The Oil and Gas Addendum

On November 7, 2019, Governor Wolf signed Act 85 of 2019 (“Act 85”) into law. This is an unfortunate and deeply flawed piece of legislation. Pursuant to Act 85, drillers may now drill horizontal wells which cross unit boundaries. In other words, a single wellbore may now hold and maintain leases which are in two completely different units. Act 85 will unilaterally change and alter thousands of oil and gas leases across Pennsylvania. While the author understands and appreciates the potential benefits of cross-unit drilling, Act 85 advances that objective at the expense of landowners and should have not been enacted.

What Does Act 85 Say?

In the General Assembly, Act 85 was known as Senate Bill 694. The iteration of Senate Bill 694 that was passed by the General Assembly and was signed by Governor Wolf provided as follows:

Section 2.2. Cross unit drilling for unconventional wells.

(a) General rule.–If an operator has the right to drill an oil or gas well on separate units, the operator may drill and produce a well that traverses, by horizontal drilling, more than one unit, if:

(1) The operator reasonably allocates production from the well to or among each unit the operator reasonably determines to be attributable to each unit. The operator may allocate production on an acreage basis for multiple units provided the allocation has a reasonable correlation to the portion of the horizontal wellbore in each unit.

(2) The traversing well is not expressly prohibited by the terms of a lease.

(b) Location requirement.–The 330-foot location requirement in section 6 of the act of July 25, 1961 (P.L.825, No.359), known as the Oil and Gas Conservation Law, shall not apply to unit lines traversed by a conservation well.

(c) Construction.–Nothing in this subsection shall be construed to:

(1) authorize an operator to drill an oil or gas well that is not subject to a valid lease or royalty agreement; and

(2) automatically expand or diminish the current surface rights of an operator to include operations related to any existing unit or any well drilled between existing units.

Where Does Act 85 Fit Into Existing Pennsylvania Statutory Law?

To gain context about Act 85, it is important to know where it “fits” into Pennsylvania’s existing oil and gas statutes. Act 85 amends the 1979 Oil and Gas Lease Act (the “1979 Lease Act”) by adding a “Section 2.2”, whose terms are replicated in the text above. Of course, this new “Section 2.2” will necessarily follow “Section 2.1” in the current version of the 1979 Lease Act. Section 2.1 of the 1979 Lease Act is another troubling piece of legislation which was pushed by drillers back in 2013 as part of Act 66. This provision also unilaterally altered and changed existing oil and gas leases by granting the driller the ability to essentially “pool” adjoining leases even if the leases did not contain a formal pooling clause. When read in conjunction with Section 2.1, Act 85 represents another example of the General Assembly granting drillers expansive and potentially abusive pooling powers that were never negotiated and agreed to by landowners.

When Does Act 85 Apply?

Act 85 does not apply to all oil and gas wells. Instead, it only applies to “unconventional wells”. Under Pennsylvania law, unconventional wells are wells that produce from an “unconventional formation” which essentially is defined as shale formations deeper than the Elk Sandstone. The Marcellus and Utica shales fall within the definition of an “unconventional formation”, so Act 85 would apply to them – but Act 85 does not generally apply to all geological formations. As for timing, Act 85 is set to go into effect on January 6, 2020. Beginning on that date, drillers will be authorized to drill and operate cross-unit wells even if the parties’ lease never expressly granted those operating rights.

What Does Act 85 Do?

The principal impact of Act 85 is that it authorizes and allows a driller to drill unconventional wells (i.e., Marcellus and Utica wells) horizontally across and through unit boundaries. At first glance, this might not seem like that big of a deal. However, under existing Pennsylvania law, a horizontal well must generally remain within the footprint of a single unit. This is because most oil and gas leases contain a “pooling” clause which outlines how and when a driller may pool the leasehold into a production unit. These pooling clauses also often contain an express formula by which the production royalty will be calculated if the leasehold is pooled. These clauses and the royalty formulas set forth therein will be essentially re-written and altered by Act 85.

The new statutory authority set forth in Act 85 is subject to two (2) conditions which must be met before the driller can drill a multi-unit well:

i) the operator must have the right to drill a well “on separate units” in the first place in order to drill across unit boundaries; and

ii) the operator cannot drill across unit boundaries if doing so is “expressly prohibited by the terms of a lease.”

