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Overview of Oil & Gas Law in Canada

Blake, Cassels & Graydon LLP


Overview of Oil & Gas Law in Canada

Table of Contents I. GEOLOGY & HISTORY ................................................................................................ 1 A. Origins, Composition & Occurrence of Oil & Gas & Oil Sands............................ 1 1. 2. 3. 4. 5. B. II. Western Canada .......................................................................................... 1 Eastern Canada............................................................................................ 2 Maritimes .................................................................................................... 2 Territories.................................................................................................... 2 Offshore ...................................................................................................... 2

Legal History .......................................................................................................... 3

OWNERSHIP & REGISTRATION ............................................................................... 4 A. Amorphous Nature of Oil & Gas ............................................................................ 4 1. 2. 3. 4. B. 1. 2. Fee Simple Ownership................................................................................ 4 Profit Prendre ........................................................................................... 5 Present Position in Canada.......................................................................... 5 Legal vs. Beneficial Title ............................................................................ 6 Torrens ........................................................................................................ 7 Registry ....................................................................................................... 7

Registration Systems............................................................................................... 6


THE OIL & GAS LEASE ................................................................................................ 8 A. Freehold Leases ...................................................................................................... 8 1. 2. B. Necessary Elements .................................................................................... 8 Specific Clauses .......................................................................................... 8

Crown Leases........................................................................................................ 15


SURFACE RIGHTS & LEASES .................................................................................. 15 A. Background ........................................................................................................... 15 1. 2. B. 1. 2. 3. 4. 5. C. History....................................................................................................... 15 General Overview ..................................................................................... 16 Negotiation................................................................................................ 16 Rights Under Legislation .......................................................................... 17 Key Elements of Surface Rights Legislation ............................................ 17 Entry for Standard & Seismic Surveying.................................................. 20 Crown Land .............................................................................................. 20

Acquiring Surface Rights...................................................................................... 16

Pipelines & Well Sites .......................................................................................... 21

1. V.

Regulatory Environment Across Canada.................................................. 21

OIL & GAS CONTRACTS............................................................................................ 22 A. B. C. D. E. F. G. Farmout Agreements............................................................................................. 22 Pooling Agreements.............................................................................................. 23 Unitization Agreements ........................................................................................ 23 Operating Agreements .......................................................................................... 24 Drilling Contracts.................................................................................................. 25 Royalty Agreements.............................................................................................. 25 Transportation & Processing Agreements ............................................................ 25


GOVERNMENT REGULATIONS & LEGISLATION ............................................. 26 A. Environmental Legislation & Conservation ......................................................... 26 1. 2. B. 1. 2. Environmental Protection ......................................................................... 26 Conservation ............................................................................................. 28 Provincial .................................................................................................. 29 National Energy Board & Legislation ...................................................... 30

Intra-provincial & International Gas Transportation ............................................ 29


ACQUISITION, DISPOSITION & ANATOMY OF AN OIL & GAS PROPERTY TRANSACTION ............................................................................................................. 31 A. Due Diligence ....................................................................................................... 31 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. B. 1. 2. C. Title Review.............................................................................................. 31 Corporate Searches ................................................................................... 31 Reserve Ownership ................................................................................... 32 Operations ................................................................................................. 33 Surface Rights........................................................................................... 33 Facilities.................................................................................................... 34 Material Contracts..................................................................................... 34 Accounts ................................................................................................... 34 Equipment, Field & Site Inspection.......................................................... 35 Environmental........................................................................................... 35 Data Room ................................................................................................ 35 Letter of Intent .......................................................................................... 36

The Bidding Process ............................................................................................. 35

Purchase & Sale Agreement ................................................................................. 37

1. 2.

Clauses & Considerations ......................................................................... 37 Closing & Post-Closing Matters ............................................................... 43

Overview of Oil & Gas Law in Canada

I. A. Geology & History Origins, Composition & Occurrence of Oil & Gas & Oil Sands

Most petroleum and natural gas substances originated from decomposed plant and animal life that existed millions of years ago. This organic material was deposited into mud and silt and with the application of heat and pressure eventually became part of the sedimentary rock that was formed from the sediments. Through this process, the organic materials within the sedimentary rock were converted into solid, liquid and gaseous hydrocarbons, collectively known as fossil fuels. Once formed, hydrocarbons were able to migrate upward through the porous rock formations until they reached an impermeable layer in the sedimentary rock and became trapped. These barriers, by preventing further migration, resulted in the accumulations of oil and gas in certain formations of rocks. The accumulations of petroleum and natural gas in reservoirs and formations are primarily comprised of hydrocarbon compounds but may also contain carbon dioxide, sulphur compounds, traces of helium and salt water. The specific chemical composition of oil and gas substances can vary from reservoir to reservoir. The potential for differences in chemical composition is important from both a commercial and production prospective. From a commercial standpoint, these differences will affect the end-product of each substance; from a production prospective, varying chemical composition may also require the use of different techniques in order to isolate individual substances during the raw processing. Within Canada there are seven distinct domains of sedimentary rock that have the potential to contain occurrences of oil and gas substances. Each province or territory includes a portion of at least one of these seven sedimentary basins. While these basins cover most of the land in Alberta, Saskatchewan and the Maritime provinces, this is not necessarily determinative of where excessive quantities of hydrocarbons can be found in Canada. 1. Western Canada

Alberta has a vast quantity of oil and gas reserves and is the principal producing province in Canada, with several different regions in the province containing significant quantities of oil and gas. The discovery of gas dates back to 1884 with the first commercial production commencing in 1909. There have been vast quantities of gas discovered in the southern, central and northern parts of the province. The first major discovery of oil in Alberta occurred in Turner Valley in 1936, but it was the discovery of the Leduc oil field in 1947 that marked the beginning of significant development of oil in Alberta. Subsequent discoveries of oil and gas have made Alberta the largest producing area in North America. In addition to traditional oil and gas reserves, Alberta also possesses extensive non-conventional oil, including oil sands, heavy oil, oil shale and carbonate oil. Of particular importance are the Athabasca oil sands, which is Canada's largest petroleum resource and is currently being developed.

In British Columbia, the Peace River district is the leading oil and gas area in the province. The majority of hydrocarbon discoveries in this area have been natural gas, while some oil has been discovered in the northern part of the province. In Saskatchewan, the first major discovery was the Lloydminster field in 1930 and is an important producer of heavy crude today. With the successful discoveries of oil and gas in Alberta, exploratory work has been conducted in regions with similar geological conditions to those of Alberta and further deposits have been found in the Willeston Basin of southern Saskatchewan. In Manitoba, the first significant discovery was made in 1951 with the Daly field in the southern part of the province. Most active drilling is now in the Waskada area which produces one-third of Manitoba's oil. 2. Eastern Canada

Discovery of oil in Ontario first occurred in 1860. This was followed with the discovery of the Petrolia field in 1867, which is still producing today. Additional discoveries were made in the early 1900s in Kent and Elgin, but since these early discoveries, very few new oil fields have been discovered in Ontario with production rates equal to those of the early years. However, commercial quantities of natural gas are currently being produced from beneath Lake Erie. In Quebec, the only wells that have produced significant quantities of oil were drilled prior to the 1900s and natural gas was only produced profitably for a short period of time in St. Maurice. 3. Maritimes

In New Brunswick, exploratory activity and drilling was pursued from 1859 onward with marginal success. Currently, oil and gas are being produced in the Stoney Creek field and there is some interest in pursuing oil shale exploration in the province. In Nova Scotia, onshore exploration has been conducted in the northern part of the province and some exploration has continued without the discovery of any commercially exploitable fields. Prince Edward Island has had few occurrences of oil and gas, and in Newfoundland no oil or gas is in production. 4. Territories

In 1920, oil was discovered in the Yukon at Fort Norman and developed during World War II. After the war ended, reserves were only developed for local markets until a pipeline was constructed in the 1980s to ship the oil to Alberta. In the Pointed Mountain region of the North West Territories and the Beaver River area of the Yukon, gas is currently being produced and exploratory activity continues to take place in Bent Horn, Amauligak and the Mackenzie Valley. 5. Offshore

