UNITIZATION FORMULAS NEED SCRUTINY

Scott B. Cline, Brian J. Stanley
Hefner Corp.
Oklahoma City

The participation formula is the most difficult matter to settle among interest owners in proposed oil field unitizations in the U.S. Interest owners should never assume that all participation formulas are equitable.

Such an assumption can be a costly mistake.

Different formulas result in a wide variation of possible unit interests. However, delaying or preventing unitization because of arguments over insignificant matters can also be costly.

In theory, unit participation formulas are based on sound engineering work and extensive geological data. The agreements are supposed to be carefully crafted to allocate to each owner an interest in the unit that reflects the relative value of his tract.

But in practice, this is not always the case. In some cases, limited engineering work or geological data underlie the participation formulas.

Also, sometimes, the formulas appear to be designed for m g the operator's revenue rather than for achieving fairness. As a result, participation formulas vary greatly, even among units with similar reservoir characteristics.

Unitization, of course, is the consolidation of separate tracts overlying a common reservoir so that many tracts can be operated as one. Unitization increases production efficiency and benefits all the unit's owners if the participation formula is equitable.

Every producing state except Texas has some sort of compulsory unitization procedure, and even Texas uses administrative orders to bring about what amounts to unitization.

To create the unit, all of these states be the consent of a certain percentage of the owners. On obtaining the statutory percentage, the applicant may create the unit over the objections of the minority dissenting owners. The required percentage varies from 62.5 to 85%.

Also, all states require the state agency with authority over oil and gas production to approve the unitization procedures and agreement. The agreement includes the participation formula.

COMMON PARAMETERS

The participation formula is the most important and difficult matter to settle. There is virtually no limit to the number of possible parameters in the unit participation formulas but there are certain factors that are frequently considered.

Disagreements often arise over not only what parameters to use but over what weight to give each parameter. Tracts are assigned a unit interest based on the tract's parameter values relative to the whole unit. Common parameters include:

Number of wells that are cased and usable in secondary operations
Recent stable production rates (i.e., the last 6-month average)
Cumulative barrels of oil equivalent (BOE) produced as of a given date
Estimated total primary oil production
Estimated total secondary oil recovery
Hydrocarbon pore volume (HCPV), which is acre feet multiplied by porosity and oil saturation
Rock quality, which is HCPV with an adjustment for low and high porosity
Productive surface area
Original oil in place
Floodable acre feet
Acre feet multiplied by permeability
Acre feet multiplied by porosity
Bottom hole pressure
Present value of future reserves.

In general, formulas can be divided in two basic categories:

Formulas that favor secondary recovery parameters such as hydrocarbon pore volume
Formulas that favor primary reserve parameters such as cumulative oil production.

The formula should, in theory, recognize the unit's stage of primary depletion.

Negotiations are more difficult when the wells in the proposed unit vary in age and are at differing stages of depletion.

Owners with older wells will support formulas based largely on cumulative production, but owners of newer wells w-M prefer formulas emphasizing current production rates and estimated ultimate production.

One common solution is to use a split formula that changes at a certain stage in the production life of the unit.

For early stages, split formulas usually favor current production rates while for latter stages, hydrocarbons remaining in place or ultimate recovery estimates are favored.

Although a state's conservation agency must approve the participation formula, owners must understand the state's role and not rely too heavily on the state for protection.

Conservation agencies have the dual and sometimes conflicting goals of encouraging efficient production and protecting the rights of individual owners. Normally, the agencies require a formula that reasonably calculates a fair revenue distribution from the unit's production. The agencies do not demand academic perfection, and they should not.

Competent engineers can and do differ over the best formula. A requirement of more than reasonable fairness could cause endless arguments and prevent unitization.

Still, owners should be aware of how lenient conservation agencies often are in approving participation formulas, and owners should take steps to protect their own interests. This can be costly and difficult. But relying on the operator's calculations can be costly.

For a large company with an engineering staff analyzing and negotiating a unit participation formula is routine. But for small companies a detailed reservoir engineering analysis may be too costly and is often not done for small waterflood units.

In this case the owner must decide whether his interest is large enough to war-rant his own engineering study.

Normally, the owner whose support for a unit is being solicited must specifically request a copy of the engineering report for unitization, if one even exists. Often the operator excludes it from the packet of information provided to the owner. Also, many times the plan specifies the proposed tract and unit interests but not the formula for calculating the interests. Of course, the owner should always request this.

Defining the unit's boundaries can sometimes be difficult.

Some operators might want to exclude leases near the edge of the common reservoir because the edges may be marginally productive. But this may be short-sighted if these excluded areas are drilled later and benefit from the waterflood without bearing their fair share of the costs.

Units must, absent valid geological or engineering reasons to the contrary, include the entire common reservoir. Conservation agencies will not intentionally approve a unit that excludes a portion of the pool.

Of course, negotiations are often concerned with whether a tract includes the common reservoir and, if so, what weight should the tract have. During negotiations, edge tracts might be excluded.

Although an interest owner should careful evaluate proposed revenue participation formulas and contest those that won't equitably distribute revenue, there is always a risk in extending negotiations or administrative adjudications.

The longer such negotiations or proceedings continue, the more likely it is that the unitization effort will collapse. Unit interest owners must weigh the economic effect of changes m participation formulas against delays in unitization caused by arguments over formulas.

EXAMPLE

Even though more than one formula might be acceptable to the state, this does not mean that all the formulas will generate the same revenue distribution to a given owner.

Five recently approved participation formulas (Table 1) for small waterflood projects demonstrate the wide variation in participation formulas that can occur even within nearby and as projects. All of these projects have very similar characteristics such as porosity, oil saturation, size, shape, depth, geologic formation, and stage of depletion The table indicates that a conservation agency does not necessarily require consistency in formulas.

Fig. 1 depicts a representative small unit typical of a Pennsylvanian age sandstone undergoing secondary recovery by waterflood. For simplicity, the example has only two tracts.

In Table 2 are the calculated unit interests and gross future revenue based on the first four formulas in Table 1.

It is evident that large differences in unit interests and future gross revenue can result from the recently approved unit participation formulas for similar fields.