ADMINISTRATION OF FEDERAL OIL

AND GAS LEASES IN NEW MEXCIO

By Gregory J. Nibert,

Hinkle, Hensley, Shanor & Martin, LLP*

I. INTRODUCTION

New Mexico has substantial production from fee (private), state (Commissioner of Public

Lands), Indian (allotted and tribal), and federal (administered by the Bureau of Land Management)

lands. First, this paper details the administration of federal minerals on the public lands by the

United States Department of the Interior, Bureau of Land Management ("BLM"), including issues

regarding leasing, transfers, segregation, and operations. BLM also administers oil and gas leasing

of Indian lands and Forest Service lands, but those matters will not be addressed in this paper. This

paper also discusses unitization, communitization, and compliance with state spacing regulations.

Related to pooling and communitization, this paper explores state forced pooling proceedings.

Understanding forced pooling is necessary for the proper management of oil and gas leases in New

Mexico.

II. FEDERAL OIL AND GAS LEASE ADMINISTRATION

A. Differences from Fee Leases: Federal oil and gas leases differ from leases of

minerals on fee lands in numerous respects. Lessees of federal land must deal with BLM in leasing

and operations. Federal lands, however, do not fall in one uniform category. The different types of

federal lands may involve different agencies, procedures, and leases or agreements. BLM authority

over federal lands requires filing of documents affecting title to the lease with BLM in addition to the

documents being recorded in county records. The documents filed with BLM must be on a

prescribed form and in multiple executed counterparts. BLM records, however, do not provide

constructive notice in New Mexico. Other agencies who have surface authority over leased lands are

also involved in various aspects of leasing and operations.

The federal statutes and regulations on oil and gas leasing, operations, and royalties limit

the contractual rights of the lessee. Notices to lessees, onshore orders, and resource or land use

management plans also restrict the lessee's contractual rights. Federal statutes which address

"public resource values" other than oil and gas may affect the federal lessee. Violations of

statutory, regulatory, or other requirements could result in fines, lease cancellation, and disbarment

from future leasing. The primary federal regulations affecting leasing and operational matters are

found in Title 43 of the Code of Federal Regulations, 43 C.F.R. Parts 3100 through 3180.

B. Leasing Authority: The Mineral Leasing Act of 1920, 30 U.S.C. Sections 181-263

(the "MLA"), replaced the claim location system, as to oil and gas, with procedures for permitting

and leasing. In comparison to the absence of federal control of mining claims patented under the

general mining laws, the MLA required lessees to pay rentals and royalties to the United States as the

lessor-landowner and to adhere to standards established by the Secretary of the Interior (the

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"Secretary") for oil and gas operations.

Under the MLA, as originally enacted, the Secretary was granted authority to issue two year

prospecting permits which gave the permittee the right to prospect for oil and gas on the lands

embraced in his permit containing up to 2,560 acres. Upon discovery of oil and gas in commercial

quantities, the permittee was awarded a lease to one-fourth of the area embraced in his permit at a

royalty rate of five percent. This lease was designated as the "A" lease. The permittee acquired a

preference right to lease the remaining three-fourths of the lands known as the "B" lease on which

royalty was based on a graduating rate from twelve and one-half percent to thirty-three and one-third

percent. Almost all of the "A" leases were lands within producing structures. Both types of leases

were considered as producing leases, and were issued for a term of twenty years with the right of

renewal for successive periods of ten years each under such terms and conditions as the Secretary

prescribed. Leases renewed after November 15, 1990, shall continue only for twenty years and so

long thereafter as oil and gas is produced in paying quantities and will not be further renewed.

Over the years, numerous amendments to the MLA modified the provisions and application

of the MLA. The most significant amendments are:

The Act of March 4, 1931, chapter 550, 46 Stat. 2148 (1931) (the

"1931 Act") permanently added to the MLA a change relating to

unitization originally contained in the temporary Act of July 3, 1930;

The Act of August 21, 1935, chapter 599, 49 Stat. 674 (1935) (the

"1935 Act") materially changed the original leasing act by granting

the right to prospect for oil and gas under a lease rather than a

prospecting permit and provided that leases were to be issued for a

fixed term with the customary thereafter clause and royalty not less

than twelve and one-half percent;

The Act of July 29, 1942, chapter 534, ' 2, 56 Stat. 726 (1942) (the

"1942 Act") gave a preference right to lessee of lease issued under

1935 Act on lands not within any Known Geologic Structure (KGS);

The Act of August 8, 1946, chapter 916, ' 15, 60 Stat. 958 (the "1946

Act") liberalized the 1935 Act in order to encourage prospecting on

the public domain and the discovery of new sources of supply of oil

and gas;

The Act of July 29, 1954, chapter 644, 68 Stat. 583 (1954) (the

"1954 Act"), commonly referred to as Public Law 555. The most

significant provision of Public Law 555 was the addition of language

to Section 31 of the MLA which provided that nonpayment of

rentals resulted in automatic termination of the lease;

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The Mineral Leasing Revision Act of September 2, 1960, Pub. L.

No. 86-705, 74 Stat. 781 (1960) (the "1960 Act") was a general

revision of Section 17 of the MLA as previously amended.

Section 27 of the MLA was also amended with regard to acreage

limitations in any one state or in the State of Alaska. New

language was added to the MLA relative to noncompetitive lease

extension, effectiveness of withdrawals, lands not within a KGS,

and noncompetitive lease extension. Section 42 was added to the

MLA, dealing with contesting Secretary decisions. This particular

provision also dealt with the question of segregation by

assignment;

The Act of October 15, 1962, 76 Stat. 943 (1962) (the "1962 Act"),

dealt with reinstatement of leases when rentals were not timely and

properly paid and this Act was further amended by the Act of May

12, 1970;

Title 3 of the Federal Land Policy and Management Act of 1976, 90

Stat. 2743 (1976), 43 U.S.C. '' 1701-1783 ("FLPMA") amended

Section 35 of the MLA;

The Federal Oil and Gas Royalty Management Act of 1982, Pub. L.

No. 97-451, Title I, ' 104(c), 96 Stat. 2452, 30 U.S.C. '' 1701-

1757 ("FOGRMA") was enacted as of January 12, 1983, and dealt

not only with onshore oil and gas leases but also with offshore oil

and gas leases and payment of royalty thereunder. It also amended

Section 31 of MLA relative to lease termination, lease reinstatement,

and royalty grades; and

The Act of December 22, 1987, the Federal Onshore Oil and Gas

Leasing Reform Act of 1987, Pub. L. No. 100-203, Title V, subtitle

B, ' 101(a), 30 U.S.C. '' 181, 187a, 187b, 188, 191, 195, 226(b)-(d)

and (f)-(h), 226-1, 226-3; 16 U.S.C. ' 3148 (the "Reform Act")

amends several sections of the MLA.

The Energy Policy Act of 1992, Pub. L. No. 102-486, 106 Stat. 3113

(Oct. 24, 1992), 25 U.S.C. ' 3501 et seq. (the "1992 Act"), changes

primary lease terms of competitive leases to 10 years and implements

various programs and funds for Indian Tribes.

These amendments changed the initial prospecting permit system to a competitive and non-

competitive leasing system that remains in effect today, although it has undergone some change

over time.

The 1935 Act established a basic oil and gas leasing process that was followed for 52 years.

The basic leasing system for the period from 1935 to 1987 consisted of competitive and

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noncompetitive leasing.

Prior to July 29, 1954, when public law 555 became law, the federal leases did not have

language which had the effect of making the lease an "unless" type lease, nor did the lease have the

1954 Act language which provided for additional drilling and reworking. No suspension royalty

exists under federal leases. Royalties and rentals must be timely paid to the Minerals Management

Service (MMS).

The 1987 Reform Act was a result of perceived abuses of the simultaneous leasing system.

The 1987 Reform Act changed the system so that noncompetitive leases are available only for lands

previously offered competitively and for which no acceptable minimum bid had been received. If no

noncompetitive offer is received within two years, the lands are again subject to leasing only

according to the competitive leasing process. All lands must first be offered for competitive bidding.

C. Federal Lease Forms: Since enactment of the MLA, various lease forms have been

adopted by the Secretary for utilization in the leasing program. A number of special stipulations also

have been promulgated which are attached to leases under certain conditions.

