FEDERAL UNITIZATION - American Association of Professional ...

FEDERAL UNITIZATION

UNIT AGREEMENTS AND UNIT OPERATING AGREEMENTS

Tom Marranzino

DISCUSSION OUTLINE

1. INTRODUCTION
2. FORMATION OF A UNIT
3. DRILLING THE INITIAL TEST WELL
4. ESTABLISHMENT OF PARTICIPATING AREAS
5. UNIT ACCOUNTING

ACKNOWLEDGEMENTS
DOC CHURCHILL – CHAMPLIN PETROLEUM COMPANY

PAUL S. CONNER – UNITSOURCE INCORPORATED
BONITA LIMPUS JONES – LIMPUSJONES, LLC

FRED MAC DONALD – BEATTY & WOZNIAK P.C.
ROCKY MOUNTAIN MINERAL LAW FOUNDATION

ƒ Rule of Capture

ƒ The legal rule stating that there is no liability for producing oil and gas that was
originally in place under the land of another, so long as the producing well does
not trespass (13 Tex. L. Rev. 391, 393 (1935).

ƒ Rule of capture made it imperative that a mineral owner drill his land as quickly
as possible to prevent drainage from another.

ƒ Implied covenant in oil and gas leases to prevent drainage.
ƒ The logical consequence of the rule was tremendous increase in drilling, waste

and destruction of the reservoir.

4

ƒ SPACING

ƒ To prevent waste, states promulgated regulations to allocate an
area to a well that promoted the most efficient drainage of a
reservoir.

ƒ Regulations vary by state and address both oil and gas reservoirs.
ƒ In the Jeffersonian system, spacing is allocated with rectangular

units i.e. 40 acres, 80 acres, 160 acres, 320 acres and 640 acres.

Pooling and Communitization

ƒ The bringing together of small
tracts sufficient for the granting
of a well permit under
applicable state regulations.

ƒ Example of pooling two leases
under a 320 acre spacing unit.

Unitization

ƒ A term used to describe the joint
operation of all or some portion of a
producing reservoir.

ƒ Usually applied to situations where
there are multiple spacing units
and/or multiple sections.

ƒ Operating Agreement governs the
relationship of the parties and the
planned development of a reservoir
under a joint operating agreement.
Usually an A.A.P.L Model Form.

ƒ FEDERAL EXPLORATORY UNITS

ƒ Conventional
Refers to a unit formed to explore conventional and unconventional
resources.

ƒ Horizontal (WY)
Refers to a unit formed for the new Niobrara Play.

ƒ CBM (WY)
Refers to a unit formed to explore coalbed methane gas.

ƒ DEVELOPMENT UNITS
ƒ SECONDARY RECOVERY UNITS

WHY UNITIZE?

ƒ Enables the exploration of a large area where common geological and
reservoir characteristics exist.

ƒ Ability to operate the area as a single lease.

ƒ Enables an operator to locate wells in the most desirable locations to
maximize efficient reservoir recovery and minimize waste.

ƒ Minimizes surface disturbance and less degradation of the environment
with fewer wells, roads and infrastructure.

ƒ Sharing in the costs and risks of exploration and production.

ƒ Relieves federal chargeability limitations. A single entity may not own more
than 246, 080 acres within a state.

ƒ Extends Leases

FEDERAL EXPLORATORY UNIT AGREEMENT

ƒ A combination of two agreements:

ƒ Unit Agreement
ƒ Unit Operating Agreement

ƒ Unit Agreement

ƒ Created under the Mineral Leasing Act of February 25, 1920, 41 Stat. 437,
as amended and described in the Code of Federal Regulations 43 CFR §
3186.1 for the purpose of conserving natural resources.

ƒ An agreement between the Bureau of Land Management (BLM) and the
proponent (Operator) of the Unit.

ƒ Unit Operating Agreement

ƒ An agreement between the Operator and other working interest owners
within the unit boundary.

