unitization clause

Will My Federal Lease Be Extended?

Like virtually all modern oil and gas leases, federal leases have a fixed primary term (typically 10 years)[1] and a habendum (i.e., “so long thereafter”) clause.  But understanding the provisions of the Mineral Lands Leasing Act of 1920 (“MLA”) and BLM regulations governing extension of federal oil and gas leases can be tricky.

Production in paying quantities.  Obtaining production is the most obvious means of lease extension – if there is a producing oil or gas well on the leased premises when the primary term expires, the lease is extended for so long as oil or gas is produced in paying quantities.[2]  The term “paying quantities” means production “sufficient to yield a reasonable profit after payment of all the day-to-day costs incurred after the initial drilling and equipping of the well, that is, the costs of operating the well, including workovers and maintenance, rendering the oil or gas marketable, and transporting and marketing that product.”[3]

However, it isn’t necessary for there to be actual production from a federal lease for it to be extended beyond the primary term; rather, the lease will be extended indefinitely if there is a well “capable of producing oil or gas in paying quantities” on the leased premises.[4]  BLM determines whether a well meets this requirement.  The well must be physically in a condition to produce by “flipping a switch” with little or no additional work.  For example, a shut-in well qualifies as capable of producing in paying quantities, but a well in which the casing has been set and cemented but not perforated does not qualify.[5]  The IBLA also has upheld lease termination when equipment required for production was not on site.[6]

This extension has its limitations, since the MLA grants BLM the authority to order the lessee to begin production within a period of not less than 60 days from receipt of notice from that agency.[7]  Failure to commence actual production within the time allowed by BLM results in termination of the lease.[8]  And because federal leases are not paid-up leases, the lessee also must pay annual rentals on or before each anniversary date of the lease until oil or gas in paying quantities actually is produced from the lease.

Drilling over primary term.  If the lessee is engaged in drilling operations at the expiration of the primary term of the lease,[9] the lease term will be extended for an additional two years if certain requirements are met.[10]  Actual drilling operations that penetrate the earth are required.  Mere site preparation, or even moving a rig on site, is not enough to obtain extension of a federal lease by drilling.[11]  The operations must be conducted under an approved application for permit to drill (“APD”).  Also, to get the drilling over extension, the lessee must have paid rentals on or before the lease anniversary date.

After commencing drilling operations, the lessee must diligently conduct such operations in a bona fide effort to drill and complete the well as a producer.  The standard is that of a reasonably prudent operator, and drilling operations must be conducted in a manner that “anyone seriously looking for oil or gas can be expected to make in that particular area, given the existing knowledge of geologic and other pertinent facts.”[12]  Notably, the drilling over extension relates only to the primary term, and it is not available if the lease was previously extended for another reason.  Nonetheless, the drilling over extension can apply if the lease was suspended (see below), since that results in tolling the lease term.

Commencement of additional drilling operations.  If production in paying quantities ceases on a federal lease in its extended term, the lessee must commence reworking operations or drilling operations for a new well within 60 days or the lease will terminate.  Because the MLA itself provides that the 60-day period to commence drilling or reworking operations begins running “after cessation of production,”[13] the safest course is to commence operations within that period.  BLM regulations, on the other hand, provide that the 60-day period does not begin until receipt of notice from BLM that the lease is not capable of production in paying quantities.[14]  As with drilling over the primary term, once commenced, continuous operations in the extended term also must be conducted with reasonable diligence.[15]

Assign part of the lease.  If the lessee assigns 100% record title (and operating rights) in a portion of a federal lease, such assignment will cause a segregation of the assigned lands into a separate lease.  Such segregation potentially can extend a federal lease in different ways.  First, if a discovery of oil or gas in paying quantities later is made on any portion of the original leased lands, both the base lease and the segregated lease will continue for the longer of the primary term of the base lease or for two years after the date of discovery.[16]  Interestingly, there is no requirement to complete a well – a discovery can be proved by other evidence.[17]  However, a well eventually must be completed as capable of producing in paying quantities in order to qualify.  As with other extensions, rental payments are still required until there is a discovery.  Second, if the base lease is in an extended term due to production (actual or allocated) or by payment of compensatory royalties, the undeveloped portion will continue for two years from the effective date of the assignment and so long thereafter as oil or gas are produced in paying quantities.[18]

Pay compensatory royalty.  If the leased premises are determined by BLM to be subject to significant drainage from a well on neighboring lands and the lessee enters into a compensatory royalty agreement with BLM and pays a compensatory royalty for the drainage, such payment will extend the lease for the period in which the compensatory royalties are paid plus one year thereafter.[19]  As a practical matter, BLM typically will not enter into a compensatory royalty agreement if it believes the lessee can drill an offset well.  The lessee also must pay rentals.