D. Status of Federal Land: The MLA authorizes the leasing of deposits of oil and

gas on lands owned by the United States. The MLA governs those lands designated as public

domain. Public domain lands are those lands or mineral deposits owned by the United States

which have not been disposed of under any of the public land laws. The public domain includes

lands acquired by cessation or conquest, lands exchanged for domain lands, lands that reverted to

the United States, lands that have never left the ownership of the United States, and all other lands

specifically designated as public domain. Public domain lands do not, however, include all lands

in public ownership. For example, lands subject to railroad or other rights-of-way may be

governed by the 1930 Right-of-Way Leasing Act (Right of Way Act, 30 U.S.C. ''301-306), not

the MLA. However, BLM has subjected some types of rights of way to leasing under the MLA

under regulations promulgated in 43 C.F.R. '3109.1 (53 Fed. Reg. 22,840 June 17, 1988). Lands

withdrawn from the public domain cannot be leased. Acquired lands may be leased under the

MLA, if the surface management agency consents. It is common for the surface management

agency to impose lease stipulations to limit the rights of the oil and gas lessee and address potential

conflicts over the use of the surface for oil and gas exploration and development operations.

Although most of the land in the national forests remain public domain land, the Secretary of

Agriculture is responsible for leases of lands within the national forests and has promulgated its

own regulations codified in 36 C.F.R. '' 228.100 - 228.116.

The determination of whether a given tract of public domain land will be leased rests in the

discretion of the Secretary. In addition, before lands are available for leasing, compliance with the

National Environmental Policy Act of 1969, 42 U.S.C. '' 4321, 4331-4335, 4342-4347 ("NEPA"),

the Federal Land Policy Management Act, 43 U.S.C. '' 1701-1784 ("FLPMA") and other statutes

relating to protection or conservation of various resource values is necessary. In other words, BLM

must undertake necessary studies prior to lease offer.

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Under the MLA definition of lands available for leasing, deposits of "oil, oil shale, gilsonite

(including all vein type solid hydrocarbons), or gas, and lands containing such deposits owned by the

United States," generally are available for leasing. Oil includes all nongaseous hydrocarbon

substances other than those leasable as coal, oil shale, or gilsonite. Gas includes natural gas

(methane and other hydrocarbon gasses), carbon dioxide gas (CO2), and according to a recent

solicitor's opinion (M-36935) gas produced by wells from coal beds. Federal oil and gas leases do

not cover helium, and helium extracted from oil and gas production under a federal oil and gas lease

is owned by the United States.

E. Lessee Qualifications. The MLA specifically authorizes four categories of interest

holders: United States citizens, associations of United States citizens, domestic corporations, and

municipalities. Associations include any form of unincorporated association such as: partnerships,

trusts, joint ventures, tenants-in-common, joint tenants, and husband and wife. Sole proprietorships

are not included as authorized owners; however, where the name of the sole proprietor can be treated

as unnecessary for an individual the interest will be deemed to be held by the individual. See

Winkler v. Andrus, 594 F.2d 775 (10th Cir. 1979). All members of an association must be United

States citizens.

1. Aliens: Aliens may not directly own an interest in a federal lease. An alien

may indirectly own an interest through stock ownership in a United States corporation, so long as the

aliens' country reciprocally gives the same rights to United States citizens.

2. Minors: Minors, as determined by state law where the land is located, may

not directly own record title to a federal lease, either individually or as a member of an association.

A legal custodian or guardian, however, may hold leases for a minor. The legal custodian must meet

the same qualifications as a lessee. It is unclear whether a minor may directly own a non-record

interest. The applicable regulation, 43 C.F.R. Section 3102.3, states "Leases shall not be acquired or

held by . . . a minor." The other regulations restricting aliens are phrased "Leases or interests

therein" which indicates that non-record interests in leases may be held by a minor.

3. Other Restrictions: Heirs and devisees must also qualify to hold an interest.

If a successor is not qualified, he or she must divest the interest within two years or lose the interest.

No member of Congress or employee of the Department of the Interior may own or hold an interest

in a federal oil and gas lease. The regulations do not expressly prohibit indirect ownership through a

corporation, particularly where a controlling interest is not held. In addition, the following persons

may be denied leases: trespassers on leases; a person found guilty of planning to circumvent or

defeat the MLA or of obtaining money or property by misrepresenting facts concerning federal

leasing; and a person found to have violated surface disturbance requirements or reclamation

standards.

F. Acreage Limitations: Limits on the number of acres in which a lessee can own an

interest are also considered as qualifications for lessees. A lessee may not hold more than 246,080

acres under federal leases in any one state, except Alaska where the limitation is 300,000 acres in

either Alaskan designated district. In addition, no more than 200,000 of those acres may be held

under options. Furthermore, an individual who owns more than ten percent of the stock in a

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corporate lessee (or in an association lessee) is charged his proportionate share of the corporation's

lease interests. Lands included within a unit agreement do not count toward the acreage limitation

requirements.

G. Bidding Process and Lease Issuance:

1. Competitive Leases: Under the Reform Act, all onshore lands available for

leasing by the Secretary shall be offered for competitive bidding. Competitive leases are to be issued

at oral auction, and the bid shall be at least in the amount specified by the Secretary as the minimum

acceptable bid for the tract. Competitive leases are to be issued for a primary term of five years.

2. Noncompetitive Leases: Noncompetitive leases are presently available only

for lands that have been offered competitively and for which no bid was received. Those lands are

available for acquisition under the noncompetitive leasing system for a period of two years following

the lease sale on a first qualified applicant basis. If more than one noncompetitive application is

filed for the same parcel on the day following the competitive lease sale, all applications shall be

considered to have been simultaneously filed, and only a single party priority application shall be

selected from the filings. Noncompetitive leases are to be issued for a primary term of ten years.

3. Sale Notices: Notice of competitive lease sale must be posted at BLM office

undertaking the issuance of the leases and at the local office of the surface management agency, if

any, at least 45 days before bid day. The notice shall specify when and where the sale will take place

and must include copies of all applicable stipulations to each respective lease. The notice will

usually contain bidding and payment requirements. The notice will also specify the date after the

auction that tracts, which received no qualifying bids at the sale, become available for

noncompetitive application. In addition, the notice will describe each parcel available for leasing in

such a manner that the parcels may be found in tract books or land plats maintained by BLM.

4. Oral Bidding: The sale is conducted by oral bidding on each parcel. The

highest bid at or above the minimum acceptable bid is the winning bid. No bid may be withdrawn,

and BLM will award the lease to the highest qualified bidder. The highest bidder must submit to

BLM on the date of the sale the minimum bonus bid of $2.00 per acre or fraction thereof, the first

year=s rental, and a $75.00 administrative fee. The balance of the bonus bid must be paid within ten

working days after the last day of the sale. If a bid is rejected for any reason, then the parcel will be

re-offered competitively.

5. Protests: After the notice of lease sale is posted, the public may protest either

the entire sale or the sale of specific parcels. If the protest is denied, the adversely affected party may

file an administrative appeal to the Interior Board of Land Appeals (“IBLA”). Following the

administrative appeal, an aggrieved party may seek review in a United States District Court.

H. Rentals:

1. Rental Rates. The terms of a federal lease provide for the payment of annual

rentals during the primary term or until production in paying quantities is established. The amount is

specified in the lease, but will vary depending upon the type and date of the lease.

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Rentals must be paid at the specified rate for the number of acres covered by the lease

or a fraction thereof, and there is no pro rata reduction in the rentals even if the United States does

not own the entire undivided mineral interest in the land subject to the lease.

2. Payment of Rentals.

(a) Manner of Payment. First year rentals are generally payable to the

Department of the Interior-Bureau of Land Management at the proper BLM office, the state BLM

office for the state where the lands are located. After the first lease year, subsequent rentals on

nonproducing federal leases should be paid to the Department of the Interior-Minerals Management

Service Royalty Management Program/BRASS, Box 5640 T.A., Denver, Colorado, 80217. Payment

of rental for the extended term for drilling over the end of the primary term or upon a segregation of

a lease is also paid to MMS, and the lessee should advise MMS that the payment is for the extended

term, and a copy should be sent to the appropriate BLM state office. Payment of rentals may be

made by personal check, cashier's check, certified check, or money order, or special arrangements

may be made for payment by such means as credit card and electronic funds transfers. Complete and

accurate records must be maintained by the lessee, operator, and other persons required to make

rental payments for purposes of demonstrating that rentals and other payments were timely and

properly made in compliance with the lease terms, applicable regulations, and orders. Such records

must be available for inspection and must be maintained for a minimum of six years. The lessee of

record is responsible for making rental payments. Such responsibility may be assigned, but MMS

must be notified of any assignment of such responsibility.

(b) Payment Date. First year rentals may be due at the time of the

competitive sale, when the application is filed, or in certain other instances, within a specified

number of days following an official notification. Payment for second and subsequent lease years

must be made on or before the lease anniversary date. Payment of full year rental will be required

even if less than a full year remains on the lease term. If the lease anniversary date falls on a day

when the MMS office is not open, payment must be received on the next day the MMS office is open

to the public. Late payment of rentals after the lease anniversary date results in the automatic

termination of the lease, unless the lease contains a well capable of producing oil or gas in paying

quantities.

