Just as shale plays are dominating oil and gas production in the US in recent years, evolving rules and regulations governing the development of those resources are dominating legal services provided to E&Ps.
Oil and Gas Investor asked four of the top lawyers serving the oil and natural gas industry to identify and discuss their E&P clients' legal concerns.Issues related to shale are foremost concerns, as are shale-related regulatory issues, including increased oversight and more rules imposed by various governmental agencies; adapting surface vs. mineral rights; adjusting financing plans to fund the huge scale of resource plays; and educating the public and, in some instances, government officials, about the industry.
Participating attorneys were Richard Burleson, managing partner, Burleson LLP; Sharon Flanery, energy team leader, Steptoe & Johnson PLLC; Buddy Clark, partner, Haynes and Boone LLP (with additional commentary from Bill Nelson, the firm's chair of capital markets); and Sean Gorman, partner, Ahmad, Zavitsanos, Anaipakos, Alavi & Mensing PC (or AZA Law).Here are some of their thoughts.
Shale is “transformative”
“The recent changes that our energy clients have and will be experiencing in the oil and gas industry cannot be overstated,” Clark says.“The local, national and global impacts from increased production due to technological advances in long-reach multistage hydraulic fracture completions in unconventional plays has been nothing less than transformative.”
Flanery says: “Not only has the industry been radically revitalized, but operations have spread to regions never before, or only long before, exposed to major extractive industrial operations.The shock and angst of operators expert in conducting their affairs within well-defined legal and regulatory structures is palpable upon encountering the reality of states with immature legal and regulatory regimes.”
The concept of working to assist states to develop and shape modern legal and regulatory systems in the absence of sound historic roots is difficult for many operators to effectively engage, Flanery says.“To meet the challenges, law firms need to be thought leaders and problem solvers.They must provide deep understanding of the core jurisprudence of all US developing jurisdictions and act as translators of complex jurisprudential concepts across state boundaries.Clients need a 'big picture' litigation approach that is nationally influenced but state-specific in order to assure that cases reach all courts in a rational sequence, without excess negative factual baggage and with a rational and adoptable legal theory.”
The main difference between resource plays and conventional production is scale, says Burleson.“In many ways, it is due to the order of magnitude.For example, there's nothing basically unique about a title opinion in a shale play.But when you have 20, 30 or 40 rigs—covering maybe 1 million acres—the law firm must be able to provide legal services on a much larger scale.”
He also notes the new regulatory issues affecting operations.These include rules governing hydraulic fracturing, water use, reuse and disposal, surface matters and endangered species.“As part of that, we have the ongoing question of who actually makes the rules, states, the federal government, or increasingly, municipalities,” Burleson says.
Regulatory oversight
E&Ps are increasingly subjected to more regulatory requirements and filings, and more oversight from various federal and state agencies.The shale boom has led to new rules or the reconsideration of existing rules, due largely to horizontal drilling.
“Outside law firms will be called on to defend E&P companies' rights to explore and produce hydrocarbons more often than in the recent past, when the stakes weren't as high.Firms will need to develop new ways to engage regulatory agencies in order to influence the creation of new regulations and to moderate the effect of implemented regulations to protect their clients' ability to use the most effective well-completion technologies,” Gorman says.
Gorman notes that disputes over rights to explore and produce are increasing.Although prior regulation created economic burdens, it rarely threatened to destroy the entire value of certain assets, like fracing regulation now does.
“The sheer volume of companies conducting their business in such a public way, coupled with all of the media attention on shale plays, and the employment of large numbers of workers, gets the attention of regulators, plaintiff attorneys and others,” Flanery says.
She notes that the Occupational Safety and Health Administration (OSHA) is changing its program to address shale development.“For example, the industry is the focus of a renewed effort by OSHA to protect workers from exposure to silica, due to the use of sand in large quantities at well sites.The fugitive dust from the use of that sand in the fracing process has caught OSHA's eye and appears to be one of the drivers of the tightened, proposed rule.
“If put into effect, it will cause those involved with well drilling to take significant measures to reduce the fugitive dust and otherwise monitor and control the level of exposure of its employees to silica dust.Engineering controls, effective respirator programs and other efforts will need to be considered.”
The industry uses many independent contractors to do various tasks in the drilling and producing of wells, Flanery says.From abstractors to employees, independent contractors are used in practically every phase of the drilling process.The state regulators are now enforcing the requirements for these contractors to become licensed to do business in the states.
