Mosburg 6-2-99-3a

AREA OF MUTUAL INTEREST PROVISIONS

by Lewis G. Mosburg, Jr.

Part Three: Drafting Area of Mutual Interest Provisions

Scope of the AMI Provision. The Area of Mutual Interest clause needs to cover the following topics:

The Area constituting the "Area of Mutual Interest."
The Rights subject to the agreement.
The Duration of the AMI.
The Procedure to be followed in implementing the AMI provision.

Defining the AMI Area. The area covered by the AMI may be coextensive with, greater than, or smaller than the Contract Area.¹ Whatever the extent of the AMI, its exact location needs to be clearly defined.

In certain areas – portions of Tennessee and West Virginia are examples – surveys are so inaccurate (or non-existent) that a "survey" description may be of little help, or even misleading, even though the area which is contemplated as the AMI can easily be located on the ground. In these instances, marking the AMI on an aerial photograph has proved a workable solution.

If the Area of Mutual Interest is relatively small, the contract may simply list the sections or townships involved; if an extensive or irregular area is involved, the more common practice is to attach a plat outlining the area.²

A particular problem in defining the Area of Mutual Interest is: What is to be done with Leases lying partially within, and partially outside, the AMI Area? Unfortunately, most AMI provisions are silent in this regard.

There is no magic solution as to how such partially in/partially out Leases should be treated. Alternative provisions would be: (i) all of the Leasehold Rights are subject to the AMI provisions; (ii) the entire Leasehold Rights are excluded; (iii) that portion of the Lease lying within the designated area is subject to the AMI rights, and the balance is not.

While the third alternative is the most common provision, this can create lease administration nightmares if only a small portion of the Lease lies within (or outside) the AMI. So, consideration should be given to including all rights, or excluding all rights, if less than (or more than) a given portion of the Lease -- expressed as both a percentage of the total acreage and/or a minimum number of acres -- lies outside (or inside) the AMI.

Rights Covered – "Leases." A number of AMI clauses, if applied literally, apply only when one of the parties to the agreement acquires a "Lease" lying within the AMI. This raises potential conflicts when a party acquires a mineral or fee interest or an option to acquire Leases (e.g., a Seismic or Drilling Option), particularly when the option need not be exercised until after the end of the AMI period.³ If applied literally, the right to participate in the acquisition might not be available under such circumstances, even though the normal intention of the parties, if the issued had been addressed at the time of drafting, would be to have included such acquisitions.

To avoid the problems just raised, the right to participate as to acquisitions within the AMI should not be limited to an acquisition of Leases, but should apply any time either of the parties acquires any "Oil and Gas Rights," which should be a defined term under the agreement. A suggested definition might be as follows:

"As used in this agreement, the term 'Oil and Gas Rights' shall mean leases and leasehold rights, mineral interests, rights to participate in the development of Oil and Gas under joint operating, pooling or unitization agreements, orders of regulatory agencies or otherwise, royalty, net profits, and all types of non-operating interests relating in any way to Oil and Gas, and fee interests, and shall further include options and contractual rights to acquire any such Oil and Gas Rights."⁴

While the foregoing definition of "Oil and Gas Rights" is quite broad, it would not include the acquisition of seismic or other data. In most instances, this is what the parties intend: I want to be free to develop or acquire information for my own account, without being obligated (unless I choose) to share that additional information. However, in some instances, the other party may have assumed that any additional data acquired would be shared, at least if that party was prepared to pay its share of the cost. This is particularly apt to occur in "seismic sensitive" arrangements, such as those involving seismic options, seismic obligations or group shoots.⁵ In these circumstances, to retain good relations with your working interest "partners" at a minimum, the issue of whether or not data acquisition is to be included in the AMI concept should be discussed and an agreement reached. If the data acquisitions are to be shared, the definition of "Oil and Gas Rights" should be expanded to include such acquisitions. (Or, of course, the matter could be covered separately.) If there is to be no forced sharing of data, the safer approach would be to expressly exclude acquisitions of data from the obligations imposed under the AMI provision.

The foregoing discussions of fee and mineral acquisitions where only "Leases" are expressly addressed in the AMI clause, and the acquisitions of additional data, assume that the wording of the contract will be interpreted literally by the courts. This is not always the case, and often turns upon the "fireside equities" existing at the time of trial. Accordingly, if language of the contract reflects the negotiated terms of the deal, but would appear to reach a harsh result, it is always better to word the contract to make clear the actual intention of the parties. For instance, if "Lease" acquisitions are in fact all you intent to have covered by an AMI, expressly exclude the more extensive rights that a court might otherwise feel were inadvertently omitted. Also, don't try to "slip one by" on your "partner": that type of conduct is most apt to engage the "fireside equity" feelings of a court.

