The Texas 3rd Court of Appeals recently issued the Magnolia v. Opiela decision on Production Sharing Agreement (“PSA”) wells. While this case provides a nice history of pooling, allocation wells, and production sharing agreement wells, including some strong guidance that PSA wells do not implicate pooling concerns, I believe that the 3rd Court’s narrow ruling is as significant for what it does not cover, as for what it does.
What Opiela does establish:
A. PSA Well DOES NOT EQUAL Pooling
Opiela makes clear that drilling an HZ well under a Production Share Agreement or producing from a horizontal well traversing multiple un-pooled tracts pursuant to a Production Share Agreement, is not pooling. What a lease says about pooling is not relevant to the Commission’s determination of whether an operator has a sufficient good faith claim to drill/operate a PSA Well, which said determination, in turn, entitles them to a permit.
B. Actual Production Sharing Agreements are Required, Not Substitute Agreements
Where the Commission says that a threshold of 65% interest owners must consent to a Production Sharing Agreement, courts will hold operators to an exacting standard of obtaining actual Production Sharing Agreements. The Opiela court rejected the operator’s position that multiple purported functional equivalent agreements – Ratifications, Pooling Consents, etc. – could be used to satisfy the 65% threshold.
That a PSA Well DOES NOT EQUAL Pooling cuts both ways. Because a PSA is a contractual agreement to allocate production amongst separately leased tracts in the absence of pooling, pooling consent is not the functional equivalent. Primarily, this is because the division of proceeds is different under pooling vs. a PSA. The court intimates but does not expressly say, that functional equivalent documents could be sufficient to meet the 65% threshold if all instruments authorize the allocation of production from the HZ well in the same manner.
What Opiela does not establish:
A. Whether the 65% threshold required to obtain a PSA Well permit is a properly adopted rule.
Generally, a PSA Well permit will be granted if the operator can demonstrate that it has obtained production-sharing agreements from 65% or more of the working and royalty interest owners in the well. The Opiela decision traces this 65% threshold to internal staff guidance issued by the Commission in 2008, not the product of any sort of formal rule-making process. While the court notes that the Commission has both rule-making and adjudicatory powers to regulate oil and gas production and that the Commission may use its “informed discretion” to select which approach to use, rulemaking is stated to be the method best used.
The 3rd Court pointed out that the Commission’s PSA Well permit grant rested on its conclusion that Magnolia had demonstrated a good faith claim sufficient to obtain the permit. This in turn was based on the operator demonstrating that 65% of the interest owners had signed a PSA. This is an important point because the court then noted that whether this conclusion was proper hinges on whether the 65% threshold is a properly adopted rule. If not, then the permit would be founded on a legal error and must be reversed.
Ultimately, the court punted on this – what I consider to be the most crucial – question of whether the 65% threshold rule is in fact a valid measure. Instead, the court made a narrower ruling that, the legality of the rule notwithstanding, the evidence did not support a finding that the 65% threshold had been reached, based on the following:
- A PSA well does not equal pooling, therefore pooling consents and ratifications are insufficient to qualify as Production Sharing Agreements.
- Because the 65% threshold was a combination of PSAs, ratifications, and pooling consents, the operator had not actually obtained the required 65% PSA threshold.
- Because the threshold had not been met, the permit was invalid regardless of whether the underlying rule was valid. No need to pass judgment on the rule, which question is largely moot because the threshold had not been reached anyway. I believe that this is a prudent decision by the court; it highlights the need for clear PSA authorization from the Commission and/or Legislature while setting out the issue for the Texas Supreme Court should they decide to address the inevitable appeal.
For a more detailed insight into Magnolia v. Opiela, download the HELG paper.