ƒ Two forms of Unit Operating Agreements:

ƒ Form 1 – Rocky Mountain Unit Operating Agreement - Oil and Gas
(Undivided Interest) (May 1954) (RMOA-Form 1)
An agreement in which the working interest owners agree to fix costs and
share of production for the life of the unit. Interests do not fluctuate as
participating areas expand or contract. Extent and uniformity of a prospect
are known.

ƒ Form 2 - Rocky Mountain Unit Operating Agreement - Oil and Gas (Divided
Interest) (Feb.1994) (RMOA – Form 2)
An agreement in which the working interest owner’s share in production
and costs is determined by its interests in a participating area. Generally
selected when the extent and uniformity of a prospect are unknown.

GETTING STARTED

ƒ Preliminary Conference
ƒ Area and Depth Application

ƒ Preparation of a formal written application for designation as provided in 43
CFR 3181.2. The application includes:
ƒ Initial Drilling Obligation with the location of initial well or wells.
ƒ Unitized land and substances, including a description of the depth and
formations. (i.e. “All oil and gas, including coalbed gas, from the
surface of the earth to the stratigraphic equivalent of the base of the
Mesaverde formation, which occurs at log depth of 4,943 feet as found
on that certain Induction/Gamma Ray well log on the AR Fee 1890 5I
well, located in SE¼ of Section 5, T-18-N, R-90-W, Carbon County,
Wyoming, are unitized under the terms of this agreement and herein
are called "unitized substances.“

Exhibit “A”

- Outlines the proposed unit
boundary, and describes the
amount and percentage of
Federal, State, and Patented
lands and total unit area.

- Further identifies boundaries
of individual tracts within the
unit.

Exhibit “B”

- A schedule of ownership of all oil and gas interests in lands within the
unit area as presently known .

Exhibit “C”
- a schedule showing Federal and State lease numbers and the acreage

to be included within the unit boundary.

ƒ Preliminary Approval
ƒ Letter from the Resource Management Group of the Bureau
of Land Management designating the outlined area as a
logical unit area.
ƒ Confirms proponent’s application for depth and formation of
test well.
ƒ Special provisions and requirements.

Tract Commitment

ƒ As a general rule, the proponent of the unit must have 85% of all tracts
committed to the unit to demonstrate to the BLM effective control of the unit
area. BLM recognizes four categories of commitment of a particular tract to a
unit:

1. “Fully committed,” means that all interest owners (record title, all
operating rights and working interest owners, and all royalty owners,
overriding royalty owners and production payment owners) are committed
to the Unit.

2. “Effectively committed,” means all interest owners, except owners of
overrides or production payments, are committed to the unit.

3. “Partially committed,” means, with respect to a fee tract, that the lessee
and all working interest owners have committed their interest but the
royalty interest is not committed. With respect to a state or federal tract,
“partially committed” means that the lessee of record is not committed but
the working interest owner is committed.

4. “Not committed,” means that less than 100% of the working interest owners
have committed their working interest to the unit.

ƒ “Fully committed” and “effectively committed” tracts receive all of the
benefits of unitization.

ƒ “Partially committed,” tracts are treated differently.

ƒ No segregation upon unit approval
ƒ No off lease drilling extension (although within the unit area, must drill

on the lease to receive a drilling extension).
ƒ No off lease production status (must HBP on a leasehold basis).

ƒ Both Wyoming and Utah provide by statute that the State must give its
authorization to commit a state lease to a Federal Unit.

UNIT OPERATING AGREEMENTS
ƒ Unit Operating Agreements, both divided and undivided govern

operations much the same as the more familiar A.A.P.L. Model Form
610 Operating Agreement. That is, it provides for the drilling of an
initial well, subsequent operations, Operator’s responsibilities and
duties and the relationship of the parties.
ƒ The agreements differ from the A.A.P.L. Model Form in that they
provide for the above operations in concert with the Federal
Exploratory Unit Agreement. Each addresses the drilling and the
sharing of costs and expenses for exploratory and development wells
and the distribution of revenue to the participating parties.