There are instances when the payment of rentals falls on a date other than a lease anniversary

date. When this occurs, the automatic termination provisions of the lease are inapplicable. Such

situations may occur where a unit is involved. For example, segregation of a lease as result of

unitization and elimination from a unit may result in a different rental date from the anniversary date.

I. Royalty:

1. Production Royalty. Royalty on production is payable on the mineral interest

owned by the United States and is generally twelve and one-half percent. This royalty rate applies to

all MLA leases including exchange and renewal leases and leases issued in lieu of patented oil placer

mining claims except for (i) leases issued after December 22, 1987 resulting from offers to lease or

bids filed on or before December 22, 1987, which are subject to the rates in effect on December 22,

1987, and (ii) leases issued on or before December 22, 1987, which are subject to the rates contained

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in the lease or the regulations at the time of issuance. Other royalty rates may apply to leases that

have been properly reinstated by BLM following termination.

2. Minimum Royalties. After a discovery of oil or gas in paying quantities

on the lease, a minimum royalty is payable at the expiration of each lease year, except that on

unitized leases, the minimum royalty shall be payable only on the participating acreage. On

leases issued after August 8, 1946, and on those issued prior thereto, if the lessee files an election

under Section 15 of the Act of August 8, 1946, the minimum royalty is $1.00 per acre or a

fraction thereof in lieu of rental. On leases issued from offers filed after December 22, 1987, and

on competitive leases issued from successful bids placed at oral auctions conducted after

December 22, 1987, the minimum royalty is an amount not less than the amount of rental which

otherwise would be required for that lease year.

3. Royalty Reduction. The federal regulations (43 C.F.R. ' 3103.4-1) authorize

the Secretary to waive, suspend, or reduce the rental or minimum royalty or reduce the royalty on an

entire leasehold or any portion thereof upon a determination that such reduction or suspension is

necessary to promote development or that the leases cannot be successfully operated under their

terms. An operator seeking relief under this authority must submit a detailed statement of expenses

and costs of operating the entire lease, the income from the sale of any production, and all other facts

which would show whether the well could be successfully operated under the fixed royalty or rental.

Where the application is for a reduction in royalty, full information is to be furnished as to whether

overriding royalties, payments out of production, or other similar interests are paid to parties other

than the United States and the amount so paid and any efforts made by the operator to reduce these

other payments. The applicant must also file the agreement of the owners of burdens on production,

other than royalty, reducing these other burdens to an aggregate of not more than 1/2 of the royalty

due to the United States. Obviously, in many cases it was difficult to obtain the agreement of the

owners of production payments and overriding royalty interests to reduce these burdens, and

therefore it was unusual to see royalty reduced by BLM under this authority.

4. Compensatory Royalty. When lands in any federal lease are being drained

by wells either on a federal lease issued at a lower rate or on non-federal lands, the lessee is required

to drill and produce the wells necessary to protect against drainage. In lieu of drilling a protection

well, the authorized officer may allow the lessee to pay compensatory royalty. The authorized officer

may assess compensatory royalty adequate to compensate the United States for failure of the lessee

to drill and produce wells required to protect the lessor from drainage by wells on adjacent lands.

The operator, rather than paying the compensatory royalty, may drill and produce the protection

wells which conform to the spacing pattern authorized by applicable law.

III. ASSIGNMENTS AND OTHER TRANSFERS

A. BLM Requirements. The MLA authorizes assignments and subleases of federal

leases. The regulations specifically recognize assignments of record title, operating rights

(subleases), overriding royalties, and production payments. Interests in oil and gas leases may be

transferred to qualified persons, subject to filing and approval requirements. Lessee name changes

and corporate mergers, in states where the transfer of assets to the surviving corporation occurs by

operation of law, must be filed with BLM, but no approval is needed.

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An assignment of record title differs from an assignment of operating rights. Upon approval

of an assignment of record title, the assignor's obligations terminate with respect to the assignor's

interest, and the assignee is treated as the original lessee. Upon the approval of an assignment of

operating rights, the owner of the underlying record title remains obligated for all lease obligations.

Thus, an assignment of record title is similar to a common law assignment of a real estate lease,

whereas an assignment of operating rights is similar to the common-law sublease.

1. Assignments of Record Title. Record title ownership means the ownership

of the basic leasehold estate as stated on BLM records. The record title holder bears the obligation to

pay rent and has the right to assign or relinquish the lease. Record title can be assigned as to an

undivided fractional interest in all or part of the leased lands or as to the entire leasehold estate in all

or part of the leased lands. Transfer of one hundred percent of the record title in only a portion of the

leased lands results in segregation of the lease. Record title cannot be assigned by transfer of

particular horizons, as to part of a forty-acre legal subdivision, or separately as to either oil or gas

under a lease. BLM approval is required before an assignment of record title is effective.

2. Transfers of Operating Rights. Operating rights are those interests carved

out of the record title, and include the right to conduct drilling and production operations under a

lease. Operating rights may be created by assignment or by the execution of an operating agreement.

An assignment of operating rights may be limited to certain horizons or zones. The regulations (43

C.F.R. ' 3106.7-4) state that the approval of a transfer of operating rights is effective the first day of

the month following the date of filing in the proper BLM office.

3. Transfers of Other Interests. The regulations also specifically allow

transfers of overriding royalties and production payments. Assignments of other interests must be

filed, but BLM approval is not required. The creation, transfer, or perfection of liens or security

interests in federal oil and gas leases is not specifically addressed in the regulations. There appears

to be some inconsistency among the various BLM state offices whether mortgages and security

instruments will be accepted for filing and, if accepted, whether such instruments will become part of

the official or unofficial records. It is suggested that the mortgagee and/or secured party make an

effort to file such mortgage or security instrument in the appropriate BLM office in an effort to give

notice, actual or constructive, to third parties. State law governs the requirements for constructive

notice for state law actions.

4. Approval Process. A request for approval of a transfer of a lease or interest

therein must be filed within ninety days from the date of the execution of the assignment. If the

transfer is filed after the ninetieth day, the authorized officer may require verification that the transfer

is still in force and effect. For assignments of record title or transfers of operating rights, the lessee

must file a request for approval and must obtain BLM approval of the assignment or transfer.

Transfers of production payments and overriding royalties are required to be filed, but BLM approval

is not necessary. The effective date of approved assignments is the first day of the month following

the date in which all required documents relating to the assignment are filed in the proper BLM

office.

5. Filing. Assignments of record title or transfers of operating rights must be

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prepared on the current BLM approved forms, in triplicate, accompanied by a non-refundable $75.00

filing fee for each lease. If a number of federal leases are to be assigned, a "mass transfer" may be

used in lieu of separate assignments for each lease. Currently, three originally executed copies of the

mass transfer affecting multiple leases may be filed with the proper BLM office together with

exhibits showing the following for each lease: (1) the serial number, (2) the type and percentage of

interests being conveyed, (3) a description of the land affected by the transfer, and (4) a photocopy of

the assignment for each lease. The mass transfer must also be accompanied by a $75.00 filing fee for

each lease. Filings of name changes, corporate mergers, or transfers to heirs/devisees should be

accompanied by a $175.00 filing fee. To view the applicable fixed fee schedule, see 43 C.F.R.

3000.12 (2006).

6. Bond. If the record title owner or owner of operating rights was required to

furnish a bond, then the assignee must file a new bond or obtain consent to the assignment from the

surety of the old bond.

B. Recording - Constructive Notice. No federal statute (and the author is not aware of

any state statute) provides for constructive notice by the filing of documents with BLM. The purpose

of BLM records is for administrative and managerial functions of BLM over federal lands. On the

other hand, the purpose of county records is to maintain permanent repository for documents

affecting real property. Consequently, in order to impart constructive notice to third persons, the

state recording statutes must be followed, and all documents affecting a federal oil and gas lease

must be filed with the appropriate county clerk's or recorder's offices. This results in double filings

that have to made with respect to assignments of interests in federal leases, and two separate chains

of title to each federal lease. Although the filings with BLM must be on a prescribed form, the

assignment or other conveyancing instrument filed for recording in the county records may differ

from the federal form of assignment and may contain all the terms and provisions of the parties

agreement which are generally not included on the form submitted to BLM. The instrument filed

with BLM and the instrument filed in county records should refer to one another to avoid any

question on whether the parties intended to make only one assignment or intended to make multiple

assignments.

Although assignments of interests in federal oil and gas leases must be filed with and

approved by the BLM, validity of the assignment may not depend upon filing with and approval by

the BLM. Failure to file with the BLM and failure to obtain approval from the BLM might not affect

the relationship between the parties and the effect of their assignment. However, the assignment not

filed and approved by the BLM would not be effective against the United States.

IV. DURATION OF THE FEDERAL LEASE

A federal oil and gas lease grants to the lessee the exclusive right to drill for, mine, extract,

remove, and dispose of all of the oil and gas deposits except helium gas, under the described tract for

a specific term of years, with the customary "thereafter" clause, being "so long thereafter as oil or gas

is produced in paying quantities." Federal regulations, however, contain many specific provisions

that will affect the duration of the lease itself.

