The Oil and Gas Addendum

Imagine you own a 95-acre farm in Washington County, Pa. The farm has been in your family since the 1930s. Your great-grandfather signed an oil and gas lease with a local driller back in 1954. Two shallow wells were drilled in the late 1950s and have produced modest gas royalties ever since. You are quite satisfied with the minimal surface disruption caused by the two shallow wells and have no interest in hosting a large Marcellus well-pad site on your property.

Some years later, your lease is acquired by a large Texas-based driller who also has leased your neighbor’s tracts to the north and east. One morning, you receive a letter from this driller advising you that your property has been combined with the neighboring tracts and that a Marcellus well pad will be constructed on your property in the next six months. You review that 1954 lease and see no clause authorizing or permitting the driller to pool your property with adjacent tracts. Can they do this without your consent? Thanks to SB 259, the answer is now yes.

On July 9, Governor Tom Corbett signed SB 259 into law. Make no mistake, this bill is controversial and will have a dramatic effect on thousands of existing oil and gas leases throughout Pennsylvania. The bill itself was originally introduced as a means to bring uniformity and clarity to the periodic royalty statements issued to landowners. At the 11th hour, the bill was amended and Section 2.1 was added.

Proponents claim that this section merely provides a formula to allocate royalties in the era of horizontal drilling and nothing else. This is wishful thinking. With one stroke of the pen, Corbett unilaterally changed thousands of existing oil and gas leases and authorized a form of forced pooling.

In order to appreciate the impact of SB 259, one must first understand the concept of pooling and the typical pre-Marcellus Shale oil and gas lease. In simplest terms, pooling is the consolidation of separate, individual parcels to form a single production unit. There are two types of pooling: (1) voluntary and (2) compulsory or forced pooling.

Compulsory pooling arises when state-imposed spacing requirements necessitate the creation of a formal unit. Many oil and gas jurisdictions have adopted well spacing requirements that regulate and limit the density and location of wells within a designated reservoir. This is because too many wells in close proximity to one another can actually hinder hydrocarbon production and result in waste. Compulsory pooling, through well spacing orders, seeks to avoid overdrilling by regulating the distance and space between wells.

Because a well spacing order may preclude drilling on one or more tracts, the creation of a production unit gives those locked-out landowners the opportunity to share in hydrocarbon production even though no well will be located on their land.

As the name implies, compulsory pooling is implemented by a state agency or board after consideration of a petition or application. It is compulsory in the sense that the landowner’s property is automatically combined with nearby acreage once the well spacing order is granted. Depending on the jurisdiction, the landowner will either receive a proportionate share of the unit’s production royalties based on the ratio of actual acreage in the overall unit or a payment based on some other fixed formula. Many compulsory pooling statutes even apply to acreage not under lease.

Voluntary pooling, on the other hand, involves a private lease agreement between a landowner and a driller whereby the landowner allows the driller to combine his or her leased acreage with adjoining leases into a production unit. No state agency is involved. The terms and conditions of the pooling clause are therefore carefully negotiated between the driller and the landowner.

In return for granting the power to pool his or her lease, the landowner will receive a production royalty from any well located within the production unit. The royalty, however, must be shared with the other landowners in the production unit based on each landowner’s proportional share of unit acreage. Many courts have described the effect of pooling as a cross-conveyance of each landowner’s oil and gas interests, as in Montgomery v. Rittersbacher, 424 S.W.2d 210 (Tex. 1968), where the court held that “pooling effects a cross-conveyance among the owners of minerals under the various tracts … so that they all own undivided interests under the unitized tract.”

Therefore, once pooled, the landowner ceases to own the full, undivided interest underneath his or her tract.

Prior to SB 259, the predominant form of pooling in Pennsylvania has been voluntary pooling because Pennsylvania’s compulsory pooling statute, known as the Oil and Gas Conservation Law, is limited and only applies to wells that penetrate the deep Onondaga formation.

While there are no precise well spacing or density requirements in the Conservation Law itself, the Department of Environmental Protection has discretion to implement spacing rules and election rights upon consideration of an appropriate petition. Again, such a petition can only be filed if the driller is contemplating a deep well. Because of its limited application, compulsory pooling under the Conservation Law is extremely rare. Since the Marcellus Shale formation sits just above the Onondaga formation, it is not subject to the Conservation Law.