FORM 1 – Undivided Type Agreement (UOA)

ƒ Article 2 provides that all costs material and equipment shall be borne
by the Parties in proportion to their respective Participating Interests
and that available production shall be owned by the Parties in
proportion to their respective Beneficial Interests.

ƒ “Participating Interest” of a Party means the proportion (expressed as
a percentage) that the acreage of its Committed Working Interest or
Interests bears to the total acreage of all the Committed Working
Interests of the Parties; for the purposes of this definition (a) the
acreage of the Working Interest in a tract within the Unit Area shall be
the acreage of such tract as set forth in Exhibit B to the Unit
Agreement and (b) if the Working Interest in a tract is owned by two
or more owners, the acreage of such tract shall be apportioned among
them in proportion to their respective Working Interests therein.

ƒ “Beneficial Interest” of a Party means the proportion (expressed as
a percentage) that the net acreage of its Committed Working
Interest or Interests bears to the total net acreage of all the
Committed Working Interests of the Parties; for the purposes of
the definition, the net acreage of the Committed Working Interests
owned by a Party shall be calculated by multiplying the acreage of
each tract in which it owns an interests, as shown in Exhibit B to
the Unit Agreement, by the percentage of the oil and gas, including
coalbed gas, which, if produced from such tract in the absence of
the Unit Agreement and this agreement, would accrue to such
Committed Working Interest after deducting Lease Burdens
(whether payable in cash or in kind) shown on said Exhibit B as an
encumbrance upon such Committed Working Interest, then adding
all such interests together.

ƒ A simple example on a 640 acre working interest unit with 40 acre
spacing for oil production is as follows:

Anadarko E&P
Company LP, etal

12.5% Royalty

St. Mary Land &
Exploration Company, etal

12.5% Royalty
12.5% Overriding Royalty

APC Committed Royalty & Revenue Beneficial Interest WI NRI
St. Mary Land Acres ORI Acres
480.00 0.125 .875 * 480= 420.00 420/540 77.77778% 0.75 0.62847
160.00 0.25 .75 * 160= 120.00 120/540 22.22222% 0.25 0.21528
540.00

Revenue will be distributed:

540/640= 0.84375 WI Share or Average Net Revenue Interest
100/640= 0.15625 RI share of production

FORM 2 – Divided Type Agreement (UOA)

ƒ Article 6 - Apportionment Of Costs And Ownership
And Disposition Of Production And Property (UOA)

ƒ Apportionment and Ownership Within Participating Area

ƒ All Costs incurred in the development and operation of a
participating area shall be borne by the Parties within the
participating area on an Acreage Basis, determined as of the
time the Costs are incurred.

ƒ All Production from a participating area shall be allocated on an
Acreage Basis to the tracts of unitized land within the
participating area.

ƒ Ownership and Costs Outside a Participating Area

ƒ All Costs incurred in the development and operation of a well
drilled outside of a Participating Area are borne on an Acreage
Basis determined by the working interest ownership within the
established Drilling Block. If the well is completed as a
producer but not in a formation included within a participating
area, the well, production, materials and equipment, costs and
all lease burdens shall be borne and paid by the Parties on the
Drilling Block basis.

Section 9 – Drilling to Discovery (UA)
ƒ Commencement of the test well within six months following the
effective date of the Agreement and drilled to the objective depth
or until unitized substances are discovered.
ƒ Diligent and continuous drilling of the initial obligation well.
ƒ Drilling of additional test wells, with not more than six months
being permitted to elapse between wells, until a discovery of
unitized substances in paying quantities is made.

ƒ Upon completion of the initial well as a well not capable of
production in paying quantities, failure to drill additional wells until
discovery shall cause the agreement to terminate automatically.

ƒ Failure to drill the initial well will cause the agreement to be
declared invalid ab initio (from the beginning).

ƒ Larger units will require additional obligation wells. In general, one
well for each additional 15,000 acres.

