UK: This Is Not America: Why US Royalty And Project Structures Are Essential To UK Unconventional Gas Developments

In the US, the pace of development of onshore unconventional gas developments has been simply astonishing. In the UK, however, the situation could not be more different. Despite the existence of a significant unconventional resources base, the rate of progress has been pitifully slow. Much of this difference in fortune can be attributed to the difference in the manner in which unconventional gas projects are developed between the two countries.

The position in the US

In the US, land (and any in-ground petroleum reserves within that land) is capable of being owned privately.

A private landowner could elect to exploit the petroleum beneath its land itself or it could lease its land to a developer for a defined term to allow that exploitation to take place. This would be done under a development lease, and the terms of such leases are well settled in US practice.

In the US there is ordinarily no compulsion upon a landowner to develop the petroleum deposits on its land. The landowner is free to let the land lie fallow if that is what the landowner wants to do. Consequently, an economic incentive to develop a petroleum deposit, through the entry of the landowner into a development lease in exchange for the promise of a royalty payment, can be seen as very necessary in order to facilitate petroleum production.

The economic heart of the development lease is the commitment of the developer to pay a defined royalty (calculated on produced petroleum) to the landowner. The rate of this landowner royalty interest is commonly expressed as a fraction which can be reduced to a percentage (e.g. 1/8 (12.50%), 4/25 (16.00%) or 3/16 (18.75%)).

Additionally, the developer assumes all of the operational risks and responsibilities associated with the production of petroleum from the tract. The landowner is, in effect, a sleeping partner in the development of its petroleum reserves.

Where a petroleum deposit underlies an area of land which is owned by multiple landowners then, through the concept of 'pooling', the landowners could act together to lease their lands to a developer. The developer would pay to the landowners a defined royalty payment in respect of any petroleum which is produced from the pooled land interests (the "tract").

Where this happens the royalty payment which is due from the developer to an individual landowner will be calculated by the application of two steps: the tract is divided by that landowner's interests in the tract, to give the landowner's 'net interest in the tract'; and the net interest in the tract is then multiplied by the defined royalty interest (which is typically written as a fraction but should be expressed as a percentage) in order to determine the landowner's 'net royalty interest.'

A notable feature of this calculation is the direct mathematical division of the tract by the landowner's interest to give the net interest in the tract without any attempt to weight the landowner's interest according to the proportion of petroleum contained in the landowner's interest when expressed as a percentage of the whole petroleum deposit. The royalty is payable irrespective of the actual profile of gas in residence under the landowner's land (i.e. whether the landowner has proportionately more or less of the total deposit) – there is not the prospect of a redetermination which typically exists in the context of a unitisation (at least in the UK).

This simple extrapolation is in contrast with the complexity of how unit equities are determined in the UK-style unitisation of a conventional petroleum deposit – where the petroleum percentage by content of the overall deposit has to be allocated to each contributory concession area according to individual content.

The position in the UK

The position outlined above in the US exists because private ownership of in-ground petroleum reserves, which can be leased by a landowner for development by a developer, is possible. In essence, there is a partnership between a landowner and a developer which benefits them both, and the landowner has clear financial incentives to develop its petroleum reserves.

In the UK, all in-ground petroleum is vested in the Crown, which licences private sector participants to explore for and to produce petroleum (with a licence granted over a defined geographical area and for a defined term). A licensee will be expected to develop petroleum deposits itself, in accordance with the terms of the licence as granted. In the UK licences are granted under the Petroleum Act 1998, which applies a series of standard Model Clauses to a licensee. There is a particular form of licence for onshore petroleum exploitation but no distinction is made for unconventional gas deposits.

The recent news that licences to be awarded for acreage in the forthcoming 14th onshore licensing round in the UK will incorporate changes which indicate an appreciation of the essential operational differences associated with shale gas developments (relating, for example, to changed term durations, flexibility in the timing of performing work obligations and the ability to retain certain areas of land from otherwise compulsory relinquishment) is encouraging, but it does nothing to represent the revolutionary change in thinking which is necessary to make a success of shale gas in the UK.

For onshore unconventional gas deposits in the UK, a combination of petroleum deposits which underlie multiple licence areas and relatively poor economies of scale for developing such deposits on an individual licence basis has suggested the need for greater collaboration between licensees.

In the UK there are two options for a group of licensees to jointly develop a petroleum deposit which underlies the areas which they variously licence:

  1. Unitisation – different licence areas which together contain a single, contiguous petroleum deposit could be developed as a single unit. This would be done under the auspices of a unitisation and unit operating agreement in which each licensee would hold a defined unit interest. Unitisation could be undertaken votively by a group of licensees or could be compelled by the Crown under the Model Clauses.
  2. Joint development – the licensees could enter into a contractual joint development commitment, with the commercial terms of the planned joint development programme to be set out in detail, but without the formality of a full unitisation. This would be a purely contractual arrangement between the licensees, which might need to be notified to the Crown under the Model Clauses.