Unit-related extensions.  If consent of the necessary parties is obtained and approval is obtained from BLM (which includes a public interest determination), the lessee may commit a federal lease to a federal exploratory unit, which can affect lease extension.  A federal lease is not extended automatically through commitment to a unit agreement alone.  However, production of oil or gas in paying quantities anywhere in the unit area will maintain a committed federal lease so long as the lease remains committed to the unit.[20]  Production from a well that meets the paying quantities test on a lease basis but which is not sufficient to establish a unit well and form a participating area (often called a “Yates well”) nonetheless will extend the leases committed to the unit.[21]  Also, the drilling over extension discussed above will extend a federal lease when actual drilling over the end of the primary term occurs on any lease committed to the unit.  Until a well capable of production in paying quantities is drilled on the lease or a participating area is established and production is allocated to the lease, the lessee must continue paying rentals.

Commitment of a federal lease to a unit with lands both inside and outside of the unit area will cause the lands outside of the unit area to be segregated into a separate lease.  The uncommitted lands will be extended for the term of the original lease, but for not less than two years from the effective date of the commitment to the unit.[22]  Similarly, when all of the leased lands in a federal lease committed to a unit are eliminated from the unit by termination or contraction of the unit, the lease will be extended for the term of the original lease, but for not less than two years from the effective date of the elimination.[23]  However, in both cases, there is no extension if the public interest requirement is not met.  The public interest requirement is met “if the unit operator commences actual drilling operations and thereafter diligently prosecutes such operations in accordance with the terms of said [unit] agreement.”[24]

Partial commitment and elimination from a unit can result in some lease extension complexities.  In particular, if a federal lease is producing beyond its primary term when it is partially committed to a unit (and thus the non-committed land is segregated), the segregated portion that does not have a producing well will remain in effect for so long as production in paying quantities continues from the existing well(s) on the other portion, regardless of which portion is committed to the unit.[25]  This typically is referred to as “associated production.”  But if the lease is still in its primary term (even if the lease is producing), the non-producing portion will not receive the benefit of the existing production after segregation.  Instead, it will remain in effect for the rest of its fixed term or two years, whichever is longer.

Additionally, a producing lease fully eliminated from a unit will receive a fixed term equal to the later of two years from the effective date of elimination or its original primary term, even though the lease is producing in an extended term at the time of elimination.[26]  This means that if the lease subsequently is partially committed another federal unit it would not receive any “associated production” as discussed above.  There are many nuances and interesting results when a federal lease has been committed to and eliminated from multiple units.  Thus, the facts and relevant law should be reviewed carefully to determine whether a lease in this situation has been properly extended.

Communitization agreement related extensions.  Commitment of lands in a federal lease to a communitization agreement is the federal equivalent of pooling.  A communitization agreement generally must conform to an existing state spacing pattern or commission order and it must be approved by BLM.[27]  Unlike unitization, commitment of part of the lands in a federal lease to a communitization agreement does not result in segregation, and thus the segregation extension mentioned above does not apply.

Similar to federal units, if any portion of a federal lease is committed to a communitization agreement, the entire lease will be extended by production in paying quantities or by the completion of a well capable of producing in paying quantities on any communitized land.[28]  In addition, actual drilling operations over the primary term of a federal lease anywhere on the communitized lands will extend the lease for two years.[29]  BLM’s approval of the communitization agreement need not be obtained prior to the end of the primary term in order to obtain the lease extension benefits, but the agreement must be signed by all necessary parties and filed with BLM prior to lease expiration.[30]  Finally, if a communitization agreement is terminated, so long as the public interest requirement was met, the eliminated federal lease will receive an extension of the remainder of its primary term or two years, whichever is longer.[31]

Suspensions.  The MLA also provides for another means of keeping a federal lease alive that technically results in tolling of the lease term and adding the period of suspension to it.[32]  The MLA gives BLM the authority to grant two types of suspension of an entire federal oil and gas lease following receipt of a timely application from all record title holders (or the unit operator with respect to all leases committed to a federal unit) showing why such relief is necessary.  First, BLM may grant suspensions of both operations and production “in the interest of conservation” (known as a Section 39 suspension).[33] Section 39 suspensions are intended to provide extraordinary relief when a lessee is denied beneficial use of its lease.[34]  For example, BLM might grant a Section 39 suspension to allow time for the reviews required by environmental statutes such as NEPA and the Endangered Species Act.  BLM also has identified many situations in which a Section 39 suspension is not warranted – a significant one being when an APD is submitted incomplete or untimely.  A Section 39 suspension terminates if the lessee undertakes activity such as road construction, site preparation or drilling. Rentals and minimum royalty payments are suspended under a Section 39 suspension.