ƒ Article 9 – Exploratory Wells (UOA)
ƒ Any party may propose a well on lands in which it owns a
Committed Working Interest by proposing a Drilling Block which
the party believes will be proved productive by the drilling of the
well. As a general rule, the Drilling Block should approximate the
spacing that would be in effect absent the formation of the unit.
ƒ Participation in the proposed well is on an Acreage Basis. This
means the participation by each Party in the proportion that the
acreage of its Committed Working Interest bears to the total
acreage of the Committed Working Interests of all Parties in the
Drilling Block.

ƒ Notice provisions are similar to those found in the A.A.P.L. Model
Form both for drilling and completion.

ƒ Parties may object to the proposed Drilling Block and lands can be
added or excluded at the Direction of Parties.

ƒ PRODUCTION IN PAYING QUANTITIES
ƒ Establishing production of unitized substances in paying quantities

prior to the expiration date of the term of a federal lease.
The Federal regulations provide that a Federal oil and gas lease
may be extended by commitment to a Federally approved unit if a
well is completed on a committed tract that is capable of producing
unitized substances in paying quantities (quantities sufficient to
repay the costs of drilling, completing, and producing operations
with a reasonable profit) prior to the expiration date of the lease.
Production in such quantities on any committed tract within the
unit boundaries is considered to be on, or for the benefit of, each
committed lease.

YATES DECISION

ƒ The Interior Board of Land Appeals in Yates Petroleum Corp. (IBLA
Decision 67 IBLA 246 (1982) concluded that a well capable of
production in paying quantities on a lease basis (quantities sufficient to
repay the costs of day to day producing operations) which is completed
on a committed tract within a unit agreement will extend the term of
all expiring Federal leases committed to the unit agreement for the life
of the agreement or for as long as the well is capable of production in
paying quantities, whichever occurs first.

ƒ If the leases are held by production by a Yates Decision, the terms and
obligations of the unit agreement still apply. A well determined not to
be capable of producing in unit paying quantities as defined by the
terms of the agreement, but is capable of producing in paying
quantities on a lease basis only, will require that the next unit well be
drilled within six months of the completion date of the well or the unit
terminates automatically.

ƒ Section 11 – Participation after Discovery (UA)

ƒ Provision provides for the establishment of a Participating Area (“PA”) upon completion of a well or
as soon thereafter as required by the AO, which includes all lands then regarded as reasonably
proved to be productive of unitized substances in paying quantities (quantities sufficient to
repay the costs of drilling, completing, and producing operations with a reasonable
profit) effective as of the date of the completion.

ƒ A separate PA is formed for each separate pool or deposit.
ƒ PA’s are revised to include additional lands which are then regarded to be productive or which are

necessary for unit operations.
ƒ Operator submits a schedule of lands to be included which includes federal, state and fee lands.

PARTICIPATING AREA PREPARATION

„ Circle-Tangent Method - Wyoming

„ Spot well on unit map.
„ Determine spacing in the absence of unitization.
„ Draw a circle using the radius below encompassing the number of

acres that would be included in a rectangular spacing unit.
„ Area = π x (radius)2
„ 40 acre spacing = 745 feet
„ 80 acre spacing = 1,053 feet
„ 160 acre spacing = 1,489 feet
„ 320 acre spacing = 2,106 feet
„ 640 acre spacing = 2,979 feet



UNDIVIDED VS DIVIDED TYPE UNITS

Undivided Type Ownership:

Divided Type Ownership: Lease Basis

„ First well in unit:
„ Drilling Block
„ May include up to the number of acres specified in the UOA but
generally includes the number of acres normally identified
under state spacing regulations.
„ Methodology varies by state. Can be rectangular or radial to
include acreage expected to be drained by a well.
„ Wyoming is radial
„ Utah generally follows State spacing.

Drilling Block Formation

„ Assume 640 acre spacing = 2,979 feet
Include every quarter-quarter section (40 acres) cut by more
„ than one-half by the circle

Divided Type Ownership

„ If the initial well is capable of producing in paying quantities, then a participating area will
be formed. The area covered by the PA will incorporate information obtained in the drilling
of the well and may or may not be the same area as the drilling block.

