clear, a company who owns oil and gas leases surrounding the UMO land can still include that land in a unit - the company does not need a lease to do so. However, just because the UMO is included in the unit does not mean the UMO will share in production from the unit well. Only if the UMO is a drillsite tract will he share in production from the well. "Drillsite tract" means that all or a part of the wellbore passes underneath the property. If it is a vertical well, the surface location and wellbore are located entirely on and underneath one tract of land. If it is a horizontal well, then there are multiple drillsite tracts, as each tract under which the wellbore passes is a drillsite tract. If the UMO tract is not a drillsite tract, the UMO does not share in any of the revenues from production fom the well. The UMO is cut out and possibly subject to being drained by the unit well depending on its proximity to the UMO tract. In this instance, the UMO's only recourse to seek relief from the Texas Railroad Commission ("RRC") to drill his own well on his tract, or to be included in the unit under the Mineral Interest Pooling Act ("MIPA"), discussed below. Neither option is desirable to a UMO in Texas.
If, on the other hand, the UMO is a drillsite tract owner, then co-tenancy laws applu, and the UMO will receive his full share of production in proportion to the number of acres owned in the unit, but only after the well pays out. For instance, suppose the UMO owns 100% of the minerals under 50 acres included in a 500 acre unit, and the UMO is a drillsite tract. The UMO would be entitled to 50/500ths of all revenues from production. If that same UMO had executed a lease with a 1/4th royalty, his share would be 1/4th of 50/500ths of production. A huge difference in terms of potential monetary gain. The risk, however, is that the UMO will not receive his first check until the well pays out. This means the point at which the company that drilled and operates the well recoups all of its costs to drill and complete the well. For a horizontal well in a shale play, such as the Eagle Ford Shale, it can cost as much as $9 million or more to drill and complete one well. If the well is a marginal producer, it may be years before it payout is reached, and it may never be reached. A leased mineral owner, on the other hand, receives their royalty share from production in accordance with the oil and gas lease, regardless of whether the well pays out.
Although there is huge upside to going unleased, there is also huge risks. Two of those risks are (1) the UMO could be a non-drillsite tract in a unit, and be cut out of any revenues from the well; or (2) even if the UMO is a drillsite tract, the well may never pay out, and thus the UMO would not receive any revenues from production.
Rule 37 Exceptions
In Texas, another risk of going unleased is the Rule 37 exception. RRC Statewide Rule 37 governs how close a well can be to any property line, lease line, or other well. No well can be drilled closer than 1200 feet from another well completed in the same horizon on the same tract, and no well can be drilled closer than 467 feet from a property line, unit line, or lease line. Upon application by a company in any particular field, the RRC can issue field rules for each specific field that prescribe longer or shorter distances. For horizontal wells, the entire length of the horizontal drainhole (penetration point to terminus point) must comply with the spacing requirements, unless the field rules prescribe otherwise. The RRC, however, can grant exceptions to the spacing rule, permitting wells to be drilled closer than prescribed.
With respect to horizontal wells, suppose Company A is tired of the demands for higher bonus and royalty made by the UMO before he will lease his minerals, and Company A's planned spud date for the well it intends to drill and pool the UMO tract in is rapidly approaching. Company A has plans for the drilling rig after it completes the subject well, and cannot change its timetables. In that instance, Company A may decide to cut the UMO tract out of the unit altogether. In that instance, Company A must comply with Rule 37, such that no portion of the horizontal drainhole can come within 467 feet of the UMO's property line. This presents a problem if the proposed wellsite or path of the horizontal drainhole is closer than 467 feet (or field rule spacing) of the UMO's property line. An extensive amount of engineering and planning goes into each well drilled, and Company A may not be able, or willing, to change the well path. A Rule 37 exception will allow Company A to drill the well closer than Rule 37 or field rules prescribed, in order to drill its well as intended without the UMO's tract. Under Rule 37, if the operator can prove there is a necessity for such an exception to prevent waste or confiscation, the RRC will likely grant the application, especially if the application is not contested (more on this below). To establish that the exception would prevent waste, the operator must show that its proposed well will recover oil or gas that would not otherwise be recoverable (i.e., the oil or gas under the unreasonable UMO's land), or that unusual geological conditions specific to the unit exist that require closer spacing to the UMO's tract. To establish an exception would prevent confiscation, the operator must show that absent the exception, it will be denied a reasonable opportunity to recover its fair share of hydrocarbons currently in place. Depending on how close the well is drilled under the Rule 37 exception, the UMO's minerals could be drained without Company A having to account to the UMO for his share.