Second, BLM may grant suspension of operations only or a suspension of production only when the lessee is prevented from operating on or producing from the lease, despite the exercise of due care and diligence, by reason of force majeure (known as a Section 17 suspension).[35]  BLM may only grant Section 17 suspension after operations on the lease have commenced and production has been obtained.[36]

[1] Competitive federal leases issued between 1988 and 1992 have five-year primary terms, and some older leases with 20-year terms subject to renewal remain in effect.

[2] 30 U.S.C. § 226(e); 43 C.F.R. § 3107.2-1.

[3] Abe M. & George Kalaf, 134 IBLA 133, 138, GFS(O&G) 3 (1995).

[4] 43 C.F.R. §3107.2-3.

[5] See Coronado Oil Co., 164 IBLA 309, 323, GFS(O&G) 10 (2005).

[6] Int’l Metals & Petroleum Corp., 158 IBLA 15, 22-23, GFS(O&G) 1 (2003).

[7] 30 U.S.C. §226(i); 43 C.F.R. § 3107.2-3.

[8] Id.

[9] The primary term expires at midnight on the day immediately preceding the lease anniversary.

[10] 43 C.F.R. § 3107.1.

[11] Estelle Wolf, et al., 37 IBLA 195, GFS(O&G) 157 (1978).

[12] 43 C.F.R. § 3107.1.

[13] 30 U.S.C. § 226(i).

[14] 43 C.F.R. § 3107.2-2. The IBLA long has held that written notice from BLM is not required when a lease ceases producing in paying quantities and, thus, the 60-days to drill starts running upon cessation of production. While the federal district court overturned the IBLA on this point in Coronado Oil Co. v. DOI, 415 F. Supp.2d 1339, 1348 (D. Wyo. 2006), that decision is narrowly construed by the IBLA.  See e.g., Atchee CBM, LLC, 183 IBLA 389, 406-08, GFS(O&G) 6 (2013).

[15] 43 C.F.R. §§ 3107.2-2 and -3.

[16] 43 C.F.R. § 3107.5-1.

[17] See Joseph I. O’Neill, Jr., 1 IBLA 56, 62 (1970), GFS(O&G) 2 (1970).

[18] 43 C.F.R. § 3107.5-3.  However, a lease in its extended terms dated prior to September 2, 1960 may be in an extended term for any reason and still be eligible for the two-year extension.

[19] 43 C.F.R. § 3107.9-1.

[20] 30 U.S.C. § 226(m).

[21] Yates Petroleum Corp., 67 IBLA 246, 252-53, GFS (O&G) 251 (1982).  A “unit paying well” sufficient to justify the formation of a participating area requires sufficient production to repay not only the operating costs, but also the costs of drilling and completing the well with a reasonable profit.  43 C.F.R. § 3186.1.

[22] 43 C.F.R. § 3107.3-2.

[23] 43 C.F.R. § 3107.4.  If only a portion of the leased lands in a federal lease committed to a unit are eliminated, the lease is not segregated and there is no extension, but the all of the leased lands will continue in effect for so long as any of the leased lands remain committed to the unit.  Continental Oil Co., 70 I.D. 473, 474, GFS(O&G) 50-1964-19 (1963).

[24] 43 C.F.R. § 3183.4(b).

[25] Celsius Energy Co., Southland Royalty Co., 99 IBLA 53, GFS(O&G) 82 (1987).

[26] Id.

[27] 43 C.F.R. § 3105.2-3.

[28] 30 U.S.C. § 226(m); 43 C.F.R. § 3107.2-3.

[29] 43 C.F.R. § 3107.1.

[30] 43 C.F.R. § 3105.2-3(a).

[31] 43 C.F.R. § 3107.4.

[32] 43 C.F.R. § 3103.4-4(b).

[33] 30 U.S.C. § 209; 43 C.F.R. § 3103.4-4(a).

[34] See Savoy Energy, L.P., 178 IBLA 313, 323, GFS(O&G) 1 (2010).

