Allocation Wells

054Oil and gas companies in the state of Texas must obtain a permit from the Texas Railroad Commission (RRC) in order to commence drilling operations. Operators applying for permits must conform to certain regulations which set forth spacing and density requirements. When leases cover smaller tracts of land, operators exercise pooling rights, combining the leases into a larger unit that will meet the spacing and density requirements.

A well written oil and gas lease requires the lessee (operator) to obtain the express consent of the owner of the royalty interest in order to pool that interest. Without that consent granted in the lease or other agreement, the operator has no right to pool the interest. In recent years, operators have circumvented this requirement by applying for and receiving permits to drill “allocation wells”.

The term “allocation well” is used in the oil and gas industry to refer to a horizontal well that is drilled across lease lines without pooling the tracts on which the well is located. Originally, these wells were permitted by the RRC based on the operator’s assertion that it has production sharing agreements (PSAs) with the royalty owners. The PSAs provide that the production from the well is allocated between or among the tracts crossed by the well lateral, for purposes of calculating royalties due, based on the number of feet of well lateral on each tract compared to the total lateral length of the well.

The PSAs have advantages and disadvantages for royalty owners. The royalty owner will get royalties on production from a new well that might not be drilled unless a production sharing agreement is signed to allow drilling across lease or unit boundaries. The disadvantage is that production from one well serves to hold all the acreage in both units for as long as it produces.

More recently, the RRC has issued permits for allocation wells without requiring the operator to obtain production sharing agreements or pooling agreements from royalty owners in the tracts crossed by the wellbore. In effect, this allows operators to force-pool tracts, which in Texas is only allowed under limited circumstances and requires an application, notice to affected parties, and a hearing.

The right to consent – or not consent – to the pooling of one’s royalty interest has been long-recognized by Texas courts, and is a significant right for all royalty and mineral owners in Texas. Texas does not have a forced-pooling statute, like those in Oklahoma and Louisiana, that force mineral owners into pooled units against their will.

The RRC staff’s issuance of permits for allocation wells was challenged by royalty owners in DeWitt County. They protested a permit application by EOG to drill the Klotzman Well 1-H in the Eagleville Field. A hearing was held in the Klotzman case and the examiners for the RRC ruled that the commission rules do not authorize the RRC to issue allocation well permits. The Commissioners overruled the examiners, but did not provide any basis for their decision.

Several DeWitt County royalty owners have joined to file a lawsuit against the RRC in Travis County District Court, asking the court to reverse their decision on permitting such wells. The outcome of this ruling will affect all royalty owners in Texas. If operators are granted permits to drill allocation wells in the absence of pooling agreements with the royalty owners, the rights of royalty owners to negotiate pooling provisions in their leases will be seriously eroded.

Oilfield Glossary

oilfield

R. King & Co. guide to oilfield acronyms and drilling terms for royalty and minerals owners to help them understand drilling and daily cost reports from their operators.

TERM          DEFINITION

AFE             authorization for expenditure
AZ               azimuth
BHA            bottomhole assembly – the lower portion of the drillstring
blinds          a circular metal disk installed in a pipeline to prevent flow
BLW            barrels load water
BLWTR        barrels load water to remove
BOP            blowout preventer
Borets         provides electric submersible pumps
BPDR          barrels per day rate
BPM            barrels per minute
BPH            barrels per hour
BTMS          battery thermal management system
CIBP           cast iron bridge plug
CSG            casing
CT               coiled tubing
CTD             coiled tubing drilling
CUDD          fracking contractor
dart             device dropped through string to activate downhole equipment & tools
DSA             drill stem assembly
EQ               equalizing valve
ESP             electric submersible pump
FCP             final circulating pressure
FLAP           fluid level above pump
GPM            gallons per minute
GYRO          gyroscopic surveying instrument – device used to determine direction angle at                      which wellbore is drifting off the vertical

H2S             hydrogen sulfide
HWDP         heavyweight drillpipe
ID                inside diameter
JFS             jacking frames
JTS             joints
KOP            kickoff point
LCM            lost circulation material
LD               lay down (pipe)
MD              measured depth
MIRU           move-in rig up
MISURU      move-in, set-up, rig-up
MWD           measurements-while-drilling
NOGO         device of a known and precise dimension that is lowered into a well to                                 determine the dimensions of another device or opening already in the well
NU              nipple up
OD              outside diameter
PBR            polished bore receptacle
pill              small volume of a special blend of drilling fluid used for a specific purpose
PJSM          pre-job safety meeting
POOH         pull out of hole
PP              pulling prong
PPG            parts per gallon
PPM            parts per million
rabbit          internal drift diameter gauge used to check casing or tubing joints
RDMO         rig-down move off
ream           enlarge wellbore
ROH            run in hole
ROP            rate of penetration
RPM            revolutions per minute
RU              rig up
RWTP          review within time period
SDFN           shut down for night
SICP            shut in casing pressure
SIP              shut in pressure
slips            device used to grip the drillstring in a non-damaging manner and suspend in                         rotary table
SLM            slick line measurement
SPM            suspended particulate matter/strokes per minute
SUB            submersible
TAG             throw away gun (perforating gun)
TBG             tubing
TFNB           trip for new bit
TIH              trip in hole
TMD            total measured depth
TOH            trip out of hole
TOTCO        electronic survey tool
TVD             total vertical depth
UBHO          universal bore hole orientation
VIS              viscosity
WO             well in work over
WOB           weight on bit
WOC           waiting on cement
WS              well string

Global Oil Price Outlook

The surge of light, tight oil unleashed by the U.S. energy revolution has caused a profound shift in the world oil market. The demand for oil is no longer the dominant factor, but the new supply made possible by the increase in U.S. production to nine million barrels daily.