-- Other Substances and Depths. Leases -- or other "rights" -- acquired within the AMI will often cover substances, formations or depths that are not covered by the base agreement.

Most AMI clauses do not contain any express guidance as to whether these additional rights are to be included, or excluded, from the nonacquiring party's right of participation; and, if they are to be excluded, whether there should be any proration of bonuses and delay rentals between the covered and the excluded rights.

The only "school solution" concerning these additional rights is that an agreement which is limited as to the formations subject to its provisions, or which is being taken in an area where an active "other minerals" search might be conducted, should expressly dictate whether or not such additional substances and formations are to be subject to the AMI rights, and, if not, whether there is to be any proration of the acquisition costs (and any subsequent delay rentals).⁶

Acquisitions by Affiliates. A related question arises when rights subject to an AMI are not acquired directly by one of the parties to the agreement, but by an affiliated party, particularly when that affiliate is a virtual alter ego. To avoid a breach of the spirit (if not the letter) of the agreement, the AMI provisions should apply whenever any of the rights subject to the AMI are acquired by a party to the agreement, "or any of its affiliates," with the term "affiliate" being defined in the agreement.

Duration of the AMI. Certain Areas of Mutual Interest will last for a term equal to the life of the base agreement containing the AMI clause. Although such a provision maintains uniformity of ownership throughout contract life (one of the objectives of the AMI), it increases the "lack of flexibility" problems mentioned earlier and the likelihood of an inadvertent breach.

A preferable provision, at least in the opinion of most explorationists, is to limit the duration of the AMI rights to a period necessary to evaluate Earning Well information and to acquire those Leases (or other Oil and Gas Rights) which now seem worthy of serious consideration as a result of this increased knowledge. A common provision, thus, is to limit the AMI to a period of 12 to 24 months from the date of the base agreement, or a specified period of time following the release of the completion rig, the final logging, etc. On longer term arrangements, such as exploration contracts, where continuous drilling provisions might – or might not – prolong the exploration period, such a provision might run from rig release, etc., on the final earning well.

The AMI Procedure In General. Whenever a contract grants either party an option or an election (such as the optional right to participate in a Lease acquisition under the AMI clause), the agreement should cover the following procedural matters:

How the other party is put on notice that an election point has been reached (in this case, that rights subject to the AMI provision have been acquired).

The duration of the election period.

How the option is to exercised.

The impact of a failure to respond on the part of the nonacquiring party.

In addition, certain special problems arise under the AMI regarding the procedures to be followed in exercising the AMI rights.

-- Time Within Which Election Must Be Made. A key point of fairness under AMI clauses is that the nonacquiring party should have to make his decision as to whether or not he wishes to participate in an acquisition within a limited period of time after the acquiring party has placed himself "at risk" by committing to the acquisition of the Leases.

If the AMI "option" is triggered only when a Lease is acquired in Farmout and Seismic or Drilling Option situations, the nonacquiring party may be able to wait until after the Earning Well has been drilled, or the seismic completed, before he must elect whether or not to participate in the related costs.⁷ Accordingly, where the acquisition involves contractual rights to acquire Oil and Gas Rights, the nonacquiring party should be required to elect within the specified period of time after the contractual commitment is made. If he elects not to participate at that point, he should have no right of new election when the Leases (or other Oil and Gas Rights) are actually acquired as a result of the acquiring party's performing its obligations under the contract.

Other Issues. The agreement needs to spell out exactly how the non-acquiring party is put on notice that the time to elect is now running, and how that election is to be exercised. The most common provision – either as a separate provision or as a part of a general "notice" provision in the underlying contract – is that the notices must be in writing; a failure to comply with this requirement could give the non-acquiring party an extended right of election until a written notice were given,⁸ or could lead to a finding that a non-written response during the election period was not sufficient. The agreement also needs to specify the consequences of a failure to reply on the part of the non-acquiring party: most commonly, the agreement will provide that a failure to response will conclusively serve as an election not to participate.

Assume that less than all non-acquiring parties elect to participate in a Lease acquisition. Will those parties election to participate share only in that portion which their normal participating interest bears to the interest of all parties, or can they increase their sharing to their proportionate part of the interest of all parties electing to participate in the Lease acquisition?⁹ Most AMI provisions fail intentionally to cover such a situation, although the wording of the agreement, if applied literally, may dictate an answer. When intentionally considered, most agreements would provide for a right fully to share, including the right to pick up a proportionate part of the interest in the Lease declined by another.

