“Forced Pooling – An Expensive Sandbox”

The game seems to be awash with money. Untold millions have been deployed to buy minerals and leases from Carter to Dewey. How does a small shop acquire interests in units that are dominated by the likes of Continental, Cimarex, and Devon? Luckily, the Oklahoma Corporation Commission (“OCC”) provides a clear avenue to participate in the wells of others, but nobody is going to promise the non-operator a rose garden.

Fortunately, the anachronistic model form joint operating agreements promulgated by the AAPL are rarely used in the drilling of new wells in Oklahoma. A vast majority of new units are governed by an OCC Forced Pooling Order (the “Order”). For the purposes of this discussion, the Order simply governs the relationship between the applicant who will most likely operate the well, and the respondents who have yet to lease or assign their interests to the applicant. The respondents are given an election to either participate in the drilling of the well or to receive compensation in lieu of participating in the well while forfeiting their unit rights. The opportunity for the bold can be found in the respondents lists attached to the Order.

A respondent will usually have 20 days from the date the Order issues in which to make his election to the applicant. This means the company attempting to bust the unit or pooling (the “NonOp”) has a limited time frame in order to acquire an interest and perfect his election to participate. There are several steps to the process and each step has potential pitfalls.

ID Prospects

The initial step for the NonOp is to identify potential acquisitions from the parties listed on the respondents list. Considering the fact that most company landmen will salt the respondents lists with false leads to deter this behavior, the identification of prospects who actually own and interest and would be a willing seller are more difficult than the novice may believe.

Negotiations with the respondent

After the NonOp finds a potential acquisition, he still must come to terms with the respondent. In the SCOOP and STACK, it is common for many NonOps to get in bidding wars with each other to acquire the respondent’s interest. It is likely the interest may sell for a multiple of 2-4x the options provided for in the Order.  It should not be left unsaid that at this point, the NonOp has no confirmation of what the respondent actually owns, if anything. He could also be acquiring a much larger interest than he has the funds to pay for.

Diligence on pooled interest

Most NonOps, admittedly, do not complete diligence on their acquisition. He might take the respondent’s word about what he owned in order to close quickly and stop the bleeding of the bidding war. Some NonOps will attempt to acquire title from the company landman by pretending they are an independent landman representing the respondent. The NonOp should not expect many favors from the company landman at this point in the process as he is driving up lease prices in the prospect.

Closing on pooled interest

The NonOp’s initial outlay of cash is usually the consideration paid to the respondent. Some NonOps merely flip or assign their contract to another company and pocket the spread. Even so, he is responsible for paying the respondent for the transaction even if it is with other people’s money.

Electing to applicant

A critical, but still overlooked step is properly electing to the applicant to participate in the drilling the well. Little grace is given to NonOps for missing election deadlines.

Pre-paying well costs to applicant

One of the major disadvantages of acquiring an interest in the unit after the Order issues is the inability to negotiate more favorable terms for the payment of well costs. A majority of Orders require the payment of completed for production costs within 25 days of the date the Order issues. These prepayments can be a large outlay of cash and can be held without interest for the term of the Order. One acre in a 640 acre unit, even with a reasonable AFE of $5m, will still cost the NonOp ~$7,800 per acre. It doesn’t take a large interest to realize that even for relatively small interests, outside capital will usually have to be raised in order to participate.

Even after the election is made and well costs are paid, the NonOp still isn’t out of the woods. He has no say in operations and most likely has little to no relationship with the operator of the well. Furthermore, and maybe the most important point, he is completely reliant on the technical expertise of the operator as most NonOps don’t have geologists or engineers on staff. The mindset of “well, if Continental is drilling it, it must be good,” can be a dangerous one as they might not be as sensitive to costs as the NonOp, or it could be another factor like they are testing the edges of their concept or experimenting with a new completions technique. However one slices it, the NonOp is along for the ride.

There is no doubt that drilling wells with horizontal operators can be exciting and lucrative. However, it is important to remember that the large independents can drill some bad wells and take risks with their subsidized debt and still raise more money from Wall Street. A stubbed toe isn’t going to doom them in the eyes of a first year Barclay’s analyst. However, an unexpected bill for a month long fishing expedition for some parted casing could easily put even a well funded NonOp out to pasture. It can be an expensive sandbox, caveat emptor.

Stephen T. Clayman is a Petroleum Landman with an independent horizontal operator. He began his career in the oil and gas industry working worm’s corner and lead tongs for Cactus Drilling Company. Prior to his entry into the oil and gas industry, he served in the United States Marine Corps. He left the service as a Captain after two deployments in support of the Afghan War. He is a native Oklahoman and a graduate of the University of Oklahoma. He and his wife reside in Tulsa.

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