58 th Annual Meeting - San Francisco June 13-16, 2012

1. Pooling In Resource Plays Allen D. Cummings 58th Annual Meeting - San Francisco June 13-16, 2012

2. Pooling in Resource Plays What is a Resource Play? • Society of Petroleum Evaluation Engineers has established technical characteristics including the following, among others: • Continuous hydrocarbons over large geographic area • Show repeatable Statistical Distribution of EUR • Hydrocarbons not found in a typical trapping mechanism such as a structural or stratigraphic reservoir – Shale is both the source rock and the reservoir • Production requires hydraulic fracturing

3. Pooling in Resource Plays What is a Resource Play? • To Land Professionals it is Shale Plays • Barnett Shale - North Texas • Haynesville - East Texas and Northwest Louisiana • Woodford – Oklahoma • Marcellus – Pennsylvania, Southern New York • Eagle Ford – South Texas • Bakken – Eastern Montana, North Dakota • Among others

4. Pooling in Resource Plays Why is Pooling an Issue in Resource Plays? • Many current Shale Plays are in areas previously exploited foroil and/or gas by vertical wells • There are many existing leases held by production (HBP) from other producing horizons (some from 1950’s) • Pooling clauses in HPB leases limit pooling for oil to 40 or 80 acres • Pooling Clauses in HBP leases do not work for horizontal wells • There are existing pooled units for vertical wells • Pooled Units pooled as to all depths • Possibility of interference with existing vertical wells • Current mineral and/or working interest owners unwilling to amend HPB leases or existing units

5. Pooling in Resource Plays Why is Pooling an Issue in Resource Plays? • 1950’s discovery of numerous oil reservoirs in the Williston Basin in North Dakota and Eastern Montana • Bakken shale became major resource play with 2000 discovery of Elm Coulee Oil Field in Eastern Montana – now producing +/-53,000 bbls/day • 1950’s discovery of Edwards limestone as a major producing reservoir in South Texas • Eagle Ford shale play took off in South Texas with discovery well in LaSalle County that produced large amounts of condensate with gas • Horizontal drilling and hydraulic fracturing technologies made exploitation of various shales economically viable • Horizontal drainholes require larger tracts than vertical wells

6. Pooling in Resource Plays How to Accomplish Pooling: • Voluntary Pooling • Implementing pooling provisions of oil and gas leases • Agreement among all owners of production in tracts to be pooled • Statutory Forced Pooling • Montana and North Dakota have Forced Pooling Statutes • Texas has Mineral Interest Pooling Act, but it has limited application • To examine pooling issues in Resource Plays compare and contrast pooling for oil in the Bakken shale with pooling for oil in the Eagle Ford shale

7. Pooling in Resource Plays Forced Pooling in Bakken Shale: • Montana §82-11-202 Pooling of Interests In Spacing Unit • Make attempt to voluntarily pool • Upon application of person owning oil and gas interest that has drilled, or proposes to drill, a well Montana Board of Oil & Gas Conservation, after notice and hearing, may order pooling of all interests in a permanent spacing unit and allocation of production in spacing unit. • Montana ARM §36.22.703 Spacing Units • Spacing Unit is area that can be drained by one well • Operator of a horizontal well may designate and obtain approval of optional drilling unit before drilling commences consisting of 2, 3 or 4 contiguous drilling units • 640 and 1280 acre drilling and/or spacing units common, but Operators are now seeking 2560 acre units

8. Pooling in Resource Plays Forced Pooling in Bakken Shale: • North Dakota §38-08-08Integration of fractional tracts • Pooling may be voluntary • Upon application or person owning oil and gas interest in spacing unit and after notice and hearing the North Dakota Industrial Commission may order the pooling of separately owned tracts or separately owned interests in all or part of spacing unit • See also NDC §43-02-03-16.3 regarding what must be included in a invitation to participate in drilling • See also NDC §43-02-03-15 regarding the size of drilling units in the absence of any order by the Commission • 1280 acre units seem to be common for undrilled Bakken shale, although some 2560 approved depending on lateral length

9. Pooling in Resource Plays Forced Pooling in the Eagle Ford Shale: • Mineral Interest Pooling Act Tex. Nat. Res Code §§102.001 et seq. • Applicant must make fair and reasonable offer to voluntarily pool • Field rules must exist establishing proration unit size • Maximum size of force pooled unit for oil is 160 acres • Only around 100 granted since statute enacted & used by parties to force their way into existing producing proration units • Application of Finley Resources, Oil & Gas Docket No. 09-0252373 • First and only time Applicant requested to force pool unleasedowners • Order permitting forced pooling very favorable to unleased owners • Allocated production on surface acreage basis • Limited to Finley, as Operator, to Barnett Shale