Market analyze 1492676

Faced with an unprecedented challenge to its market domination, OPEC decided to maintain current levels of production, which led to U.S. oil prices trading in the high $60 per barrel for the first time since the summer of 2009.

OPEC’s motivations for standing pat have been ascribed to their desires to smother the U.S. fracking boom, avoid losing market share, or allow time for the oil market “to stabilize itself eventually”, according to the Saudi Oil Minister. In the view of many industry analysts, OPEC will be surprised by the resilience of new U.S. oil production, and fail to achieve the first two of its goals.

Oil prices at five-year lows have made the economic climate for U.S. oil production more challenging than it has been in years. But royalty owners should remain optimistic about monetizing their mineral leases. A new IHS analysis of well data finds that 80% of new tight-oil production in 2015 would be economic between $50 and $69 per barrel. Data from individual companies reveals that some projects are profitable down to about $40 a barrel.

Technological advances that lower the cost of drilling each well have been driving this change. Statoil reports that their costs have fallen 50% in two years, and could keep falling another 15% by 2016. In addition, producers are generating more oil per well. The result is fewer wells, at lower cost, with higher overall production.

OPEC’s gamble on allowing oil prices to plunge may hurt their own members, and non-member Russia, more than the U.S. Venezuela depends on oil revenues for up to 65% of government spending and its economy is already in chaos. Iran depends on oil for 50% of its budget and sanctions have cut its oil exports almost in half. With oil providing over 40% of the Russian budget and the value of the ruble falling rapidly, Russia is headed for recession.

U.S. mineral owners can take comfort in the fact that experts believe the biggest impact of lower oil prices on future output will be a slowdown and reduction in major new investments around the world. The losers will be countries in Africa, Asia and Latin America trying to woo investment for new oil and gas projects. This lack of new projects will benefit U.S. royalty owners in the long term because it will cause oil prices to rise once again.

Percentage Depletion Deduction Threatened

royalty-taxes-returnThe percentage of income from a producing mineral property which one can claim as a deduction to account for depletion is currently 15% for oil and natural gas. For many royalty owners, the percentage depletion deduction is the only deduction they can take on their mineral royalty income. The purists involved in reforming the tax code want to lower the maximum corporate and individual rates to either 25% or 28% by ending numerous deductions. This would eliminate two vital deductions benefiting mineral and royalty owners.

In June of 2013 the Senate Committee on Finance Chairman Max Baucus and Ranking Member Orrin Hatch announced that they were determined to complete tax reform during the current session of Congress.  They planned to operate from an assumption that all exclusions, credits, and deductions were out unless there was clear evidence that they:  (1) help grow the economy, (2) make the tax code fairer, or (3) effectively promote other important policy objectives.

The deduction of Intangible Drilling Costs (IDCs) by oil and gas producers benefits mineral and royalty owners by promoting drilling activity.  IDCs permit a portion of the costs of drilling a well to be deducted fully in the year those costs are incurred, rather than being capitalized over several years. It has been estimated by industry experts that total drilling activity would decrease by thirty percent if current tax treatment of IDCs, percentage depletion, and the passive loss exception were ended.

In the face of this threat to royalty owners and producers, the National Association of Royalty Owners (NARO) and the Domestic Energy Producers Alliance (DEPA) joined forces to obtain a letter signed by four Senators and sent to the Senate Finance Committee.  Delivered on July 26, 2013, the letter strongly supported the retention of percentage depletion and IDCs, and disclosed the negative effects on the U.S. economy and energy security if they are eliminated.

In spite of the stated support of several Senators, the Senate Finance Committee issued their discussion draft on Nov. 21, 2013 proposing to eliminate percentage depletion and changing IDCs from a current year deduction to a five year amortization. The Senate Finance Committee discussion draft does great harm to domestic independent producers and royalty owners.

Fortunately for royalty owners and producers, Senator Max Baucus has been nominated as the next ambassador to China.  He is expected to be replaced as chairman of the Finance Committee by Senator Ron Wyden of Oregon.  Most observers believe that the tax reform issue will be put on the back burner until the new Congress convenes in January of 2015.

Royalty and mineral owners should not become complacent, but use the time wisely by contacting their Senators and Representatives to remind them that there are 8.5 million American private owners of oil and gas mineral and royalty interests.  Maintaining the percentage depletion deduction is a vital concern for all of them.