[35] 30 U.S.C. § 226(i); 43 C.F.R. § 3103.4-4(a).

[36] See Savoy Energy, L.P., supra, at 325.

Unitizing the Lessor’s Interest: No, It’s Not the Same as Pooling

The terms “pooling” and “unitization” are often used interchangeably, but they have different meanings. Pooling is “the bringing together of small tracts sufficient for the granting of a well permit under applicable spacing rules,” while unitization is “the joint operation of all or some portion of a producing reservoir.”[1] While pooling and unitization are both used to prevent waste and protect correlative rights,[2] unitization works on a much larger scale, allowing an operator to maximize the amount of resources extracted from an entire field or reservoir, without regard to lease or property boundaries. Generally, the lessee of a fee (private) oil and gas lease is free to commit its working interest to the unit agreement, but the lessee can only commit the lessor’s interest through voluntary ratification, compulsory unitization, or a unitization clause. This article will focus specifically on the third option: the unitization clause in fee leases.

Unitization clauses (if included at all) generally follow two patterns. First, the unitization clause may be interwoven into the pooling clause. Second, the unitization clause may appear separately, often immediately following the pooling clause (we believe this to be the preferred method). There are typically four parts to a “standard” unitization clause.

Part One – When can the lessee unitize the lessor’s interest?

Example: Lessee shall have the right to unitize, pool, or combine all or any part of the leased premises with other lands in the same general area by entering into a cooperative or unit plan of development approved by any governmental authority.

The unitization clause should expressly grant to the lessee the authority to unitize the leased premises under a cooperative or unit plan of development. Depending on the type of unit being formed (for example, a federal exploratory unit or a state voluntary unit), the language should be broad enough to cover the proposed plan of development. Because the lessee may not know its future unitization plans at the time it negotiates a lease, the lessee should ensure that the unitization clause is broad enough to cover all forms of unitization.[3]

Even with a unitization clause, the lessee has an implied duty of good faith and fair dealing when pooling or unitizing a fee oil and gas lease.[4] This means that the lessee should be careful when attempting to commit a lease that is about to expire or includes non-productive lands, or when the lessee’s economic interests are not aligned with those of the lessor. However, if the unit plan of development is approved by a governmental entity (such as the BLM or the state conservation commission), courts will generally defer to the government’s approval in determining whether the lessee acted in good faith.[5]

Unfortunately, when describing how the leased premises can be unitized with other lands, it is not uncommon to find combined pooling/unitization clauses where the lessee mistakenly used pooling language (such as “into a drilling or spacing unit in conformance with a state drilling or spacing order”) instead of replacing it with unitization language (such as “to one or more unit plans or agreements for the cooperative development or operation of one or more oil and/or gas reservoirs or portions thereof”).

Properly drafted unitization clauses should cover the development of a field or reservoir as opposed to just those lands within a single drilling or spacing unit.

Part Two – How will the terms of the lease be affected?

Example: When such a commitment is made, this lease shall be subject to the terms and conditions of the unit plan or agreement and this lease shall not terminate or expire during the life of such plan or agreement.

To effectively extend the lease under the unit plan of development, the lease terms should be amended to conform to those of the unit agreement. This can be done either by having the lessor ratify the unit agreement or by including express language to that effect (such as described above) in the unitization clause. This will ensure that the lease won’t expire while the operator of the unit is actively engaged in drilling operations under the unit agreement.

Conforming the lease to the unit agreement may not be the end of the analysis in terms of lease extension. Specifically, all or a portion of the leased premises could still expire if the lease contains a severance provision in the unitization clause or a separate Pugh clause. A severance provision in a unitization clause could result in lease expiration as to any non-unitized lands at the end of the primary term. For example:

Anything in this lease to the contrary notwithstanding, actual drilling on, or production from, any unit or units (formed by private agreement or by any State or Federal governmental authority, or otherwise) embracing both lands herein leased and other land, shall maintain this lease in force only as to that portion of Lessor’s land included in such unit or units, whether or not said drilling or production is on or from the leased premises.

Similarly, a Pugh clause could result in lease expiration as to any non-producing lands at the end of the primary term. For example:

Notwithstanding any provision to the contrary, this lease shall terminate at the end of the primary term or any extended term, as to all the leased land except those lands within a production or spacing unit prescribed by law or administrative authority on which is located a well producing or capable of producing oil and/or gas or lands on which Lessee is engaged in drilling or reworking operations.