A. Lease Extensions. In general, there are eleven ways to extend a lease:

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1. Payment of rentals or minimum royalties extends the lease into the next year of its

primary term or extended term.

2. Production of oil or gas in paying quantities extends the lease. Paying quantities is

an amount sufficient to return a reasonable profit over and above costs of operating.

The BLM makes the determination of whether the lease is capable of production in

paying quantities.

3. Completion of a well physically capable of production in paying quantities extends

the lease. The well does not need to be actually producing, but the well casing must

be perforated and physically capable of production. The IBLA held in Amoco

Production Co., 101 IBLA 215, GFS(O&G) 31(1988), that shut-in gas wells may

qualify as a well physically capable of producing in paying quantities. In both

situations above, the emphasis is on obtaining actual production or showing clearly

that production can be obtained. However, if the lessee fails to place the lease in

production within sixty days of notice from the BLM to do so, the regulations,

43 C.F.R. Section 3107.2-3, provide that the lease will expire.

4. Actual drilling operations conducted in a diligent manner at and over the end of the

primary term will earn a two-year extension. Actual drilling operations not only

means "turning to the right" or "making hole," but also includes testing, completing,

or equipping a well for production. BLM will determine whether the operations are

being conducted in a diligent manner so as to earn the extension. Generally, a new

well must penetrate at least one formation recognized in the area as potentially

productive of oil or gas, and reentry of an existing well must penetrate at least one

new and deeper formation recognized in the area as potentially productive. A well

may be commenced and total depth reached during the primary term of the lease, but

it is possible that such operations may not result in the extension of the lease because

nothing occurs across the end of the primary term. Even if actual drilling operations

are conducted over the end of the primary term, many leases automatically terminate

for failure to pay rentals for the first year of the extended term prior to the expiration

date of the lease. Eleventh year rentals must be paid on or before the lease

anniversary date to prevent the lease from automatically terminating. Failure to

timely pay rental is a common and costly mistake.

5. Extensions Involving Unitization. With respect to unitization, leases may be

extended where there is: (i) drilling in the unit area over the expiration of the

primary term of a lease (extension for two years for such committed lease upon the

timely payment of eleventh year rentals); (ii) production in paying quantities

(extension for as long as lease is committed to the unit); (iii) termination of the unit

agreement (extension for remainder of term or two years, whichever is longer); or

(iv) segregation of a federal lease partially committed to a unit entitles the segregated

portion of the lease outside the unit to be extended for the remainder of its term or for

two years, whichever is longer.

6. Extensions Involving Communitization. With respect to communitization, leases

may be extended if the public interest requirement is met and where there is: (i)

12

production in paying quantities (extension for as long as there is such production);

(ii) drilling over the end of the primary term of a lease (extension for two years for

such committed lease upon the timely payment of eleventh year rentals); or (iii)

termination of the communitization agreement (lease continues for the remainder of

the primary term or for two years, whichever is longer, and so long as there is

production in paying quantities).

7. Discovery after Segregation by Assignment. Where a base lease has been

segregated into two separate leases by assignment and discovery is made on one of

the segregated leases, all of the segregated parts can be continued for the remainder

of the term or extended for two years, whichever is longer. Rentals on the

nonproducing lease must be paid to prevent termination of that lease.

8. Extension by Assignment and Segregation from a Producing Lease. Leases issued

prior to September 2, 1960, which are in their extended term, allow the undeveloped

portions of the lease that are assigned out of the base lease to continue in effect for

two years after the effective date of assignment. Otherwise, leases in their extended

term when segregation occurs shall entitle the nonproducing portion to an extension

of two years and so long thereafter as oil or gas is produced in paying quantities from

the nonproducing segregated portion. The nonproducing lease does not receive the

benefit of production from the segregated producing lease.

9. Compensatory Royalty. Where federal lands are being drained, in lieu of drilling

necessary protection wells, the lessee may, with the consent of the authorized officer,

pay compensatory royalty. The payment of compensatory royalty extends the term of

the lease for the period during which compensatory royalty is paid and for a period of

one year after the discontinuance of such payments.

10. Extension after Reinstatement. If the authorized officer finds that the

reinstatement will not afford the lessee a reasonable opportunity to continue

operations under the lease, the lease may be extended to provide adequate

opportunity. An extension after reinstatement is subject to the following limitations:

(i) no extension shall exceed a period equal to the unexpired portion of the lease or

any extension thereof remaining at the date of termination, and (ii) when the

reinstatement occurs after the expiration of the term or extension thereof, the lease

may be extended from the date the authorized officer grants the petition but in no

event for more than two years from the date the reinstatement is authorized and so

long thereafter as oil or gas is produced in paying quantities.

11. Extension for Subsurface Storage. Authorization for subsurface storage of oil or

gas, whether from federal or other lands, extends the lease for the period of storage

and so long thereafter as oil or gas not previously produced is produced in paying

quantities. Rentals must be paid during the period of storage.

B. Suspensions. Suspensions fall into two general categories: suspensions of rentals or

royalties, and suspensions of operations and/or production. These general types of suspensions arise

13

in various situations and are briefly identified below.

1. Suspension of Rentals or Royalties. BLM may suspend, waive, or reduce

rental or royalty in order to promote the development of leases or when the leases cannot be

successfully operated under their terms.

2. Suspension of Operations and Production. The suspension of operations

and production provisions of the MLA afford a period of relief to lessees who are unable to operate

for various reasons. Suspensions have been granted for severe winter weather, rig unavailability,

conflicts between mining claims and oil and gas leases, and delays in approvals to drill caused by

environmental studies or Environmental Impact Statements. Suspension of both operations and

production is possible when the BLM finds that suspension is in the interest of conservation of

natural resources. If both operations and production are suspended, the term of the lease is tolled for

the entire period of the suspension. In addition, a lessee is relieved of rental and royalty obligations

during the period of suspension of both operations and production.

C. Termination. A federal oil and gas lease will terminate as a result of failure to make

timely and proper rental payment, failure to discover or develop a well physically capable of

producing in paying quantities, cessation of production, or cancellation due to lease violations or

mistake. Cancellations differ from the other types of terminations in that cancellations require

administrative or judicial action, whereas the other terminations are automatic by operation of law.

A lease which has terminated for failure to discover a well capable of producing in paying

quantities during the term or for cessation of production cannot be revived. Production in paying

quantities, for the purposes of extending a lease, means production sufficient to return a profit to the

lessee, after operating and marketing costs. The term of a lease, if a producing well has not been

discovered, is for the initial primary fixed term of years or for an extended fixed term of years. Upon

expiration of the primary term or fixed extended term without a well capable of producing in paying

quantities, the lease automatically terminates. Discovery of a well physically capable of producing in

paying quantities will extend the primary term. The IBLA has held that although discovery of a well

capable of producing in paying quantities extended a lease for two years after the primary term, the

lease terminated at the end of the extended term because the well was not shown to be physically

capable of producing in paying quantities. The IBLA held in Jim's Water Serv., Inc., 114 IBLA 1,

GFS(O&G) 21(1990), that a lease expired even though it contained a well which was drilled over the

end of the primary term resulting in a discovery of production in paying quantities, because it was

not shown to be physically capable of production by the end of the extended term. A well capable

of production will not automatically extend the lease, if the well is not timely put into production. A

lease on which there is a well capable of producing in paying quantities terminates if the well is not

put in production within sixty days of an order from the BLM requiring production.

1. Cessation of Production. A lease in its extended term due to production will

automatically terminate upon a permanent cessation of production. The extended term continues

only "so long thereafter as oil or gas is produced in paying quantities." Once the well on a lease in its

extended term ceases to produce in paying quantities, the lessee has sixty days from receipt of notice

from the BLM to start reworking or additional drilling operations or to place the well in production.

If no reworking or drilling operations are commenced within sixty days after receipt of a notice of

14

cessation of production, or if reworking or drilling operations are timely commenced, but not

pursued with reasonable diligence in reestablishing production, the lease terminates.

2. Lessee Relinquishment. If the record title holder files a relinquishment of the

lease, the lease terminates. When a lessee voluntarily surrenders the lease by relinquishment, the

lessee remains responsible for any accrued rentals and royalties. Upon relinquishment the lessee

must plug and abandon the well and comply with all reclamation obligations.

D. Reinstatements. A federal lease may be reinstated after it automatically

terminates for failure to timely and properly pay rentals. The lease is reinstated for the remainder

of the original primary term or any extension and so long thereafter as oil or gas is produced in

paying quantities. Where the reinstatement occurs after expiration of the original term or an

extension, or where the reinstatement would not provide a reasonable opportunity to continue

operations, the lease may be extended up to two years and so long as oil or gas is produced in

paying quantities. 43 C.F.R. ''3108.2-2, 2-3 (2006).

