In many ways, the Utica Shale play caught Ohio off guard. The state became a main focus of the oil and gas industry almost overnight. Ohio responded by updating its oil and gas laws, including major overhauls resulting from Senate bills 165 in 2010 and 315 in 2012. But in some cases, operators and regulatory agencies are still applying old law that was written with conventional drilling methods in mind. In this post, part 3 of our series on compelled participation (see Part 1 and Part 2), we look at unitization — one of these old laws being put to new use.
What Is Unitization?
Unitization is the creation or designation of a contiguous area of land, called a “unit,” for the efficient development of the oil and gas resources underlying that land. Units can be formed by order of the Ohio Department of Natural Resources (ODNR), on application from an operator. Units also can be formed voluntarily by consent of interest owners, usually owners of the leasehold. Inevitably, the land sought to be unitized — really the geologic formation below the surface — is subject to a patchwork of different ownership interests. The operator attempts to negotiate lease rights with all such land or mineral rights owners, but it is often the case that the operator cannot reach an agreement with all of them. When an operator has the consent of all but a small portion of the land for a unit, Ohio law allows the operator to apply for ODNR to compel the non-consenting interest owners to join the unit.
Unitization is a close relative of mandatory pooling, in that mineral rights owners who are unwilling to lease their rights for drilling operations are compelled to cooperate by ODNR. The difference lies in the size of the unit. Mandatory pooling is about gathering sufficient land to meet minimum spacing requirements set by law to create a “drilling unit” of 40 acres or less, depending on the total depth of the well. Unitization, on the other hand, is about gathering all the mineral rights for a specific portion of oil and gas resources and bringing its development under common control. In the context of drilling in the Utica Shale, this creates units hundreds of acres in size.
A New Context: What Is a “Pool” These Days?
Before going further, we should clarify a key term. ODNR issues unitization orders in relation to a “pool” of oil or gas. To obtain a unitization order, the owners of at least 65% of the land overlying a pool must apply to ODNR to have the pool, or part of it, operated as a unit. R.C. §1509.28. Usually, it is the operator who makes the application pursuant to the authority granted to him in the leases. A “pool” as used here, is distinct from mandatory pooling (we’ve discussed these confusing terms before). A “pool” is defined in the Revised Code as “an underground reservoir containing a common accumulation of oil or gas, or both, but does not include a gas storage reservoir.”
Herein lies the new application of an old law. Passed in 1965, Ohio’s unitization law predates the advent of horizontal drilling methods. A “pool” as defined in 1965 fits with the idea of liquid contained in a geologic trap susceptible to conventional drilling. A “pool” was just that: an underground reservoir of oil or gas, sloshing around in liquid or gaseous form usually within a sandstone formation. In the context of unconventional — i.e., horizontal — drilling, the concept of a pool has broadened to include geologic formations of source rock such as shale.
Qualifying for a Unitization Order: Is Unitization Necessary to Increase Recovery?
To obtain an order, the operator must present evidence that the proposed unit qualifies under the statutory legal standard. This legal standard is whether or not the proposed unit is “reasonably necessary to increase substantially the ultimate recovery of oil and gas, and the value of the estimated additional recovery of oil or gas exceeds the estimated additional cost [of operating the unit].” R.C. §1509.28. The applicants must prove that having control of a large area is important enough to justify compelling unwilling mineral owners to cooperate.
In support of unitization applications, operators point out that the oil and gas resources lying in shale rock formations are not economically viable with vertical drilling methods. “It is unlikely that vertical development of the unit would ever take place,” wrote Chesapeake in its Colescott South application. Application for Unit Operation, Colescott South Unit, at 6. However, horizontal drilling brings a certain efficiency to bear that allows shale oil and shale gas to be economically produced, with less impact to the surface of the land.
