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No Risk, No Reward: The Liberty v. NDIC Decision Holds That Risk Penalties Can be Recovered From Total Unit Production

AUTHOR(s)

lafayette oil and gas

In Liberty Petro. Corp. v. N.D. Indus. Comm’n,111 N.W.3d 851 (N.D. 2024). the Supreme Court of North Dakota addressed whether nonconsent risk penalties must be assessed on a well-by-well basis or can be recovered from overall unit production. The court agreed with the North Dakota Industrial Commission’s (“NDIC”) approval of a unit plan that allowed risk penalties to be recovered from unit production as opposed to limiting recovery to the specific nonconsent well.

I. Background & Unitization

In 2022, Burlington Resources Oil & Gas Co. LP (“Burlington”) filed for unitization with the NDIC, creating the Haystack Butte Unit (the “Haystack Unit”) in McKenzie County, North Dakota. The goal of unitization was to allow wells to be drilled without regard to prior drilling and spacing unit (“DSU”) boundaries that would restrict the length and location of horizontal wellbores. As part of the application process, Burlington submitted a proposed unit agreement (the “Haystack UA”) and a proposed unit operating agreement (the “Haystack JOA”). Liberty Petroleum Corporation (“Liberty”) contested the unitization.

Prior to the plan of unitization, the Haystack Unit area consisted of multiple DSUs with 19 producing wells. Liberty owned a working interest in six of the DSUs containing 11 of the producing wells. Liberty had elected to participate in seven of the 11 wells and was “nonconsent” in the remaining four wells. Notably, three of the four nonconsent wells were located in DSUs that also had wells where Liberty was participating. Liberty had been assessed a 200% risk penalty for each nonconsent well under the North Dakota Compulsory Pooling Statute,2N.D. Cent. Code § 38-08-08. and had an outstanding drilling, completion, and risk penalty balance at the time of the petition for unitization.

The Haystack JOA provided that the operator could recover risk penalties out of unitized production — including the prior outstanding balances due on the 4 nonconsent wells.  In other words, under the JOA, the operator could withhold production from the seven consent wells to satisfy Liberty’s penalty balances on the four nonconsent wells. Liberty, on the other hand, argued that penalties could only be recovered from production from the specific nonconsent well in which the penalty accrued. Anything else, Liberty argued, was “unfair and inequitable” and even a constitutional regulatory taking.

Rejecting Liberty’s arguments, the NDIC approved the Haystack UA and JOA, finding that the unitization as proposed was in the public interest, protected correlative rights, and maximized production of oil and gas. The NDIC based this reasoning on the fact that production from the wells in the unit area is no longer attributable to individual wells and spacing units but instead is attributable to the tracts in the unit on a pro rata acreage basis. Liberty appealed this decision to the district court who affirmed the NDIC’s decision. On appeal to the Supreme Court, the issue was narrowly framed as whether pre-unitization risk penalty balances can be recovered out of subsequent unit production or must be recovered at the well level.

II. How are Past Risk Penalties Assessed?

Chapter 38–08 of the North Dakota Century Code (“Control of Oil and Gas Resources”) creates separate but similar compulsory pooling schemes for: (i) pooled units (for example a two-section or “1280” DSU); and (ii) larger reservoir-based unitized areas covering a common source of supply. The Compulsory Pooling Statute authorizes a risk penalty on leased working interest owners in the amount of 200% of the nonparticipating owner’s share of the reasonable actual costs of drilling and completing the well. The Pooling Statute goes on to state that the risk penalty may be recovered out of, and only out of, production from the pooled spacing unit.3Id. at § 38-08-08(3)(a).

Similarly, the Compulsory Unitization Statute authorizes a risk penalty on leased working interest owners in the amount of 200% of the nonparticipating owner’s share of the unit expense. The Unitization Statute then provides that the 200% risk penalty can be recovered out of, and only out of, production from the unit.4Id. at § 38-08-09.4(3)(a). Article 11.8 of the Haystack JOA similarly states that risk penalties shall be satisfied out of proceeds from the sale of Unitized Substances attributable to the affected tract.

