Status of an oil well should be decided with reference to the original purpose for which is was drilled, court says

Out-Law News | 04 Jul 2012 | 3:12 pm | 2 min. read

The "predominant purpose" for which an oil well was originally drilled should be the most important consideration when deciding what type of activity it is used for and therefore what legal obligations apply, the High Court has ruled.

In his judgment, Mr Justice Popplewell said that an oil well could fall within the 'production' category of well for the purposes of dividing up liability under a joint venture agreement regardless of whether it was "targeting proved reserves", as long as the participants who made the decision agreed that it should be so designated.

The case concerned a joint operating agreement (JOA) between three energy companies involving the 'Jacky J03' well in the inner Moray Firth area of the North Sea. Under the rules of the JOA the project's minority partner North Sea Energy (NSE) was obliged to contribute to the cost of the project despite voting against drilling the well. Had the well been designated an 'appraisal' well, as argued by NSE, the company would have been entitled to opt out of contributing under the terms of the JOA.

Energy law expert Katharine Davies of Pinsent Masons, the law firm behind Out-Law.com said that the decision would provide security to operators in the oil and gas industry, as "voting dissenting parties into" the cost of production wells was "general industry practice" in North Sea JOAs.

"The decision provides some security to operators and their partners that, when they make a decision in good faith to drill a particular type of well – and their documentation and plans going forward support this – they can be reasonably certain that, when the planning and drilling begins, the designation of the well and the funding arrangements supporting it will not later be open to challenge by a dissenting partner," she said.

Pinsent Masons represented one of the project's majority partners, Ithaca Energy.

In a statement on its website Ithaca said that NSE was obliged to contribute to the costs of the well in accordance with its 10% stake in the project. NSE had not requested leave to appeal, it said, and had been ordered to pay Ithaca's legal costs.

Oil wells generally fall under one of four categories of activity: exploration, appraisal, development and production. Appraisal is the phase which is carried out after a discovery has been made by an exploration well, but before the oil company decides to apply for permission from the regulator to develop the discovery. However, the term can also apply to various incremental exploration projects after regulatory approval has been granted.

North Sea oil and gas operations are commonly based on JOAs between several partners in order to spread both the substantial investment costs and the risk. The lead partner, known as the 'operator', puts forward proposals to an 'operating committee' made up of representatives from each partner, which then votes on whether a course of action or piece of expenditure should go ahead.

Ithaca, with a 47.5% stake, had the largest share in the Jacky J03 project while partner Dyas, which also voted in favour of the development, held a 42.5% share.

"NSE's case rested on the well being not, in fact, a 'production' well but actually an ' appraisal' well, to which different conditions and obligations were attached," Davies said. "Effectively the company was challenging the operating committee's designation of the well. Had they been successful, they would have argued that they were not liable to contribute to the costs of the well - which, in turn, would have shaken the basis of most North Sea oil and gas funding structures, profoundly affecting the industry."

Mr Justice Popplewell acknowledged that identifying the "primary or predominant purpose" of a well could in some circumstances be complicated by it bring "possible to have different purposes driving the same project in the minds of different participants". However, the purpose was clear in this case due to "what was communicated by ... Ithaca and Dyas".

"Labelling by the operating committee at the time is not determinative," he added. "But contemporaneous descriptions by the parties and interested observers are not wholly irrelevant ... The individuals concerned were experienced in this industry and can be taken to have understood the import of describing activity as 'appraisal' or 'production'."