ABOUT TDM
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Industry Practice in Equity Redeterminations
James G. Ross
Summary
Where an oil or gas field underlies both sides of a licence boundary, and the optimum development of that field is by the implementation of a single, integrated exploitation plan, it is common for the licensees in the field to negotiate a Unitisation and Unit Operating Agreement (UUOA) so that they may proceed with a unitised development (i.e. the field is developed as a single “unit”). Indeed, it may be possible for the relevant authorities to enforce unitisation on the licensees. The UUOA will cover the basis for the parties to work together (as in a Joint Operating Agreement), but will also document, inter alia, the equity split (or “tract participations”), being the percentage share of costs and benefits (production volumes or revenues) attributable to the parties each side of the boundary. In many of these agreements there is an opportunity for the tract participations to be modified in the future in a process known as equity redetermination.
Much of current industry practice in equity redeterminations has been developed in the North Sea and subsequently exported to other parts of the world.
Introduction
A key aspect of most, if not all, unitisation agreements (UUOAs) is that where redeterminations are permitted, the latest redetermined tract participations are assumed to be a better (more fair and equitable) estimate of the equity split than all previous estimates, whether made at the time of an earlier redetermination or at the initial unitisation. This is because the process of field development and exploitation provides more information about the field over time, primarily through the drilling of additional wells and monitoring of reservoir behaviour, and hence should permit a more accurate estimate of the proportion of the field underlying each side of the boundary. Consequently, implementation of the redetermined tract participations will require that both historical costs and production (either in revenue or volume terms) are adjusted in some way.
The recent article on "Unitization - A Mathematical Formula To Calculate Redeterminations", published in OGEL Volume I, Issue 01 (January 2003) set out a mathematical basis for implementing an adjustment following a redetermination. This approach was based on an adjustment wholly in monetary terms. For comparison, this paper will outline current industry practice in the North Sea. Similar approaches to that found in the North Sea have been also been seen in South East Asia and Australia.
Also, the authors of the above-mentioned article stated that many disputes arose in the redetermination process, both in the agreement of the redetermined equity split and in its implementation, “often resulting in arbitration and/or litigation”. However, industry practice in the North Sea in particular, and also in examples seen elsewhere, is to use expert determination rather than arbitration or litigation as the dispute resolution mechanism where the redetermination of tract participations cannot be agreed.
Background
The relatively more recent development of the offshore environment of the North Sea has led to some significant differences in industry practice in unitisation from that seen onshore North America. It is useful to consider the reasons for these differences, which stem from two distinct factors: optimum oil and gas field development practices, and ownership of the in-place resources.
Note that the following comments are meant as a simplistic overview - every oil/gas field is different.
In an onshore situation, in many cases a field may be initially developed simply by drilling roughly equally spaced wells across the field and it may be that overall recovery efficiency is not significantly impacted by the specific drilling schedule. Given the common situation in North America, where the landowner owns the underlying mineral rights, freedom to drill when and where the owner wanted was the general rule. This led to the situation that when a cross-boundary field was identified, each owner would drill as many wells as possible close to the boundary in order to "suck" as much oil as possible from the other side (i.e. the law of capture applied). This problem was eventually resolved by most states in the USA imposing well spacing or production quota restrictions. It is then only when secondary recovery techniques are to be applied that it is necessary to formally unitise the field, as this may require, for example, water injection wells being drilled on one landowner's property that will increase the oil recovery from wells on another's property. In such cases, the formula used for determining the tract participations often involves many technical parameters but, as the field is generally well-understood by this time, redeterminations are not considered necessary.
In an offshore environment it is often necessary to commit to a relatively inflexible development plan for the field prior to any production. For example, key decisions at this time include whether it would be better to have two production platforms or one larger centrally located platform, and is it necessary to include on the facilities the capability for water injection. At this point, knowledge of the field will be quite limited and more will be known after the development wells have been drilled and some production performance data are available.
