Hamish McArdle and Denmon Sigler of Baker Botts LLP look at recent and rapid developments in shale gas.
While the technology required for unconventional gas extraction is not new, recent technological advancements and the integration of horizontal wells with hydraulic fracturing practices, together with recent discoveries of shale reservoirs and the ability now to develop them on a scaled basis, a favourable regulatory environment and an extensive pipeline infrastructure network in the US has enabled the rapid development of shale gas and liquids resources in the United States. As a result, the US shale gas experience has been dramatic in terms of volume/supply and pricing.
With reported global shale gas reserves apparently plentiful, the prospect of cheaper hydrocarbons in abundant supply, coupled with some level of energy security, now exists for many energy import-dependent countries and the appetite to replicate the US shale development experience now exists internationally. While the US model cannot be easily duplicated elsewhere, this article explores at a high level how several of the legal and contractual issues identified and applied in the US shale gas industry may inform non-US shale gas exploration and development.
Hydrocarbon Rights and Granting Instruments
Shale plays are large in scale and, subject to specific geology, have relatively uniform structures and producing qualities. Oil and gas companies typically acquire large acreage positions, often rapidly, on limited data and in competition with other companies.
US Granting Structure
In the US, most mineral rights are owned privately. This means that in most cases, exploration and development leases can be negotiated directly with the mineral owner without requiring government agreements. Given the significant acreage position, cost of development and short development periods (typically three to eight years depending on the shale play), shale transactions in the US are typically structured as an unincorporated joint venture between an experienced operator and one or more financial or industry investors or as a farmout or other “pay as you go” exploration agreement. These arrangements usually also include area of mutual interest (AMI) agreements allowing the mineral owners to continue to acquire acreage within a specified area.
Granting Structure Outside of the US
Outside of the US, hydrocarbon ownership is typically vested in the state/government that has the exclusive right to exploit the resource and grant rights to that resource. Typical contract structures outside of the US include production-sharing contracts, service contracts and licences between the oil and gas companies and the state/government. With conventional structures these state/government-granted concessions are often, initially, of large acreage, with obligations to periodically relinquish land during the exploration phase and, at the point where a commercial discovery of a gas or oil field is determined, to relinquish the balance of the acreage that is not part of the agreed development area. The average length of the exploitation/development period of such concessions is in the 20–30 year range.
Shale Development Outside the US
Several key provisions of a typical state/government concession for shale plays deserve attention to address and promote the exploration and development of shale resources in areas outside the US. In particular, the following factors should be considered:
The concept of relinquishment in state/government concessions may need to be adapted in order to secure rights to the shale formations for the duration of the licence.
The AMI concept is likely to be less important than in the US, given the certainty and exclusivity over defined areas that the typical government concessions provide to operators.
The likelihood of immediate production and the attendant need to handle, transport and monetise such production from the outset of operations will need to be addressed, particularly in areas lacking distribution infrastructure.
Issues around the amount and timing of an operator’s cost recovery, and the terms and period for the carry of a government party (where applicable), may need to be adapted.
The split of production and entitlement to hydrocarbons under a typical production-sharing contract structure may need to be adapted, to address both the significantly higher cost base of shale drilling and developments (as it impacts the project rate of return) and the lower exploration risk.
Joint Venture Issues and Operating Agreements
In a typical US shale joint venture where non-operators have assumed certain funding and possibly drilling carry obligations, the operator and non-operators will agree a joint development agreement setting out development parameters, and addressing the structure of their development committee (if any), initial work plan and budgets, specific requirements as to the drilling of wells, the sharing of information (including seismic), reporting and cooperation. Such joint development agreement, which grants specified rights of scrutiny to the non-operator over the operator’s activities, may last only a few years and thereafter be replaced by a joint operating agreement (typically an AIPN US model form agreement), under which the operator has a greater degree of control and non-operators have less involvement in day-to-day operating decisions. Access to hydraulic fracturing and horizontal drilling technology are typically secured through direct acquisition of rights to data/information, through secondment opportunities to the operator, and/or through participation in the development committee (planning drilling programmes and setting work programmes and budgets). In US shale operations, access to rights over such technology and key decision-making may be points of tension between operators and non-operators, hold value and be negotiable on a case-by-case basis.
