Potential Oil Proration by the Texas Railroad Commission: Background and Impacts

1. Summary of RRC Oil Proration Comments; OPEC Invitation

On March 20, 2020, RRC Chairman Wayne Christian issued a press release in response to recent suggestions from certain oil and gas producers that the RRC resume prorating the production of oil in order to stabilize markets. In the release, Chairman Christian states that “[w]hile I am open to any and all ideas to protect the Texas Miracle, as a free-market conservative I have a number of reservations about” using prorationing of oil as a solution to the economic issues attributable to current international market instability.

Additionally, it was recently announced that RRC Commissioner Ryan Sitton was invited to the June meeting of the Organization of Petroleum Exporting Countries (OPEC), following the proposal to curtail oil production in coordination with Saudi Arabia and Russia.¹ If Commissioner Sitton were to attend, this would be the first time an RRC member has attended an OPEC meeting since 1988.

Although Chairman Christian appears hesitant to implement any oil proration rules in the recent press release, especially in light of Commissioner Sitton’s potential attendance at the upcoming OPEC meeting, it is important for producers and their capital sponsors to understand (i) what the contours of any such oil proration measures would be (if implemented) and (ii) the impact such proration measures could have on current operations. 

2. Background

In the early days of oil and gas exploration, Texas courts adopted the “ownership in place” theory subject to the “rule of capture” to address the problem of fitting migratory oil and gas into traditional concepts of property law. Under the ownership-in-place theory, each landowner is deemed to own the oil and gas beneath his property as well as any oil and gas that migrates to his property as a result of legal drainage from a neighbor’s land. A landowner’s only remedy for losing oil and gas as a result of drainage was to drill an off-set well on his own property to capture the oil and gas before it was recovered by his neighbor. Originally, this off-set well remedy was unregulated by the state and each property owner had the right to drill as many wells on his property as he desired (in other words, a race to the bottom).

To conserve natural resources and protect citizens’ welfare, an amendment to the Texas Constitution was adopted in 1917 that provides “the conservation and development of all of the natural resources of this State ... are each and all hereby declared public rights and duties; and the Legislature shall pass all such laws as may be appropriate thereto.”²

The jurisdiction of the RRC over Texas oil and gas operators derives from, among other sources, the specific authority granted by enabling statutes in Chapters 81 through 111 of the Texas Natural Resources Code and Chapter 27 of the Texas Water Code. Under these delegations of authority from the Texas legislature, the RRC has broad authority to require operators to conduct oil and gas activities in ways that will prevent waste and protect correlative rights, and it also has the authority to regulate operator activities to prevent pollution of surface waters and groundwater.

Despite the broad grant of statutory authority primarily found in Chapters 81 through 111 of the Texas Natural Resources Code, the power of the RRC to regulate oil and gas production in Texas is limited to the authority granted by the legislature. The Supreme Court of Texas has held that a statute clearly defining the public policy of the state is a prerequisite for the RRC to have authority to promulgate any rule, regulation or order relating to the production of oil or gas and that the power to pass laws rests with the legislature.³

3. Does the RRC Have the Authority to Implement Oil Proration Measures?

Section 85.053 of the Texas Natural Resources Code grants the RRC power to implement rules or orders that limit or fix the production of oil if the RRC finds that such action is necessary to (1) prevent waste or (2) adjust the correlative rights and opportunities of each owner in a common reservoir. The Texas courts have held the RRC’s regulation of the production of oil and gas to be a valid exercise of the policy powers of the state.⁴

Currently, the RRC implements allowables on oil well production through the yardstick tables set forth in Section 3.45 of the Texas Administrative Code. This allowable may be modified based on specific circumstances, including pursuant to the penalty gas-oil ratio rule set forth in Section 3.49 of the Texas Administrative Code, the horizontal oil well allowable rules set forth in Section 3.86 of the Texas Administrative Code or by special order of the RRC.

The RRC’s statutory authority to limit such production derives from Chapter 85 of the Texas Natural Resources Code. In relevant part, the Texas proration statute:

a) prohibits the “waste” of oil (Tex. Nat. Res Code § 85.046);

b) defines the term “waste” as including, among other things, the production of oil in excess of “reasonable market demand” (Tex. Nat. Res. Code § 85.046(10);⁵

c) authorizes the commission to determine when production of oil is in excess of “reasonable market demand” (Tex. Nat. Res. Code § 85.058); and

d) gives the commission power to (i) limit production of oil, (ii) prorate allowable production and (iii) make and enforce rules, regulations and orders necessary for the exercise of these powers (Tex. Nat. Res. Code §§ 85.046, 85.054 and 85.058).

However, the statute expressly prohibits the RRC from prorating production based on reasonable market demand under Section 85.046(10) of the Texas Natural Resources Code for any field with less than 10,000 barrels of oil a day of aggregate production.⁶ In addition, the courts have limited the RRC’s authority by providing that “proration orders would not be valid if shown to bear no reasonable relation either to the prevention of waste or the protection of correlative rights, or if shown to be otherwise arbitrary.”⁷

The constitutionality of market demand prorationing was tested in Oklahoma and upheld in Champlin Refining Co. v. Corporation Commission, 286 U.S. 210 (1932). In Texas, a pre-Champlin constitutional challenge to some early proration orders in federal court based on due process considerations was initially successful,⁸ but after Champlin the federal constitutional issues would seem to be resolved in favor of the regulator’s authority to prorate to address market demand. 

To the extent that the oil proration measures being contemplated by the RRC are implemented, producers in Texas should be prepared to comply with such restrictions on production pending the outcome of any judicial challenges with respect thereto.

4. Business Risks Arising From Implementation of Oil Proration Rules

Companies operating in the Texas oil and gas industry should consider the risks associated with the RRC’s consideration of once again implementing oil proration rules. If the RRC were to reduce the amount of recoverable oil from any or all of a company’s wells below 100 percent of production capacity, any or all of the following business risks, among others, could be implicated:

a) MVC Obligations. Restrictions on allowable oil production from proration could cause a company to fail to satisfy its minimum volume commitment (MVC) obligations under gathering and other midstream agreements or generate a force majeure dispute.

b) Credit Facilities. Restrictions on allowable oil production from proration could cause a company to breach leverage ratio or other maintenance covenants or affect other obligations under its credit facilities.

c) Oil and Gas Leases. Companies should analyze lease maintenance covenants and continuous drilling obligations in key leases to ascertain compliance risks and possible mitigants (e.g., force majeure clauses).

d) Reserves Reporting. Securities and Exchange Commission registrants in particular should consider whether and to what extent imposition of a broad scale proration order could affect their reported proved reserves.

Given the fluidity of the current regulatory framework, we encourage companies operating in the Texas oil and gas industry to reach out to a member of the Sidley Energy and Infrastructure or Global Finance Teams with questions regarding specific situations. We note that we will continue to monitor any legislative developments with respect to the RRC and implementation of oil proration rules.