In Pennsylvania, if the landowner does not negotiate a pooling clause in his or her lease, the driller cannot pool or combine the landowner’s acreage unless the DEP issues an integration order under the Conservation Law. This is consistent with most oil and gas jurisdictions in the United States, as in Tittizer v. Union Gas, 171 S.W.3d 857 (Tex. 2005), in which the court held that “a lessee has no power to pool without the lessor’s express authorization, usually contained in the lessee’s pooling clause,” and Jones v. Killingsworth, 403 S.W. 2d 325 (Tex. 1965), in which the court held that “absent express authority, a lessee has no authority to pool.” As noted, the Conservation Law simply does not apply to most oil and gas leases in Pennsylvania and is almost never used. As such, power to pool must be expressly granted in the parties’ lease.

Horizontal drilling of the Marcellus Shale formation cannot occur without a valid pooling clause. This is because the horizontal wellbore, which can exceed 5,000 feet in length, will likely pass through a number of separately owned parcels. Each parcel must be under lease and each lease must authorize pooling. Each tract under which the horizontal wellbore passes is considered a drill site, as in Browning Oil v. Luecke, 38 S.W.3d 625 (Tex. App. – Austin 2000), where the court held that “each tract traversed by the horizontal wellbore is a drillsite tract and each production point on the wellbore is a drillsite.” Gas extracted from one section of the wellbore is commingled and combined with gas extracted from other sections of the wellbore. Therefore, unless the landowner has agreed to pool his or her acreage, and essentially share his or her gas production with others, the horizontal wellbore cannot pass underneath his or her property.

This is where SB 259 changes everything. Many older oil and gas leases, especially in Western Pennsylvania, either contain no pooling clause or contain a very narrow clause authorizing only the pooling of the deep Onondaga formation. The pooling clauses in these older leases simply do not allow the driller to pool the Marcellus Shale or shallower formations.

Recognizing this legal and operational limitation, drillers over the last five years have reached out to landowners in an effort to amend and modify their older leases by inserting language that expressly allows the pooling of these hydrocarbon formations. These lease modification agreements are routinely negotiated between landowners and drillers and provide an opportunity for both parties to modernize the entire lease, including the lease’s economic terms. SB 259 will allow drillers to bypass this process completely and proceed with horizontal drilling without the need of a valid pooling clause.

How does SB 259 do this? Section 2.1 simply unilaterally modifies every existing lease to allow for horizontal drilling:

“When an operator has the right to develop multiple contiguous leases separately, the operator may develop those leases jointly by horizontal drilling unless expressly prohibited by a lease.”

By virtue of this language, a pooling clause is no longer needed. All the driller needs is “multiple contiguous leases” and it can commence horizontal drilling under those tracts. This language is, quite simply, a game changer.

Proponents of SB 259 contend that Section 2.1 is not forced pooling. They are partially correct. It may be worse. Now a driller can essentially force-pool multiple parcels for horizontal drilling without any regulatory oversight or control. Recall that under the Conservation Law, the compulsory pooling mechanism is at least implemented and monitored by the DEP. Remarkably, there is no regulatory component to SB 259. Drillers now have unlimited power to pool and combine leases without any statutory limitations or parameters. The potential for abuse is staggering.

What is equally alarming is that the broad language of Section 2.1 could theoretically be used to justify any operation related to horizontal drilling. For example, if a landowner opposes the location of a water impoundment or a compressor facility on his or her property, the driller could argue that it has the absolute right to install those facilities, as part of its horizontal drilling operations, under Section 2.1. The same theory could be used to support seismic testing or the construction of access roads. In short, there is grave concern that Section 2.1 will be used to authorize surface operations and activities that were never contemplated or permitted by the parties’ existing lease.

SB 259 is bad for landowners, is bad policy and sets dangerous legislative precedent. Section 2.1 rewrote thousands of existing leases by allowing horizontal drilling without an agreed-upon pooling clause. At a time when the regional energy industry badly needed certainty, this bill created more uncertainty and confusion going forward and will unfairly alter the landowner-driller relationship.