But accessing the oil and gas using horizontal drilling methods requires space, and a lot of it. To be profitable, horizontal shale drilling requires large, uninterrupted areas of mineral rights. Drilling units of the size commonly associated with vertical wells are too small — they won’t produce enough to be profitable and they aren’t large enough to drill horizontally in the first place. The most efficient horizontal shale drilling techniques use horizontal well bores or “laterals,” which may extend one or two miles from the well pad. In its application for the Colescott South Unit, Chesapeake argued that “oil and gas recovery from horizontal drilling methods is directly related to the length of the [horizontal] lateral — limit a lateral’s length and you limit its ultimate recovery.” Id. Chesapeake presented evidence that its proposed unit, which would grant Chesapeake rights to 75 extra acres (a 12% increase), would result in a 48% increase in oil and gas recovery. Id.
Further, to maximize economic efficiencies and reduce potential environmental impacts and surface disturbance, operators frequently drill multiple laterals from a single well pad. Chesapeake’s Colescott South Unit, depicted at right, shows three laterals extending from one well pad but it is not uncommon for an operator to drill as many as eight laterals from one pad.
Because the law imposes spacing requirements between wells (the laterals) and from each well to the boundary of the unit (generally, an operator must allow 1,000 feet between wells and 500 feet to the boundary of the unit, unless a variance is granted), in this case 549 acres are necessary to accommodate the three laterals in the unit shown at right. Chesapeake negotiated leases of the mineral rights underlying all but five tracts, which are shaded in red. Because the owner of the five shaded tracts would not lease, Chesapeake applied for — and was granted — a Unitization Order forcing these tracts into the unit. Order No. 2013-06, Order for Unit Operations of the Utica/Point Pleasant Formations for the Colescott South Unit, Carroll County, Ohio, March 7, 2013.
The Unitization Order
If ODNR is satisfied that a proposed unit meets the legal standard and is necessary for increased recovery, it will issue a unitization order. The order is required by statute to “be upon terms and conditions that are just and reasonable,” and must contain certain descriptions of the unitized area, the dates for drilling operation to begin and terminate, and the nature of the drilling operations. R.C. §1509.28(A).
Operators and the forced-in mineral owners pay particular attention to one part of the order — the money/payment provisions. Because the mineral owner never agreed to a lease, ODNR determines the terms by which the mineral owner is included in the unit operations, including the royalty interest, working interest and risk penalty. The terms of the order will differ as the situation dictates.
In two orders issued to Chesapeake, each forced-in mineral owner received a 1/8 royalty interest, which commences upon production, and a 7/8 net production revenue interest that begins to pay out only after the operator recovers 200% of the cost of drilling and operation for the first well and 150% of the costs of any subsequent wells. For two orders issued to BP, because the chance of production was perceived as riskier, ODNR raised the risk penalty to 300% of costs for both initial and subsequent wells, but awarded the mineral owners a 15% royalty interest and 85% of net production revenue. One of the ODNR orders also required BP to pay the mineral owners a one-time payment, akin to a privately negotiated signing bonus.
In addition, the BP orders provide for forcing in “uncommitted working interest owners” — i.e., non-operating leasehold owners. ODNR compelled these leasehold owners to participate as if they had signed an operating agreement with BP. Here, too, ODNR prescribed a 300% risk penalty for the first and subsequent wells if the working interest owner cannot meet their financial obligations, i.e., to pay in their share of the cost up front.
Unitization as a Policy: Correlative Rights and Balancing Interests
As with mandatory pooling, unitization relies on the principle of correlative rights as a restraint on the rule of capture. The correlative rights doctrine (explained in Part 1), prevents a few recalcitrant landowners from standing in the way of development of their neighbor’s natural resources. In the Colescott South Unit, for example, Chesapeake had voluntarily acquired rights to 88% of the proposed unit. The doctrine dictates that the other 12% (who were mostly non-responsive, rather than overtly unwilling) should not be allowed to prevent the majority from reaping the benefits of the minerals owned by the majority.
But correlative rights works both ways: The same doctrine motivates ODNR to award “just and reasonable” royalty interests to the mineral owners who were forced into the unit. By relying on the correlative rights doctrine, unitization is ultimately a balancing of interests. In looking for the right balance, Ohio has found new use for an old law.