FEDERAL UNITIZATION EXPLORATORY UNIT AGREEMENT A combination of two agreements: Unit Agreement Unit Operating Agreement Unit Agreement Created under the Mineral Leasing Act of February

FEDERAL UNITIZATION

UNIT AGREEMENTS AND UNIT OPERATING AGREEMENTS

Tom Marranzino

DISCUSSION OUTLINE

1. INTRODUCTION

2. FORMATION OF A UNIT

3. DRILLING THE INITIAL TEST WELL

4. ESTABLISHMENT OF PARTICIPATING AREAS

5. UNIT ACCOUNTING

ACKNOWLEDGEMENTS

DOC CHURCHILL – CHAMPLIN PETROLEUM COMPANY

PAUL S. CONNER – UNITSOURCE INCORPORATED

BONITA LIMPUS JONES – LIMPUSJONES, LLC

FRED MAC DONALD – BEATTY & WOZNIAK P.C.

ROCKY MOUNTAIN MINERAL LAW FOUNDATION

Rule of Capture

The legal rule stating that there is no liability for producing oil and gas that was originally in place under the land of another, so long as the producing well does not trespass (13 Tex. L. Rev. 391, 393 (1935).

Rule of capture made it imperative that a mineral owner drill his land as quickly as possible to prevent drainage from another.

Implied covenant in oil and gas leases to prevent drainage.

The logical consequence of the rule was tremendous increase in drilling, waste and destruction of the reservoir.

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SPACING

To prevent waste, states promulgated regulations to allocate an area to a well that promoted the most efficient drainage of a reservoir.

Regulations vary by state and address both oil and gas reservoirs.

In the Jeffersonian system, spacing is allocated with rectangular units i.e. 40 acres, 80 acres, 160 acres, 320 acres and 640 acres.

Pooling and Communitization

The bringing together of small tracts sufficient for the granting of a well permit under applicable state regulations.

Example of pooling two leases under a 320 acre spacing unit.

Unitization

A term used to describe the joint operation of all or some portion of a producing reservoir.

Usually applied to situations where there are multiple spacing units and/or multiple sections.

Operating Agreement governs the relationship of the parties and the planned development of a reservoir under a joint operating agreement. Usually an A.A.P.L Model Form.

FEDERAL EXPLORATORY UNITSConventionalRefers to a unit formed to explore conventional and unconventional resources.Horizontal (WY)Refers to a unit formed for the new Niobrara Play. CBM (WY)Refers to a unit formed to explore coalbed methane gas.

DEVELOPMENT UNITSSECONDARY RECOVERY UNITS

WHY UNITIZE?

Enables the exploration of a large area where common geological and reservoir characteristics exist.

Ability to operate the area as a single lease.

Enables an operator to locate wells in the most desirable locations to maximize efficient reservoir recovery and minimize waste.

Minimizes surface disturbance and less degradation of the environment with fewer wells, roads and infrastructure.

Sharing in the costs and risks of exploration and production.

Relieves federal chargeability limitations. A single entity may not own more than 246, 080 acres within a state.

Extends Leases

FEDERAL EXPLORATORY UNIT AGREEMENT

A combination of two agreements:Unit AgreementUnit Operating Agreement

Unit AgreementCreated under the Mineral Leasing Act of February 25, 1920, 41 Stat. 437, as amended and described in the Code of Federal Regulations 43 CFR §3186.1 for the purpose of conserving natural resources.

An agreement between the Bureau of Land Management (BLM) and the proponent (Operator) of the Unit.

Unit Operating AgreementAn agreement between the Operator and other working interest owners within the unit boundary.

Two forms of Unit Operating Agreements:

Form 1 – Rocky Mountain Unit Operating Agreement - Oil and Gas (Undivided Interest) (May 1954) (RMOA-Form 1)An agreement in which the working interest owners agree to fix costs and share of production for the life of the unit. Interests do not fluctuate as participating areas expand or contract. Extent and uniformity of a prospect are known.

Form 2 - Rocky Mountain Unit Operating Agreement - Oil and Gas (Divided Interest) (Feb.1994) (RMOA – Form 2)An agreement in which the working interest owner’s share in production and costs is determined by its interests in a participating area. Generally selected when the extent and uniformity of a prospect are unknown.

GETTING STARTED

Preliminary Conference

Area and Depth Application

Preparation of a formal written application for designation as provided in 43 CFR 3181.2. The application includes:

Initial Drilling Obligation with the location of initial well or wells.

