Participation Agreements in the Shale Plays
by Arthur Wright
Recently, unconventional plays have dominated the industry news. These plays require technical expertise and are “cash hungry.” Some companies have acquired significant acreage but lack the necessary funds to develop it in time to hold it under oil and gas leases with near-term expiration dates. Other players have cash to invest but lack technical know-how or the necessary acreage. Thus, companies are entering into joint development arrangements to participate in unconventional gas plays. One of the most common is a contractual relationship governing the joint exploration and development of specific assets or areas (a “Participation Agreement”).Variants include “Joint Exploration Agreements” and “Joint Development Agreements.”
Structure and Function of Participation Agreements
Participation Agreements range in length from two-page letter agreements to 60-plus page documents and normally include a Joint Operating Agreement for future operations and development of a project area. The parties (Participants) usually disclaim fiduciary obligations, joint liability, or the creation of a partnership or joint venture. The area to be explored and/or developed is defined by geographic area and/or geological structure. To avoid confusion it is important to describe applicable geologic formations with specificity, including descriptions of their depths by reference to existing wells.
Typically, all parties to a Participation Agreement are required to participate in the initial planned development, whether it is the first well in the overall exploration area or the first well in a specific prospect area. The Participation Agreement will then detail the procedures for proposing the development of further areas or prospects, including the initial well proposal for such prospects and the Participants’ elections whether to participate.
These procedures usually require that proposals for additional development areas include an expenditure authority, geologic information, and prospective feature and interpretative data for the area’s initial well. Each Participant then has a certain period of time to elect whether to participate. It may be advisable to include a mechanism to prevent less financially strong Participants from being forced out of prospects by an aggressive drilling program proposed by a larger Participant. A Participant that forfeits its interest in a prospect area for non-participation often forfeits its rights in a related area of mutual interest and to seismic and drilling results, and may be bound by a non-compete provision with respect to such prospect area.
Management and Development Issues
Given the vast undeveloped acreages frequently encountered in shale plays, the Participants may agree upon a plan of development (POD) to facilitate the prompt development of an exploration area, thereby reducing the risk of lease termination. A POD is typically limited to a certain period of time, and sets forth the Participants’ intentions regarding drilling and how to modify the plan.
Participants typically name one Participant (or its affiliate) as the operator. The party named as operator has primary responsibility for lease acquisition and making development proposals, and will carry out its duties in accordance with one or more Joint Operating Agreements governing actual operations and well proposals within established prospects. Where the exploration area is large, the Participants may elect to form a management committee to oversee broad development plans and ensure proper and timely development of the entire area. Limits are often set on bonuses, royalties and overriding royalty interests on new leases acquired in the exploration area. The Participation Agreement should set an overall budget for such lease acquisitions and have clear procedures for Participants to pay for and receive their interests in new leases. Similarly, Participants should specify procedures for acquiring, sharing, and interpreting seismic data.
The Participation Agreement should specify a required number of scheduled meetings per year, along with a list of information that must be provided to each management committee member prior to each scheduled meeting. Such information may include budgets, the operator’s drilling proposals and a look-back review of actual performance versus budgeted performance. The scope of information to be provided is often a point of negotiation when drafting the Participation Agreement. In addition to information provided in connection with meetings, Participants should have reasonable rights to audit the operator’s records regarding the financial aspects of the project.
The Participant who originated the project or who acquired the acreage frequently receives a carried interest for its efforts. The form of such carry can vary widely. When designing a carry, Participants should specify (i) whether the carry will apply to lease acquisition costs or only to the costs of drilling and completion, (ii) the amount of the carry, (iii) whether the carry is for dollars or a number of wells, (iv) an obligation to maintain records of the amount of carry paid and a right to audit such records, and (v) an affirmative election to treat the arrangement as a tax partnership to permit the deduction of intangible drilling costs attributable to the carried interest.
Arthur J. Wright serves as the Thompson & Knight Oil and Gas Practice Group Leader and focuses on acquisitions and dispositions of, and joint ventures relating to, E&P and midstream properties. He can be reached at Arthur.Wright@tklaw.com.