E. Cancellation. Cancellation of a lease differs from a termination of a lease in that

cancellation requires action by the Secretary or a judicial proceeding, whereas termination by

operation of law is automatic. There are two general grounds for cancellation of a lease: (i) for

cause and/or (ii) error or mistake. Cancellation for cause arises where the lessee has either violated

or not complied with the MLA, regulations, orders, or lease provisions. Cancellation for mistake or

error arises when a lease has been issued through either administrative error or mutual mistake of the

authorized officer and the lessee. The Secretary may administratively cancel a lease where there has

been failure to comply with lease terms and no well capable of producing in paying quantities exists

on the lease or lands to which the lease is committed through a cooperative, unit, or communitization

agreement. Cancellation must occur through judicial proceedings in a United States District Court

whenever there is a well capable of producing in paying quantities on the lease or if the lease is on

lands committed to a cooperative, unit, or communitization agreement. During cancellation

proceedings a lessee can waive his or her rights to drill or to assign interests and obtain a suspension

of the lease term and rental obligations.

Cancellations do not adversely affect interests held by bona fide purchasers. A bona fide

purchaser is someone who purchases an interest in good faith, for valuable consideration, and

without notice of violation of law. However, a person cannot be a bona fide purchaser to a lease

where there is an active preexisting lease on the same lands, even when the BLM erroneously found

the preexisting lease had terminated and mistakenly issued a lease to the person claiming to be a

bona fide purchaser. The IBLA held in Petrolex 84-1 Limited, 118 IBLA 372, GFS(O&G) 18

(1991), that the subsequent lease on land already subject to a lease is void ab initio.

V. SEGREGATION

A federal lease will be segregated into separate and distinct leases upon the occurrence of the

following events:

Assignment of Record Title. Whenever one hundred percent of the

record title in a lease is assigned covering only a portion of lands

15

subject to the lease, the lands assigned and the lands retained are

segregated into separate leases. However, segregation does not occur

if the party making the record title assignment owns less than one

hundred percent of the record title.

Unitization. Where only a portion of the land subject to a federal

lease is committed to a unit, that portion not committed is segregated

into a separate lease. Segregation does not occur when a portion of a

committed federal lease is eliminated from a unit.

Federal lessees should understand the full impact of segregation issues that may arise when

assigning record title in a federal lease or committing the lease to a unit. Several of the obvious and

common effects of segregation are set forth below.

A. Separate Leases. The segregated portion of the lease is issued a new lease number,

and from that point forward the two leases are separate and distinct. The segregated leases shall each

retain the original anniversary date, terms, and conditions, including all special stipulations.

1. Operations and Production. After segregation, operations on and

production from one segregated lease will not serve to extend the other segregated lease.

2. Rental and Minimum Royalty Obligations. Each segregated lease shall

continue to maintain the rental and/or minimum royalty obligations that it would otherwise be

subject to, but the amount of such obligation due is calculated on the actual acreage of each

segregated lease. Whether there is production before or after segregation on one of the segregated

leases but not on the other, the productive segregated lease will be on a royalty status and the

nonproductive lease will be on a rental status. Where the base lease is producing prior to

segregation, the nonproductive lease will revert to a rental status upon segregation, even though the

term of the lease may be further extended by virtue of the productive base lease.

B. Unit Segregation Situations. Segregation of a federal lease upon commitment of a

portion of the leased lands to a unit may raise several lease maintenance issues. Where only a

portion of a federal lease is committed to a unit, the portion that is not committed is segregated into a

separate lease and shall continue in effect for the term thereof, but not for less than two years from

the date of the segregation. The uncommitted segregated lease retains its rental status, but automatic

termination for failure to pay rental does not apply in situations where additional rental may become

due on a date other than the anniversary date of the lease.

If the federal lease is in its extended term by reason of production and the lease is thereafter

partially committed to a unit so that the producing portion is included within the unit, and the non-

producing portion is segregated outside of the unit, the segregated non-productive lease is extended

for so long as oil or gas is produced in paying quantities from the segregated productive portion

committed to the unit. This exception is caused by Congress' use of the word "term" in the MLA.

"Term," as utilized therein, "means the entire term of the lease or period that the lease had to run,

whether that period was definite or indefinite as it existed on the date of segregation." Celsius

Energy Co., 99 IBLA 53, GFS(O&G) 82 (1987); Solicitor's Opinion M-36349, 63 I.D. 246,

GFS(O&G) SO-1956-47(1956). This is the exception to the rule that a segregated lease must stand

16

on its own. Solicitor's Opinion M-36592, GFS(O&G) SO-1960-39(1960), states:

1. Upon commitment of nonproducing portion to a unit prior to expiration of the

primary term of the lease (or its extended 5-year term), such production will not

extend the term of the unitized portion for the duration of production;

2. Where a lease is in its extended term by reason of production and the

nonproductive portion is committed to a unit, the segregated unitized portion will

continue during the life of production on the nonunitized portion, and if production is

obtained on the unit prior to the time production ceases on the nonunitized portion,

the unitized portion will continue for the life of the unit; and

3. That Section 17B of the Mineral Leasing Act (60 Stat. 952 (1946)) does not

provide for segregation of a lease which is partially eliminated from a unit by

contraction of the unit.

However, commitment to a unit agreement of a portion of a producing lease which is still in

its fixed term, will not entitle the uncommitted nonproductive segregated lease to an extension by

virtue of such production.

As a result of the Celsius decision, after September 8, 1987, simultaneous termination and

partial commitment of the lease to a new unit will not result in the non-unitized segregated lease

having a term coterminous with the new unitized lease. Prior to September 8, 1987, the IBLA held

that the non-unitized segregated lease had a term coterminous with the unitized lease, but not less

than two years from the date of segregation, and so long thereafter as oil and gas is produced on the

non-unitized lease in paying quantities.

Where only specific formations are unitized, segregation of the lease may be made along

horizontal lines so as to segregate the unitized formations from the non-unitized formations. After

W.C. McBride, Inc., GFS(O&G) BLM-1968-22(1968), the decision allowing horizontal segregation,

the Solicitor stated whether horizontal segregation occurs depends upon the intent of the parties to

the unit agreement, the facts and circumstances of the unitization, and the understanding of the

authorized officer when approving the agreement with respect to the reasons for and the goals to be

attained pursuant to such unitization. Solicitor's Opinion M-36776, GFS(O&G) SO-1969-15(1969).

The BLM has taken the position that it generally will not approve unitization of only specific

formations in an onshore exploratory unit which would result in a horizontal segregation. If

horizontal segregation occurs, the payment of rentals and royalties is based on the entire area

included in each segregated lease, notwithstanding the fact that a multiple payment may result for the

same land.

Leases covering the non-unitized portion of the lands, segregated by assignment, and leases

segregated upon partial commitment to a unit are entitled to an extension for at least two years

following the date of segregation. Following segregation by partial assignment, both leases generally

continue in effect for the longer of the primary term of the base lease or for two years following

discovery of oil or gas in paying quantities on either lease. As for leases issued after September 2,

1960, if the original lease is beyond its primary term and held by production at the time of

17

segregation, the unproductive segregated lease shall remain in effect for two years and so long

thereafter as oil and gas is produced in paying quantities. As for leases issued prior to September 2,

1960, and currently in their extended term, the nonproductive segregated tract shall remain in effect

for two years after the effective date of the assignment causing segregation, but will not have the

benefit of the production from the other segregated productive lease. For more discussion of the

effects of unitization on a lease, see Section X below.

VI. RENEWAL LEASES

An application for a renewal lease must be made by the record title owner and may be joined

in or consented to by the operator. The applicant is required to show whether all monies due to the

United States have been paid and whether operations under the lease have been conducted in

compliance with applicable regulations. The applicant or its operator must furnish with the

application for renewal, in triplicate, copies of all agreements for overriding royalties or other

payments out of production from the lease which will be in existence as of the date of its expiration.

The application must be filed at least ninety days, but not more than six months, prior to the

expiration of the term of the lease, and must be accompanied by a non-refundable filing fee of

$75.00.

Twenty-year leases issued under the original provisions of the MLA were entitled to

automatic ten-year extensions by a renewal lease. However, a 1990 amendment to the MLA Act of

November 15, 1990, Pub. L. No. 101-567 (codified at 30 U.S.C. ' 188(g)(4)), now provides for one

final renewal. "Notwithstanding any other provision of law, any lease issued pursuant to Section 14

of the Act shall, upon renewal on or after enactment of this paragraph, continue for twenty years and

so long thereafter as oil or gas is produced in paying quantities." Thus, leases renewed after

November 15, 1990, shall continue only for twenty years and so long thereafter as oil and gas is

produced in paying quantities and will not be further renewed. No regulation implementing this new

amendment has yet been promulgated by the BLM, but the amendment repeals, by implication, all

prior provisions of law concerning renewal leases of the twenty-year leases issued pursuant to the oil

and gas prospecting permit. This statutory amendment may very well have the effect of taking

property rights of vested lessees and, perhaps, may constitute a due process violation if enforced.