The continental shelf off the East Coast has the potential for large occurrences of oil and gas in Baffin Bay, Saglak, Hopedale Basin, East Newfoundland Basin and Scotian Basin. Exploratory activity has also occurred off the north shores in the Beaufort Sea and Artic with discoveries being made which are still producing today. However, further development of these occurrences have environmental and technical problems that will need to be addressed. On the west coast, some exploratory activity has occurred in the Queen Charlotte and Tofino Basins, but no significant discoveries have been made. Renewal of exploration activities is expected once the federal and provincial governments reach an agreement regarding the management of these

resources. There is currently in place a moratorium preventing the further exploration or development of oil and gas off Canada's West Coast. B. Legal History

Although some oil and gas rights are held privately in "fee simple" or in "freehold estates", the foundation of Canada's oil and gas industry has been the exploitation of minerals that are owned by the provincial governments. Section 109 of the Constitution Act, 1867, explicitly granted ownership of all lands, mines, minerals and royalties to the original provinces of Ontario, Quebec, Nova Scotia and New Brunswick in 1867. On entry to Canada, the provinces of British Columbia, Prince Edward Island and Newfoundland were also granted ownership of the mineral resources from the federal government. Only the prairie provinces of Alberta, Saskatchewan and Manitoba were not originally granted ownership of the mines and minerals upon their entry into Canada. At the time, these interests remained vested in the federal government. It wasn't until 1930 that the federal government, subject to certain exceptions (such as land located in national parks and on Indian Reserves) transferred these interests to the prairie provinces. The federal government still owns and administrates the mines and minerals located outside of the provincial boundaries in the three Territories, with the exception of freehold estates that have been created in those regions. A second area where the federal government has retained mineral ownership is offshore of Canada's coasts. The Supreme Court of Canada decision in the Offshore Minerals Reference granted the federal government (not the British Columbian government) ownership and the right to exploit minerals off the west coast in the territorial sea. Although this decision was originally considered by the federal government to be conclusive for all offshore land, later decisions have proven that is not the case, particularly for inland waters. Although ownership issues for certain offshore areas still need to be addressed on a case-by-case basis, ownership of these resources will remain vested in the government rather than private individuals. Mines and minerals not owned by either the federal or provincial governments have been granted at some point in time to individuals or corporations creating freehold estates. Prior to the federal government transferring mineral rights to the prairie provinces, several grants had already been made that created the existence of freehold estates in these regions. In 1670, King Charles granted the Hudson's Bay Company a substantial portion of land in central and eastern Canada, which was later surrendered in 1869. For surrendering this land, the Hudson's Bay Company in turn was able to retain approximately 7 million acres of land which included all surface and subsurface rights. Another significant grant of mineral rights located in the prairie provinces was given to Canadian Pacific Railway as a subsidy to help settle the west, which included approximately 22 million acres of land. Freehold estates were also granted to homesteaders to encourage people to move out west, and it wasn't until 1887 that the government began to reserve mines and minerals from these homestead grants. A final significant source of ownership of mines and minerals in Canada is land held by the federal government in trust for aboriginals. Most of the reserve land that has already been set aside for aboriginal people includes the accompanying mine and minerals rights. An area of concern is the aboriginal land claims relating to unfilled treaty entitlements. These claims are occurring in several areas of Canada, including oil and gas rich regions in the prairie provinces.

This could potentially have an adverse effect on third parties currently holding an interest in and are producing on those lands. II. A. Ownership & Registration Amorphous Nature of Oil & Gas

The fugacious nature of oil and gas substances is a key characteristic that distinguishes it from other solid minerals. Generally speaking, these substances are relatively stationary when undisturbed under original reservoir conditions, or in situ. Any changes made to those undisturbed reservoir conditions, whether occurring naturally or as a result of exploration and penetration of the reservoir, could alter how the substances are situated beneath the land. It is this ability of oil and gas to continually migrate within the limited space of a formation or reservoir that has created difficulties in determining ownership. Clearly the principles of ownership that govern stationary minerals, such as coal, are difficult to apply to a substance that is capable of migration before it has been reduced to possession. With increased scientific knowledge of reservoir conditions and mechanics, it has also become clear that, despite the fugacious nature of oil and gas, the substances are confined within a specific reservoir. Consequently, early ownership analogies of oil and gas to water have been abandoned. It is this inadequacy of applying traditional contract and property law principles to confined migratory substances that has helped define oil and gas law as its own special legal category. As a result, ownership of oil and gas in situ on freehold land has created a difficult problem for the courts to address. 1. Fee Simple Ownership

Several of the issues that have arisen regarding ownership of oil and gas in Canada were of the first instance and had not been subject to previous judicial consideration by England or other commonwealth countries. Therefore, many aspects of Canadian oil and gas law have not been well developed, with the number of decided cases being relatively few and often inconsistent. Unlike American Courts, Canadian courts have yet to decisively settle on a single theory of oil and gas ownership, of which could include absolute ownership, a qualified property interest or no ownership with only the exclusive right to explore. Instead they have chosen to avoid adopting an ownership theory and have proceeded on a case-by-case basis. In taking this approach, case law has focused on what ownership interest is being created under an oil and gas lease and avoided the separate issue of the legal character of oil and gas in situ. Thus, the courts have not clearly recognized or explained the distinction that exists between ownership of oil and gas in the ground before it is reduced to possession and ownership of only the right to recover that oil and gas. For land that is held in a fee simple estate, the general principle setting out the extent of a person's ownership extends to what is contained above and below the surface of the land. If oil and gas substances are capable of being owned in situ, then under this principle they will form part of the freehold estate and be owned absolutely under the fee simple title. However, the migratory nature of oil and gas and the fact that it could be drained from underneath the land by production on adjacent property calls into question whether oil and gas can be owned absolutely in situ or if it can only be owned after being reduced to possession. In the leading Canadian oil

and gas case, Borys v. C.P.R. and Imperial Oil Ltd.1 ("Borys") the courts assumed for the purposes of the decision that gas could be owned in situ without explanation, conceding that this ownership would not extend to those substances that had migrated away from the land. Adopting this assumption allowed the courts to interpret the mineral reservations in lease to determine who owned the right to recover gas without consideration of who owned them in situ. The conclusion reached in Borys assumed gas was owned in situ and did not take into account the conceptual difference that exists between corporeal and incorporeal interests. A corporeal interest in land is possessory in nature. This is contrasted with an incorporeal interest in land which is non-possessory in nature and, because it lacks substance, has to be passed by grant. When considering the transfer of mines and minerals, a grant could confer a corporeal estate and be owned in situ if it was intended not to limit the rights conveyed to the minerals alone but to also extend to the strata where the minerals were located. The right to recover just minerals cannot exist by itself as a corporeal interest because it lacks the necessary substance. If the court is prepared to find that oil and gas can be owned in situ, as they did in Borys, then the interest would be corporeal and ownership would extend to the entire strata and continue after the minerals had been severed from the estate. The problem with making this assumption is that it does not reflect the true intention of the granting instrument, which is the right to recover oil and gas and not the right to possess the strata where those substances are located once they have been severed. 2. Profit Prendre

While the courts have not adopted a single ownership theory to establish the legal interest of oil and gas in situ, in Berkheiser v. Berkheiser2 the Supreme Court of Canada held that a modern day oil and gas lease creates a profit prendre. A profit prendre provides the holder with an irrevocable licence to search for and to win the substances. The holder of a profit prendre does not own the specified substance in situ, as the right conveyed is incorporeal in nature. A profit prendre will only allow the holder of the interest to retain title to what they are able to sever from the land and reduce to their possession. While a profit prendre does not grant absolute ownership, it does have some rights that are of a possessory nature and will allow the holder to bring actions of trespass at common law for any infringements that could affect the ability to recover the substances granted in the lease. In determining that an oil and gas lease is a profit prendre, it is not treated as an ordinary lease by the Canadian courts. One of the significant differences between an oil and gas lease and an ordinary lease is that an oil and gas lease conveys only a profit prendre, an incorporeal right, rather than the corporeal right that is granted in an ordinary lease. Also, the granting of profit prendre can be for an indefinite period of time, unlike a leasehold estate, without being void for uncertainty. 3. Present Position in Canada