If a driller has the right to drill horizontal wells on separate units and cross-unit drilling is not expressly prohibited by a lease, then Act 85 ostensibly allows a driller to drill a horizontal wellbore that may cross from one unit into another. The author submits that an argument could be made that many pooling clauses in existing leases may trigger the prohibition set forth in subsection ii. Unless the driller complies with the royalty formula set forth in the underlying pooling clause, the purported multi-unit well may not be authorized under Act 85. The statute itself, however, is unclear on what constitutes an express prohibition and, therefore, this question will have to be resolved by Pennsylvania courts.

Of course, if an operator drills wells across unit boundaries, a question arises about how the volume of hydrocarbons that enters the wellbore will be allocated among the two geographic areas that the well traverses. To this end, Act 85 states that the driller must “reasonably allocate[] production from the well to or among each unit the operator reasonably determines to be attributable to each unit.” The author submits that this language is alarmingly vague and open-ended. Again, the statute does not define what is meant by “reasonably determines”. Nor does the statute define when such a determination must be made by the driller. Finally, the statute does not identify what factors must be taken into account by the driller when evaluating how to allocate production between the two units. This last omission is especially troubling. The drafters could have simply used a formula that allocates production between the two units based on the linear length of the wellbore in each unit. This would have provided an objective and uniform metric that would govern production allocation. The absence of any such clear guidelines is inexcusable and a recipe for disaster.

Why Is Act 85 A Concern For Landowners:

From a landowner’s perspective, there are a number of substantive defects with Act 85 that raise significant legal issues with how or when the Act will be applied.

i) Impairment of Private Contract

A significant question arises as to whether Act 85 is an unconstitutional impairment of private contracts. Article 1 § 17 of the Pennsylvania Constitution states that “[n]o ex post facto law, nor any law impairing the obligation of contracts, or making irrevocable any grant of special privileges or immunities, shall be passed.” Demonstrating whether a law runs afoul of Article 1, Section 17 requires proof of two elements: i) the law operates as a substantial impairment of a contractual relationship and ii) the lack of a significant and legitimate public purpose behind the law. See, South Union Township v. Commonwealth, 839 A.2d 1179 (Pa. Commw. Ct. 2003). As explained below, the author submits that an argument can be made that Act 85 will alter and change existing oil and gas leases and, therefore, may run afoul of Section 17.

Before we address the impact of Act 85 on existing oil/gas leases, a brief review of pooling is warranted. In order to drill and operate horizontal wellbores, drillers must often form large production units consisting of 600 to 1200 acres. These units are created by combining and aggregating numerous contiguous leases into a single unit. This is because the horizontal wellbore, which can exceed 6,000 feet, will likely pass through a number of separately owned parcels. Each parcel must be under lease and each lease must authorize pooling.

It is well-established throughout the United States that absent express authority in the lease, a lessee has no power or authority to pool. See, Southeastern Pipe Line Co. v. Tichacek, 997 S.W.2d 166, 170 (Tex.1999) (“A lessee has no power to pool without the lessor’s express authorization, usually contained in the lease’s pooling clause”); Jones v. Killingsworth, 403 S.W.2d 325, 327-28 (Tex.1965) (“Absent express authority, a lessee has no power to pool interests in the estate retained by the lessor with those of other lessors.”). For pooling to be valid, it must be done in accordance with the method and purposes specified in the lease. See, Tittizer v. Union Gas Corp., 171 S.W. 3d 857 (Tex. 2005) (court recognizing that lessee has no implied power to pool); Amoco Production co. V. Heimann, 904 F.2d 1405 (10th Cir. 1990) (“Without such a clause, the lessee has no authority to pool or unitize the interests of the lessor”). Since the pooling must be expressly authorized, courts have refrained from implying such a right when the lease is silent. See, Leonard v. Barnes, 404 P.2d 292 (N.M. 1965) (since parties’ lease contained no express authority to pool, the court will not strain to interpret the contract to provide for pooling). In short, the authority to pool is clearly based on the existence of a contractual agreement between the driller and the landowner.