Both the 1946 Act and the 1954 Act provided for the extension of valid leases under certain

conditions. These provisions are no longer in effect insofar as leases issued under the Reform Act

are concerned.

VII. APPLICATION FOR PERMIT TO DRILL

No drilling operations nor surface disturbance preliminary thereto may be commenced prior

to the authorized officer's approval of an Application for Permit to Drill ("APD"). Form 3160-3,

must be submitted 30 days prior to the anticipated commencement of operations with all of the

appropriate attachments. 43 C.F.R. ' 3162.3-1(d). BLM must open the APD to comment from the

public for a period of 30 days. The operator must locate its well in conformity with an acceptable

well spacing program at a surveyed location approved or prescribed by the authorized officer.

Upon receipt of the APD or Notice of Staking, the authorized officer must make certain

information available for public inspection at least thirty days prior to any action to approve the

18

APD. The required posting shall be in the office of the authorized officer and in the appropriate

surface management agency, if other than the BLM. When an APD is received, the authorized

officer must consult with the appropriate federal service management agency and with other

interested parties. No APD may be approved before the authorized officer prepares an

environmental record of review or an environmental assessment as appropriate. These environmen-

tal documents will be used in determining whether an Environmental Impact Statement ("EIS") is

required and in determining any appropriate terms and conditions of approval of the submitted plan.

The regulations provide that not later than five working days after the conclusion of the

thirty-day notice period the authorized officer shall (i) approve the APD as submitted or with

appropriate modifications, (ii) return the application and advise the applicant of the reasons for

disapproval, or (iii) advise the applicant, either in writing or orally, of the reasons why final action

will be delayed along with a date such final action can be expected. However, it is not uncommon

for BLM to disregard these time periods in approving or disapproving APDs, particularly in

"sensitive areas." In the case of Indian lands, the action must be taken within thirty days from receipt

of the application. For lands administered by the National Forest Service, the surface use plan of

operations must be approved by the Secretary of Agriculture or his representative prior to the

approval of the APD.

If an APD is denied, the lessee or operator may request an administrative review within

twenty days before the appropriate BLM State Director. Any party adversely affected by a state

director's decision may appeal that decision to the IBLA. An adverse decision by the IBLA may be

appealed to the United States District Court.

Perhaps of more importance to the operator is the effect of the appeal process when the APD

is granted, not denied. Any interested or affected party may seek review of the order or decision of

the authorized officer. The authorized officer may grant approval of an APD in an area considered

by some to be environmentally sensitive. In such cases, it is common for environmental groups to

appeal the granting of the APD to the State Director and then to IBLA. See e.g., Michael Gold,

108 IBLA 231, GFS(O&G) 64(1989), on reconsideration, 115 IBLA 218, GFS(O&G) 40(1990),

reversed by the Secretary on June 25, 1991, GFS(O&G) SO-1(1991); Colorado Environmental

Coalition, 108 IBLA 10, GFS(O&G) 52(1989). The APD appeal regulation, 43 C.F.R. § 3165.4,

was amended to provide that all decisions and approvals of the authorized officer remain effective

pending appeal to the IBLA, unless the IBLA determines otherwise upon consideration of the public

interest. This is an effort to preclude the holding up of valid lease rights by a "41 cent appeal" from a

party who simply does not want the drilling activity to commence.

VIII. OPERATIONAL REGULATIONS

After the granting of the APD, and subject to any lease stipulations, NTL's, onshore orders,

or other conditions or modifications imposed by the authorized officer, the operator may enter the

land, build a location, and spud the well. The operator is required to conduct operations in a

manner which protects the mineral resources, other natural resources, and environmental quality.

The operator must exercise due care to assure that leasehold operations do not result in undue

damage to the surface, subsurface resources, or surface improvements. Without prior written

approval of the authorized officer the operator must drill its well without deviating significantly

19

from vertical. The regulations also specifically address instances of encountering high pressure

pockets and lost circulation and steps the operator must take for the protection of freshwater and

other mineral bearing formations. Of particular importance to the operator in relation to the

conduct of drilling operations is a regulation providing that a contractor on the leasehold shall be

considered as the agent of the operator for such operations with full responsibility for acting on

behalf of the operator for the purpose of complying with applicable laws, regulations, lease terms,

NTL's, oil and gas orders, and other orders, and instructions of the authorized officer.

The operator must keep accurate and complete records with respect to all lease operations

including, but not limited to, production facilities and equipment, drilling, producing, redrilling,

deepening, repairing, plugging back and abandonment operations, and other matters pertaining to

operations. Within thirty days after the well is completed, the operator must submit Form 3160-4

(Well Completion Report) along with two copies of all electric logs and other logs run on the well.

Upon request, the operator must submit to the authorized officer copies of other records

maintained in connection with the well. Not later than the fifth business day after any well begins

production on which royalty is due anywhere on a lease site or allocated to a lease site, or resumes

production where the well was off production for more than ninety days, the operator shall notify

the authorized officer by letter or sundry notice on Form 3160-5 or orally followed by a letter or

notice of the date on which such production has begun or resumed. In addition, all records and

reports must be kept for at least six years. The operator must notify the authorized officer by letter

or Sundry Notice on Form 3160-5, of the date upon which production has been begun or resumed.

All records and reports must be maintained for six years. After production has been established,

the operator must report monthly production data to the BLM until required to begin reporting to

the MMS.

IX. GEOPHYSICAL OPERATIONS

A federal oil and gas lessee does not have the exclusive right to conduct geophysical

explorations. Persons other than the lessee may conduct geophysical explorations on the leased

land if the requirements are met, and BLM, or other appropriate agency, approval is given.

X. UNITIZATION

Unitization is a method used to promote the conservation of oil and gas resources.

Section 17 of the MLA, 30 U.S.C. Section 226(m), and the regulations promulgated pursuant

thereto, 43 C.F.R. subpart 3105 and part 3180, provide that cooperative and unit plans must be

for the purpose of conserving the natural resources of the pool, field, or area involved and must

be determined by the Secretary to be necessary or advisable in the public interest. The purpose

of unitization is to allow the entire unit area to be operated as a single entity without regard to

lease boundaries, the goal of which is to maximize production by utilizing the most efficient

spacing pattern and minimize costs by providing, to the extent possible, common facilities to

service all wells within the unit area.

Unitization is an attempt to provide for unified development and operation of an entire

geologic prospect or producing reservoir. Unfortunately, the terms communitization, pooling, and

20

unitization are incorrectly, but commonly, used interchangeably. This leads to confusion and

precipitates miscommunication between parties.

The agreements for exploratory units differ from unit agreements concerning enhanced

recovery. Whenever the United States owns the mineral estate in more than ten percent of the lands

proposed to be unitized for an exploratory unit, the BLM will insist upon the use of the Model

Onshore Unit Agreement for Unproven Areas (Federal Unit Agreement) promulgated in the

regulations, 43 C.F.R. subpart 3186. There is no federal form of unit agreement for enhanced

recovery.

The unit agreement becomes effective upon approval, but the public interest requirement is

satisfied only if the unit operator commences actual drilling operations and diligently prosecutes such

operations in accordance with the terms of the unit agreement. If the public interest requirement is

not met, the leases committed thereto shall be treated as if the unit had never been formed, and any

segregation and extensions that occurred by reason of commitment to the unit shall be invalid. A

notice of the unit agreement and unit operating agreement should be recorded in the county records

in which the lands are located for constructive notice purposes.

A. Effect on Lease Maintenance. Unit formation affects several federal lease

maintenance issues. One of the primary benefits of unitization is that operations anywhere within the

unit are considered to be operations on each of the committed leases. Production of unitized

substances serves to extend all leases committed to the unit beyond their primary term and for so

long thereafter as the lease remains committed to the unit. Federal leases committed to the unit

remain in a rental paying status until production of unitized substances. The obligation to pay annual

rentals remains in effect for federal lease acreage outside of an established participating area.

B. Participating Areas, Allocation of Production, and Minimum Royalty. Once a

well is capable of producing unitized substances in paying quantities, the unit operator is required to

define the participating area, which should include all lands regarded as reasonably proven to be

productive of unitized substances in paying quantities or necessary for unit operations. Paying

quantities for purposes of meeting the drilling obligations of Section 9 of the Federal Unit

Agreement is defined as quantities of unitized substances sufficient to repay the costs of drilling,

completing, and producing operations, with a reasonable profit. Section 11 of the Federal Unit

Agreement provides that the unit operator shall submit such area for approval by the authorized

officer of the BLM to form the participating area. The effective date of the participating area is the

date of completion of the well or the effective date of the unit agreement, whichever is later. The

formation of the participating area is most important because in most unit agreements the

participating area determines who is entitled to a share of production. Allocation of production from

each participating area to the several tracts therein is made on an acreage basis.

