Technology Changed the Game for Mineral Rights Owners - 2018
Horizontal Well Drilling and Completion Technology Changed the Game
Advancements in horizontal well drilling and completion technology have changed the oil and gas industry forever - like the way the jet engine changed the aviation industry about sixty years ago. The jet engine was a game-changer that has allowed aircraft to fly higher, faster and more efficiently than the piston-driven propeller engine. Horizontal wells drilled into tight shale formations are a present-day game-changer which has resulted in the discovery of massive volumes of oil and natural gas reserves in North America.
Because of these huge discoveries, North Americans will be far less reliant on imported oil and more likely to use clean-burning natural gas as the fuel of the future. The development of these reserves will provide royalty income for owners of mineral rights in North America as natural gas prices improve and new wells are brought on production.
Oil and Gas Reservoirs - Simplified
It is widely believed that oil and natural gas (“hydrocarbons”) were formed from the degeneration of organic matter within sedimentary rock formations, often known as organic-rich shales. Over millions of years, hydrocarbons sourced from these dense shales tend to slowly migrate into the adjacent rock strata and often remain trapped in the overlying reservoir rocks, such as sandstone. To see an example of the properties of a sandstone reservoir, hold a sugar cube between your fingers and dip it in coffee. The sugar cube will immediately darken as it absorbs and retains the coffee between the sugar crystals. Think of the sugar cube as the sandstone reservoir with the sugar crystals as the sand grains, the spaces between the crystals as porosity, the connections between the crystals as permeability and the coffee as the “oil”. What you now have between your fingers is a porous, permeable example of an excellent reservoir rock that is saturated with oil (coffee).
The Old “Conventional” Exploration Game
In the past (think pistons and propellers), oil and gas Companies would start with a geological concept, lease the lands in prospective areas and then conduct a seismic program to image the subsurface formations in search of a structure and a potential reservoir. Structure is important, because over millions of years, oil and gas tends to migrate within the rock formations and accumulate on the structurally highest part of the reservoir. Why? Because natural gas is lighter than oil, oil is lighter than water and salt water often underlies hydrocarbons within a reservoir. To contain the hydrocarbons in a reservoir, an impermeable rock layer above the reservoir is required to create the hydrocarbon trap. Drilling an exploratory well into a seismically-defined structure will test the presence or absence of hydrocarbons and if this risky and expensive drilling operation is a success, the well will encounter a porous and permeable reservoir and economic amounts of hydrocarbons. When a well is drilled into a reservoir which is subject to the pressure of one or two miles of overburden rock, hydrocarbons will tend to flow to the surface, a region of lower pressure. Not all reservoirs contain hydrocarbons however, and many contain only salt water. Statistically, a drilling venture like this will result in a dry hole with economic success being encountered only one or two times out of ten. Not for the faint of heart or for Companies with limited funds. For an exploration Company to have a chance at long-term success, the Company requires the projects, land, money and expertise to drill eight or nine more times - seeking the one or two successes that will pay for the failures.
If the first exploratory well results in the discovery and production of oil, as the oil reserves are extracted the reservoir pressure depletes and each additional barrel is harder to extract. If an oil well can efficiently drain only 40 acres of the reservoir and the oil pool is much larger, less-risky development wells are drilled to ensure efficient drainage from the pool. Water or carbon dioxide may be injected into the reservoir which will maintain reservoir pressure and assist with the sweep of oil from the pool. For natural gas wells, drainage areas, reservoir pressure, reservoir porosity and permeability are also critical factors for the ultimate recovery of natural gas. Vertical oil and gas wells drilled into good reservoirs will often require a frac (more later on this) or similar wellbore stimulation to enhance the productivity of the well drainage area and improve the extraction of oil or gas from the reservoir. A conventional vertical well will always have its limitations - it is a very small hole into the target reservoir.