Under Rule 37, the operator is required to send notice to all affected UMOs of their application for an exception, and notify them of the date the RRC will hear the application. It is up to the UMO to appear and contest the application. The UMO will need to hire an attorney familiar with the RRC rules and administrative process. Typically, the UMO lacks the resources to meaningfully contest the applications. If uncontested, the applications are usually granted.
As can be seen, going unleased does not necessarily mean the UMO tract will be included in a unit, and in fact, it could mean a well will be drilled so close to the UMO's property line that the UMO's minerals get drained. Again, the UMO's only recourse is to apply to the RRC to drill his own well, or apply for relief under MIPA.
Mineral Interest Pooling Act ("MIPA")
There is no automatic right for a UMO to be included in a unit in Texas. Texas' version of forced pooling is MIPA, but the burden upon a UMO under MIPA is so high, it has rarely been used.
Under MIPA, a UMO must apply to the RRC to force their way into an existing unit if the UMO meets certain criteria. First, their must be an existing RRC designated common reservoir for the field in which the unit is located, and existing or temporary field rules. Second, the UMO must show that the unit operator did not make a fair and reasonable offer to lease or pool the UMO's tract in the unit. What is considered fair and reasonable depends on the circumstances, however, typically an offer for the UMO to share on the same "yardstick" as others in the unit is usually considered fair and reasonable. Third, the MIPA unit is to be limited to 160 acres for an oil well and 640 acres for a gas well plus 10 percent tolerance, and must contain the "approximate acreage" of the proration units under the field rules. The UMO must also show that his acreage reasonably appears to be within the productive limits of the reservoir. Fourth, the UMO must propose the economic terms on which he is to be paid if force pooled. In past cases, the RRC has determined that the UMO is to be paid (1) on the royalty share of their interest, the fair market royalty rate at the time of the order with no bonus, and (2) on the working interest share of their interest, the difference of 100% and the royalty interest being pooled. In other words, if the market royalty is 1/4, then the UMO would receive a 1/4th royalty and a 3/4ths carried working interest. The MIPA unit typically dissolves one year after its effective date if no production or drilling operations has taken place, six months after a dry hole is completed, or six months after cessation of production. The UMO must provide notice of the hearing on its application to all interest owners (working, royalty, overriding royalty, etc..) in the unit.
Vice-versa, the unit operator can apply to the RRC to force pool a UMO's tract into an existing unit. The operator is required to meet the same elements, except that for element two, the operator must show a fair and reasonable offer was made but rejected by the UMO.
Seeking relief under MIPA is expensive (e.g., attorney's fees and expert witness fees), and very difficult to win. It has rarely been utilized by UMOs or operators.
Conclusion for Mineral Owners
If you are not happy with the oil company's offer to lease, and are considering going unleased or just waiting until a better offer comes along, be sure to consider the foregoing risks associated with being unleased. You may lose the benefits of mineral ownership altogether.
Ben Elmore
Board Certified in Oil, Gas & Mineral Law by the TX Board of Legal Specialization. He represents mineral owners and companies in all varieties of oil and gas disputes, as well as negotiation of oil and gas leases in Texas in the Eagle Ford Shale, Haynesville Shale and Permian Basin plays.