Computation and payment of all royalty, overriding royalty, or payments out of production or

other burdens on the respective leasehold interests is on an acreage basis. However, the allocation of

production attributable to the working interests may be on an acreage, fixed percentage, or such other

basis as the working interest owners agree in a unit operating agreement.

C. Extensions. A well within the unit capable of producing sufficient quantities to pay

21

the cost of operating and marketing, but not sufficient to recover the cost of drilling, will temporarily

extend all federal leases committed to the unit. The IBLA held in Yates Petroleum Corp., 67 IBLA

246, GFS(O&G) 251 (1982), that such a well will extend all leases committed to the unit for six

months, being the period provided for commencement of the next obligation well. If no further wells

are commenced or only dry holes are drilled the unit agreement will terminate, and the leases will

receive the two year extension upon elimination from the unit. A federal lease may also be extended

for two years by actual drilling operations being diligently prosecuted over the end of the primary

term. If the unit is terminated or if the lands subject to the federal lease are automatically eliminated

from the unit pursuant to the terms of the unit agreement, the lease shall be extended for the

remaining term of the lease or for two years from the date of such event, whichever is longer, and for

so long thereafter as oil and gas is produced in paying quantities. However, if the public interest

requirement is not met, the unit agreement is void ab initio and no extension by elimination or

termination occurs.

D. Unleased Federal Land. Each unleased tract shall be considered a "Not Committed

Tract," unless the mineral interest owner commits the tract to the unit agreement and the unit

operating agreement. Under unit agreements prior to January 29, 1990, unleased federal land within

the unit would be considered a "Not Committed Tract." After January 29, 1990, BLM was instructed

to revise all subsequent unit agreements to include a provision to allow the United States to recover

its share of production from any unleased federal land within the unit. The regulations have now

formally been changed to provide for the payment of royalty to the United States for any unleased

tract within a participating area of a federal unit even though the tract has not been committed to the

unit. Sections 12 and 17 of the federal unit agreement should be reviewed to determine how this

issue should be resolved in a particular case.

XI. EFFECT OF STATE SPACING, POOLING, AND FORCED POOLING

A. State Spacing. Like most oil and gas producing states, New Mexico has enacted

legislation, the New Mexico Oil and Gas Act, Section 70-2-1 et. seq. (AOGA@), regarding the

establishment of spacing or proration units from which oil and gas may be produced with an

emphasis on protecting correlative rights without wasting oil or gas in the pool or wasting the

reservoir=s energy. To this end, the New Mexico Oil Conservation Division (AOCD@) has

established state-wide spacing and field pool rules for specific spacing where the facts indicate the

state spacing pattern should be altered to carry out the goal of protecting correlative rights and

preventing waste. 6 H. WILLIAMS & C. MEYERS, OIL AND GAS LAW ' 901, at 2 (2006). Section 70-

2-17(C) of the OGA provides as follows:

When two or more separately owned tracts of land are embraced within a

spacing or proration unit, or where there are owners of royalty interests

or undivided interests in oil and gas minerals which are separately owned

or any combination thereof, embraced within such spacing or proration

unit, the owner or owners thereof may validly pool their interests and

develop their lands as a unit. Where, however, such owner or owners

have not agreed to pool their interests, and where one such separate

owner, or owners, who has the right to drill has drilled or proposes to

drill a well on said unit to a common source of supply, the division, to

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avoid the drilling of unnecessary wells or to protect correlative rights, or

the prevent waste, shall pool all or any part of such lands or interests or

both in the spacing or proration unit as a unit.

Standard spacing requirements are based on the type of production (oil or gas), distance from

existing production (wildcat or development), the area of the state where the well is located

(Northwest or Southeast), and the depth of the producing formation. OCD Rule 104 sets forth the

standard spacing. Special pool rules may vary the standard spacing pattern for a designated pool.

Upon application, notice, and hearing the OCD has authority to increase or decrease the spacing unit,

permit unorthodox locations, and/or allow additional wells to be drilled within the unit. See

Sections 70-2-1 et. seq. N.M.S.A.

Pooling is the mechanism to consolidate leases and tracts of land to form a spacing or

proration unit. Pooling is the term utilized to reflect the consolidation of two or more leases to form

the spacing or proration unit. Communitization is the same concept where federal or state leases are

involved. On the other hand, unitization is a different concept, and the term is often misused as a

substitute for pooling or communitization, as is discussed above. Pooling may be voluntary, or in

New Mexico, may be forced by order of the OCD. Pooling and forced pooling are discussed below.

B. Pooling and Communitization. An owner might voluntarily contract with other

owners in an area to pool their interests into a single drilling or spacing unit. WILLIAMS & MEYERS,

' 923, at 509. Voluntary pooling is accomplished by the agreement of all interest owners, and a

Designation of Pooling should be recorded in the county records. See Owens v. Superior Oil Co.,

105 N.M. 155, 730 P.2d 569 (1986). While the focus is usually on agreements between working

interest owners to pool their respective leases, the royalty interests of lessors, overriding royalty

interest owners, non-participating royalty interest owners, and owners of other burdens on production

also require pooling. In most oil and gas leases and assignments creating these interests the power to

pool the interest is granted to or reserved by the working interest owner. Where the instrument

creating such interest is silent or does not provide for the power to pool in the working interest

owner, ratification of the pooling, joinder, or a forced pooling order must be secured. When a

federal lease is involved, the BLM must approve a communitization agreement, and when a state

lease is involved the Commissioner of Public Lands must approve a communitization agreement.

1. Effect. Once properly established either voluntarily or by forced pooling, as

discussed below, operations on and production from the pooled unit shall be deemed for all purposes

to have been conducted upon each tract within the unit. Production is allocated on an acreage basis

in the proportion the number of surface acres in the tract bears to the total number of acres in the

pooled unit.

2. Communitization Agreement Form. Federal regulations do not prescribe a

federal form of communitization agreement. The BLM Manual, Manual Transmittal Sheet Release

3-215 dated July 7, 1988, regarding 3160-9-Communitization, contains a communitization

agreement form "Model Form of Federal Communitization Agreement" that is generally followed.

The Commissioner of Public Lands for the State of New Mexico also has suggested forms of

communitization agreements when state lands are involved and can be accessed on its website at

www.nmstatelands.org.

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Generally, communitization agreements specifically define the communitized area,

communitized depths or formations, the substances communitized, and set forth the various

communitized tracts, including the acreage in each tract. The communitization agreement should

identify the formations and substances to be communitized and will usually only cover one

formation. The communitization agreement may also be limited to gas and associated liquid

hydrocarbons or to oil and associated gaseous hydrocarbons produced from the specified formation.

The BLM will not approve a communitization agreement that purports to communitize all horizons

below the surface. The authorized BLM officer and/or Commissioner of Public Lands must approve

the communitization agreement upon a finding that communitization is in the public interest.

The communitization agreement must be executed by all working interest owners and lessees

of record and should be either executed or ratified by the royalty, overriding royalty, and production

payment interest owners. When the communitization agreement covers unitized and non-unitized

lands, all royalty and working interest owners must sign the agreement; however, the unit operator

may sign on behalf of all committed unitized interests if the communitization agreement specifically

states that the unit operator is executing on behalf of all such interests.

The executed agreement must be filed with the proper BLM office in triplicate. However, it

is advisable to submit sufficient executed copies to allow the BLM to retain three copies after

approval, plus a sufficient number of extra copies to submit to any appropriate state agencies, and a

copy for recording in the county for constructive notice purposes.

Approved communitization agreements are effective from the date of the agreement or from

the date of production from the communitized formation, whichever is earlier, except when the

spacing unit is subject to a state pooling order after the date of first sales. In that case, the effective

date of the agreement may be the effective date of the order. Approval of the communitization

agreement shall be invalid if an application for voluntary termination is received during the fixed

term or if the agreement automatically expires at the end of its fixed term without satisfaction of the

public interest requirement.

(a) Extension of Leases. Production on any tract within the

communitized area will be considered as production on all tracts. The leases covering the several

tracts will be regarded as producing leases and shall be extended beyond their primary terms. Unlike

unit agreements, inclusion of only a portion of a lease in a communitization agreement does not

effect a segregation of the lease, and all lands subject to the communitized leases are maintained by

virtue of production from the communitized area. Production in paying quantities for purposes of

extending a federal lease committed to a communitization agreement is defined as quantities

sufficient to yield a reasonable profit over and above the marketing and operating costs. This

standard does not require that drilling costs will ever be recovered, as in the case of a unit well

determination. Under the current regulations, the communitization agreement must be filed with the

BLM prior to the expiration of the communitized federal lease or leases.