In Canada it is still not clear how to characterize oil and gas in situ without an ownership theory. With the long line of authorities treating oil and gas leases as profit prendre, it is not likely that
1 2

Borys v. Canadian Pacific Railway (1953), 7 W.W.R. 546 (P.C.) [Borys] Berkheiser v. Berkheiser, [1957] S.C.R. 387.

the courts would apply a non-ownership theory and conclude that, due to the fugacious nature of oil and gas, the substances cannot be owned in any sense until reduced to possession. In Western Canada, the oil and gas industry has operated on the basis that an interest in oil and gas can be conveyed as an interest in land. This would require the holder of the right to recover oil and gas substances under a lease either have a qualified ownership interest in the right to recover the minerals or an absolute ownership interest of the minerals in situ to give effect to the transfer. Therefore, it is probable that the courts would recognize some form of ownership in the right to recover oil and gas without the substances having to be reduced to actual possession. While case law has not explained the distinction between the right to recover oil and gas and the right to own oil and gas in situ, most cases, including Borys, are decided when the issue of who has the right to recover the oil and gas is determined and there is no further problem in deciding ownership. However, it is important to note that this does not mean that the incorporeal right to recover oil and gas is equivalent to actual ownership of oil and gas, as it could migrate to neighbouring lands and be taken into possession by that third party. It appears that in Canada the freehold oil and gas interest is a qualified property interest and not a possessory ownership interest. The person who holds the lease, or profit prendre, has the right to take the minerals but this right is less than absolute ownership as it can be defeated due to the migratory nature of oil and gas. However, by classifying it as a qualified property interest, it is an interest that can be subject to the usual conveyancing rules and registrations, as reflected by current industry practice. 4. Legal vs. Beneficial Title

Legal title to an oil and gas interest is owned by the named lessee on either a freehold oil and gas lease or a Crown mineral lease. Through various industry agreements, a third party may own a working interest in certain lands but not be novated into a freehold lease or receive an assignment under a Crown lease transfer. Therefore, the party with a working interest would have no legal title but would have its beneficial title held in trust by the holder of legal title. In these situations, the parties that are listed as the lessee under the freehold or Crown lease (i.e. the holder of legal title) would be holding part or all of the legal title for the benefit of that third party to the lease. Thus, when determining who holds the interests granted in a lease, it is the beneficial title and not the legal title that must be followed. A working or beneficial interest for freehold leases can be caveated on the certificate of title to evidence this interest in the event a party is not novated into lease. B. Registration Systems

Each province maintains its own registration system for real property. Within each province, there usually exists one system for freehold mineral rights (including oil and gas) as well as one for Crown mineral rights. Crown mineral tenure systems administered by each of the provinces are typical tenure systems pursuant to which the province grants leases to individuals, partnerships and corporations and then maintains an electronic and paper system to indicate legal title. Freehold mines and mineral rights in Canada are generally administered through one of the registration systems described below.



In 1858, a system of land registration known as the Torrens system was created in Australia. A version of the Torrens system has become the dominate form of land registry systems in Canada. It is used in several provinces, including British Columbia, Alberta, Saskatchewan and the Northwest Territories, and is partially applied in Manitoba and Ontario. The fundamental principle of the Torrens system is that the registration of a conveyance would raise a "indefeasible title" that would be good against any claim made to the land, notwithstanding any flaws in the chain of title proceeding it, subject only to statutory exceptions. The basic exceptions set out in the governing statutes for each province (the Land Titles Act) include: reservations and exceptions that the statute imposes on a certificate of title whether or not they are listed; registrations obtained by a purchaser through fraudulent means; people claiming interests under a prior certificate of title; misdescriptions of the boundaries or parcels included; and corrections of clerical errors.

The principle benefit of using the Torrens system for land registration is that it can establish certainty with respect to ownership of land and the encumbrances that exist against a particular piece of land by allowing a person to rely on the certificate of title. The Torrens system would no longer require a purchaser to review every document relevant to the chain of title in order to ensure title had been properly conveyed each time. Therefore, under the Torrens system, the only way an interest in land or an estate can be acquired is through registration in the appropriate land titles office. Registration would allow a certificate of title for that interest to be issued by the registrar to the transferee evidencing their title. A certificate of title under the Torrens system can transfer an entire interest in an estate or can transfer only a portion of an estate, such as the mines and minerals. 2. Registry

Despite the advantages of the Torrens system, the old registration system still applies to some jurisdictions of Canada and is still used in the Atlantic provinces. In Manitoba, land settled prior to 1914 is still subject to the old registry system and as such any land transfer would be subject to the common law property rules. In Ontario, the use of the Torrens system is limited in its application and the old registration system applies to most land in the province. Under the rules of the Registry Act in Ontario, a person may be required to show a good and sufficient claim of title extending back 40 years where title has not been adversely affected to prove ownership.


The Oil & Gas Lease Freehold Leases

Although the majority of Canada's oil and gas is owned by provincial governments, and to a lesser extent federal governments, some private landowners do own the oil and gas beneath their lands. Privately owned oil and gas is referred to as "freehold" oil and gas. Most of the freehold oil and gas occurs in the provinces of Ontario, Manitoba, Saskatchewan, Alberta and British Columbia. For example, approximately 14% of Alberta's oil and gas is privately owned. Given the high cost of exploring for and producing freehold oil and gas, private landowners typically lease the substances to oil and gas companies who have the experience and resources to undertake such activities. The relationship between freehold oil and gas owners (the "lessors") and oil and gas companies (the "lessees") is governed by the freehold oil and gas lease. Because intense development of early oil and gas occurred on freehold lands, the bulk of Canadian oil and gas jurisprudence involves freehold leases. Although most development now occurs on Crown lands, an understanding of the issues relating to freehold leases is essential to understanding Crown leases. Early freehold leases, often referred to as "conventional" leases, contained several problems for both the lessor and the lessee. In an attempt to rid the lease of these pitfalls, the Canadian Association of Petroleum Landmen ("CAPL") created a standard form of lease known as the CAPL lease, for Alberta, Saskatchewan and Manitoba freehold oil and gas. Both the conventional lease and the CAPL lease have been heavily litigated, and as a result, each have been greatly modified since their inception. Although the latest version of the CAPL lease (the 1999 CAPL lease) is widely used today, older CAPL leases and conventional leases are still in use, as are the problems associated with each. 1. Necessary Elements

Although the oil and gas lease is a contract between private individuals or entities and allows the parties the freedom to draft the lease as they wish, leases typically include standard clauses. Despite these standard clauses, the wording of such clauses may vary and, as discussed below, even slight variations can be problematic. Both conventional and CAPL leases typically include the following types of clauses (as further described below): A. B. C. D. 2. Granting Clause Habendum Clause Bonus Clause Delay Rental Clause E. F. G. H. Royalty Clause Offset Well Clause Shut-in Well Clause Pooling Clause

Specific Clauses (a) Granting Clause

The granting clause essentially sets out what the lessor is granting to the lessee. A granting clause typically states, "The Lessor doth hereby grant and lease unto the lessee all petroleum, natural gas, and related hydrocarbons together with the exclusive right

and privilege to explore, drill for, win, take, remove, store and dispose of the leased substances." The granting clause may also limit the grant of the substances within specified formations beneath the surface. As discussed, the oil and gas lease is a profit prendre, thus, the granting clause grants to the lessor the right to prospect for and remove the specified minerals. Given that oil and gas freely move beneath the surface from and into adjoining lands, the granting clause only provides the lessor with the right to the oil and gas which it actually produces, not the oil and gas in or under the specified lands at any given time. In split-title situations, where the petroleum and natural gas are not owned by the same owner, Canadian courts have held that, unless otherwise expressed in the lease, the petroleum owner owns all hydrocarbons in liquid form under initial reservoir conditions prior to human intervention.3 Thus, a grant of petroleum includes the solution gas (also known as associated gas) and evolved gas, as both are in liquid form prior to human intervention even though they emerge at the surface as gas rather than liquid. Gas-cap gas belongs to the natural gas owner because it remains in a gaseous form throughout the entire production process. Although Canadian courts have found that the existence of the grant by the lessor necessarily implies the right to recover the specified minerals and the right to work them, there has been some controversy over whether a lessee is entitled to inject substances for the purposes of increasing production where the granting clause is silent on the matter. In order to avoid litigation, the granting clause in the 1999 CAPL lease expressly provides for the activity. Further, although included in many conventional and early CAPL leases, the right to build and maintain oil and gas related infrastructure such as pipelines and roadways is not for the mineral owner to grant, but rather the surface owner. As such, the 1999 CAPL lease does not expressly permit such activities. (b) Habendum Clause

The habendum clause establishes the duration of the lease. A typical clause provides that the lease remains in force for five years, which is known as the primary term, or so long thereafter as there is production from the lands granted pursuant to the lease. Although the primary term is negotiable, current practice is to use a primary term of one to five years. In order to carry the lease beyond the primary term, there must be "production" on the lands. Production requires actual production or deemed production. The lease will typically provide for deemed production in two circumstances: first, where a "shut-in" royalty fee has been paid; and second, where the lands have been pooled or unitized and there is production on the pooled or unitized lands even though there is no production on the leased lands or the "said lands". Shut-in royalty fees and pooling and unitization are discussed in further detail below.

