Joint operations in the oil and gas industry long have been one of the conventional ways to reduce and spread the economic risks associated with exploration, drilling and production of crude oil and natural gas. With the recent downturn in oil and gas commodity prices, the lien and security provisions in joint operating agreements (“Operating Agreements”) have once again become a significant component of the risk mitigation strategy of joint operations. Indeed, both Operators and Non-Operators must take pre-emptive actions under Operating Agreements to assure themselves that the non-performance of one of their co-owners does not leave them unprotected from a costly default.

A.A.P.L. Form 610-1989: Protection for Operators and Non-Operators To secure both the Operator’s and the Non-Operators’ proportionate share of all of their respective obligations under the Operating Agreement, including payment of expenses, under the A.A.P.L. Form 610-1989 Model Form Operating Agreement (“AAPL Form 610-1989”), the most commonly used form of Operating Agreement, the parties grant to each other a lien and security interest in both current and future acquired real property located within the “Contract Area,” and a security interest in the currently-owned and after-acquired personal property and fixtures related to the real property. In addition, the lien and security interest granted extends to the oil and gas when extracted. While each party represents to the other parties that the lien and security interest granted under the Operating Agreement will be a “first and prior lien,” and that the granting party will maintain the priority of such lien and security interest, Operators and Non-Operators, in order to obtain such priority, must perfect their respective security interests by a recording in the applicable state and county records. This can be accomplished by the execution, acknowledgment and recording of the form of Memorandum of Operating Agreement and Financing Statement that is an exhibit to the Operating Agreement. If a Contract Area under the Operating Agreement is located in two or more counties, parties, as part of prudent practice, should record the Memorandum in all applicable counties.

A.A.P.L. Form 610-1982: Protection for Operators Only The A.A.P.L. Form 610-1982 Model Form Operating Agreement (“AAPL Form 610-1982”), less common than the Form 610-1989 but still in use, does not provide that the Operator grants a lien and a security interest to the Non-Operators; therefore, Non-Operators under the vintage AAPL Form 610-1982 must amend the Operating Agreement in order to create a provision that grants a lien and security interest to the Non-Operators.

Third Party Concerns; Potential Conflicts with Pre-existing Reserve Base Production Loans Certainly it is not uncommon for Operators and Non-Operators alike to have leveraged their respective assets with reserve base production loans. Care should in taken in accepting at face value the recitation in Operating Agreements that the lien and security interest granted thereunder in fact create a “first and prior lien.” Properly perfected pre-existing production loans may stand in the way. Care, too, should be taken by Operators and Non-Operators with such loans in place. For the “first and prior lien” representation to be true in either the Operating Agreement or the loan agreement, the priority of the lien created by the other instrument must be carved out as an exception to the regime otherwise created by the respective agreement. Finally, Operators and Non-Operators with reserve-based lending or other financing should review the covenants in the applicable agreements to ensure that proper notice is given or consent obtained, so that another party’s perfection of the Operating Agreement lien does not cause a breach of those covenants.

Client Alert 2014-342