However, unconventional gas deposits have a troubled geology, which does not readily lend itself to the process of unitisation in the same way as would apply to a conventional gas reservoir. In coalbed methane ("CBM"), the gas is adsorbed onto the surface of the methane-bearing coal and in shale gas the need to liberate captive gas from fissile shale deposits leads to difficulty in defining a petroleum deposit against which unit equities can be determined. Furthermore, appraisal drilling in order to delineate the profile of the deposit is not as readily achievable as is the case for a conventional gas reservoir.

Thus, for the joint development of an unconventional gas deposit which is spread across multiple licence areas, a joint development programme could be more attractive than a unitisation.

In contrast to the US, where there is ordinarily no compulsion upon a landowner to develop the petroleum deposits on its land, in the UK the licensee will ordinarily be subject to certain conditions in the licence which oblige it to take steps to explore for and to produce petroleum from the licence area. Failure of the licensee to do so could ultimately result in forfeiture of the licence. That said, the renegotiation of licence terms to allow more time is not uncommon and the UK regulator will usually do so where a sensible case for procrastination can be made by the licensee.

The headline point here is that in the UK the licensee arguably does not need the benefit of an economic incentive to produce petroleum from its licence area because it has a very pressing regulatory imperative to do so, but this is not entirely right. The generally poor project economics which characterise onshore individual unconventional gas development prospects enhance the need for some creative economic input, and this (like the position in the US) is where a third party coming in as a project developer could have a key role to play.

Bringing US practices to the UK

Notwithstanding the regulatory imperative outlined above in the UK for licensees to develop their interests, the truth is that when it comes to promoting onshore unconventional gas production (particularly CBM and shale gas) progress has been painfully slow. No major CBM or shale gas development has yet come to fruition in the UK and it is certainly arguable that licensees would benefit from a clear economic incentive (such as a carefully structured joint venture effort and the engagement of a third-party developer) to make more progress.

US-style royalty payments by a developer to a landowner simply do not fit within the UK context as it presently stands because there is no private landowner and because the licensee is the developer.

Although it is sometimes discussed by commentators, there is no real prospect of a wholesale regulatory change which would see the transfer of in-ground mineral rights from the Crown to private landowners, such that the economic conditions applying to onshore developments in the US could be replicated in the UK. This would represent an enormous, and most unlikely, change of legal direction.

Consequently, something has to be done within the confines of the existing regulatory framework and some very creative thinking is required.

An option for the effective joint development of a UK unconventional gas deposit is the following:

  • The joint development platform – a group of licensees who together hold licences in respect of an area which together contains an unconventional gas deposit would enter into a contractual joint development commitment which applies to all of their licences in order to create a single combined area of operations. There is nothing in the Model Clauses which precludes this, although it could be necessary to present such a joint venture arrangement to the Crown for approval. There would be a direct division of the totality of the licence areas which together make up the combined area of operations by each individual licensee's area interest to give each licensee a net interest in the combined area, without any attempt to weight each licensee's interest according to the proportion of gas which is believed to be contained in each licensee's interest when expressed as a percentage of the entirety of the gas deposit across the combined area. This is not precluded by the Model Clauses, since it is done essentially as a matter of contract between the licensees, but it might be presented to the Crown for approval as part of the joint development arrangements. There would also be a need to manage possible acreage relinquishment rights under the licences to ensure a stable estate.
  • Securing the operational knowhow by the appointment of a single project contractor – all of the licensees would jointly operate a single contractor with responsibility for managing the activities necessary to explore for and produce gas from the combined area of operations. This would be done under a relatively standard form of services contract; this is not precluded by the Model Clauses. Remuneration of the contractor would be by payment in kind from the resultant gas production. The contractor would have significant previous experience in developing unconventional gas deposits and so would be more attuned to the notion of taking the risks associated with development activity and non-performance of the deposit.
  • Risk shifting and the payment of a defined royalty – the appointed contractor would agree to pay a defined royalty to each licensee. This royalty would be calculated and applied between the licensees, and paid by the contractor, in the same manner that a developer pays a royalty to a group of landowners in the US, as described above. Any value in produced gas which remains after payment of the royalty would be for the account of the contractor and would represent the compensation payable to the contractor for the performance of its services. Paying the contractor out of the proceeds of sale of gas production effectively shifts the risk of non-performance of the gas deposits onto the contractor. This, however, is a risk which a skilled unconventional gas project developer should be comfortable to assume. Acknowledgement by the Crown of this fiscal structure between the licensees and the contractor would be required.

In the UK poor economics of scale militate against the development of unconventional gas deposits on an individual licence basis. This realisation drives licensees to the conclusion that a multiple-interest collaborative venture is necessary. Unitisation of the blocks is the first thought that then comes to mind, but unconventional gas deposits and unitisation are not natural bedfellows. Thus, some sort of pooling arrangement makes better sense.

It will be apparent from the above construction that some dialogue with the Crown regarding the intended joint development arrangements will be necessary, but this should not be a troublesome prospect. The UK Government has repeatedly signalled its keen support for the promotion of unconventional gas developments and should welcome an innovative approach which imports techniques from a jurisdiction with a proven track record in the successful development of unconventional gas deposits in order to make the most of the UK's unconventional resources.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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