Borys, supra note 1.

Most leases also permit operations conducted on the lands to continue the lease beyond the primary term. However, careful consideration should be given to the wording of the clause. The lease in the decision of Canada-Cities Service Petroleum v. Kininmonth4 provided that the lease would remain in force for ten years or so long thereafter as the substances or any of them were being produced and, if, at any time after expiry of the ten-year term, the substances were not being produced on the lands but the lessee was then engaged in operations, the lease would remain in force. The Supreme Court of Canada held that, based on the wording of the clause, operations could not carry the lease beyond the primary term, only production could, after which point continuous production was not necessary but rather, operations on the lands would suffice to continue the lease in force. Thus, only a properly worded operations clause will serve to continue the lease after the primary term expires. Most leases will define in detail what constitutes "operations", however, where that term is not clearly defined, the courts have held that all activities directed at bringing about production constitute operations (i.e. preparations for spudding in).5 The courts have also held that because there will always be gaps in time in the second term where neither operations nor production is being conducted, such gaps are permissible. The 1999 CAPL lease restricts gaps to a period of 90 consecutive days. (c) Bonus Clause

Consideration must be paid in order to ensure that the lease is enforceable. Early leases required the lessee to pay to the lessor a bonus upon signing the lease, however, the bonus was often not paid until some time later. This raises the issue as to whether the lease is enforceable because the language often makes the payment a condition precedent to a valid lease. Today, the issue is avoided by specifying in the lease that a nominal consideration is to be paid on the date the lease is executed, and payment of the remaining bonus consideration must be paid within a specified period of time once title has been investigated and the lessee's interest has been protected by registration of a caveat. (d) Delay Rental Clause

The clause in a typical conventional lease states, "...provided that if operations for drilling of a well are not commenced on said lands or pooled lands within one year from the date hereof, this lease shall terminate and be at an end on the first anniversary date, unless the lessee shall have paid to the lessor before said anniversary date the sum of _________________________." The delay rental fee is generally $1/acre (i.e. $160 per quarter section). The clause allows the lessee to defer drilling in every year of the primary term except the last year by paying an annual sum in lieu of drilling. The clause may also provide that if at any time during the primary term the lessee conducts operations but drills a dry well, or the lessee obtains production but production ceases, the lease terminates on the next anniversary date unless the lessee commences further
4 5

[1964] 47 W.W.R. 437 [S.C.C.] [Kininmonth]. See Canadian Superior Oil Ltd. v. Crozet Exploration Ltd. (1982), 18 Alta. L. R.(2d) 145 (Alta. Q.B.) [Crozet].


operations or pays the delay rental fee. Given the trend toward shorter primary terms (sometimes one to two years), the delay rental clause does not appear in the 1999 CAPL lease but is still a cause for concern when dealing with older leases. The delay rental fee must be paid every year in the primary term for which there are no operations or drilling conducted, except the last year. The payment of the delay rental fee cannot continue a lease beyond its primary term. In absence of the delay rental clause, the lessor could do nothing throughout the majority of the initial term so long as operations for drilling are being conducted or production is obtained by the end of such primary term. There are two categories of delay rental clauses: the "unless clause"; and the "or clause". Under the "unless clause", the lease automatically terminates unless the lessee either drills or pays the fee on time. The "or clause" is less stringent in that the lessee must drill or pay, but if the lessee fails to drill, the lessee has an obligation to pay the fee and late payment does not result in an automatic termination of the lease, but rather a breach of contract. Similar to any other breach of contract, the lessor must provide the lessee with notice of the breach and the lessee has a certain period of time to remedy the breach by either drilling or paying the fee. (e) Royalty Clause

The royalty clause specifies the amount of production, generally expressed as a percentage, that the lessor is entitled to for so long as there is production. This is referred to as the lessor's royalty. Although the parties are free to negotiate the royalty, today the rate is approximately 20% of production. The royalty clause generally accomplishes five things: (i) (ii) (iii) (iv) (v) reserves to the lessor a share of the leased substances produced; specifies the royalty rate; indicates that any sale by the lessee must include the lessor's share of production; allows the lessee to use a portion of the production for its own operations (i.e. evaporation, spillage, flaring); and specifies the manner in which the lessor is to be paid its royalty.

Some royalty clauses provide the lessor with the option of taking its royalty share in kind, meaning the lessee must deliver to the lessor the leased substances themselves rather than the proceeds from their sale. For example, if the royalty is 20% of oil produced and the well produces 100 barrels of oil, the lessor is entitled to 20 barrels of oil rather than the cash equivalent. Due to the difficulties associated with processing and marketing natural gas, taking in kind is essentially limited to oil. The lease will often specify that the royalty is to be calculated based on the current market value at the wellhead. Determining the point at which to calculate the royalty is


important because both oil and natural gas are more valuable in a processed state. It is clear that the costs of bringing the oil and gas to the surface are not deductible by the lessee and are the responsibility of the lessee. However, the costs incurred by the lessee between the wellhead and the point of sale are deductible; the lessor is responsible for its portion of these costs. Determining exactly which costs may be deducted when computing the lessor's royalty has been heavily litigated in Canada. It is common practice in modern leases to expressly set out which costs are deductible. The 1999 CAPL lease allows the lessee to deduct all reasonable expenses incurred for water disposal and for separating, treating, processing, compressing and transporting leased substances beyond the wellhead, including a reasonable rate of return on investment in such things as processing facilities and pipelines. In practice, deductions will be negotiated in great detail only when the lessor is also an oil and gas company having knowledge of the issues that may arise. In an attempt to limit deductions, modern leases (including the 1999 CAPL lease) restrict deductions by providing that the royalty cannot be less than a certain percentage of the royalty that would have been paid had no deductions been allowed. (f) Offset Well Clause

The offset well clause is intended to protect the lessor's right against drainage. Drainage may occur when a neighbouring landowner's production from a well on his or her lands alters the pressure in the reservoir or field causing the flow of substances from adjacent lands toward the well bore on the neighbouring land. The offset well clause allows a lessor to force its lessee to drill on the lessor's land if a well is drilled on adjoining lands in order to capture some of the leased substances that may escape through the well on the adjoining lands. There are three requirements necessary for the triggering of the offset well clause: (i) (ii) (iii) neighbouring well must be on adjoining lands; neighbouring well must be commercially producing; and neighbouring land must not be owned by the lessor or, if owned by the lessor, not leased to the lessee.

Older leases require the neighbouring well to be on laterally adjoining lands for the offset well clause to be triggered. Modern leases, including the 1999 CAPL lease, tend to favour the lessor by allowing the clause to be triggered by neighbouring wells on both laterally and diagonally adjoining lands. Most leases today contain a definition of "commercial production", however, some older leases do not. Where the lease is silent on the matter, one must consider whether a reasonable lessee would view the situation as warranting the drilling of an offset well. Drilling is only warranted if the neighbouring well is economical.


