Landowners in Ohio should call their Legislators and ask them to vote against House Bill 8. House Representative Al Landis described the bill as an effort to “help” private landowners. In fact, HB 8 does the exact opposite. It will seriously undermine their ability to negotiate for favorable lease terms.
Under House Bill 8, a forced landowner will have to pay a “reasonable interest charge” of “not less than two hundred percent” for his pro rata share of drilling and production costs. There is nothing “reasonable” about such a charge.
Under HB 8 if a forced landowner owns 1/10th of the unit, and unit operations cost $10 million, then the operator would first recover the landowner’s 1/10th share of the cost — $1 million – from the sale of the landowner’s share of hydrocarbons. Thereafter, the operator would recover an additional 200% of these costs in interest. In other words, the operator would recoup $3 million before the landowner saw any value from his working interest. That number may well never be reached.
When a landowner is forced into a unit, he becomes a passive investor in an oil and gas operation. As such, under state law, he collects no money for his “working interest” in production until such time that the operator has recouped the landowners’ pro rata share of drilling and production costs. However unlike other passive investors, the forced landowner is “carried” through operations – meaning he does not put money at risk in the event of commercial failure. Bankers refer to this as a “non-recourse loan.”
Non-recourse loans are not like other loans – the interest rate has to account for not only the time-value of money, but also for the risk of not getting paid back in the event of failure. So to determine a “reasonable” interest rate, you have to consider two issues: (1) how much risk is there for failure? And (2) how long will it take to repay the loan?
For conventional operations, the risk is high. Commonly, one well in four is successful. Shale wells, on the other hand, have a 98% commercial success rate. The only place where there is real risk of commercial failure is when drilling takes place in frontier areas, such as we saw in Medina County. Otherwise, there is virtually no risk of a commercial failure.
Likewise, payback time for shale drilling is short — less than a year. This is because production of oil and gas from shale is front-loaded. About 2/3 of the total production occurs in the first year, and about 90% over the first three years. Few operators would drill a well that would take more than a year to reach payout.
HB 8 condemns forced landowners to pay conventional drilling penalties, and does not reflect the realities of shale development. It allows for a minimum of 200% in interest recovery for a loan that has a 2% chance of failure and is paid back in one year. Ask any banker (or loan shark) if he would take that deal.
Normal commercial loan rates should be applicable in the core shale areas. But if interest rates must be adjusted for risk, then the rate should be no worse than that used for non-recourse loans for the acquisition of conventional producing properties might be sensible. The transactions I have worked on have typically carried interest rates of around 27-28%.
Why does this matter? HB 8 invites operators to lowball landowners everywhere in lease negotiations. The threat of forced unitization will ensure eventual landowner submission. And up to 35% of a unit can be forced.
If HB 8 passes into law, oil and gas operators will play hardball with landowners on lease terms. Landowners should aggressively fight this bill.