„ If the well is not capable of producing in paying quantities, then it will be operated on a
lease basis.

Ownership and Royalties

„ The determination of whether or not the well is capable of production in paying
quantities determines not only the ownership of the well but the apportionment of
royalties:

„ A Participating Area is approved
„ Royalties for the Unit Well are shared on an acreage basis within the
Participating Area. If a working interest owner receives an interest in
production then so does the underlying royalty owner.
„ Leases that are fully or effectively committed within the Unit are treated as
HBP

„ A Participating Area is not approved
„ Royalties for the Lease Well are paid to the mineral owner from which the
well is producing.
„ Operator must commence drilling within 6 months of completion to attempt
to establish production in paying quantities to avoid unit termination.

„ During the time after a discovery in paying quantities and approval of a
Participating Area by BLM, at a minimum it is advisable to pay royalty and
overriding royalty owners on the lease from which the production is produced.
Payment on production statutes, require in general that proceeds from the sale
of production be made within 6 months of following the date of first sale.

„ Drilling a 2nd Well

Undivided Type Ownership: Identical to the initial test well

Divided Type Ownership:

„ 1st Well Ownership

Divided Ownership after drilling 2nd Well

„ 2nd Well Ownership

Expansion of PA

Divided Ownership after drilling 2nd Well

„ 1st Well Ownership and 2nd Well Ownership

Participating Area acreage is recalculated based upon
the total acreage in the PA

Participating Areas for Horizontal Wells (WY)

„ The Resource Management Group requires the circle-tangent method
to establish a Participating Area boundary unless additional information
is available. The PA is established by constructing 40 acre circles
around the terminus of the lateral and the entry point of the lateral into
the participating area formation and then constructing tangents
between each circle. All 10 acre subdivisions cut by the circles and the
tangents will be included in the PA.

„ If a well is determined to be a nonpaying unit well, then a drilling
spacing unit will be formed if the horizontal lateral intersects Federal
and non-federal mineral interests. Upon establishing a spacing unit
under State Regulations, a communitization agreement will be
approved by the BLM.

INVESTMENT COST ADJUSTMENTS (UOA)

This is a “little ditty about Jack and
Diane two American kids growin’
up in the heartland.”

Jack and Diane each invested
$50,000 to buy a piece of the
American Dream for a rental
property.

Several years later Jack and Diane
decided to buy a second house but
they didn’t have enough money so
they invited John Cougar to join with
them in equal shares to purchase a
$125,000 home.

Their agreement provided that each
would also purchase a share in the
two homes and ownership would be
proportionate to their investment.

LEASE W.I. OWNER GROSS LEA SE TRA CT TRA CT
MIN AC W.I. FA CTOR W. I.

1 Jack 10.00000000 0.50000000 0.50000000 0.25000000
1 Diane 10.00000000 0.50000000 0.50000000 0.25000000

2 Jack 10.00000000 0.33333340 0.50000000 0.16666670
2 Diane 10.00000000 0.33333330
2 John 10.00000000 0.33333330 0.50000000 0.16666665
Tract Acres (as is) 20.00000000
0.50000000 0.16666665

Jack 0.41666670

Diane 0.41666665

John 0.16666665

The accounting for the transaction looks something like this:

Credit Charge Total

January 1, 2007 1st Home $ 50,000.00 $ (2, 083. 33)
Value: $100,000.00 $ 50,000.00 $ (2, 083. 34)
Jack $ 4,166.66
Diane 0.5000000 $ 100,000.00
January 1, 2008 0.5000000
1.0000000 $ 41,666.75
Jack $ 41,666.63
Diane Second Home $ 41,666.63
John Value: $125,000.00
$ 125,000.00
Jack 0. 33333400
Diane 0.33333300 $ 91,666.75 $ 93,750.08
John 0. 33333300 $ 91,666.63 $ 93,749.96
1.0000000 $ 41,666.63 $ 37,499.96

Investment Cost Adjustment
Value: $225,000.00

0.41666700
0.41666650
0.16666650