Unitized land and substances, including a description of the depth and formations. (i.e. “All oil and gas, including coalbed gas, from the surface of the earth to the stratigraphic equivalent of the base of the Mesaverde formation, which occurs at log depth of 4,943 feet as found on that certain Induction/Gamma Ray well log on the AR Fee 1890 5I well, located in SE¼ of Section 5, T-18-N, R-90-W, Carbon County, Wyoming, are unitized under the terms of this agreement and herein are called "unitized substances.“

Exhibit “A”

- Outlines the proposed unit boundary, and describes the amount and percentage of Federal, State, and Patented lands and total unit area.

- Further identifies boundaries of individual tracts within the unit.

Exhibit “B” - A schedule of ownership of all oil and gas interests in lands within the

unit area as presently known .

Exhibit “C” - a schedule showing Federal and State lease numbers and the acreage

to be included within the unit boundary.

Preliminary Approval

Letter from the Resource Management Group of the Bureau of Land Management designating the outlined area as a logical unit area.

Confirms proponent’s application for depth and formation of test well.

Special provisions and requirements.

Tract Commitment

As a general rule, the proponent of the unit must have 85% of all tracts committed to the unit to demonstrate to the BLM effective control of the unit area. BLM recognizes four categories of commitment of a particular tract to a unit:

1. “Fully committed,” means that all interest owners (record title, all operating rights and working interest owners, and all royalty owners, overriding royalty owners and production payment owners) are committed to the Unit.

2. “Effectively committed,” means all interest owners, except owners of overrides or production payments, are committed to the unit.

3. “Partially committed,” means, with respect to a fee tract, that the lessee and all working interest owners have committed their interest but the royalty interest is not committed. With respect to a state or federal tract, “partially committed” means that the lessee of record is not committed but the working interest owner is committed.

4. “Not committed,” means that less than 100% of the working interest owners have committed their working interest to the unit.

“Fully committed” and “effectively committed” tracts receive all of the benefits of unitization.

“Partially committed,” tracts are treated differently.No segregation upon unit approvalNo off lease drilling extension (although within the unit area, must drill on the lease to receive a drilling extension).No off lease production status (must HBP on a leasehold basis).

Both Wyoming and Utah provide by statute that the State must give its authorization to commit a state lease to a Federal Unit.

UNIT OPERATING AGREEMENTS

Unit Operating Agreements, both divided and undivided govern operations much the same as the more familiar A.A.P.L. Model Form 610 Operating Agreement. That is, it provides for the drilling of an initial well, subsequent operations, Operator’s responsibilities and duties and the relationship of the parties.

The agreements differ from the A.A.P.L. Model Form in that they provide for the above operations in concert with the Federal Exploratory Unit Agreement. Each addresses the drilling and the sharing of costs and expenses for exploratory and development wells and the distribution of revenue to the participating parties.

FORM 1 – Undivided Type Agreement (UOA)

Article 2 provides that all costs material and equipment shall be borne by the Parties in proportion to their respective Participating Interests and that available production shall be owned by the Parties in proportion to their respective Beneficial Interests.

“Participating Interest” of a Party means the proportion (expressed as a percentage) that the acreage of its Committed Working Interest or Interests bears to the total acreage of all the Committed Working Interests of the Parties; for the purposes of this definition (a) the acreage of the Working Interest in a tract within the Unit Area shall be the acreage of such tract as set forth in Exhibit B to the Unit Agreement and (b) if the Working Interest in a tract is owned by two or more owners, the acreage of such tract shall be apportioned among them in proportion to their respective Working Interests therein.

“Beneficial Interest” of a Party means the proportion (expressed as a percentage) that the net acreage of its Committed Working Interest or Interests bears to the total net acreage of all the Committed Working Interests of the Parties; for the purposes of the definition, the net acreage of the Committed Working Interests owned by a Party shall be calculated by multiplying the acreage of each tract in which it owns an interests, as shown in Exhibit B to the Unit Agreement, by the percentage of the oil and gas, including coalbed gas, which, if produced from such tract in the absence of the Unit Agreement and this agreement, would accrue to such Committed Working Interest after deducting Lease Burdens (whether payable in cash or in kind) shown on said Exhibit B as an encumbrance upon such Committed Working Interest, then adding all such interests together.