The New Exploration Game - “Unconventional Resource Projects”
The game-changer provided by horizontal drilling and fracking (think jet engines) has provided industry with a new way to explore. Today, the oil and gas industry explores for hydrocarbons which are often referred to as “unconventional resource plays”. A resource play is one which often has the characteristics of a mining project. The presence of hydrocarbons is well-known over a wide area and multiple horizontal wells can be drilled sequentially to develop the resource. To extract the hydrocarbon resource, ownership and control of large tracts of mineral rights and surface rights are critical factors for drilling and production operations.
With the application of modern well drilling and completion techniques, oil and gas operators are now drilling horizontally into known reservoirs or into the hydrocarbon-rich shales, where the oil or natural gas was actually formed, and are producing directly from these shales. These unconventional shale reservoirs are dense and tight hydrocarbon-filled rock formations which lack the porosity or permeability of the “sugar cube” reservoir. In unconventional reservoirs, the exploration Company knows that the hydrocarbons are present so the risk of encountering hydrocarbons is minimized. Using the sugar cube as an example of an excellent reservoir, this time think about spilling your coffee on your impermeable granite kitchen countertop - not much happens. If your countertop was made of shale however, your coffee would slowly seep into the shale and leave a stain. Shale reservoirs hold hydrocarbons because the hydrocarbons were formed there and have not yet migrated into conventional reservoir rocks. Shales and other relatively poor-quality reservoirs may be so tight (lacking effective porosity or permeability) that the only way to extract hydrocarbons will be to horizontally drill a mile or so within this rock (think increased surface area) and then create mini-fractures (“frac”) to allow the horizontal well to produce. To get to the target formation, often the well must be drilled a mile or so vertically and then steered and drilled horizontally into the target formation for an additional mile or two. Technically challenging, but done successfully every day, thanks again to technology. Interestingly, more often than not, the exploration Company knows that the hydrocarbons are in this tight rock - they just need help from technology to get the horizontal well to produce. Quite different from the “old” way of exploring where the Company never knew if the reservoir was there or if the hydrocarbons were present until the exploratory well was drilled and tested. One of the key challenges for the industry will be managing horizontal well drilling and completion costs which are commonly three to five times the cost of a vertical well. Production rates from horizontal wells can be several times those of a vertical well which significantly accelerates the payout of a well while also providing increased recovery of hydrocarbon reserves.
Fracking a Well
A frac involves pumping a fluid and sand/proppant mixture under very high pressure down the wellbore, out the perforations in the well casing or frac assembly and into the surrounding rock formation. The intent of this down-hole operation is to enhance the productive capabilities of the rock near the wellbore so that the hydrocarbons can move through the fracture pathway, back to the well and flow to the surface. Fracs have been safely conducted on vertical wells for decades with great success. In a horizontal well, frac technology has advanced such that multiple frac operations are now conducted within horizontal wells at periodic intervals as close as 100 feet apart. Generally, fracs are conducted at a significant depth and well below the water table. That said, the surface casing of the well (the shallow pipe which is cemented to the shallow formations and isolates the vertical portion of the well from the surrounding shallow groundwater aquifer) is important to any well drilling operation and wellbore integrity. Much has been written about the technical benefits of fracking a well and the potential risks. A significant volume of fluids (water, oil, surfactants, chemicals) are used with each frac operation and once introduced into the formation and subsequently flowed back to surface, these products need to be contained and disposed. Previously believed to be a trade secret for many operators, the composition of frac fluids that are injected down-hole are now being disclosed by well operators in many jurisdictions. This disclosure trend will likely grow and become regulated in the interest of the landowner and the public. Public safety, protection of the environment and protection of the water table is the common goal of all concerned. It should be noted that large volumes of water are consumed during a frac operation and it is now becoming evident that frac water supply and post-frac water disposal and recycling are significant issues for oil and gas well operators.