In some instances, the non-acquiring party might feel that a Lease covering extensive acreage included both desirable and undesirable lands, that the interest being offered it was desirable but expensive, or that Leases presented in a "block" again lumped desirable with less desirable acreage. Whether or not the non-acquiring party can elect to participate in less than the full acquisition obviously depends upon the wording of the particular agreement. Under most common wordings, there would be no right (absent the consent of the other parties) to participate in a Lease as to only a part of its leased premises, or to accept less than its full proportionate interest in the Lease.¹⁰ However, under common wording, there is a right to "cherry pick" among separate Leases: the acquiring party has no right to present a group of Leases on a "take all or take none" basis.

If any of these answers are not appropriate for the particular venture, the wording of the AMI provision needs to be modified.

Cost of Acquisition. A related question in such "earning" situations is exactly what the nonacquiring party's costs of participating in the acquisition should be. The AMI provision should make it clear that his proportionate part of "acquisition costs" includes an obligation to participate in all the contractual obligations required to earn the rights under the Farmout or Seismic Option, etc.

In Lease acquisition situations, the AMI provision should also make clear that "acquisition cost" is not limited to bonuses paid for the rights, but includes related costs, such as recording fees, "broker" fees, title opinions and curative, etc. Normally, "in-house" costs of title examination, lease acquisition, etc., should not be included and should in fact be expressly excluded; if such costs are to be included, the agreement should expressly so provide.

Don't make the mistake of saying that the Lease acquisition costs will be determined "as provided in the attached Accounting Procedure: the standard COPAS Accounting Procedure assumes that necessary Leases have already been acquired and does not cover such costs!

Coming Next: Administrative Issues

¹Having an AMI that is broader than the Contract Area of the Farmout or Joint Operating Agreement in which the AMI is included can be extremely useful when you aren't sure of the exact areal extent of the prospect or where there is a possibility of unexpected zones that could cover a different geographical area.

²In the past, issues have arisen on a small-scale map where the AMI is marked with a broad-tipped marker: is the boundary of the AMI the outer or the inner edge of the mark? (Believe it or not, tremendous amounts of money turned on this issue!) Also, just to avoid confusion – or controversy – it's better not to say "marked in red" where all but the original of the plat will be black-and-white copies.

³Additional problems arise in the "option" situation as to when the non-acquiring party must elect whether or not he wishes to participate in the acquisition, and exactly what his share of the "acquisition costs" should be. These issues will be discussed below.

⁴The definition can and should be varied to match the objectives of the parties in connection with the particular prospect. For instance, in some deals, the intentions might be, "If you acquire anything relating to oil and gas, I want a right to share." Under these circumstances, non-participating/non-operating interests should be included in the definition of "Oil and Gas Rights." On the other hand, if the unstated objective of the clause was to permit participation in acquisitions that authorized the conduct of oil and gas operations, non-operating interests should be excluded from the definition of "Oil and Gas Rights." And if sharing in the acquisition of data is contemplated, further modification would be required: see below.

⁵For a further discussion of seismic and seismic options, see the multi-part Mosburg, "The Use of Seismic Options and Exploration Agreements as Exploration Tools," contained in the "archives" section of this Newsletter.

⁶There is no overwhelming "industry custom and practice" as to either of these issues: most commonly, the agreement is simply silent. When (rarely) considered and expressly provided for, the more common solution would be to exclude pro ratio of bonuses and royalties, although there is sometimes a provision for pro ratio of delay rents (and sometimes bonuses) fifty percent to the shared and fifty percent to the excluded interests. There simply does not seem to be a "common" practice as to including, or excluding, the additional formations/depths covered.

⁷This would be true if an "assign when earned" (rather than a "present assignment") Farmout was involved. (For a discussion of the difference between these two types of agreements, see Mosburg, "An Introduction to Oil and Gas Contracts (Part One): Introductory Concepts; Farmout Agreements," contained in the "archives" section of this Newsletter.)

⁸In at least one case, a several-year delay between the date of the (improper) telephonic notice of acquisition and the attempted exercise of the right to participate was held barred by laches.

⁹Cf. Article VI.B.2.(a) of the A.A.P.L. Model Form Operating Agreement (1989 version), p. 6, ll. 40-50.

¹⁰A smaller company with limited resources might seek to negotiate and add a special provision that it could participate, at its election, for "up to 50%, but not less than 10%" of the interest in the newly-acquired Lease. Similarly, if significant sums were being spent to acquire substantial amounts of additional acreage in a broad "rank wildcat" area, the parties might agree that elections must cover all – or none – of Leases on a block-by-block (defined) basis and that each party would advance to the Operator its proportionate party of estimated Lease acquisition costs for the next (specified) period.

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