If the three requirements are met and the lessor demands that the lessee drill a well, the lessee is generally given two options: drill an offset well within the specified period of time set out in the lease (typically six months) or surrender the lands. The 1999 CAPL lease provides for two additional options, namely, the lessee may opt to pool or unitize the lands so as to include the neighbouring well and achieve deemed production on the lessor's lands, or the lessee can pay a royalty to the lessor in an amount equal to that which the lessor would have received had the lessor drilled the offset well. Pooling and unitization are discussed in further detail below. Earlier leases did not provide for any option other than drilling the offset well and failure to do so by the lessee resulted in a breach of contract with the potential for damages. If the lessee's breach was because drilling was thought to be uneconomical, damages would be minimal. The use of horizontal drilling has posed an additional issue for the offset well clause because, although a well is drilled on lands adjacent to the lessor, the well may actually be drawing from a formation several kilometres away and which is not adjacent to the lessor's lands. The 1999 CAPL lease solved this dilemma by providing that the neighbouring well must be on adjoining lands containing the productive formation. (g) Shut-in Well Clause

The shut-in well clause comes into play where a successful well has been drilled, but due to lack of infrastructure or market, the well cannot be put on production by the end of the primary term. The shut-in well clause allows the lessee to shut-in or suspend such a well and pay a shut-in well payment in lieu of producing the well. Recall that in order to continue a lease beyond the primary term, the habendum clause requires production, or in some cases, operations; however, a properly shut-in well constitutes deemed production and, provided it is shut-in on or prior to the expiry of the primary term, will serve to continue the lease in force beyond the primary term. The clause is advantageous to lessees who have invested money and capital in exploration and drilling but for one reason or another are unable to put the well on production. Early leases required that the well, which although capable of production, could not be produced as a result of market conditions. Over time, lessees felt that this clause was too restrictive and it was broadened to apply not only to a lack of or intermittent market, but also to an unprofitable market or any cause beyond the lessees reasonable control. Clauses of this nature are known as the "intermediate shut-in well clause". There also exists an "unlimited shut-in well clause" which requires only that a producing well exist and that it be shut-in. The timing of the shut-in payment is extremely important and late payment by some lessees has been fatal. The courts have interpreted the shut-in well clause as an option available to the lessee to either continue the lease (by paying the shut-in payment) or allow the lease to automatically terminate, provided of course no other provisions of the lease can be employed to validate it (i.e. operations are being conducted). The clause is similar to the "or" delay rental clause discussed above in that there is no notice requirement allowing the lessee time to remedy the default. The payment must be made on time.


In determining whether the conditions necessary to trigger the shut-in well clause are satisfied, the lessee must consider the distance to the nearest pipeline, pipeline and plant capacity, ability to obtain access to the pipeline and plant, including applying for regulatory orders, and the overall economics of the undertaking. (h) Pooling & Unitization Clause

Provincial governments in Canada have attempted to conserve their natural resources by limiting the number of wells that can be drilled on any given portion of lands. This helps to maintain adequate pressure in reservoirs, ultimately increasing the ability to recover the leased substances. For example, in Alberta, the provincial government has specified that only one well can be drilled per spacing unit. Unless otherwise approved by the Minister, Alberta's spacing unit for oil is 160 acres (one quarter section of land) and a spacing unit for gas is 360 acres (four quarter sections of land, which amounts to one full section). In addition, before a lessee can obtain a drilling license, it must own the appropriate rights to the entire spacing unit in which it wishes to drill. As a result of these legislative requirements, a lessee who wishes to drill for gas, but has the rights to only part of the spacing unit, must obtain the rights to the remainder of the spacing unit. This can be achieved by pooling the lands. Pooling is the voluntary or compulsory agreement to combine interests in tracts of land in order to form a spacing unit. Due to the conservation benefits of pooling, the provincial government will force an unwilling lessee to pool its interest. Pooled interests will generally be shared on an aerial basis (i.e. if a lessee contributed a quarter section to drill a gas well, it will share in one quarter of the costs and revenues) unless this is proven to be inequitable. An aerial basis may be inequitable where most of the gas is located beneath only part of the spacing unit but all the owners who contributed lands to form the spacing unit share equally. Unitization is similar to pooling but must be voluntary and generally involves much larger tracts of land. Subsurface oil and gas exists in large reservoirs or fields which may extend for several miles. Like pooling, unitization serves to encourage an efficient number of wells. For example, a field may extend below sixteen sections, each individually owned, but it would be extremely inefficient to drill 16 wells. In order to maintain pressure and allow for increased recovery and lower costs resulting from the shared efforts, the parties can voluntarily unitize the sections and drill fewer wells. The parties typically share in the costs and revenues according to the percentage of the reservoir beneath the lands they each contributed. Generally, the parties involved in the unitization will enter into a unit agreement detailing how the unit will be developed and operated. Unit agreements will be discussed in further detail under the Oil & Gas Contracts section below. Most leases provide that production on the pooled or unitized lands constitutes production on the leased lands or the "said lands". Where such a clause exists, even though there may be no production on the leased lands themselves, production on any of the lands making up the pooled or unitized lands will be sufficient to prevent the lease from expiring. Thus, where a lessee does not wish to drill a gas well and the lease is nearing the end of the primary term, pooling or unitizing the lands with lands which have


been brought onto production will serve to continue the lease beyond the primary term and so long thereafter as there is production. Similarly, where the lease so provides, pooling or unitizing the said lands with lands on which (a) there is a shut-in well, (b) operations are being conducted, or (c) on which a delay rental payment is being made, will serve to validate the lease. In summary, pooling or unitization of the leased lands with lands on which there is production, operations or a shut-in well is generally deemed production on the said lands which will serve to preserve the lease even though there may have been no activity conducted on the leased lands. However, as many lessees have found out, the lease must expressly provide that an activity on the pooled or unitized lands is treated as if it were conducted on the leased lands (i.e. it must state "upon the lands, the pooled lands or the unitized lands").6 B. Crown Leases

Federal and provincial governments own the majority of Canada's oil and gas resources. The federal government's ownership is, however, much smaller in comparison to the provincial government's ownership, with most of its ownership being made up of oil and gas in national parks and Indian reserve lands. Like private landowners, governments also lease their resources to oil and gas companies who are more experienced and better able to bear the risks associated with production. The relationship between the government and the oil and gas company is governed by the Crown lease. The acquisition and development of Crown oil and gas is set out in legislation and regulations in force in each province, and in federal legislation and regulations in the case of federally owned oil and gas. Each province's legislation and regulations differ slightly. In Alberta, the government grants oil and gas licences for exploration purposes and leases for drilling purposes. Licences, which generally have a term of two to five years, are disposed of through a bidding system, while leases, having a primary term of five years and can be extended in a manner similar to freehold leases, are issued out of a licence or are disposed of through a bidding system. Leases are generally transferable provided the consent of the Minister is obtained. Similar to freehold leases, lessees must pay a royalty set by the Crown and the lease can be continued beyond the primary term by satisfying certain conditions set out in such lease. Alberta's oil sands are regulated under a separate regime. IV. A. 1. Surface Rights & Leases Background History

Under Canadian common law, a presumption existed that a mineral right included the right to win and work the minerals using reasonable and lawful means. Thus, owners of subsurface

Shell Oil Company v. Gunderson, [1960] S.C.R. 424 (S.C.C.) [Gunderson].


mineral rights were entitled to immediate surface access to the extent necessary to permit working of the minerals. In addition, it was not uncommon for mineral leases to include express language proposing to permit the lessee to enter onto the land in order to work the mineral interest. Such right of surface entry and mineral removal, either invoked through common law or imposed by express grant in the mineral lease, has been qualified in Canada by legislation, of which Alberta's statutory scheme is generally typical. Such legislation has removed the paramountcy provided to mineral estates such that consent of all surface owners and occupants (either a person or the Crown) is required and additional consideration must be paid prior to accessing the surface for the purposes of oil and gas operations. However, procedures are in place to allow mineral owners to receive a right of entry order should consent of surface rights holders not be forthcoming. 2. General Overview