The contractual authority granted in a pooling clause essentially results in a cross-conveyance of the landowner’s royalty interest. This is significant. When an oil and gas lease is signed, the landowner conveys to the driller the exclusive right to extract hydrocarbons and also a working interest in the eventual production. In return for signing the lease, the landowner retains a royalty interest in the eventual production (i.e., production royalty). A royalty interest is generally recognized as an interest in real estate. See, 3 Kuntz, Law of Oil and Gas §38.2 (1967) (“…it is generally recognized that an unaccrued royalty is properly classified as real property”); Clyde v. Hamilton, 414 S.W.2d 434 (Tex. 1967) (“…a right to future royalty payments is an interest in land”); GeoStar Corp. v. Parkway Petroleum, 495 N.W.2d 61 (N.D. 1993) (“…an unaccrued oil and gas royalty is an interest in real property”). As an interest in land, it cannot be changed, altered, conveyed or diluted without the owner’s consent. See, Brown v. Smith, 174 S.W.2d 472 (Tex. 1942). Pooling, as a cross-conveyance of this royalty interest, can and does modify and change the landowner’s royalty interest. See, Montgomery v. Rittersbacher, 424 S.W.2d 210 (Tex. 1968) (“[P]ooling effects a cross-conveyance among owners of minerals…so that they all own undivided interests under the [pooled] tract in proportion their contribution bears to the [pooled] tract”). Given this impact, consent must be given before the landowner’s royalty interest can be pooled:

“[S]uch a significant change in ownership rights, which reduces the percentage of ownership the mineral and royalty owners had in their original tracts, necessarily requires express authorization of the owner.”

See, PYR Energy Corp. v. Samson Resources, 456 F.Supp.2d 786 (E.D. Texas 2006). As such, the pooling clause is a complex and critically important component in every oil and gas lease.

A typical pooling clause in the Marcellus Shale region often has the following language:

Lessor grants Lessee the right to pool, unitize, or combine all or parts of the Leasehold with other lands, whether contiguous or not contiguous, leased or unleased, whether owned by Lessee or by others, at a time before or after drilling to create drilling or production units either by contract right or pursuant to governmental authorization. Pooling or unitizing in one or more instances shall not exhaust Lessee’s pooling and unitizing rights hereunder, and Lessee is granted the right to change the size, shape, and conditions of operation or payment of any unit created. Lessor agrees to accept and receive out of the production or the revenue realized from the production of such unit, such proportional share of the Royalty from each unit well as the number of Leasehold acres included in the unit bears to the total number of acres in the unit.

Act 85 will alter, change and possibly negate the last sentence in the example above. With respect to the cross-unit well, the landowner’s royalty, if any, will no longer be based on the number of “leasehold acres” included in the unit. Act 85 simply says that the operator may “allocate production on an acreage basis…provided the allocation has a reasonable correlation to the portion of horizontal wellbore in each unit.” This language, to the extent it even addresses the calculation of a royalty, changes the formula set forth in the typical pooling clause. When the lease was negotiated and signed, the landowner never anticipated or authorized the cross-unit wells. Nor did the landowner consent or agree to a different royalty formula than the formula set forth in the negotiated pooling clause. Act 85 ignores these realities and unilaterally changes thousands of leases on behalf of drillers and operators. It is respectfully submitted that such changes will operate as a “substantial impairment” of an existing contractual right (i.e., the royalty formula in the pooling clause) and therefore trigger Article 1, Section 17 of the Pennsylvania Constitution.

ii) Allocation of Royalties

The author anticipates that the proponents of Act 85 will defend the constitutionality of the legislation by pointing out that the law itself does not mention the payment of royalties. In other words, because the statute is silent about the actual payment of landowner royalties, there can be no “impairment” of the royalty formula set forth in the underlying pooling clause. If there is no impairment of the royalty formula, Section 17 is not implicated and Act 85 will pass constitutional muster.