A simple example on a 640 acre working interest unit with 40 acre spacing for oil production is as follows:

Anadarko E&PCompany LP, etal

12.5% Royalty

St. Mary Land &Exploration Company, etal

12.5% Royalty12.5% Overriding Royalty

Committed Royalty & Revenue Beneficial Interest WI NRIAcres ORI Acres

APC 480.00 0.125 .875 * 480= 420.00 420/540 77.77778% 0.75 0.62847St. Mary Land 160.00 0.25 .75 * 160= 120.00 120/540 22.22222% 0.25 0.21528

540.00 Revenue will be distributed:

540/640= 0.84375 WI Share or Average Net Revenue Interest100/640= 0.15625 RI share of production

FORM 2 – Divided Type Agreement (UOA)

Article 6 - Apportionment Of Costs And Ownership And Disposition Of Production And Property (UOA)

Apportionment and Ownership Within Participating Area All Costs incurred in the development and operation of a participating area shall be borne by the Parties within the participating area on an Acreage Basis, determined as of the time the Costs are incurred.

All Production from a participating area shall be allocated on an Acreage Basis to the tracts of unitized land within the participating area.

Ownership and Costs Outside a Participating Area

All Costs incurred in the development and operation of a well drilled outside of a Participating Area are borne on an Acreage Basis determined by the working interest ownership within the established Drilling Block. If the well is completed as a producer but not in a formation included within a participating area, the well, production, materials and equipment, costs and all lease burdens shall be borne and paid by the Parties on the Drilling Block basis.

Section 9 – Drilling to Discovery (UA)

Commencement of the test well within six months following the effective date of the Agreement and drilled to the objective depth or until unitized substances are discovered.

Diligent and continuous drilling of the initial obligation well.

Drilling of additional test wells, with not more than six months being permitted to elapse between wells, until a discovery of unitized substances in paying quantities is made.

Upon completion of the initial well as a well not capable of production in paying quantities, failure to drill additional wells until discovery shall cause the agreement to terminate automatically.

Failure to drill the initial well will cause the agreement to be declared invalid ab initio (from the beginning).

Larger units will require additional obligation wells. In general, one well for each additional 15,000 acres.

Article 9 – Exploratory Wells (UOA)

Any party may propose a well on lands in which it owns a Committed Working Interest by proposing a Drilling Block which the party believes will be proved productive by the drilling of the well. As a general rule, the Drilling Block should approximate the spacing that would be in effect absent the formation of the unit.

Participation in the proposed well is on an Acreage Basis. This means the participation by each Party in the proportion that the acreage of its Committed Working Interest bears to the total acreage of the Committed Working Interests of all Parties in the Drilling Block.

Notice provisions are similar to those found in the A.A.P.L. Model Form both for drilling and completion.

Parties may object to the proposed Drilling Block and lands can be added or excluded at the Direction of Parties.

PRODUCTION IN PAYING QUANTITIES

Establishing production of unitized substances in paying quantities prior to the expiration date of the term of a federal lease.

The Federal regulations provide that a Federal oil and gas lease may be extended by commitment to a Federally approved unit if a well is completed on a committed tract that is capable of producing unitized substances in paying quantities (quantities sufficient to repay the costs of drilling, completing, and producing operations with a reasonable profit) prior to the expiration date of the lease. Production in such quantities on any committed tract within the unit boundaries is considered to be on, or for the benefit of, each committed lease.

YATES DECISION

The Interior Board of Land Appeals in Yates Petroleum Corp. (IBLA Decision 67 IBLA 246 (1982) concluded that a well capable of production in paying quantities on a lease basis (quantities sufficient to repay the costs of day to day producing operations) which is completed on a committed tract within a unit agreement will extend the term of all expiring Federal leases committed to the unit agreement for the life of the agreement or for as long as the well is capable of production in paying quantities, whichever occurs first.

If the leases are held by production by a Yates Decision, the terms and obligations of the unit agreement still apply. A well determined not to be capable of producing in unit paying quantities as defined by the terms of the agreement, but is capable of producing in paying quantities on a lease basis only, will require that the next unit well be drilled within six months of the completion date of the well or the unit terminates automatically.

Section 11 – Participation after Discovery (UA)

Provision provides for the establishment of a Participating Area (“PA”) upon completion of a well or as soon thereafter as required by the AO, which includes all lands then regarded as reasonably proved to be productive of unitized substances in paying quantities (quantities sufficient to repay the costs of drilling, completing, and producing operations with a reasonable profit) effective as of the date of the completion.