The threat posed by either of these provisions requires careful review of the lease as a whole. Oftentimes, Pugh clauses are negotiated independently of the general lease terms and ultimately included on an addendum attached to the lease. As a result, they are not always consistent with the other terms of the lease. To avoid ambiguity, when negotiating a fee oil and gas lease, it is prudent to review any included Pugh clause (and all other lease terms) and consider how it will reconcile with the unitization clause. Ideally, the Pugh clause should only result in lease expiration as to those lands outside of an approved unit. However, at a minimum, the Pugh clause should be drafted (or amended) so as to not sever the lands within a unit production area (for example, a participating area in a federal exploratory unit).

Part Three – How will the lessor’s royalty interest be calculated?

Example: Where there is production on any particular tract of land covered by such plan, it shall be regarded as having been produced from the particular tract of land to which it is allocated and not to any other tract of land and the Lessor’s royalty interest shall be based upon production only as so allocated.

Generally, a pooling clause will allow the leased premises to be combined with other lands to form a drilling unit, wherein proceeds from production anywhere on the drilling unit are allocated according to the percentage of the acreage of each tract divided by the total acreage of the drilling unit. However, because units are concerned with the development of a field or reservoir, the unitization clause should provide that proceeds from production should only be allocated to that tract included in a unit production area (such as a participating area in a federal exploratory unit). In other words, if the lessor’s interest is properly committed to a cooperative or unit plan of development, production anywhere on the unit will hold the lease, but the lessor will only receive proceeds from production if its tract is included in a unit production area containing a producing well (not the drilling or spacing unit that would exist if the well was drilled outside of the unit).

So what happens if the lessee’s working interest is committed to the unit agreement, but the lessor’s royalty interest is not? While the lessee will be allocated proceeds according to its proportionate share of the unit production area, the lessor will be allocated proceeds on a leasehold basis. This can result in a windfall either for the lessor or the lessee (compare the allocation of proceeds from the 1H and 2H wells in the diagram to the right, assuming 320 acre standup spacing units).

Part Four – How can the lessee commit the lessor’s interest?

Example: Lessor shall formally express Lessor’s consent to any cooperative or unit plan of development by executing the same upon request of Lessee.

The mechanism for the lessee to commit the lessor’s interest to a cooperative or unit plan of development varies depending on the unitization clause. Many unitization clauses allow the lessee to unilaterally commit the lessor’s interest by executing the unit agreement. In some cases, such unitization clauses require the lessee to record a memorandum of the unit agreement. Other unitization clauses, such as the example above, require the lessor to formally consent to the unit plan of development when requested by the lessee. This is typically done by executing a ratification of the unit agreement. In any event, the agency administering the unit (for example, the BLM for a federal exploratory unit) may need to confirm the commitment status of the fee lessor. As such, and to avoid a potential dispute down the road, the lessee may decide to obtain the lessor’s ratification of the unit agreement, even if the terms of the lease do not require it.

Unitization Clause Checklist:

  • ✓ Is there a unitization clause?
  • ✓ Does the unitization clause cover the proposed type of unit?
  • ✓ Does the unitization clause allow the leased premises to be combined with other lands for the development of a field or reservoir (as opposed to a single drilling unit)?
  • ✓ Does the unitization clause amend the lease terms to those of the unit agreement?
  • ✓ If there is a severance provision in the unitization clause, will it impact the proposed operations?
  • ✓ If the lease contains a Pugh clause, is it consistent with the unitization clause? Will it impact the proposed operations?
  • ✓ Does the unitization clause allocate proceeds from production within the unit production area (as opposed to a drilling or spacing unit)?
  • ✓ Will the proposed unitization plan be exercised in good faith?
  • ✓ If required, did the lessor execute a ratification of the unit agreement? Was it recorded?

[1] Williams & Meyers, The Law of Oil and Gas, § 8-U.
[2] In Utah, for example, correlative rights are defined as “the opportunity of each owner in a pool to produce his just and equitable share of the oil and gas in the pool without waste.” Utah Code Ann. § 40-6-2(2).
[3] See, e.g., Trans-Western Petroleum, Inc. v. U.S. Gypsum Co., 584 F.3d 988 (10th Cir. 2009).
[4] See, generally, Williams & Meyers, The Law of Pooling and Unitization § 8.06.
[5] See Amoco Prod. Co. v. Heimann, 904 F.2d 1405 (10th Cir. 1990).

Co-Authors
David Hatch and Andrew LeMieux