NPRI’s: a simple and innocent concept, accompanied by a complex and convoluted legal framework. The associated rules regarding pooling, royalty allocation, and ratification by NPRI owners are important concepts of which oil and gas professionals absolutely must be aware. Last week we discussed the basics of what NPRI’s are, what they burden, and how they are measured. This week we take it one step further.
(This is Part Two of a series, continuing from last week’s NPRI’s Part One: Fundamental NPRI Characteristics.)[toc]
Recap of Part One
Just to recap what we had discussed last week:
- Royalty Only: An NPRI is a right only to royalty, which burdens (comes out of) an associated mineral interest;
- Independent of Lease: An NPRI owner gets his royalty whether the mineral interest owner leases or self develops;
- No Executive Right: An NPRI owner cannot negotiate leases or develop the minerals himself;
- The Executive Owner Negotiates: The mineral owner is said to own the Executive Right, meaning he can negotiate most lease terms on behalf of the NPRI owner; and
- Two General “sizes:”
- floating (you multiply its fraction with whatever royalty fraction the associated mineral owner negotiates); and
- fixed (the NPRI owner simply gets his fraction with no further math).
NPRI Lease Terms and Pooling Authority
Texas law clearly states that the holder of the executive right has the authority to bind NPRI owners to most lease provisions. ((Manges v. Guerra, 673 S.W.2d 180, 183 (Tex. 1984) (citations omitted); Montgomery v. Rittersbacher, 424 S.W.2d 210, 212-13 (Tex. 1968).)) But there is one major exception: courts consistently hold that “pooling on the part of the holder of the executive rights cannot be binding upon the non-participating royalty owner in the absence of his consent.” In other words, sure, the NPRI owner will be held to the lease the executive owner negotiates, but the NPRI owner himself must grant a lessee some form of pooling authority before his interest can be pooled. ((Benjamin Holliday, New Oil and Old Laws: Problems in Allocation of Production to Owners of Non-Participating Royalty Interests in the Era of Horizontal Drilling, 44 St. Mary’s L.J. 771, 800 (2013); see also Montgomery, 424 S.W.2d at 213 (citing Minchen v. Fields, 162 Tex. 73, 345 S.W.2d 282, 285 (1961) ).)) While a mineral owner typically has a single opportunity to negotiate pooling authority in a lease, the same is not true for an NPRI owner. If an NPRI owner decides he does not want to pool his interest, he has this ability as well. This gives the NPRI owner a sort of superior right or ability – he can decide whether to pool his interest after the cards have already been dealt. How many wells will be drilled, where, in what time frame? All these factors can be weighed in deciding whether to pool, and how to pool his interest.
Methods of Pooling an NPRI
Method One: Ratify the Oil and Gas Lease
The most common form of pooling ratification given by NPRI owners is to ratify the relevant oil and gas lease. ((See James E. Key, The Right to Royalty: Pooling and the Capture of Unburdened Interests, 17 Tex. Wesleyan L. Rev. 69, 81 (2010).)) This will have the same effect as if the NPRI owner had executed the lease, and will ratify all subsequent pooling efforts made by the operator under the terms of that lease. ((Ruiz v. Martin, 559 S.W.2d 839, 844 (Tex. Civ. App.—San Antonio 1977, writ ref’d n.r.e.) (holding that the ratification of a lease was the same as execution of the lease, and thus their interests were pooled or unitized as a matter of law with all other interests in all three tracts covered by the lease).)) Where an NPRI owner ratifies the lease, his interest will be diluted by the pooling of the leased land with any other lands. In other words, if the NPRI owner owns 20 acres, and ratifies a lease covering that 20 acres, and that leased land is pooled with a neighboring 80 acre tract, then the NPRI will receive his royalty interest, but it will be diluted by 20/100. This can greatly reduce the value of his interest.
Method Two: Chose Not To Ratify
However, an NPRI owner also has the power to decide not to pool his interest. Where the NPRI is on a “drillsite tract,” it can be highly beneficial for an NPRI owner to refrain from entering into any pooling agreements or ratifying the lease, because he will then receive his interest undiluted by pooling. Sophisticated NPRI owners will weigh several factors in determining whether pooling or not pooling his interest is the most beneficial tactic to employ in his particular scenario.