The proponents are correct: the statute itself says nothing about the actual payment of royalties on any production from a cross-unit well. This omission is troubling and should be of grave concern to landowners. It is unclear whether the drafters of Act 85 deliberately omitted any reference to royalties or if this was simply sloppy drafting. Nonetheless, as currently drafted, Act 85 places no affirmative duty or obligation on the part of the operator of a cross-unit well to actually pay a royalty to any landowner. While Act 85 apparently requires the operator to “allocate production”, that likely speaks only to the working interest in the production as opposed to the royalty interest. The author fears that drillers, in an effort to avoid paying royalties, will argue that if the General Assembly intended the allocation language in Act 85 to apply to the calculation and payment of royalties, the General Assembly would have expressly said that in the bill. They did not. Given this silence, drillers may argue that cross-unit wells are exempt from any statutory royalty obligation and, as such, no royalties are owed to landowners in either unit. While such an argument may seem far-fetched, landowners should be prepared to confront this scenario in the event a cross-unit well is drilled in and around their unit.

Could This Have Been Done Differently?

There are a number of conceivable benefits to cross-unit drilling. An obvious potential benefit is reduced surface disturbance. Surface facilities, like well pads, access roads, pipelines, etc. can have a tremendous impact on the quality of life for those who live near oil and gas developments. The presence of oil and gas infrastructure on properties can make it difficult to subdivide them for developments due to the presence of easements and uncertainty about further surface developments. If an operator can drain a certain area through horizontal wellbores from a single well pad, there is no reason to disturb the surface for another well pad, access road and pipeline routing a short distance away.

A second conceivable benefit of cross-unit drilling is the economy of development. Surface development activities are expensive and can be time-consuming. If operators could drill longer horizontal laterals in producing formations and avoid the time and cost of acquiring land and permitting well pads and the capital investment to construct those well pads and drill vertical wells to reach the oil and gas, that could result in considerable savings to operators. Operators could then invest those savings into additional wells that produce hydrocarbons. The more capital deployed to wellbores that penetrate productive formations benefits operators and royalty owners alike.

That said, Act 85 was not, and is not, the correct approach. The author submits that the General Assembly should have considered and followed the approach taken by Oklahoma. Back in 2011, Oklahoma enacted the “Shale Reservoir Development Act” which specifically addressed multiunit horizontal wells (the “Oklahoma Act”). Unlike Act 85, the Oklahoma Act requires an operator to seek and obtain regulatory approval before drilling a cross-unit well. Section 52-87.8(B)(6) states that the cross-unit application will not be granted unless “…the proposed multiunit horizontal well or wells will prevent waste, protect correlative rights and likely aid in the full and efficient development of each of the affected units.” Act 85 provides for no application process and no regulatory oversight – drillers can form and operate cross-unit wells without any involvement or approval by the PaDEP. The prospect of unregulated and unlimited cross-unit drilling is frightening.

Second, the Oklahoma Act contains a clear and objective formula for calculating royalties. Section 52-87.8(B)(1) and (B)(7) provide as follows:

“1. The allocation factor for each affected unit shall be determined by dividing the length of the completion interval located within the affected unit by the entire length of the completion interval in the subject multiunit horizontal well. The Commission shall have the authority to adjust the allocation factors, based upon reasonable testimony and evidence presented to the Commission, if necessary to prevent waste and adequately protect the correlative rights of the owners of the oil and gas rights in each of the affected units.

…

7. The wellbore royalty proceeds for a multiunit horizontal well shall be allocated to each affected unit by multiplying the royalty contribution factor of the unit by the wellbore royalty proceeds, with the resulting product being the royalty proceeds for that unit. Each royalty interest owner in an affected unit shall be entitled to receive the owner’s proportionate royalty share of the allocated royalty proceeds for that unit.”

Unlike Act 85, the Oklahoma Act clearly requires the operator to calculate and pay a royalty on the production from the cross-unit well. Moreover, the Oklahoma Act removes any discretion from the allocation formula – it is based on the length of the wellbore in each unit. This objective criterion removes any doubt or ambiguity and insulates the calculation from driller manipulation or abuse. In stark contrast, Act 85 simply allows the driller to “reasonably allocate” production between the two units but provides no guidelines or parameters.

In conclusion, Act 85 is deeply flawed. It provides for no regulatory oversight and contains no statutory obligation to pay royalties. It provides no clear formula or methodology to allocate production between the two units. These glaring omissions should concern all landowners. We can only hope that these flaws will be addressed and corrected in the next legislative session.