This paper will review the provisions of CO&O agreements that deal with the purchase and transfer of interests in facilities, and particularly with the purchase of the Operator's interest. We will discuss the key business issues that a purchaser should review before completing the purchase and provisions in agreements that may restrict dispositions. We will also examine the provisions in CO&O agreements for a change of Operator, and what obligations a new Operator assumes. In all of these discussions, we will assume that the purchaser is buying all of the seller's interests in the area served by the processing facility. Finally, we will outline some of the complications that occur when a midstream processor is the purchaser of the Operator's interest. In this case we will assume that the midstream processor does not purchase the former Operator's production, but does become the Operator of the facility. Part II of this paper will be presented in the Fall issue of JVViews.

A. CO&O Agreement Provisions for Transfer of Interest

The provisions in the CO&O agreement that cover the transfer of an Owner's interest in a facility typically range from those that place no restrictions on the transferring Owner, to those that place severe restrictions on the transferring Owner. These provisions are very similar to those contained in operating agreements for land and mineral interest, such as the Canadian Association of Petroleum Landmen ("CAPL") operating procedure.

1. Notification to Other Owners

If the original Owners of the facility were content with each Owner having full rights to transfer its interest without restrictions, they may have set up the CO&O agreement with provisions that resemble the following:

"The Disposing Owner shall be under no obligation to obtain the consent of the other Owners or to provide the other Owners with a right to acquire that Disposing Owner's interest in the Facility."

PJVA Model CO&O agreement, Alternate A, Clause 9.01, Exhibit "A"

With this provision, the other Owners do not have any say in who becomes their new joint venture partner. Typically, the disposing Owner only notifies the Operator, who revises the working interest Exhibit and advises the other Owners of the change in Ownership.

2. Consent of Other Owners

If the original Owners of the facility wanted a say in who could become their joint venture partner, the agreement provisions might be as follows:

"The Disposing Owner shall obtain the consent of the other Owners, and shall provide them with information regarding the disposition, including the description of the Functional Unit Participation proposed to be disposed and the identity of the proposed assignee. Such consent shall not be unreasonably withheld, and it shall be reasonable for an Owner to withhold its consent to the disposition if it reasonably believes that the disposition would be likely to have a material adverse effect on its Functional Unit Participation or Joint Operations, including, without limiting the generality of all or any part of the foregoing, a reasonable belief that the proposed assignee does not have the financial capability to meet prospective obligations arising out of this Agreement, provided that an Owner which withholds its consent shall include in its notice its reasons for withholding consent. However, an Owner shall be deemed to have consented to the disposition to the proposed assignee, unless, within twenty (20) Days, the Owner advises the other Owners, by notice, that it is not prepared to consent to such disposition."

PJVA Model CO&O agreement, Alternate B, Clause 9.01, Exhibit "A"

This provision requires that the disposing Owner obtain the consent of the other Owners for the disposition/transfer. This type of provision is common in older CO&Os, but there is no time limit placed on the Owners for giving consent. Getting a timely formal consent from the Other Parties has been a problem, so the PJVA introduced the timed deemed consent to this provision. For facilities governed by CO&O agreements without the timed consent provision, many parties now send notifications to the Owners that state that consent will be deemed, if a response is not received before a date stated in the letter. Another method used by parties to obtain Owner's consent, is to request that the Operator issue a Mail Ballot to the Owners for approval of the disposition/transfer. This method also avoids the problems relating to "timeliness of the response".

3. Right of First Refusal

If the original Owners in the facilities wanted a first right option to purchase a disposing Owner's interest, the provisions in the CO&O agreement granting a right of first refusal ("ROFR") are as follows:

"The Disposing Owner shall, by notice, advise each other Owner (in this Article called an "Offeree") of its intention to make the disposition, including in such notice a description of the Functional Unit Participation proposed to be disposed, the identity of the proposed assignee, the price or other consideration for which the Disposing Owner is prepared to make such disposition, the proposed effective date and closing date of the transaction and any other information respecting the transaction which the Disposing Owner reasonably believes would be material to the exercise of the Offerees' rights hereunder (such notice in this Article called "the Disposition Notice")."

PJVA Model CO&O agreement, Alternate C, Clause 9.01, Exhibit "A"

This provision can be quite onerous for the Owner disposing of an interest, as a value must now be placed on the facility interests, even if those interests are included in a larger disposition, which includes oil and gas reserves and/or other facilities. ROFR provisions are also difficult to administer when the interests transferred are part of swaps between two parties. Today, some parties try to avoid the ROFR provisions by obtaining waivers of the ROFR and consent for the disposition/assignment from the other Owners.