Firstly, to be clear - hydrocarbons do not care if the wellbore from which hydrocarbon production is being obtained is a vertical or a horizontal well. Hydrocarbons want to move from areas of high pressure to areas of lower pressure. When you open the valve on a well, if oil or natural gas is entering the wellbore, it generally wants to flow to the surface tank or pipeline. If you are the landowner who is fortunate enough to own the mineral rights overlying a reservoir or organic-rich shale, you could be sitting on buried treasure. Oil and gas operators will want to lease your mineral rights and potentially drill your lands. An oil and gas lease typically reserves the mineral rights owner a royalty share of production from the lands and if a successful well is drilled on these lands, significant financial rewards are possible.
Land is the Basis of All Wealth, Adam Smith, 1776 “The Wealth of Nations”
The “old” exploration game and the “new” exploration game have one very important common denominator - mineral rights ownership. Control of the land is the foundation for the development of an oil and gas prospect. The Company geologist or geophysicist who created the drilling prospect is powerless to test the concept without first having control of the mineral rights to the play. Without the legal right to drill, a drilling Company is trespassing. To acquire the right to drill, the Company must be able to demonstrate that it has contractually obtained the privilege to do so from the owner of the mineral rights. In North America, mineral rights are often owned by individuals but also by Corporations, States, Provinces or the Federal government. Worldwide it is estimated that approximately 80% of the “exploitable” oil and gas reserves are owned by the sovereign nations themselves, often by their National Oil Companies (“NOC’s”).
The Role of Mineral Landmen in Oil and Gas Leasing
In North America, the individual or Company that owns or has leased the mineral rights essentially controls the project and its pace of development. A mineral landman has the task of securing the right to drill either by leasing or purchasing the mineral rights from the owner or by committing to drill to earn an interest from the Company that holds the lease. Many US companies have committed large budgets to wide-area mineral leasing programs if they see the potential for repeatable oil or gas drilling targets. These companies will employ hundreds, even thousands of mineral landmen to scour the County Recorder’s offices in search of the owners of the mineral rights. After the owners are located, the landmen will make lease offers which, in many cases, are the first lease offers these owners have ever seen. This is due to two main reasons. Firstly, the new resource plays are in areas which may have been inactive for many years and secondly, the current owners of the mineral rights probably inherited the mineral rights and had no knowledge of their value.
Mineral Lease Terms
In oil and gas mineral leasing there are a few key issues for mineral landowners to consider. The mineral lease signing bonus (per net acre), the lessor royalty reserved to the landowner, the lease primary term (and lease renewal provisions) and the Lessee’s drilling plans are all important. It is worth noting that many mineral owners do not own full title to their mineral rights as a result of prior transactions by prior owners. Mineral landowners can only grant a lease on what they own. It is common that mineral landowners hold title to less than a 100% interest in the lands or that the prior owners may have retained royalty rights or lease bonus rights. As mineral rights owners convey ownership through the estate process, split mineral titles will become more common and increasingly complex. Due to these issues, it is highly recommended that mineral landowners consult with an oil and gas land professional or attorney in all leasing transactions.
Mineral Lease Signing Bonus
A lease signing bonus can be a small part of the lease negotiation or the most important component, depending on the landowner’s objectives. If the landowner needs the money now, versus a share of potential future production in the form of a landowner (lessor) royalty, the goal may be to maximize the up-front lease bonus amount. Mineral lease signing bonus amounts can be anywhere from a dollar per net mineral acre to thousands of dollars per net acre. In many of the large oil plays such as the Bakken in North Dakota, Montana and Saskatchewan or the Eagle Ford play in Texas, mineral lease signing bonuses can be up to five thousand dollars per acre. Similar lease bonus amounts have been paid in the last few years for undeveloped mineral rights in natural gas plays such as the Barnett, Haynesville and Marcellus shales in the USA or for the Duvernay and Montney shales in Canada. Lease bonus prices trend up or down based on many factors which include commodity prices, area activity, area success and levels of competition. A factor which has negatively affected lease bonus amounts in North America recently is the reality that Companies have discovered huge reserves of natural gas in the last few years – thanks to horizontal drilling and frac technology. Demand has stayed the same and natural gas supply went way up. That said, in a hot play with a rising market for a limited amount of acreage, landowners are in an enviable position.
