Structuring shale gas development agreements

By Pat Maguire and Vivek Warrier, Bennett Jones LLP
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In the past few years the international oil and gas industry has committed billions of dollars to the development of shale hydrocarbon opportunities in Canada, primarily in British Columbia.

Rich finds

Two areas in northeastern British Columbia have caught the interest of international producers. These areas are also uniquely positioned to meet Asian energy demand as they are near the closest North American port to Asia. This can save approximately 60 hours of transpacific sailing time, relative to ports in California.

Pat Maguire Partner Bennett Jones LLP
Pat Maguire
Partner
Bennett Jones LLP

The Horn River Basin play covers around 1.28 million hectares with estimated reserves of 109,000 billion cubic feet of gas, of which 29% is conventional gas and 71% is shale gas. The Montney play is located in the Peace River Regional District and encompasses seven municipalities.

Exploration companies have spent more than US$2 billion to acquire drilling rights from the government and as of July 2009, 234 horizontal wells were producing an average of 376 million cubic feet per day. Even though official reserve estimates have not been finalized, they are estimated to be between 80,000 billion and 700,000 billion cubic feet of gas.

Uniqueness of shale

Several factors distinguish large-scale shale development from more traditional gas transactions. Besides the relatively larger scale of a shale gas development, the nature of the shale reservoirs requires a relatively expensive drilling pattern and stimulation through fracturing.

Secondly, there is often existing infrastructure for which parties need to negotiate arrangements to obtain the benefit of their share of production.

Thirdly, shale development often occurs in areas that do not have significant midstream infrastructure. As a result, the parties need to anticipate the need for significant capital expenditures associated with midstream development, including gathering and processing, which can often result in a second related joint venture.

Transaction structure

An entity such as a limited liability company or limited liability partnership that is co-owned by investors is less common than a joint venture in the development of large-scale shale gas plays. In a joint venture, each participant owns an undivided percentage of working interest in the project assets and is responsible for its participating interest share of production and all liabilities and obligations.

In addition, farmouts of large-scale shale development often include an upfront payment and an upfront conveyance of a working interest to the farmee. If all of the transactional consideration is not paid up front, the remainder is typically paid as a carry. Where some of the total transaction consideration is payable subsequent to closing, the beneficiary party may require the party with such an obligation to provide credit support.

Vivek Warrier Partner Bennett Jones LLP
Vivek Warrier
Partner
Bennett Jones LLP

Tax and similar attributions vest directly with each participant according to their participating interests. In Canada, tax hurdles make structuring traditional farmout arrangements more difficult. For tax reasons, the use of a partnership to co-own these types of projects is frequently considered, as the vending company can contribute assets into a partnership in which it is a partner on a “rollover” basis, thus avoiding the tax result that would be associated with the outright sale of an interest in the project.

Complications often arise where the joint venture partners are resident in different jurisdictions – especially if one partner is resident where the assets are located. Under such circumstances, the local partner generally avoids investing in a separately taxable company, preferring instead a fiscally transparent entity such as a partnership.

Governance

Large-scale shale ventures often employ standard form operating agreements in conjunction with other project documents, including joint development agreements or participation agreements or both. This is in contrast to traditional gas joint ventures, which typically rely on standard form operator agreements where the conduct of the joint operations is determined by the operator.

A challenge unique to larger-scale developments is the extent to which the failure to agree gives rise to the right to undertake sole risk or independent operations, and the extent to which there are any restrictions on a right to undertake such operations.

Large-scale joint ventures typically deal with certain matters among the parties and establish a decision-making body to consider important issues. This body should endeavour to balance the need for legal certainty and rigour that will withstand less than amicable circumstances with a practical desire for efficient and timely governance.

The joint development agreement will address most of the larger overarching joint venture issues. It must be carefully linked to the operating agreement to make sure that the suite of documents work together as the parties intended.

Pat Maguire and Vivek Warrier are partners at Bennett Jones LLP. Bennett Jones is a leading Canadian law firm with over 400 lawyers in offices throughout Canada and in the UAE.

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