4. Exceptions to Consent and ROFR Requirements

Typically, the provisions in a CO&O agreement allow the transfer of an Owner's interest if it is under any of the following conditions:

"
1. a disposition to an Affiliate of the Owner, or in consequence of a merger or amalgamation of the Owner with another corporation or pursuant to an assignment, sale or disposition made by an Owner of its entire Facility Participation to a corporation in return for shares in that corporation or to a registered partnership in return for an interest in that partnership;
2. if a portion of an Owner's interest in the Facility is disposed of as a result of the conversion of a gross overriding royalty interest or other interest to a working interest in a well pursuant to an agreement in existence as of the Effective Date, and the production from such well is required to be delivered to the Facility;
3. a disposition made by an Owner of all, or substantially all, or of an undivided interest in all or substantially all, of its petroleum and natural gas rights in the province or territory where the Facility is situated, and for the purposes of this Subclause, "substantially all" means a percentage of ninety percent (90%) or more of the net hectares held by such Owner in that province or territory;
4. a disposition made by an Owner of all, or substantially all, or of an undivided interest in all or substantially all, of its petroleum and natural gas rights in wells producing to the Facility, and for the purposes of this Subclause, "substantially all" means a percentage of ninety percent (90%) or more of the working interest held by such Owner in such wells; and
5. a disposition made by an Owner of a portion of its petroleum and natural gas rights in wells producing to the Facility, where such disposition is accompanied by the disposition of a proportionate part or share of the Facility."

PJVA Model CO&O agreement, Clause 9.02, Exhibit "A"

This type of provision could allow the transfer of the facility interests to be unrestricted. However, the ROFR provisions in each CO&O agreement should be thoroughly evaluated, as provisions in older CO&O agreements seldom contain as many exceptions to the application of the application of the ROFR as this PJVA Model Clause. Also, in cases where a midstream processor is purchasing an Owner's facility interest, the disposition probably does not include a disposition of the Owner's petroleum and natural gas rights, or wells. Therefore, any ROFR provisions in the CO&O agreement would apply.

5. Administrative Requirements

CO&O agreements also require that the new Owner file the following with the Operator:

• An executed copy of the CO&O agreement counterpart execution page; and
• A copy of the instrument, executed by both parties, evidencing the change in Ownership. (older CO&Os may require an original assignment agreement)

Today, most parties supply the Operator with a simple assignment notice for the facility, signed by the assignor and the assignee. This is preferable to giving the Operator a copy of the full purchase and sale agreement.

6. Administration of the Transfer of Interest

The provisions of the CO&O agreement relative to transfer of interest, require that the Operator recognize the new Owner's interest effective the beginning of the month following receipt of notice, and a counterpart execution of the agreement. Since Purchase and Sale agreements ("P&S") are often retroactively effective to a number of months before the closing of the P&S, the effective date of the new Owner's interest in the facility CO&O agreement, will not correspond to the effective date in the P&S. This time lag in getting official Owner status in the CO&O agreement could be further extended if the CO&O agreement has ROFR provisions. For example, if:

• The disposition was effective (P&S) March 1, 1999, and
• The P&S closed on May 20, 1999, and
• Notice was sent to the facility Operator on June 5, 1999
• The transfer per the CO&O would be effective on July 1, 1999.

In this case, the time lag between the effective date of the sale, and of the effective date of the transfer of interest in the facility CO&O agreement, is four months. If the ownership of the production was transferred to the new owner in May, the facility Operator may consider the May and June production to be owned by a non-Owner in the facility, and that production could be charged a non-Owner processing fee. It is therefore critical that notices to the Operator of a facility are sent immediately after closing.

B. Facility Purchase Complications

1. Provisions that Restrict Transfers

Some facilities were built to serve and process specific reserves, such as all production from a unit or pool. In these cases the facilities were often constructed as "unit facilities", with the whole operation governed by the Unit Operating agreement. If the facilities served more than one unit or pool, a facility CO&O agreement may have been developed, but the ownership may have been held by the Unit Operators, on behalf of the Unit Owners. In such cases, the Ownership in the facilities can only be sold by selling an interest in the unit. This means that ownership of the unit production and of the facilities is not separable.

The CO&O agreements for some facilities that were constructed to serve units contained provisions that restricted the Owners from selling their interest in the facility, unless a "corresponding interest" was sold in the unit. The Unit Operating agreement then had a similar clause requiring that a disposing owner sell a "corresponding interest" in the facility. This also means that ownership of the unit production and of the facilities is not separable. However, for the facilities, the term "corresponding interest" has been interpreted so as to only restrict the sale of capacity that serves the current unit production; an Owner's surplus capacity that is not used for unit production can then be sold.

2. Effect of ROFRs

Even if the facility CO&O agreement does not have any ROFR provisions, ROFRs may exist on some or all of the reserves/production served by the facility. If these land ROFRs are exercised, the purchaser may end up owning facilities, but have no owned production using them. In the reverse, if the facility CO&O agreement has a ROFR, which is exercised, but the reserves/production are purchased, the purchaser could end up with production that has no priority to use the processing capacity in the facility.

The same can happen if various required facilities, such as compression, gas gathering lines, or delivery/sales pipelines, are governed by separate CO&O agreements. The purchaser could end up with stranded facilities, or stranded reserves and production.