The other factor, ownership, reflects the fact that virtually everywhere else in the world the in-place resources belong to the state. The state has a duty to ensure that its resources are developed in an optimum manner and hence it is usual for the relevant authority to have the right to approve all development plans. A plan for a cross-boundary field which only addressed one side of the field would not, in most cases, result in the optimum development of the field and would therefore not be approved. Consequently, it is usual for the UUOA to be negotiated in parallel with the development plan and, since the field is not well-understood at that time, provision for future redeterminations may be included. In any event, the country’s petroleum law may give the state the right to impose unitisation under specified circumstances. For example, in federal waters of the USA, the Minerals Management Service (MMS) has the right to impose unitisation to "(1) Prevent waste; (2) Conserve natural resources; or (3) Protect correlative rights, including Federal royalty interests".[1]
Where the field underlies licences awarded under the same terms (e.g. the same level of royalties), the state may not be concerned with the actual level of tract participations. However, where the terms vary, the state will want to have some say in the agreement. Where an international boundary is involved, the states will obviously be involved to a much greater extent, though many of the general principles of unitisation can still be applied (e.g. several fields have been unitised across international boundaries between the UK and its neighbours).
The formula used for computing tract participations is generally much simpler in agreements which pre-date primary development, though it is actually rare for them to be based on an estimate of reserves that will be recovered from each side of the boundary. Reserves are, by definition, the estimated economically recoverable portion of the oil or gas in the ground. In the majority of cases, these UUOAs are based on oil or gas volumes in-place. However, where the reservoir rock is highly variable in quality, the formula may include a weighting factor to adjust for the assumed differences in recovery across the field (e.g. the Markham gas field, which underlies the UK/Netherlands international boundary).[2]
Redetermination Adjustments
The standard industry approach in the North Sea does not require any specific formula for the implementation of redetermination adjustments as it is a fairly simple process that does not attempt to balance interests on a monetary value basis. As a consequence it may not always be perceived to be "fair and equitable", but the industry appears to accept it as it continues to be the usual mechanism. The adjustment is implemented as follows:
· Historical capital costs are adjusted immediately, in cash, and usually with interest;
- Historical production is adjusted on a volume basis, using a production overlift/underlift for a specified period following the redetermination (e.g. 12 or 24 months), with a cap on the proportion set aside for adjustment so that all parties maintain some cashflow. There is no mechanism to adjust for the likelihood that oil or gas prices will be different when the adjustment volumes are received from the prices that would have been received if the adjusted equity had been in place from the start of production. This is the primary reason why the adjustment may not be "fair and equitable" and in at least one case (Balmoral Field) it led to some parties wanting to reduce their equity interests in a redetermination;
· Operating expenses are not adjusted as these are payable in proportion to the share of production taken at any point in time.
I am not aware of any litigation in the UK with respect to disputes over this adjustment mechanism.
Dispute Resolution
As mentioned above, in the North Sea (and elsewhere) the primary mechanism for dispute resolution with respect to the redetermination of tract participations is almost invariably expert determination and not litigation or arbitration. This form of dispute resolution process recognizes that the issue is primarily a technical one and is therefore best addressed by an independent technical consulting company rather than lawyers (though lawyers are still likely to have some involvement). The process is, in almost all cases, explicitly addressed in the UUOA as not constituting arbitration and is therefore purely a matter of contract. Arbitration law does not apply to the process to be followed by the expert or to his decision, which would typically be stated in the agreement to be "final and binding". Expert determination is a well-established process under English law, being used to resolve many different types of disputes.[3] However, there may be significant differences in the way the courts view the process under other legal systems.
There have been a few examples of litigation in the UK where the expert's decision in an equity redetermination has been challenged in the courts but, under English law, such challenges will only be successful on extremely limited grounds (e.g. where the expert is found to have departed from his instructions in a material way or, where the UUOA specifically allows such a challenge, has made a "manifest mistake").
Summary
There are many North Sea fields that have been unitised and most are subject to at least one redetermination. The process for redeterminations, including adjustments and dispute resolution, is well established and has been applied in other parts of the world. It may not always be "fair and equitable" but the process does work reasonably well, in the sense that relatively few redeterminations end up being resolved by an expert and even fewer of those have been subject to subsequent challenge by litigation. If there is a problem, it is that the actual cost of each redetermination can be very significant, and this is one reason why it is becoming more common for fields to be unitised with fixed equity positions, i.e. not to permit any equity redeterminations, particularly where the field is marginal in terms of economic viability.
[1] Code of Federal Regulations, Title 30, Volume 2, 30CFR250.1300 (revised as of July 1, 2001).
[2] Sharples, D.M., et. al., The Markham Field, a Trans-median Development, paper SPE 28839, Society of Petroleum Engineers (1994).
[3] For a detailed discussion of expert determination, see Kendal, J., Expert Determination (3rd ed.) (London: Sweet & Maxwell, 2001).