Before any mineral exploitation or development activities are undertaken by an operator holding subsurface mineral rights by virtue of a lease or other instrument, the operator must obtain appropriate rights to the surface of the land which must be accessed. As required by surface rights legislation (in Alberta, the Surface Rights Act), such rights are obtained by procuring the consent of the surface rights owners and occupants, or a right of entry order to that effect, and, in most cases, providing compensation for surface access. Although the legislation has the effect of curtailing surface rights previously held by mineral owners at common law, the general policy behind the surface rights legislation still works to accord priority to a mineral owner or operator, who will be granted rights to enter and develop the interest, provided surface rights holders are notified and compensated. The surface rights regulatory authorities7 are not authorized to refuse an order for entry carte blanche. Where an operator owns subsurface mineral rights and the surface rights holders refuse to provide voluntary consent to access, then by virtue of surface rights legislation the operator will generally be entitled to obtain an order and enter onto the lands for purposes relating to assessing and exploiting their mineral rights. However, the surface rights owner is entitled to and has complementary rights to be given notice, be heard and receive an order requiring compensation to be paid. B. 1. Acquiring Surface Rights Negotiation

Negotiation is the primary method of obtaining surface rights in Canada. Generally, the surface owners and occupiers can be persuaded to provide consent to access their land for the purposes of oil and gas operations in exchange for some form of compensation. The agreement will normally be recorded in the form of a surface lease (Alberta) or consent to enter (British Columbia and Saskatchewan).

In Alberta, the Surface Rights Board; the term "surface rights boards" will be used to collectively refer to similar surface rights authorities across the provinces.



Rights Under Legislation

The purpose of the provincial surface rights legislation in Canada is to regulate the rights, obligations and procedures relating to entry orders granted by the surface rights boards whom have been given authority to hear and determine such matters. The legislation does not purport to regulate rights or obligations arising under private agreements. However, the surface rights boards may hear disputes regarding compensation between a landowner and operator who are parties to a surface lease or right of entry order, so long as the lease does not contain other dispute resolution procedures. 3. Key Elements of Surface Rights Legislation

As noted above, Alberta's Surface Rights Act (the "Act") is generally typical of Canadian surface rights legislation. Its key elements are described below. Where applicable, differences in other producing jurisdictions have been noted. (a) No Right of Entry

Section 12 of the Act provides that no operator has a right of entry in respect of the surface of any land: (i) (ii) for the removal of minerals contained in or underlying the surface of that land or for or incidental to any mining or drilling operations; for the construction of tanks, stations and structures for or in connection with a mining or drilling operation, or the production of minerals, or for or incidental to the operation of those tanks, stations and structures; for or incidental to the construction, operation or removal of a pipeline; for or incidental to the construction, operation or removal of a power transmission line; or for or incidental to the construction, operation or removal of a telephone line,

(iii) (iv) (v)

until the operator has obtained the consent of the owners and occupants of the surface of the land or has become entitled to right of entry by reason of an order of the board pursuant to the Act. The Act further clarifies that, notwithstanding any language contained in a lease or other instrument pertaining to include a right of entry as part of a grant of a mineral interest, an operator does not obtain the right of entry in respect of the surface of any land unless the grant, conveyance, lease, licence or other instrument provides a specific separate sum in consideration for the right of entry of the surface required for the operator's operations. (b) Obtaining Right of Entry

Section 15 of the Act outlines the procedures available to an operator who is unable, through negotiation, to obtain consent of the surface landowners and occupants


(including the Crown). The operator may apply to the board for a right of entry order in respect of the land that may be necessary for the performance of the operator's operations. On receipt of an application, the surface rights board may make an immediate right of entry order either upon the filing of evidence of consent of the landowner, or, if there has not been consent, after the expiry of 14 days from the date of service of the application on the landowner. The order received will describe the portion of the surface of the land that is necessary for the performance of the operator's operations, and may contain such conditions as the board feels is appropriate. However, where the proposed activity is the subject of a licence or other approval granted by the Alberta Energy and Utilities Board, Alberta's energy resource regulatory authority (the Alberta Energy and Utilities Board, or "AEUB"), such conditions must not be inconsistent with the terms of the licence or other approval. If the right of entry order made by the board is objected to by the landowner, a hearing will be held with respect to the application. At the hearing (in some jurisdictions, the "hearing" will be in the form of mediation or arbitration), the surface rights board will accept submissions from all interested parties to determine the scope and conditions of the right of entry order, as well as determine appropriate compensation to be paid to the surface owners and occupiers. (c) (i) Compensation Entry Fee & Security Deposits In Alberta, an operator is required to pay to a holder of surface rights (other than the Crown) an entry fee of the lesser of $5,000 or $500 per acre for each quarter section of land for which a title has been issued. The entry fee is a statutory obligation and cannot be waived or negotiated by the parties. It applies to entry pursuant to both a privately negotiated surface lease and an order of the board and is in addition to any compensation owing for the right of entry. The entry fee concept is unique to Alberta. Other provinces, such as Saskatchewan and British Columbia, generally require the operator to pay a security deposit before receiving an entry order to ensure any compensation later ordered to be provided to surface rights holders will be paid. Security deposits range from a set amount of $1,200 in Saskatchewan, to a requirement in British Columbia that the operator deposit an amount the board considers necessary for the purpose of ensuring that the owners of the land will be paid any subsequently ordered amounts. (ii) Determining Compensation Factors Surface rights legislation in each province sets out a list of non-exhaustive factors which may (i.e. in Alberta and British Columbia), or in some cases (i.e. in Saskatchewan) shall be considered by the surface rights boards in determining right of entry to the surface. In Alberta, Section 25 of the Act lists the following factors the surface rights board may consider:

A. amount the land granted to the operator might be expected to realize if sold in the open market by a willing seller to a willing buyer on the date the right of entry order was made; B. per acre value, on the date the right of entry order was made, of the titled unit in which the land granted to the operator is located, based on the highest approved use of the land; C. loss of use by the owner or occupant of the area granted to the operator;

D. adverse effect of the area granted to the operator on the remaining land of the owner or occupant and the nuisance, inconvenience and noise that might be caused by or arise from or in connection with the operations of the operator; E. damage to the land in the area granted to the operator that might be caused by the operations of the operator; and F. any other factors that the Board considers proper under the circumstances.

The above factors are generally considered to be akin to principles of compensation for expropriation, even though fee simple ownership is retained. The appropriateness of this point has been debated in the case law, as has the propriety of providing compensation for both per acre value and loss of use. In appropriate situations, such compensation may be appropriate, so long as the surface rights board is cognizant of the risk of double compensation. In determining the amount of compensation payable, the board may fix certain amounts payable in the manner and over the periods the board decides. Compensation may be paid in a lump sum or by periodic payments. (iii) Effect of Right of Entry Order Alberta's Act expressly states that a right of entry order vests in the operator, who will then have exclusive right, title and interest in the surface of the land in respect of which the order is granted, other than: A. the right to a certificate of title issued pursuant to the Land Titles Act; and

B. the right to carry away from the land any sand, gravel, clay or marl or any other substance forming part of the surface of the land. The effect of an order for entry has been the subject of discussion of courts in both Alberta and British Columbia. The courts held that the order had the effect of giving the operator oil company a forced acquisition of an interest in the surface of the land, non-permanent and carrying no right to obtain a certificate of title. It would not alter the municipal tax roll so as to shift the burden of taxes from the landowner to the company, nor would it remove from the landowner the obligation to pay water rates and for water rights in an irrigation district. The


company would retain dominion over the surface for the purpose of removing oil, gas and other minerals only so long as production should continue. The landowner retained the right to sell the land subject to the entry order or bequeath it to his or her beneficiaries. The court in British Columbia further stated that the surface rights board had no power to order the landowner to grant a lease, easement or right-of-way and doubted that the entry order created any interest in the land, even if registered in the land registry office. 4. Entry for Standard & Seismic Surveying (a) Standard Surveying

Surface rights legislation authorizes operators to access land for surveying purposes on notice to (or after reasonable attempts to notify) the surface rights holders. Consent and compensation is generally not required. (b) Seismic Surveying