10. Pooling in Resource Plays Railroad Commission of Texas Rules – Horizontal Drainholes: • Rule 86 governs horizontal wells generally • Zero between well spacing rule allows horizontal drainholes to be drilled close to together to maximize effect of hydraulic fracturing and to maximize recovery of hydrocarbons • Take point rule allows distances to nearest lease line to be measured from the nearest take point so that Rule 37 Exceptions are not necessary • Box Rule allows horizontal drainhole to be in compliance with well permit so long as deviation is inside a box extending a stated number of feet either side of drainhole. • Rule 86 Additional Acreage sets forth acres that can be added to standard proration unit for a field’s rules for vertical wells.

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13. Pooling in Resource Plays Railroad Commission of Texas Special Field Rules: • Texas Operators have requested special field rules for shale plays • Most of those granted are for gas in Barnett and Haynesville • Application of EOG Resources, Inc. Docket No. 02-0264101for Temporary Field Rules Eagleville (Eagle Ford) Field, Karnes County Texas – Final Order March 2010 • EOG evidence that wells require 2500 to 3500 foot lateral with up to 30 stage fracture stimulation • 80-acre density for oil field • 330’ spacing to lease lines; 0 betw’n well spacing (wells 100 – 200’ apart) • 33’ box rule • No proration plats (P-12); file P-15 Statement Productivity Acreage • Field = correlative interval 10,294 to 10,580 continuous across area

14. Pooling in Resource Plays Railroad Commission of Texas Policy – Not in Rules • Approve Production Sharing Agreements for modified P-12 Proration Plat if 65% of royalty and leasehold owners approve • Drilling permits issued without production sharing agreement or pooling authority if Applicant has a good faith claim of right to produce from each of the tracts to be penetrated by horizontal drainhole • Takes no position on whether leases permit the Applicant to drill across lease lines in the absence of production sharing agreement or pooling authority • Requires no unleased interests intracts within field rule minimum lease line distance – not apply to tracts penetrated • Takes no position on allocation of production which is a contractual matter under between lessor and lessee.

15. Pooling in Resource Plays Texas Pooling Issues in Eagle Ford Shale Oil Zone: • HBP Leases (1950’s) that limit units pooled for oil to 40 or 80 acres precluding horizontal wells for oil • Existing pooled units pooled as to all depths or from the surface to the base of the Edwards limestone (which is below the Eagle Ford shale) • Refusal of lessors of existing HBP Leases to amend oil pooling to permit larger oil units on reasonable terms • Refusal of royalty and leasehold owners to ratify dissolution of units as to non-producing zones • Refusal of non-participating royalty owners to ratify leases covering tracts in which they own that will be penetrated by horizontal drainhole • No statutory authority to force pool unleased owners.

16. Pooling in Resource Plays Texas Pooling Issues in Eagle Ford Shale Oil Zone: • In absence of statutory forced pooling, Operators must deal with unleased undivided interests in tracts penetrated by drainhole according to common law cotenant rules • Unleased undivided cotenant owner must be carried by drilling cotenant(s) who bear the entire financial risk of a dry hole or a marginal well that will never payout • Non-drilling cotenant not entitled to share in production until drilling cotenant(s) recover 100% reasonable and necessary well costs • Rule 86 not establish any exception to Statewide Rules 37 and 38 for horizontal wells in the absence of special field rules • 467’ from lease lines • 1200’ between wells • 40 acre well density

17. Pooling in Resource Plays Alternatives for Dealing with Existing Units: • Amend or dissolve units pooled as to all depths so pooling is just as to the producing interval • Most standard form oil and gas leases do not expressly permit such amendments or dissolution • Without ratification by mineral, royalty and leasehold owners there is a possibility for litigation • Production Sharing Agreements • Treat exiting pooled unit as a single tract in a larger pooled unit including unpooled leases • Without agreement of all parties there is possibility of litigation • Ignore, drill and allocate production using “allocation yardstick” and allocate to owners in pooled units based on unit participation factor

18. Pooling in Resource Plays Browning Oil Co. v. Luecke, 38 S.W.3d 625 (Tex. App. – Austin 2000, pet. den’d) • Browning Oil drilled horizontal well and pooled leases covering tracts penetrated by drainhole in violation of lease restrictions on pooling • Court held the leases not validly pooled and therefore production could not be allocated under pooling clause based on surface acreage • Issue: In absence of pooling, how to allocate production to the several tracts penetrated by a horizontal drainhole. • Held: • Each tract penetrated by horizontal drainhole is drill site • Production in considered to take place only on the tract where production actually occurs (rejecting “confusion of goods” doctrine asserted by royalty owners of surface location tract)