This can be a serious problem for drilling companies, because the regulators can fine the contractors and even shut down projects, until the contractors get all of the proper licenses.Seeing an opportunity to add to their coffers, municipalities are also looking for license fees, because many of them also require contractors to be licensed.Some drilling companies, faced with possibly shutting down their projects, are assisting the contractors in getting their licenses, even by hiring law firms to assist them.“We also see an increased risk of failure to comply with state law on wage payment to employees and overtime issues,” Flanery says.
The EPA and state environmental agencies are increasing permitting and reporting obligations.For example, air emissions are now subject to permitting and emissions limits, because of the increased air emissions from shale operations.
“Drilling activities as they relate to the Endangered Species Act have also become an issue.But the industry is heading down the right path by trying to pre-empt these issues through collaborative arrangements with groups like the Environmental Defense Fund,” Burleson says.
“Disclosure of fracing fluids is huge, and has become something of a lightning-rod issue for regulators and activists.Different states have different regulations, and the federal government is trying to overlay its own rules on top of those.That has raised a real question of whether a 'one size fits all' regulatory scheme works, or if policies should be left to state regulators, who have a better understanding of local geology, water resources, etc.,” Burleson says.
Regarding the Department of Labor and OSHA, it is a simple equation, Burleson says.“They're coming after oil and gas companies because that's where the money is.”
Clark identified trends the industry should expect under states' regulation of fracing.“States are moving toward greater regulation of fracing.Based on our survey of the laws related to fracing in over 20 states, plus various federal governmental agencies, we are seeing a growing emphasis on disclosure requirements; stronger regulation of produced fracing fluids disposal focusing on the protection of existing surface or groundwater assets; and requirements over replacement or remediation of contaminated surface or groundwater assets.”
States will also continue to jockey over their power to regulate oil and gas operations, while local communities try to control fracing and other drilling operations.“This state versus local battle will be fought in every producing state with multiple county and municipal stakeholders.The industry will have its hands full weighing in where appropriate and monitoring the outcome of these battles,” Clark says.
“Disputes over rights to explore and produce are increasing, and although prior regulation created economic burdens, it rarely threatened to destroy the entire value of certain assets, like the regulation of fracing does,” Gorman says.
Surface vs. mineral rights
“From a jurisprudential standpoint, the biggest question that states will need to settle, probably through case law, is where fracing that can be proven to cross property boundary lines and that facilitates draining of an unleased neighboring tract constitutes trespass,” Clark says.
Case law is currently limited, but the prevailing attitude seems to be that the rule of capture allows such drainage, unless the owner of the drained tract can prove damages outside of lost ultimate recovery from his tract.Another question is whether fracing that enhances production from one tract, but is detrimental to ultimate recovery for an entire unit, will be found to run afoul of the conservation efforts of state agencies, Clark says.
Burleson says the rise of horizontal drilling has also raised issues related to pooling and unitization.Different states have different rules about how to form a unit.Law firms working in multiple states have to understand the differences and the ramifications for drilling operations.“Once again, there is the matter of scale: The bigger the operation, the greater the potential impact on surface rights.And with the emerging development of stacked plays, we are having to sort through the myriad rights of mineral owners at varying formation depths,” he says.
“This state vs. local battle will be fought in every producing state with multiple county and municipal stakeholders.” Buddy Clark, Haynes and Boone says.Two major issues here are access to water rights and disposal of water.
Flanery notes that subsurface estates have always been recognized as having a right of surface use.“The law around the nation has produced various forms of a fair balancing test for the rights of surface and subsurface owners, generally known as 'the reasonable accommodation doctrine,'” she says.
“Given the longer laterals and larger frac jobs, we expect a greater increase in disputes between neighboring landowners and producers,” Clark says, due to the impact of completion operations on adjacent wells.
Does drainage of an adjacent property resulting from fracing constitute trespass?That remains a controversial issue.
Clark notes that in 2008, the Texas Supreme Court reversed the lower court decision that had found a producer liable for subsurface trespass in connection with natural gas.The natural gas was produced from hydraulic fracturing on the adjacent landowner's tract.The fractures were created by the producer's operations.
The Supreme Court declined to decide the general issue of whether fracing constituted trespass in the case, where the only damage claimed by the plaintiff was drainage, noting that then-existing technology could not prove the direction and length of the fractures.