III. The Supreme Court Takes a Broad View on Recovering Risk Penalties

Neither the Compulsory Pooling Statute nor the Compulsory Unitization Statute specifically address recovering a risk penalty that accrued in a spacing unit that was later made part of a larger unitized area. However, the court found that “unit expense,” as used in the Unitization Statute has a broad meaning, covering “any and all cost and expense in the conduct and management of its affairs or the operations carried on by it.”5N.D. Cent. Code § 38-08-09.13(4). Thus, the court held that under the Unitization Statute and Article 11.8 of the Haystack JOA, the prior risk penalties can be satisfied out of proceeds from the sale of unit production.

An analysis of the Compulsory Pooling Statute leads to a similar result. The statute allows for recovery of a risk penalty on nonconsent wells from production from the pooled spacing unit. The Statute does not state that the risk penalty must be recovered from a specific well. Therefore, under either Statute risk penalties are assessed and recovered at the unit level regardless of whether a non-operator has consented and/or is being carried in one or more wells. The court declined to defer to prior NDIC Order No. 32353 (the “Twin City Technical Case”) that had ruled that risk penalties on nonconsent wells can only come out of that specific well’s production.

The court also rejected Liberty’s argument that Article 11.8 of the Haystack JOA was an unconstitutional taking under the United States and North Dakota Constitutions. So-called “total regulatory takings” occur when regulations completely deprive an owner of all economically beneficial use of their property. To the contrary, Liberty continued to own its own working interests and be credited with its share of production while the production pays down its penalty balance. Per the court, “[t]his is not a situation where Liberty is not receiving any economic benefit for its interest – rather, this is a situation where Liberty is receiving a different economic benefit than what it would prefer.”611 N.W.3d 851, 858.

Finally, the court deferred to the NDIC order itself, holding that its findings were supported by substantial and credible evidence, and contained fair, reasonable, and equitable provisions. The NDIC’s decision (1) was in the public interest and reasonably necessary to increase ultimate recovery, prevent waste, and protect correlative rights, (2) complied with Chapter 38–08 of the Century Code, and (3) was for the common good. The court also noted that under its deferential standard of review, it “accord[s] greater deference to Industrial Commission findings of fact than we ordinarily accord to other administrative agencies’ findings of fact.”7Id at 861.

IV. Takeaway

This holding allows operators more flexible accounting procedures when it comes to calculating payout thresholds at the DSU or unitized level. It may be particularly useful for situations where a party has consented to some wells and is being carried or has “gone nonconsent” in others. Note that this case addressed recovering risk penalties allocable to prior DSUs when they have been “dissolved” into a larger, unitized area covering a common source of supply. The court holds that risk penalties can be recovered on unitized (or pooled) lands at the unit level as opposed to the well level, regardless of when the penalties accrued.

What is less apparent is the effect this holding may have on overlapping lease line wells and units. Overlapping units occur when two or more prior DSUs are “combined” to allow for drilling in a lease line setback corridor, but the lands are not formally unitized. Overlapping pooling orders typically state that they do not reallocate production for wells producing on the underlying “base” units. The base unit wells remain committed to their base units, and the overlapping units typically contain a single lease line well (or occasionally two stacked lease-line laterals) that is committed to the new overlapping unit. It would thus appear that although risk penalties can be recovered from the collective wells on a DSU, it would be less likely that recovery could be made from a lease line well in an overlapping unit for prior penalties allocable to the base unit wells. This is because the Compulsory Pooling Statute allows recovery only from the actual “pooled spacing unit” of which the wells are a part.

This case also underscores the level of consideration North Dakota courts give to the NDIC, affording them even greater deference than they do other administrative agencies. This is generally because courts recognize the high degree of specialized and technical knowledge it takes to regulate oil and gas production.

  • 1
    11 N.W.3d 851 (N.D. 2024).
  • 2
    N.D. Cent. Code § 38-08-08.
  • 3
    Id. at § 38-08-08(3)(a).
  • 4
    Id. at § 38-08-09.4(3)(a).
  • 5
    N.D. Cent. Code § 38-08-09.13(4).
  • 6
    11 N.W.3d 851, 858.
  • 7
    Id at 861.

Brad represents clients in connection with upstream energy transactions, complex mineral titles, pooling issues, lease analysis, joint operating agreements, surface use issues, title curative and general oil and gas business matters.

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