Lessor Royalty on Production
Royalties are like gold. If you don’t believe this, ask a recording producer or a recording artist who has the benefit of receiving a royalty every time their tune is downloaded or played on the radio. Generally, the song owner is entitled to a royalty payment every time that song is played or downloaded.
In the oil and gas business, if the mineral rights landowner (“lessor”) has leased out their mineral rights to a third party and reserved a lessor royalty on production and a successful well has been drilled, the lessor is entitled to a royalty share of the proceeds from the sale of the oil or gas production from their lands. The lessor receives a monthly royalty check, often subject to certain deductions, but has taken no financial risk in the risky drilling venture. The royalty revenues will continue until the oil and gas reserves are depleted.
Royalty rates can vary with all mineral lease negotiations. The lessor royalty rate is negotiable (unless State, Federal or Provincial lands) and can vary from 12.5% to as much as 25% - perhaps more.
Lease Primary Term
The primary term of an oil and gas lease is essentially the initial period for which a mineral lease is granted. A short term is generally better for the lessor and a longer term is better for the lessee (operator). Longer term leases give the lessee the time to assemble a larger acreage block which is commonly required for resource plays which may increase the likelihood of future drilling activity. Common primary terms for mineral leases can vary from 1-5 years with the majority of leases in the longer time frame. Mineral leases generally continue beyond the primary term if drilling has occurred on the lands or on lands pooled with these lands to form a production spacing unit. Production spacing units can vary in size from less than 5 acres to greater than 640 acres but are dependent on a number of factors (oil vs gas, vertical vs horizontal wells, regulatory or production reasons). Wells may also be shut-in and not produced for regulatory or commercial reasons which can retain the lease in good standing after the primary term. Some leases have lease renewal provisions which essentially grant an option to the lessee to renew the lease on pre-determined terms. These leases are not common so a professional landman or attorney should be consulted when reviewing a lease which has these terms.
Who am I leasing to?
Landmen often acquire mineral leases on behalf of their Company, for undisclosed clients or perhaps for their own account. Due to the increasing complexity of titles, leasing enough acreage in some of the emerging shale plays can take months or years to accumulate sufficient leased acreage to enable the drilling of a play. Companies may utilize multiple landmen and lease brokers to seek out the owners and lease the mineral rights to a new play or prospect. Once leased, the mineral rights may be sold, assigned or farmed out to the dominant operating Company to enable the drilling of a well. The assignment by a Company (lessee) of a mineral lease to a new lessee is common and to be expected by the mineral owner (lessor). Company landmen often buy, sell or farmout leases on a regular basis and in some cases the Companies themselves may be acquired simply for the acreage they hold under lease.
Surface Rights Ownership
In many jurisdictions, mineral rights and surface rights are owned separately. This situation often leads to situations where the mineral rights owner wants to see drilling activity but the surface owner does not. Generally, mineral rights and the surface rights are distinct “bundles” of ownership and come with certain rights and privileges. A surface rights owner is generally compensated for any “adverse effect” and “loss of use” resulting from drilling and production operations. While it is recognized that surface rights owners are impacted by the drilling of an oil or gas well, it is also recognized that the mineral rights owner has the right to drill to the underlying mineral rights. In order to deal with the complex issues regarding surface rights ownership, surface landmen perform a key role in obtaining the right to conduct oil and gas drilling operations from the surface landowner. Many jurisdictions have provided legislation to ensure that the rights of surface owners and mineral owners are protected.
Summary for Owners of Mineral Rights
Leasing your oil and gas mineral rights
Leasing is a real estate transaction - get advice and do your homework. By leasing, you are granting the Company/Landman (lessee) the exclusive right to drill and produce your mineral rights for a period of time (primary term).
Tips for the mineral landowner
Oil and Gas Lease Definitions
© Baycrest Energy Ltd. 2018
www.baycrestenergy.com This article is for information only. Consult a professional when considering a mineral leasing or sale transaction.