A separate PA is formed for each separate pool or deposit.

PA’s are revised to include additional lands which are then regarded to be productive or which are necessary for unit operations.

Operator submits a schedule of lands to be included which includes federal, state and fee lands.

PARTICIPATING AREA PREPARATION

Circle-Tangent Method - Wyoming

Spot well on unit map.Determine spacing in the absence of unitization.Draw a circle using the radius below encompassing the number of acres that would be included in a rectangular spacing unit.

Area = π x (radius)240 acre spacing = 745 feet80 acre spacing = 1,053 feet

160 acre spacing = 1,489 feet320 acre spacing = 2,106 feet640 acre spacing = 2,979 feet

UNDIVIDED VS DIVIDED TYPE UNITS

Undivided Type Ownership:

Divided Type Ownership: Lease Basis

First well in unit:Drilling Block

May include up to the number of acres specified in the UOA but generally includes the number of acres normally identified under state spacing regulations.Methodology varies by state. Can be rectangular or radial to include acreage expected to be drained by a well.

Wyoming is radialUtah generally follows State spacing.

Drilling Block Formation

Assume 640 acre spacing = 2,979 feetInclude every quarter-quarter section (40 acres) cut by more than one-half by the circle

Divided Type Ownership

If the initial well is capable of producing in paying quantities, then a participating area will be formed. The area covered by the PA will incorporate information obtained in the drilling of the well and may or may not be the same area as the drilling block.

If the well is not capable of producing in paying quantities, then it will be operated on a lease basis.

Ownership and Royalties

The determination of whether or not the well is capable of production in paying quantities determines not only the ownership of the well but the apportionment of royalties:

A Participating Area is approvedRoyalties for the Unit Well are shared on an acreage basis within the Participating Area. If a working interest owner receives an interest in production then so does the underlying royalty owner.Leases that are fully or effectively committed within the Unit are treated as HBP

A Participating Area is not approvedRoyalties for the Lease Well are paid to the mineral owner from which the well is producing.Operator must commence drilling within 6 months of completion to attempt to establish production in paying quantities to avoid unit termination.

During the time after a discovery in paying quantities and approval of a Participating Area by BLM, at a minimum it is advisable to pay royalty and overriding royalty owners on the lease from which the production is produced. Payment on production statutes, require in general that proceeds from the sale of production be made within 6 months of following the date of first sale.

Drilling a 2nd Well

Undivided Type Ownership: Identical to the initial test well

Divided Type Ownership:

Divided Ownership after drilling 2nd Well

1st Well Ownership

2nd Well Ownership

Expansion of PA

Divided Ownership after drilling 2nd Well

1st Well Ownership and 2nd Well OwnershipParticipating Area acreage is recalculated based upon the total acreage in the PA

Participating Areas for Horizontal Wells (WY)

The Resource Management Group requires the circle-tangent method to establish a Participating Area boundary unless additional information is available. The PA is established by constructing 40 acre circles around the terminus of the lateral and the entry point of the lateral into the participating area formation and then constructing tangents between each circle. All 10 acre subdivisions cut by the circles and the tangents will be included in the PA.

If a well is determined to be a nonpaying unit well, then a drilling spacing unit will be formed if the horizontal lateral intersects Federal and non-federal mineral interests. Upon establishing a spacing unit under State Regulations, a communitization agreement will be approved by the BLM.

INVESTMENT COST ADJUSTMENTS (UOA)

This is a “little ditty about Jack and Diane two American kids growin’ up in the heartland.”

Jack and Diane each invested $50,000 to buy a piece of the American Dream for a rental property.

Several years later Jack and Diane decided to buy a second house but they didn’t have enough money so they invited John Cougar to join with them in equal shares to purchase a $125,000 home.

Their agreement provided that each would also purchase a share in the two homes and ownership would be proportionate to their investment.

LEASE W.I. OWNER GROSS LEASE TRACT TRACTMIN AC W.I. FACTOR W. I.

