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Originally published in the Permian Basin Landmen’s Association January 2017 Newsletter

As a quick review, an allocation well is a well drilled across multiple leases, held by a common lessee, without pooling authority. The Texas Railroad Commission has determined that an applicant for a permit to drill a well across lease lines does not need to demonstrate his right to pool the leases so long as the applicant holds all leases on the affected tracts. To issue the permit, the Railroad Commission merely requires a good-faith claim to the right to drill, which can be satisfied by leasehold rights or by fee ownership of minerals.[1]

There is a considerable amount of controversy involved with the permitting of allocation wells given their commingling of production from adjoining tracts without consent of the lessors. Some perceive allocation wells as a violation of property rights or, at the very least, a breach of contract under leases that do not include pooling authority. The Texas Railroad Commission itself has stated that “payment of royalties is a contractual matter between the lessor and the lessee.”[2] The Commission has repeatedly made it clear that the granting of a permit to drill an allocation well is not an endorsement of the method used by a lessee to allocate royalty payments.

To say that the State Bar is split on the issue of allocation wells is an understatement. The following paragraphs explore the opposing viewpoints put forth by some of Texas’ leading jurists: (My apologies in advance for the oversimplification of their positions).

In Applying Familiar Concepts to New Technology: Under the Traditional Oil and Gas Lease, A Lessee Does not Need Pooling Authority to Drill a Horizontal Well that Crosses Lease Lines,[3] Ernest Smith argues that production from allocation wells does not constitute pooling. He reasons that a typical oil and gas lease, which conveys a fee simple determinable, gives the lessee all the authority needed to drill a lateral from one side of a leased tract to the other. Whether a lessee can cross that lease line and drill on the adjacent tract is determined by the lease covering the adjacent tract and not by the terms and conditions of the lease covering the original tract.

Smith goes on to state that “as long as the lessee is not purporting to convey a portion of the lessor’s royalty interest to someone else [i.e. dilution by pooling], and as long as the lessee continues to pay royalties to each lessor based on the production allocable to that lessor’s tract, the typical mineral lease gives the lessee all of the authority needed to produce from a lease [by means of an allocation well].” He concludes that payment of royalties is to be determined with “reasonable probability,” which stands as an undefined term found in Texas case law.

The concept of “reasonable probability” is the driving force behind the legislative remedy to the allocation well controversy. Proposed in the 84th Legislative Session in 2015, House Bill 1552, introduced by former Speaker Tom Craddick (R-Midland), allocated “production to each tract in the proportion that the operator or lessee reasonably determines reflects the amount produced from each tract.”[4] HB 1552 died in committee, and it is yet to be seen whether an allocation well bill will be introduced in the 85th Legislative Session, which convenes on January 10, 2017.

Bret Wells’ article, Allocation Wells, Unauthorized Pooling, and the Lessor’s Remedies,[5] argues that the development of multiple tracts under leases lacking pooling authority is an illegal act. According to Wells, Texas law recognizes the interpretation of oil and gas leases as a contractual matter, and ambiguities should be construed against the lessee. As the typical oil and gas lease does not allow the lessee to “combine [the leased premises] with other land for the purpose of obtaining a drilling permit, commingle production…and allocate royalty between the various landowners based on some allocation methodology determined by the lessee…,” such actions by a lessee amount to an unauthorized, unilateral “equivalent of a production sharing agreement.” Such unauthorized action by a lessee then, would give rise to a lessor’s petition to set aside the drilling permit and, in some circumstances, seek (i) damages for lost leasehold benefits; (ii) injunctive relief; and (iii) punitive damages.

John McFarland, an Austin oil and gas practitioner, sees both Smith and Wells as asking the wrong question when examining the permissibility of allocation wells. A typical oil and gas lease requires “royalties to be paid on the oil and gas ‘produced and saved from the leased premises’.”[6] Instead of determining whether allocation wells constitute unauthorized pooling, McFarland would hold allocation wells impermissible on the grounds of breach. He theorizes that the commingling of production from several tracts violates the very terms of the lease and, therefore, results in a breach of the lease.

Although uncertainty abounds, I predict that lessors will win at the trial and appellate levels, but will ultimately lose in the Texas Supreme Court. Ernest Smith’s strong arguments, combined with the reality of the proliferation of horizontal drilling, will likely prove persuasive to the Court, and the fight will then shift to what constitutes “reasonable probability” when determining royalty payments. This ambiguity should prove fertile ground for future litigation.

 

 

[1] Tex. R.R. Comm’n, Application of EOG Resources, Inc. for its Klotzman Lease (Allocation), Well No. 1H (Status No. 744730), Eagleville (Eagle Ford-2) Field, Dewitt County, as an Allocation Well Drilled on Acreage Assigned from Two Leases, Docket No. 02- 0278952 (Sept. 24, 2013) (final order)

[2] Id.

[3]http://texasbar.informz.net/texasbar/data/images/OGE%20Applying%20Familiar%20Concepts%20to%20New%20Technology.pdf

[4] HB 1552, 84th Texas Legislative Session, 2015; http://www.legis.state.tx.us/tlodocs/84R/billtext/html/HB01552I.htm

[5] http://www.baylor.edu/content/services/document.php/271080.pdf

[6] John McFarland, Debate Over Allocation Wells Continues, Oil and Gas Lawyer Blog (July 18, 2016);

Debate over Allocation Wells Continues

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