The court instead held that the established rule of capture precluded a finding of trespass in that the plaintiff could self-protect and drill an offset well.Given advances in micro-seismicity, there may come a time in the near future where that decision gets revisited in Texas, or determined differently in other producing states, he says.
The value of leases and disputes over exploration and production rights are dramatically increasing, Gorman says.“The immense run-up in value of certain fields as a consequence of new horizontal drilling and fracing techniques has increased the economic incentive of landowners and competing E&P companies to challenge an E&P company's right to produce hydrocarbons from those fields.”
Gorman says his firm is seeing a growing number of disputes over whether leases, now of immense value as a result of new drilling and fracing techniques, terminated when their primary terms expired because continuous production in paying quantities had not been achieved prior to newly planned drilling and fracing programs.“A landowner's financial incentive to declare a lease terminated, and by doing so reclaim the ability to lease the mineral rights based on their new value, is huge,” he says.
Major shift in economics
In addition to the emergence of shale oil and gas opportunities, a major change the industry faces is a radical shift in the economic environment in which E&P activities are conducted, Flanery says.“The ability to prove and monetize reserves in place taking primacy over the production and marketing of resources has imposed a need for E&P company leaders and their counsel to hone a new vision and focus.
“We expect private equity, initial public offerings and other forms of transactional and development financing to continue to grow.The major new trend in E&P financing is the welcome entry of smaller private-equity investors who are quickly acclimating to their new area of operation and providing essential and important capital.”
Uses of capital are also evolving.“The way companies use capital to exploit plays is very different than it has traditionally been in conventional plays,” Burleson says.“Private equity, capital markets and joint ventures—including foreign national oil companies—have all emerged as important sources of capital and on a scale much larger than before.Also, the way that operators partner with providers of capital is more complex.
“The deal flow has been, and continues to be, substantial.We're seeing many companies divesting noncore assets in order to fund drilling operations.These deals require a lot of due diligence, a lot of corporate law work, and a lot of transactional work in general.”
Burleson expects IPO work will pick up.“Remember, we're still just coming out of the recession, and the capital markets are opening up and companies are seeing public funds as a low cost of capital.Companies have a large inventory of drilling positions, and it takes a lot of money to exploit those positions.IPOs are a cost-effective way to get it.”
Financing will take many forms, he says.“We're going to continue to see more IPOs, follow-on offerings, and joint ventures with foreign national oil companies.And, there will be more private-equity deals, and they'll get bigger and bigger.In other words, the move will be toward a more extensive use of capital in all of its available forms.”
More consolidation is on the way.“Big companies will get bigger, but they will spin off their noncore assets.Those assets will get picked up by smaller independents, which will take them and push the envelope for identifying yet more resource plays with the use of technology and innovation,” Burleson says.
Bill Nelson, chair of capital markets for Haynes and Boone, says: “Private equity has transformed the private E&P landscape.There has been a significant increase since 2004, although there was a downward blip during the first years of the recession in 2009-2010.Capital from private-equity shops is more aggressive and less patient than the prior investors.This formula has worked as commodity prices and property prices increase, but I am not sure if it is sustainable in a stable commodity environment or in a depressed commodity price environment to continue to expect 2% or higher return on investments.”
Nelson adds, “I think we will continue to see MLPs and other structures employed to take advantage of the tax benefits to E&P companies, including upstream IPOs.”
Foreign investment
Nelson expects to see plenty of interest from international firms in investing in the US “Our international projects practice is actively representing foreign investors, such as heavy industrial Japanese clients investing in resource plays but also considering moving manufacturing facilities to the US to be closer to take advantage of the lower-cost energy than in Asia and Europe,” he says.“HB has had one of the largest offices in Mexico City for more than 20 years and has participated in historical efforts to liberalize Mexico's oil regime.
“While we have recently worked on a couple of US export natural gas pipelines and were recognized as participating in the Latin American deal of the year involving a Mexican natural gas pipeline, there are potentially much greater opportunities for our US energy clients in direct investment in Mexico in the near future,” Nelson says.
The rapid run-up in value of US nonconventional producing properties has attracted overseas investment like never before, agrees Gorman, who represents a European company that has invested heavily in Texas shale assets.
Burleson summarizes the relationship between outside legal firms and E&Ps.“The bottom line is this: We're helping operators who have been working in a conventional world to be successful in, and seize the opportunities of, an unconventional shale world.Energy companies want what they've always wanted—informed lawyers who can give them good advice.The difference is that lawyers have to be more informed, on more issues, than ever before.”
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