Five Lessons Learned From Executing Shale Drilling Transactions

by Liskow & Lewis
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Shale drilling transactions typically involve (1) a party who holds oil and gas leases with underlying shale formations but who may not have the risk capital or expertise to explore such formations (the “Lease Party”) and (2) a party who has the risk capital and the expertise to drill and complete successful horizontal wells in shale formations using hydraulic fracturing techniques (the “Drilling Party”).

In these transactions, the Drilling Party pays for or “carries” all or a substantial portion of the Lease Party’s share of the costs of drilling and completing one or more wells on the leases (“Earning Wells”).  If an Earning Well is completed as a well capable of producing hydrocarbons, the Lease Party will assign a portion of its working interest in the lease or spacing unit to the Drilling Party.

Shale drilling transactions are executed through an agreement providing for the terms of earning working interests and any continuous drilling program associated therewith – typically referred to as an earning and joint development agreement (the “EJDA”).  Also included is a joint operating agreement (“JOA”) to govern the drilling and operation of additional development wells in a formation once a working interest in that formation has been earned in accordance with the provisions of the EJDA.

The Five Lessons

1. Take advantage of the geology.

Many oil and gas properties have (a) unconventional shale formations that may be exploited with horizontal wells and hydraulic fracturing and (b) conventional formations that may be exploited with traditional vertical wells.  In these cases, when designing the drilling and earning transaction, consider packaging one or more conventional formations with an unconventional shale formation to create a designated “earning zone”.  In properties with stacked formations, consider using multiple earning zones that package the various conventional and unconventional shale formations together into separate earning zones in which a working interest can be earned.

What this does is reward the Drilling Party with additional earned formations once an Earning Well into the shale formation in the earning zone is completed as a well capable of producing hydrocarbons.  This incentive may help the Lease Party find a willing partner to drill in an otherwise down market for drilling transactions.  If this approach is utilized, the parties should consult their tax advisors as to whether a tax partnership agreement should be included in the transaction documents to avoid possible unforeseen tax consequences on the earning of such additional formations.

And, if this approach is utilized, the EJDA should provide for the reversion of the formations that are earned but not drilled and exploited within a specified period of time.  The EJDA also should provide that production from the producing shale formation will secure the Lease Party against the Drilling Party’s failure to perform obligations in the earning zone and its other conventional formations, as well as other earning zones.

2. Structure the earning provisions of the EJDA to incentivize the drilling of Earning Wells.

Lease Parties generally are interested in maximizing the number of wells drilled on their oil and gas properties.  This objective can be accomplished by incorporating a “Continuous Drilling Program” into the EJDA pursuant to which the Drilling Party must continue to drill Earning Wells in order to continue to earn working interests in the various earning zones in the oil and gas properties subject to the EJDA.  In other words, the earning of working interests in the subject oil and gas properties is staged in accordance with certain drilling requirements.  The failure to timely spud a new Earning Well within a specified period of time (typically 120 days after releasing the rig from the last Earning Well) terminates the Continuous Drilling Program.

Depending on market conditions, the Lease Party also may offer the Drilling Party the opportunity to drill a limited number of development wells in previously-earned formations to satisfy the timely drilling of wells under the Continuous Drilling Program.  Cash flow from these less risky development wells may help the Drilling Party fund additional more risky Earning Wells.

3. Structure the “carry” requirements in the EJDA to incentivize the drilling of Earning Wells.

Lease Parties typically prefer to be carried for all of the costs of the initial well drilled into a previously undrilled formation.  In order to achieve that objective, and to minimize the overall working interest percentage assigned to the Drilling Party for drilling and completing an Earning Well, the Lease Party may consider offering a well payout provision to the Drilling Party.  Many shale drilling transactions, however, do not include well payout provisions.  While such a provision reduces risk to the Drilling Party by increasing its cash flow during the payout period, it also extends the point at which the Lease Party begins to participate in the cash flow from an Earning Well.  Depending on the expected production decline curve for the shale formation, immediate participation in the Earning Well may be preferable to the Lease Party.  If no payout provision is included, the Drilling Party should consider including a tax partnership agreement as a part of the transaction documents in order to deduct all of its intangible drilling and developments costs incurred for the Earning Well.

It is also important to specify in the EJDA how far the “carry” extends.  Many carry provisions end when the Earning Well is completed as a well is capable of producing hydrocarbons.  But the investment downstream of the completed well is significant, so Lease Parties may bargain for a carry that extends through the construction of the storage tanks and the custody transfer meter.  Extending the carry downstream from the wellhead reduces risk and cost to the Lease Party, but, by increasing individual well costs to the Drilling Party, may result in the drilling of fewer Earning Wells.

Finally, the EJDA should define the length of the lateral portion of the horizontal well that is required to earn a working interest.  While the interests of the Lease Party and the Drilling Party should be aligned in drilling and completing the best well possible at the most economical cost, there may be instances in which the Drilling Party may attempt to minimize the length of the lateral to minimize the cost to earn.  Lengths of laterals generally are provided for in the applications for permits to drill.  To avoid conflict, the required length of the lateral can be specified in the EJDA as a percentage of the maximum permitted length or otherwise specified in the EJDA.  Consideration also should be given to specifying the percentage of the lateral that must be shown to be within the shale formation.

4. Protect “Operatorship” of the formations underlying the Leases.

Lease Parties put significant time and effort into determining the operators who are capable of economically drilling successful shale formation wells.  In many jurisdictions, the designation of operator for a well on a spacing unit is determined by the first party to file a permit to drill the well.  In such case, the Lease Party will want the EJDA to require the Drilling Party to provide an accelerated timetable for filing permits to drill Earning Wells in as many of the formations underlying as many of the oil and gas properties as possible to avoid losing operatorship to other working interest owners.

The Lease Party also should consider negotiating for an opportunity to file permits where the Drilling Party fails to do so timely and withdraw those permitted formations from the Continuous Drilling Program.

5. Take into account lease maintenance requirements.

Oil and gas leases typically provide that production from a well in “paying quantities” will hold the lease beyond its primary term.  If there is no shallow production holding the Lease Party’s oil and gas leases that are subject to the EJDA, then the definition of an Earning Well needs to be drafted carefully so that an Earning Well not only earns an interest in the earning zone but also can hold the lease beyond its primary term.  In these instances, the EJDA should define an Earning Well as the first well into an earning zone that is drilled and completed as a well capable of producing hydrocarbons in “paying quantities”.

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