3. Dedicated Reserves/Production

Many CO&O agreements contain provisions that require the Owners to "dedicate" all of their production to the facility. These dedications may be based on:

• Wells producing to the facility
• Reserves in a specified pool or horizon
• Owned reserves in an area (area of dedication)

In CO&O agreements with dedication provisions, the "Owners Substances" are often defined as "substances produced from within the area of dedication". This was originally done to give first priority of processing to the production that was dedicated to the facility. However, this also means that the Owner's production from outside the area of dedication is treated as "Outside Substances", which may not be processed (exclusively) in the Owner's capacity. The Owner's Outside Substances will, therefore, be subject to processing fees charged by the Operator, on behalf of all of the Owners. The dedication provisions have the effect of restricting the Owner's right to use their owned capacity to process any production, other than their "Owners Substances".

Even if the CO&O agreement allows the Owners to use their owned capacity to process their "Outside Substances", the Outside Substances may not have the same priority of processing (i.e. what gets processed first, second, etc.) as the dedicated production has. If there is more production available than the facility has capacity to handle, production of Owner's Outside Substances may be cut back.

Dedication provisions will also prevent an Owner from taking its production to another facility. This may be problematic for a new Owner, if, for instance, that new Owner has existing production within the area of dedication that is already processed at another facility.

These types of provision, that dedicate the Owner's production to the facility, are frequently found in older (10+ years) CO&O agreements. They are seldom included in newer CO&O agreements.

C. Facilities Outside the CO&O Agreement

1. Facilities Without Operating Agreements

Gas gathering systems, field compressors and dehydrators, or plant inlet compressors for specific streams, may have been constructed by the owners of the wells to handle and transport production to a processing facility. These types of facilities are normally not included in the processing facility CO&O agreement, and may not be governed by any CO&O agreement. They are usually constructed based on an AFE (Authority For Expenditure) and are operated based on the ownership in the AFE. Even though these facilities do not have CO&O agreements, they are joint venture facilities, and should be the subject of due diligence. This includes reviewing the interest being conveyed (vs the AFE, if it is available) and any outstanding liabilities. Assignment notices should also be sent to the other owners in such facilities; these notices should include the interest being assigned.

2. Facilities Operated under CAPL

Some facilities can also be constructed by well owners, to handle production from a single well, or group of wells, with the same working interest. These facilities can be operated under the CAPL 90 Operating Procedure. Disposition of these facilities will be governed by the provisions of the land agreements. The interest in these facilities remains with the well ownership, and cannot be separated unless all of the well owners unanimously agree.

D. Other Considerations in Facilities

A number of other items/issues should be considered when purchasing an interest in joint facilities. The affect of these items should also be reviewed as part of the due diligence process.

1. Cost Sharing

How are the operating costs of the facility shared? In some older CO&O agreements, costs are shared on working interest. The normal practice is for operating costs to be split into fixed and variable, and for the fixed costs to be allocated based on working interest, while variable costs are allocated based on throughput. Typically the fixed costs are approximately 10% of the total operating costs. However, in some agreements, the fixed operating costs are defined differently, and could be much higher than 10% of the total operating costs. This allocation can have a significant affect on the economics of a new facility owner.

2. Non-Owner Processing

Does the facility have any outside processing and what are the arrangements for this service? Some plants may have committed the Owners' capacity to firm processing of non-Owner production. This could mean that all of an Owner's capacity may not be available for that Owner to use.

Also, fees for processing non-Owner production may be fixed for a long term, which could mean that the Owners have to absorb all increments in operating costs of the facility.

3. Owner's Excess Usage

What fees are charged for Owners using in excess of their capacity; how are these calculated? If the excess usage fee structure is very attractive, other Owners may be encouraged to bring in new production. For a midstream processor, the production owned by other Owners may have priority of processing over the midstream processor's customer's production.

4. Use of Capacity

Do the Owners have the right to piggyback production owned by non-Owners into their capacity? Some CO&O agreements allow all Owners to process non-Owner production in their capacity; some allow all co-mingled production from wells in which an Owner has ownership to be processed in that Owner's capacity. Some CO&O agreements require that all non-Owner production that is produced in a co-mingled stream with an Owner's production be considered to be processed in that Owner's capacity. This type of provision could serve to restrict an Owner's access to its owned capacity.

5. Delayed Accounting

Many CO&O agreements call for the Operator to adjust the annual operating cost based on throughput. These adjustments are called 13th month adjustments, because they always occur after the end of the year. Older agreements required that the 13th month adjustments be completed by 90 days after the end of the year; newer agreements allow the Operator 180 days to complete the 13th month adjustment. Industry practice seems to be that 13th month adjustments are completed anywhere from 180 to 365 days after the end of the year. The purchaser should anticipate these retroactive adjustments, and if the purchaser is to become the facility Operator, responsibility for administration of these adjustments should be defined in the P&S agreement.

Excess usage fees and non-Owner processing fees are also typically adjusted after the end of the year, when the 13th month operating cost adjustment is completed. These should also be anticipated and the responsibility should be clearly defined in the P&S Agreement.

Outstanding turnaround costs, AFEs or capital expenditures should be noted in the P&S agreement. The responsibility for these costs should be defined in the P&S agreement, if they occur before, during, or and after the effective date of the change of interest.

(In our next issue, Ib will discuss provisions for change of Operatorship and midstream processors as purchasers of facilities.)

Ib Moller, P. Eng., Principal - Gas Processing Management Inc.