Right of entry for the purposes of conducting geophysical operations, or seismic, has not been specifically dealt with by statute except in British Columbia. In British Columbia, an operator is required to obtain a geophysical license prior to conducting geophysical exploration. In Alberta, Saskatchewan and Manitoba, seismic survey falls under the general legislative scheme applying to surface access for mineral exploration and excavation. All provinces require the operator obtain consent of the surface owner or an order for entry and to provide compensation for any loss or damage suffered as a result of the geophysical operation. 5. Crown Land (a) Provincial Crown Land

Generally, surface access to provincial Crown lands is governed by the same surface rights legislation applicable to privately held land. Alberta's Surface Rights Act applies to all land in Alberta, with the exception of land within the geographic area of a Metis settlement. Other provinces, such as British Columbia, have complementary legislation (such as the Lands Act) which set out specific procedures for the acquisition of surface rights on Crown land. (b) Federal Crown Land

An operator may enter unoccupied federal lands to which the Canada Oil and Gas Operations Act applies for the purposes of exploring or exploiting oil and gas. Entry onto occupied land may not occur until consent or proper authorization by the decision of an arbitrator or, if the land is located in the territory of Nunavut, a decision of the Nunavut Surface Rights Tribunal, in accordance with the legislation is obtained. Federal land may be subject to other specific statutes, such as the Indian Oil & Gas Act or the Veterans Land Act. In such instances, additional requirements may need to be met to gain surface entry to work subsurface minerals interests.



Pipelines & Well Sites

The surface rights legislation in Canada is distinct from the legislation and regulatory control over the licensing and approvals required to drill wells and construct roads and pipelines for the access and transport of oil and gas. An operator must ensure that it has obtained both right of entry for the purposes of constructing and operating well sites, access roads and pipelines and the approval required to actually construct and operate such structures. Right of entry proceedings are ancillary to and in aid of the oil and gas activities authorized by the applicable energy regulatory authority (in Alberta, this entity is the AEUB). Right of entry orders must be consistent with any licence or other order made by the energy regulatory authority. An owner may not collaterally attack a well licence or other order during surface rights proceedings. 1. Regulatory Environment Across Canada (a) (i) Pipelines Provincial Provincial legislation (generally entitled the "Pipeline Act") authorizes expropriation of land necessary for the construction and maintenance of intra-provincial pipelines using the procedures and the board authorized by the surface rights legislation, should negotiation with surface owners be unsuccessful. The same factors are to be given consideration in arriving at appropriate compensation to be paid to the affected landowners. (ii) Federal Federal inter-provincial and international pipelines are regulated by the National Energy Board (the "NEB"). Upon application, the NEB may grant an immediate right of entry order for the purposes of surface access necessary for the construction, maintenance or operation of a pipeline. Compensation for entry is governed by a three-part procedure under the NEB Act. First, the Act sets out the requirements for a voluntary land acquisition agreement between an owner and a company. Where such agreement cannot be reached, the Act sets out a negotiation procedure. If negotiation is unsuitable or unsuccessful, a compensation order may be granted by an arbitration committee. Entry onto land for the purposes of surveying, examining or making other necessary arrangements on the land for fixing the site of the pipeline is authorized without previous consent or licence. (iii) Constitutional Concerns In Canada, the dividing line providing jurisdiction to the provinces over intra-provincial pipelines and jurisdiction to the federal Crown over inter-provincial and international lines of transport has been a matter of some


debate. The difficult question is whether a pipeline system that is in some respects intra-provincial, but is connected to inter-provincial lines, is sufficiently closely connected with the inter-provincial system to be treated as such and fall under federal jurisdiction. (b) Well Sites

Entry to land upon which a well site is or will be existing is governed by the surface rights legislation discussed above, which provides access and compensation for the entire area required for the drilling and maintenance of well sites. The surface rights legislation and boards can be considered ancillary to and in aid of energy licensing authorities, like the AEUB, in authorizing the necessary well licences and other approvals required to construct and maintain a well site. V. Oil & Gas Contracts

Various forms of contracts and agreements have developed over the history of the oil and gas industry in Canada. Owners of oil and gas and oil sands rights regularly negotiate and enter into a multitude of commercial contracts. Some of the more typical types of agreements (and their respective typical terms) are described below. A. Farmout Agreements

The farmout agreement allows a holder of an oil and gas lease (or other right to produce petroleum substances) (the "Farmor") to approach a person to contribute funds to carry out the exploration or drilling work on the lands (the "Farmee"). The act of the Farmor granting an interest in its lands is called "farming out" and the act of the Farmee earning an interest in the lands is called "farming in". The farmout agreement is an effective agreement for allocating the risk of drilling to more than one party, meeting drilling deadlines in leases and for attracting capital. Farmout agreements are beneficial to oil and gas companies with expertise in finding prospects and own lands (land-rich), but do not have the capital (cash-poor) or the expertise to conduct the drilling on their own. A basic farmout agreement contemplates the Farmee agreeing to drill a well on certain of the Farmor's lands (the "Farmout Lands") in order to earn an interest in such lands. The type and amount of interest a Farmee earns in the Farmout Lands will depend on the specific terms agreed upon in each farmout agreement. The simplest form of farmout agreement requires the Farmee to pay 100% of the costs of exploration and development of a well on or before a certain date to in turn earn an undivided 50% interest in the Farmout Lands. Common variations to the aforementioned process are as follows: Farmee earns a 100% interest in the Farmout Lands subject to a convertible overriding royalty payable to Farmor. Upon payout (Farmee recovering its costs of drilling the well), the Farmor may elect to remain in an overriding royalty position or convert its royalty to a prior agreed upon working interest;


Farmee may earn a greater interest in the spacing unit of the well drilled than in the remainder of the Farmout Lands; the farmout agreement provides for multiple wells or options to drill additional wells; and the farmout agreement requires the Farmee to conduct seismic testing instead of drilling a well to earn an interest in the Farmout Lands.

Farmout agreements often contain areas of mutual interest ("AMI") as drilling on the Farmout Lands may provide information with respect to certain lands surrounding such Farmout Lands. An AMI is most often an area surrounding the Farmout Lands and the Farmor and the Farmee will have the right, for a specified period of time, to jointly participate in the acquisition of such AMI lands. This is not a required feature of a farmout agreement. B. Pooling Agreements

Conservation legislation in Alberta provides that a well may not be drilled without a license, and in order to obtain a licence, a party must control the entire rights to a spacing unit. Current legislation provides that a spacing unit for an oil well is a quarter section and that the spacing unit for a gas well is one full section. In circumstances where the holder of the rights to part of a spacing unit desires to drill a well, that person may enter into a pooling agreement with the holders of the rights to the remainder of the spacing unit, whereby all the holders agree to "pool" their lands in order to form a spacing unit. The pooled lands are then operated as one lease and the costs and revenues from the pooled lands are shared among the parties. Pooling is usually expressly contemplated and permitted by oil and gas leases. In the event that all parties do not voluntarily agree to pool their interests, conservation legislation contemplates compulsory or forced pooling. A pooling agreement may be cross-conveyed or non cross-conveyed. A cross-conveyed pooling agreement affects title to the ownership interest insofar as each party who pooled their lands will obtain a working interest in the other party's pooled lands. A non cross-conveyed pooling agreement merely provides for a sharing of revenue from the pooled lands and, in the event the pooling agreement is terminated, the parties will have the same working interest in the lands as they did prior to entering into the agreement. Most pooling agreements are non cross-conveyed pooling agreements, but where cross-conveyancing is used, concerns over rights of first refusal may arise. C. Unitization Agreements

While pooling occurs prior to the development of lands, unitization generally occurs after development, once the parameters of a producing formation are known. Unitization joins together well, lease and royalty interests within a pool or part of a pool in a common reservoir of oil and gas. Operations may be conducted by one operator for the benefit of all participants and costs of operation are distributed among owners according to their tract participation. Typically, in unitization there is not a cross-conveyance, merely a sharing of revenue according to a tract participation formula. The tract participation formula is agreed to by all parties and is determined by different factors, some of which may include examining the surface area of lands


the owner is contributing and/or how much of the reservoir pool is contained under a certain owner's lands. Frequently, the subject matter of the unit agreement is restricted to one substance from one formation. Unitization is desirable to encourage more efficient production. The owners have the rights to drill wells, but choose to unitize for more economically efficient reasons. In addition, petroleum substances are fugacious in nature and this prevents one owner from capturing for itself all of the petroleum substances that may have been under an adjacent owner's lands. Unitization will usually be evidenced by the existence of two agreements: a unit or unitization agreement and a unit operating agreement. A unit agreement will typically establish the unitization, assign tract factors to each party and be executed among all of the lessee and lessors of lands contributed to the unit. A unit operating agreement will typically appoint one of the lessees as the operator and provide a system for the operation of the lands and the contribution of funds and the distribution of revenues amongst the parties. D. Operating Agreements