If the public interest requirement is satisfied, a federal lease eliminated from an approved

communitization agreement or any federal lease in effect at the termination of the agreement shall

continue in effect for the original term of the lease or for two years after elimination or termination,

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whichever is longer, and for so long thereafter as oil or gas is produced in paying quantities. 43 C.F.R.

' 3107.4. In contrast to the regulations, the IBLA has held in R.E. Hibbert, 8 IBLA 379, GFS(O&G) 6

(1973), that when federal lease is committed to a valid communitization agreement which expires upon

cessation of production in paying quantities and additional drilling or reworking operations are not

conducted within sixty days after cessation of production as provided in 43 C.F.R. ' 3107.2-2, the

lease expires notwithstanding extension provisions of 43 C.F.R. ' 3107.4. But as noted in 2 LEWIS C.

COX, LAW OF FED. OIL & GAS LEASES, UNITIZATION AND COMMUNITIZATION, ' 18.08[5] (1993),

Hibbert, although it has not been overturned, does not appear to be good law. There is not a similar

extension provision for New Mexico state oil and gas leases.

The public interest requirement will be satisfied only if the well dedicated to the

communitization agreement has been completed for production in the communitized formation at the

time the agreement is approved, or if the operator thereafter commences and/or diligently continues

drilling operations to a depth sufficient to test the communitized formation or establish to the

satisfaction of the authorized officer that further drilling of the well is unwarranted or impracticable.

(b) Allocation of Production. Generally, each tract within the

communitized area is allocated production based on the number of acres in said tract, divided by the

total acreage of the communitized area, multiplied by the production of communitized substances.

C. Forced Pooling. If an owner within a spacing unit refuses to voluntarily pool his

interest, the OGA allows the parties wishing to drill the well to force the uncooperative owner to

pool its interest. Section 70-2-17(C); see also WILLIAMS & MEYERS, ' 905.1, at 16. Forced pooling

proceedings are common in New Mexico. Forced pooling generally arises when an unleased mineral

owner refuses to join in the proposed drilling operations or one or more working interest owners

cannot agree on who will operate and how operations should proceed. Such proceedings may also be

used to secure the joinder of royalty owners and owners of other burdens on production who refuse

to consent to pooling.

The concept of compulsory pooling first arose in the 1920s through certain municipal zoning

ordinances that limited drilling within the municipal boundaries to one well per each designated

spacing unit, with nondrilling owners sharing in production of that well. WILLIAMS & MEYERS, '

905.1, at 14-15. In 1935, New Mexico and Oklahoma became the first states to enact compulsory

pooling statutes, inspiring many other producing states to enact similar statutes to prevent waste

caused by excessive drilling. WILLIAMS & MEYERS, ' 905.1, at 16-18. Generally, compulsory

pooling statutes require owners of small or irregularly shaped tracts of land to develop their lands as

a single drilling unit of prescribed size. WILLIAMS & MEYERS, ' 901, at 3. While other states, such

as Texas, have compulsory pooling statutes, the procedure is rarely used. In New Mexico, however,

compulsory pooling is a commonly practiced procedure; and therefore, knowledge of its effects on

administering leases in New Mexico is significant.

1. Authority. Authority for compulsory pooling in New Mexico is found in

Article 2 of the OGA. NMSA 1978, ' 70-2-17. OCD may order compulsory pooling of interests

within an established spacing or proration unit Ato avoid the drilling of unnecessary wells or to

protect correlative rights, or to prevent waste.@ ' 70-2-17(C). Nonconsenting parties face a

nonconsent penalty of up to 200 percent of development and operation costs. Id. The statute further

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states that such orders shall be made only after certain procedural requirements are satisfied. Id.

2. Attempt Voluntary Pooling. An operator must attempt to obtain consent for

voluntary pooling of all interests within the spacing or proration unit. When consent is not obtained,

the operator may then commence force pooling proceedings. Failure to obtain either voluntary

pooling or an order from OCD results in the operator having to pay to each interest owner the greater

of the interest it would be entitled to if pooling had occurred or the amount it is entitled in the

absence of pooling. 70-2-18(B). This exposes the operator to having to pay the owners of the tract

on which the well is located their share of 100 percent of production and owners of the other tracts

within the spacing or proration unit their prorata share of production from the well.

3. Procedure. OCD has enacted a number of procedural regulations found in

Title 19 of the New Mexico Administrative Code. 19.15 NMAC (2005). The forced pooling

procedures can be divided into four parts: (i) an application must be filed; (ii) notice must be given;

(iii) a hearing must be held; and (iv) an order must be issued.

(a) Application. Any person with standing, which includes OCD,

attorney general, and any operator or producer, may file an application with the OCD to establish a

compulsory pooling unit. 19.15.14.1206 NMAC (2005). The application must include (i) the

applicant=s name, (ii) the applicant=s, or their attorney=s, address including an e-mail address and

fax number if available; (iii) the name or general description of the common source(s) of supply or

area the order affects; (iv) the general nature of the order sought; (v) a proposed legal notice for

publication; and (vi) any other matter required by the rules or a division order. Id. Written

application is filed with the OCD at least thirty days before the date of the scheduled hearing. Id.

(b) Notice. After an application is filed, the rules and regulations require

both OCD and the applicant to provide notice.

(i) Notice by OCD. OCD must provide Areasonable notice@of

the scheduled hearing regarding the application to pool interests. NMSA 1978, ' 70-2-23 (1977);

see Johnson v. New Mexico Oil Conservation Comm=n, 1999-NMSC-021, &19, 978 P.2d 327, 331

(requiring reasonable notice: (1) by posting on OCD=s website, (2) by mail, and (3) by publication in

the newspaper, as required by 19.15.14.1207(B)). The notice must be given at least ten days before

the hearing, and in no case less than ten days before, except in an emergency. ' 70-2-23; see also

19.15.14.1207 NMAC (listing specific requirements for form, content, and posting of notice).

(ii) Notice by applicant. In addition to the notice provided by

OCD, the applicant must Agive notice to any owner of an interest in the mineral estate of any portion

of the lands the applicant proposes to be pooled@ if the applicant has knowledge of the interest or if

it is evidenced by record, and as long as the owner=s interest has not already been voluntarily

committed to be pooled. 19.15.14.1210(A)(1)(a) NMAC; see generally 19.15.14.1210 NMAC

(listing specific form, content, and posting requirements for notice by applicant).

(c) Hearing. After the application is filed and proper notice is given, a

hearing will be held in Santa Fe, New Mexico by the OCD examiner. ' 70-2-13. The OCD

examiner will take the appropriate measures to conduct an orderly meeting, such as swearing in

26

witnesses, receiving testimony and exhibits as evidence, and creating a complete record of the

proceeding. Id.; see 19.15.14.1211-1215 NMAC.

(d) Order. At the end of the hearing, the OCD examiner will consider all

evidence presented and, if necessary, issue a force pooling order. OCD shall enter an order directing

the pooling of the interests within the spacing or proration unit upon terms and conditions that are

"just and reasonable and will afford to the owner or owners of each tract or interest in the unit the

opportunity to recover or receive without unnecessary expense his just and fair share of the oil or gas,

or both." OCD will generally allow the parties willing to take the risk in drilling the well a risk or

nonconsent penalty to be charged against the interests of those parties who do not voluntarily join in

the drilling of the well. If an unleased mineral owner is involved, seven-eights of his interest shall be

considered as a working interest and one-eighth shall be considered a royalty interest. The order

establishing a compulsory pooled unit must describe the land to be included in the unit, identify the

pool(s) to which the order applies, designate an operator for the unit and set forth the applicable

nonconsent penalty. ' 70-2-17(C).

XII. CONCLUSION

Administration of fee leases in New Mexico is not unlike your experience in Texas and most

oil and gas producing states. Due to the substantial acreage owned by the federal government in New

Mexico, the statutory and regulatory framework that applies to federal oil and gas leases must be

understood by most oil and gas operators in New Mexico. It is my hope that this paper provided you

with a brief overview of federal oil and gas lease issues and the impact of New Mexico spacing rules

on development, including the State’s application of force to allow oil and gas operations to proceed.

* This paper has been prepared by Hinkle, Hensley, Shanor & Martin, L.L.P. and was extracted from other articles,

papers and books authored by members of Hinkle, Hensley, Shanor & Martin, L.L.P. As a result, this paper may not be

copied or reproduced without prior written consent of Hinkle, Hensley, Shanor & Martin, L.L.P. 8 2012 Hinkle,

Hensley, Shanor & Martin, L.L.P. We refer you to L.C. Cox, The Roadmap to Administering Federal Onshore Oil and

Gas Leases, 38 ROCKY MT. MIN. L. INST. 19-1 (1992).