1 Jack 10.00000000 0.50000000 0.50000000 0.250000001 Diane 10.00000000 0.50000000 0.50000000 0.25000000

2 Jack 10.00000000 0.33333340 0.50000000 0.166666702 Diane 10.00000000 0.33333330 0.50000000 0.166666652 John 10.00000000 0.33333330 0.50000000 0.16666665

Tract Acres (as is) 20.00000000 Jack 0.41666670Diane 0.41666665John 0.16666665

The accounting for the transaction looks something like this:

Credit Charge Total

January 1, 2007 1st HomeValue: 100,000.00$

Jack 0.5000000 50,000.00$ Diane 0.5000000 50,000.00$

1.0000000 100,000.00$ January 1, 2008

Second HomeValue: 125,000.00$

Jack 0.33333400 41,666.75$ Diane 0.33333300 41,666.63$ John 0.33333300 41,666.63$

1.0000000 125,000.00$

Investment Cost AdjustmentValue: 225,000.00$

Jack 0.41666700 91,666.75$ 93,750.08$ (2,083.33)$ Diane 0.41666650 91,666.63$ 93,749.96$ (2,083.34)$ John 0.16666650 41,666.63$ 37,499.96$ 4,166.66$

This was a little ditty about Jack and Diane, two American kids doing the best they can.

Oh yeah, life goes on……

Section 12 – Allocation of Production (UA)

Allocation of production under the Unit Agreement only establishes a basis for settlement of the royalty, overriding royalty, and production payment obligations of the working interest owners.

All unitized substances produced from a participating area established under this agreement shall be deemed to be produced equally on an acreage basis from the several tracts of unitized land, and unleased Federal land, if any, included in the participating area established for such production.

Each tract of Unitized land within a Participating Area is credited with such percentage of production as the number of acres of that tract bears to the total number of Unitized acres within the participating area.

Article 14- Supervision of Operations by Parties (UOA)

Each operation conducted by Unit Operator under this Agreement or the Unit Agreement shall be subject to supervision and control by the Parties that are chargeable with the Costs thereof.

Parties chargeable with the Costs of the operation shall have the right to vote in proportion to their respective obligations for such Costs. Agreements generally provide for 65% approval of the parties.

Section 18 - Leases And Contracts Conformed And Extended (UA)

“The terms, conditions, and provisions of all leases, subleases, and other contracts relating to exploration, drilling, development, or operation for oil or gas on lands committed to this agreement are hereby expressly modified and amended to the extent necessary to make the same conform to the provisions hereof but otherwise to remain in full force and effect.”

Provides for the “One Lease Theory” - operations performed upon any tract of unitized lands will be deemed to be performed upon, and for the benefit of, each and every tract of unitized land, and no lease shall be deemed to expire by reason of failure to drill or produce wells situated on the land therein embraced.

Any fee lease which, by its terms might expire prior to the termination of this agreement, is hereby extended beyond any such term so provided therein so that it shall be continued in full force and effect for and during the term of this agreement.

Any Federal lease committed to the Unit shall continue in force beyond the primary term, provided that production of unitized substances in paying quantities is established prior to the expiration date of the term of such lease; or, in the event actual drilling operations are commenced on unitized land in accordance with provisions of this agreement prior to the end of the primary term of such lease and are being diligently prosecuted at that time, such lease shall be extended for 2 years and so long thereafter as oil or gas is produced in paying quantities.

Section 20 – Effective Date and Term

Agreement becomes effective upon approval and shall automatically terminate 5 years from said effective date unless:1. Extended by AO2. Terminated prior to expiration because exploration revealed lands

incapable of producing unitized substances in paying quantities.3. Unitized substances in paying quantities have been discovered, in

which event, the agreement shall remain in effect for such term and so long thereafter as unitized substances can be produced in quantities sufficient to pay for the cost of producing same from wells on unitized land within any participating area established hereunder. (Notice this is not a paying quantities definition).

4. Voluntarily terminated by 75% of the working interest owners after the initial drilling obligation has been met.

General Requirements

Unit Requirement Conventional Unit HORIZONTAL CBM Unit

Size Size negotiated depending on well commitment

25, 000 acres 25, 000 acres or larger depending on well commitment

Formations Usually all depths Determined by proponent Surface to the base of the coal

Drilling Obligation Drill a single well within 6 months (two or more if a larger unit area)

Drill a single well within 6 months Drill 5-9 wells (depth and dollar dependent) within first 12 months

Continuing Obligation Drill every 6 months from completion until producing

Drill every 6 months from completion until producing

Drill 5-10 wells per year for 10 years

Productivity Requirement Paying well determination Paying well determination Single well producing 75 MCFPD or multiple well producing 300 MCFPD.

Participating Area Revisions Each well must receive a paying well determination

Each well must receive a paying well determination

Once productivity requirement met, any well drilled within 1,320’ of a PA (well spacing dependent)