19. Pooling in Resource Plays Browning Oil Co. v. Luecke, 38 S.W.3d 625 (Tex. App. – Austin 2000, pet. den’d) [Continued] • Held: • Each owner is entitled to their tract share of production allocable to each tract • Each tract penetrated by the horizontal drainhole is allocated the share of production attributed to each tract with “reasonable certainty” • How much production the is attributable to each tract penetrated by a horizontal drainhole is a fact question to be decided by the fact finder, be it a judge or a jury • Proof of how much production can be attributed to a particular tract along horizontal drainhole with reasonable certainty will require expert geological and/or engineering testimony • Battle of expert testimony

20. Pooling in Resource Plays Allocation “Yardsticks:” • Surface acreage in tract compared to total surface acres in unit, which is pooling clause allocation yardstick & is contractually agreed • Percentage of the drainhole length under each tract compared to total length of drainhole • Need to show that formation geological characteristics, fracturing techniques and take points make it reasonably certain that the amount of production being obtained at any one point on the horizontal drainhole is substantially the same as at any other point on the horizontal drainhole • Take point to take point drainhole length • Ratio of take points under each tract to total take points in drainhole • Need evidence that production from each take point is substantially the same at every take point on the drainhole

21. Pooling in Resource Plays Allocation “Yardsticks:” • How to deal with tracts penetrated with no actual production (e.g. no take points/no perf zone) from the tract • Absent pooling or agreement by all owners on allocation yardstick, use of any allocation yardstick to determine production attributable to each tract penetrated by horizontal drainhole may result in litigation • Will any allocation yardstick chosen meet the burden of establish the actual production attributable to each tract with reasonable certainty • Take points and frac stages developed after Browning Oil decision, so technology facts may be different today

22. Pooling in Resource Plays Partial Pooling/Communitization: • Can Operator pool some owners and allocate production as to these owners on surface acreage basis and pay the remaining owners based on an allocation yardstick; OR • Can Operatorobtain agreement of some owners to be paid on an allocation yardstick basis, and pay the remaining owners on that basis until they object • What factors should Operatorconsider: • If no one is paid Operatorwill be sued • What threshold of pooling and/or agreement of owners must be achieved to outweigh the risks of litigation to have the production attributable to each tract determined with reasonable certainty by a jury?

23. Pooling in Resource Plays Partial Pooling/Communitization: • What factors should Operator consider [cont]: • Will Operator end up with excess royalty to pay if Operator is paying owners using two different yardsticks, e.g. surface acreage and length of drainhole? • Will paying every owner on the same yardstick until they object reduce the risk of litigation • If Operator has signed division orders that may not protect it on payments made, because the issue is allocation of production not the ownership interest in production • Will Operator be protected by the rolling 4-year statute ol limitations for improperly paid royalty • Will full disclosure on allocation yardstick used protect Operator against claims for fraudulent concealment or just invite litigation

24. Pooling in Resource Plays Partial Pooling/Communitization: • Damage control when owners object: • Evaluate whether to continue to pay all pooled owners or owners who have agreed to an allocation yardstick • Evaluate risk that jury will find that production should have been allocated differently based on expert testimony about production attributable to each tract with reasonable certainty • Evaluate whether to suspend payments to objecting owner(s) or to interplead funds • Beware of the risk of defensive interpleader • Do you interplead only funds payable to objecting owner or all production • Interpleader puts all allocation in controversy, because Operator is saying to court it claims no interest in the funds interplead – court must determine how funds should be paid

25. Pooling in Resource Plays Partial Pooling/Communitization: • Damage control when owners object[cont]: • Evaluate monetary exposure if court determines that a different allocation of production was appropriate

26. Pooling in Resource Plays The NPRI problem: • Vertical wells could be located to avoid drill site NPRIs • NPRI owner’s fractional ownership in production from a tract can’t be diluted by pooling without NPRI owner’s consent • If Operator does not pool and allocates production using an allocation yardstick, then NPRI owner will be paid on a “lease” basis • If there is a community lease in which some of the tracts are burdened by NPRI, and others are not, the lessors’ interests are pooled, but the NPRI owner is not pooled • If drainhole penetrates NPRI tract, the NPRI will be paid on an undiluted basis based on production allocated to the tract • Look for lease language that says “all royalty payable on the lands covered by this lease will be paid from the royalty reserved in the lease”

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