Model Outside of the US
The structure described above is unusual in conventional oil and gas developments outside of the US, which are typified by a contractual joint venture whose members are parties to the government concession directly, and as between themselves parties to a joint operating agreement, which sets out in detail the rights and obligations of the parties and their respective proportion of joint venture liabilities, as well as the roles of the operator, the rights of non-operators and the joint operating committee, and the substantive degree of control that the non-operators generally exercise over the operator. In short, non-operators are truly partners in the joint venture, with decision-making rights and a direct contribution to operational decisions, and not merely the source of funding for operations and the recipients of their share of production. Access to rights to technology and key decision-making are less likely to be points of tension between operators and non-operators because the interests of the joint venture parties are more aligned than in the typical US model.
Shale Development Outside the US
Shale development joint ventures outside of the US are likely to be a hybrid of the US and non-US models described above, including with respect to the following:
Joint ventures will likely include an operating committee with significant decision-making authority, be of longer duration and include greater minority owner rights than are perhaps typical in the US.
Ownership rights to technology and data frequently pass to the state under government-granted concessions – and to the extent that the joint venture considers it to be proprietary and confidential and of long-term value to the joint venture, it will need to address this in its agreement with the government.
Non-operators are likely to take advantage of secondment rights under joint operating agreements.
Non-operators will likely expect significantly more information, earlier and more often, than is perhaps the case now in non-US conventional hydrocarbon operations.
Certain concepts in the classic joint operating agreement for non-US operations will be modified for shale development, including provisions relating to exclusive operations, indemnification of the operator, duration of the typical annual work programme and budget, remedies for default, and rights of transfer or withdrawal.
Environmental and Community Challenges
Environmental arguments against the use of hydraulic fracturing to exploit shale reservoirs are well known, including claims of aquifer pollution and induced seismic events. So too are associated environmental claims of methane leakage, negative climate change impact, excessive water usage, issues relating to wastewater storage and disposal, and general landscape industrialisation through increased noise and visual pollution. In many US states such concerns and opposition have not presented a serious challenge to the industry at least in terms of unduly burdensome regulation, whilst in others, such as California and New York, these concerns have been directly reflected in additional regulations and moratoriums. Whilst some federal environmental laws directly impact shale development activities there is in practice no overarching set of laws that regulate shale activity in the US and permitting is addressed principally at the state level.
A more recent development in the US has been the collaboration by major shale industry participants to directly address the environmental arguments directed against shale activities, and to educate both the public and their elected representatives and to engage them at an early stage and at all levels of the process in order that such arguments are properly addressed and do not become unwarranted barriers to the shale activity. Whilst there are many examples in the US of local communities and state and municipal authorities opposing shale exploration and development on social, economic and environmental grounds, in general the pattern across the US – and especially in areas with a tradition of hydrocarbon exploitation, such as Texas – has been one of general acceptance and approval of shale operations as bringing direct social and economic benefits at the local level. Whilst this may be replicated in some countries, it likely to be the case in many – and is already the case in Europe – that the issue of local community benefit is a challenge to these types of projects, and presents a genuine obstacle to their proceeding in the short to medium term.
Internationally, particularly in Europe, such environmental and community benefit arguments arguably present a greater challenge to the industry than has been the case in the US to date. With respect to environmental issues, the US experience demonstrates that transparency and openness and engagement with key players, and thorough application of the science goes a long way to overcoming the most fundamental and often incorrect assumptions and opposition to the industry as a whole. Unlike the US, shale development in most countries will be subject to a single legal regime (often comprised of a range of statutes and regulations working together to cover the exploration, development and production phases). This offers both a potential challenge to the industry in terms of the additional cost of regulation, but also an opportunity to leverage national government support for the industry and the undoubted benefits that come from the process of consultation and engagement with key stakeholders, including the industry and community bodies, in the formulation of the applicable legal regime.
Notwithstanding the essential differences between the US and the rest of the world, the typical legal structures and concepts applied in the US can, with care, be adapted to any particular international hydrocarbons regime, provided that the purpose and structure of the underlying host government and joint venture agreement(s) are understood, and there is flexibility on the part of the government and oil and gas companies to put in place workable contracts and a legal regime, addressing the fundamental technical and economic drivers of shale developments that differ significantly from conventional hydrocarbons development. The approaches taken by industry to the regulatory, environmental and social challenges have application internationally, where arguably greater challenges are faced, particularly in those countries with little experience of hydrocarbon exploitation.