NPRI On Drillsite Tract
For example, where a well is placed within the NPRI owner’s tract, a non-pooled NPRI owner is entitled to his full fractional share (fixed or floating) of the production from that that tract, not diluted by pooling with other tracts included in the unit. ((See MCZ, Inc., 708 S.W.2d at 53 (stating that an NPRI owner is entitled to an undiluted full fractional royalty interest from a well within his tract where his interest has not been properly pooled).)) So who has to pay for this larger royalty owed to the NPRI owner? Texas law makes it clear that the owner of the burdened mineral interest will bear the cost of this excess royalty to the extent his royalty interest will allow, and any further excess must be sustained by the working interest owner. ((Id. (rationalizing this ruling in part due to the fact the lease signed by the burdened mineral interest owner contained a proportionate reduction clause).))
In other words, if a mineral owner has executed a lease, of which is later largely diluted by pooling, a well is placed on this tract, and an NPRI burdening this mineral owner refuses to grant pooling authority, things can get messy. This can frequently lead to a scenario where the NPRI owner is entitled to more royalty than would be “divvied out” to that mineral interest owner. If this is the case, the mineral interest owner would essentially receive no royalties in that tract, and the working interest owner would have to make up any difference in compensating the NPRI for his full undiluted royalty.
NPRI’s on Non-Drillsite Tracts
Conversely, if a well is placed outside the NPRI owner’s tract, and his tract is included within the unit, the NPRI owner will likely prefer to grant pooling authority. This is because, in Texas, where an NPRI owner fails to pool his interest, where the drillsite is not on his tract, and where community lease concepts are not applicable, he is generally entitled to no royalties. An NPRI owner has considerable power in this regard, as they are able to wait to see where the wells are drilled prior to taking action. If it is drillsite, don’t ratify, and it is not, then ratify. ((However, i will later discuss “When Must the NPRI Owner Ratify” for a discussion of the possible defense of laches for a particularly delayed ratification.))
Method Three: Separate Pooling Agreement
Where an NPRI owner generally ratifies an Oil and Gas Lease, his interest will be pooled (diluted) with all wells drilled under the terms of that lease. Generally, an NPRI owner cannot later change his mind, or make different pooling elections for future wells. However, with the recent proliferation of oil and gas development, horizontal drilling and fracking ((spell it how you’d like.. fraccing, fracing, hydro-fracking, etc. Honestly, whatever keeps the combative-enviros off my back)), NPRI owners have become much more sophisticated, and have increasingly rejected the far-reaching consequences of a blanket ratification of an oil and gas lease. ((Allen D. Cummings, Pooling and Community Leases: Problems and Options for the Executive Owner, the Non-Executive Owner and the Lessee, in State Bar of Texas, 15th Annual Advanced Oil, Gas and Mineral Law Course, at I-1, I-30-31 (1997).))
NPRI owners are more frequently granting a lessee pooling authority by use of a pooling agreement or other form of limited pooling authorization. ((Id.)) Sophisticated NPRI owners, instead of ratifying the entire lease, will negotiate a separate Pooling Agreement with the lessee that grants the limited authority to pool the NPRI owner’s interest only for the specific pooled unit. ((Cummings, supra n. 12, at 34.)) This will allow the NPRI owner to repeat the process of determining whether to ratify or not ratify in the future, based on which action would be most beneficial to his interest. ((Compare Montgomery, 424 S.W.2d at 215 (allowing NPRI owner to ratify lease, entitling owner to proportion of production from pooled unit, but binding NPRI to full authority of all leasing provisions), with MCZ, Inc., 708 S.W.2d at 53-54 (permitting an NPRI owner to ratify a pooling provision for one pool and reject provision for a second pool, thus allowing the collection of proportional royalties from the former pool and full royalties from the latter pool).))
Method Four: Community Lease
Perhaps the most simplified definition of a community lease is this: a single lease, executed by multiple parties, covering multiple tracts of land. Texas courts have also classified a lease as a community lease where one the NPRI burdens differed as to the tracts covered by the lease. Where there is a community lease, all the tracts covered thereby are presumptively pooled together. We will cover more on this topic in Part Three.
In conclusion, NPRI owners are generally presented with three options: (1) refuse to ratify ( which is frequently a good decision where the well is located within his lease, because he is then entitled to an undiluted royalty), (2) ratify the lease (which authorizes all pooling authority in the lease), or (3) selectively ratify the pooled unit by way of a pooling agreement (which can strategically provide for limited pooling authority). This places NPRI owners in enormously powerful bargaining positions, of which Texas courts have tended to protect. ((See, e.g., Montgomery, 424 S.W.2d at 215 (expanding the ability of an NPRI holder to either ratify or repudiate a provision of a lease).))