An operating agreement is an agreement which governs the operation of lands held by more than one person. In Canada, the operating agreement frequently adopts the form of the Canadian Association Petroleum Landmen (CAPL) Operating Procedure. An operating agreement sets out the rights and obligations of the operator and the non-operator owners with respect to the exploration, development and/or production of jointly owned lands. An initial operator is appointed under an operating agreement. It is the role of the initial operator to conduct the operations on behalf of all the parties in accordance with the terms of the agreement. The operator is responsible, inter alia, for collecting funds needed from the owners to conduct the operations on the jointly owned lands. An operating agreement deals with joint operations (those participated in by all parties) and independent operations (those participated in by less than all parties). In most circumstances, if a party declines to participate in an operation, it will be placed in a "penalty" position. The nonparticipating party is penalized for lack of participation by not sharing in production from the operation until the participants have recovered their costs associated with the operation multiplied by a specified percentage. In certain situations (for example, operations relating to a "title preserving well"), failure to participate may result in a forfeiture of an owner's working interest. An operating agreement also sets forth the terms upon which the joint interest owners may assign their working interest ownership to third parties. The parties have the option to require the other working interest owner(s) to offer their working interest to the existing working owner(s) before offering it to a third party. This is commonly referred to as a right of first refusal ("ROFR"). A party may want to include a ROFR in an agreement in circumstances where they would like to increase their working interest percentage in the jointly held lands and/or when they want to be able to control the identity of the other working interest owner in such lands.



Drilling Contracts

A drilling contract is an agreement whereby the owner/operator of certain lands contracts with a third party (the "Contractor") who will be able to provide the expertise, personnel and necessary equipment to drill the required well on behalf of the owner/operator. Drilling contracts can take many forms depending on how payment is to be made and such forms include the following: Meterage Contract the Contractor is paid at an agreed upon price per meter drilling upon reaching the agreed upon contract depth and such amounts are paid on a regular basis; Day Work Contract the Contractor is paid an amount based on work done within a 24-hour period; or Turnkey Contracts the Contractor is only paid when it reaches the agreed upon contract depth or formation.

The most important provision included in drilling contracts is typically one that sets forth the specified rates to be paid to the Contractor and on what terms the Contractor is entitled to receive such payment. Drilling contracts should also specify the liability of each party. It is generally agreed that the owner/operator will be responsible for those items under its control and vice versa, the Contractor will be responsible for those items under its control. F. Royalty Agreements

A royalty agreement is an agreement whereby a party who holds a certain interest in petroleum substances (the "Grantor") grants a certain percentage share in production of petroleum substances to another party (the "Royalty Owner"). Royalty agreements will typically specify which substances the royalty will apply to (i.e. oil, natural gas, hydrocarbons, etc.) and what percentage is to be paid on each substance. A gross or net overriding royalty can be granted. The most traditional type of royalty is a gross overriding royalty. A gross overriding royalty generally does not allow for production costs, lease costs or other encumbrances, but will allow for the costs of marketing and processing the royalty substances. In addition, royalty agreements often provide the Royalty Owner the option to take its interest in kind, which means they can take their percentage of the specified petroleum substances and market them themselves. This may be desirable if the Royalty Owner is concerned with the price the petroleum substances are being sold for or that the marketing or processing deductions are unreasonable. G. Transportation & Processing Agreements

A transportation agreement governs the delivery of petroleum substances to and from certain points for a fee and a processing agreement governs the processing of petroleum substances to meet certain quality specifications. Transportation and processing agreements can be on a firm service or interruptible basis. Interruptible or reasonable efforts means that the services may be interrupted upon prior agreed

upon terms (i.e. no capacity, discretion at any time, etc.). Firm service or guarantee contracts are generally based on volume and a party will be required to take a certain minimum amount of volume at a certain fee. This often takes the form of a "take or pay" clause in which a party is required to pay a certain fee for a volume of petroleum substances whether it actually takes such substances or not. VI. Government Regulations & Legislation

The division of powers between federal and provincial governments is set out in the Canadian Constitution Act, 1867. Generally, the federal government has jurisdiction over matters of inter-provincial, national and international scope, while the provinces have jurisdiction over matters of a local or private nature. The two levels of government exercise constitutional powers in respect of different but sometimes overlapping aspects of energy development, transportation and marketing. Jurisdiction will typically be determined based upon the location, dominant nature and/or scope of the matter and certain other factors. In the event of a conflict or inconsistency between federal and provincial statutes, the doctrine of paramountcy applies to give effect to the federal statute. A. Environmental Legislation & Conservation

When Canada was formed in 1867, some matters were not contemplated and therefore are not assigned to either level of government. Environmental concerns are one such matter. In that regard, the Supreme Court of Canada has determined that both levels of government may enact laws regarding the environment in respect of and ancillary to existing listed heads of power. Set forth below is a brief description of environmental and conservation legislation in place that has the potential to impact upon the oil and gas industry in Canada (depending upon the specific resource being exploited and the circumstances under which it is under development). The authors have restricted the description of provincial legislation below to Alberta, given that Alberta's legislation is very typical of that of other provinces. 1. Environmental Protection (a) (i) Federal The Canada Environmental Assessment Act The purpose of the Canada Environmental Assessment Act is to ensure that projects are carefully reviewed in order to avoid significant adverse environmental effects and to encourage sustainable development. Under this Act, the requirement for an environmental assessment will be triggered where a Federal Authority proposes a project, grants money to a project, grants an interest in land to a project, or exercises a regulatory duty in relation to a project. Once the requirement to conduct an environmental assessment has been triggered, it is up to the federal authorities to identify the scope of the proposed project, scope of the factors that must be considered in the environmental assessment and the time line for the assessment. After the assessment has been conducted and a report based on the findings of the assessment reviewed, the responsible authority

decides whether adverse environmental effects are likely to be significant. This decision is taken into account when determining whether to proceed with the project itself when the federal authority is the proponent, or otherwise to provide the funding, land, permit or other authorization. (ii) The Canada Environmental Protection Act The Canada Environmental Protection Act is the primary element of the federal legislative frame work for protecting the Canadian environment and human health. The key aspects of this Act are the prevention and management of risks posed by toxic and harmful substances, managing environmental and human health impacts of products of biotechnology, marine pollution, disposal at sea, vehicle, engine and equipment emissions, fuels, hazardous wastes, environmental emergencies and other sources of pollution. (iii) The Canada Fisheries Act The Canada Fisheries Act applies to all territorial seas and inland waters and is binding on the federal, provincial and territorial governments. One of the goals of the Fisheries Act is the protection of fish habitat, which includes "any (area) on which fish depend directly or indirectly in order to carry out their life process." To this end, the Act provides a prohibition on the deposit of deleterious substances in fish habitats and a general prohibition on the destruction of fish habitat without federal authorization. The federal Department of Fisheries and Oceans is one of the federal authorities that may have responsibility for conducting an environmental assessment under the Canadian Environmental Assessment Act. (b) (i) Provincial The Alberta Energy and Utilities Board The oil and gas industry in Alberta is largely regulated by the AEUB and Alberta Environment. The AEUB is an independent, quasi-judicial agency of the Government of Alberta. Its mandate is to ensure that the discovery, development and delivery of Alberta's energy resources and utilities services take place in a manner that is fair, responsible and in the public interest. The AEUB has jurisdiction under several environmental and conservation acts (including the Alberta Oil and Gas Conservation Act, the Oil Sands Conservation Act and the Alberta Energy Resources Conservation Act) to consider and address potential impacts on the environment. The AEUB's environmental jurisdiction is exercised throughout project approval, including preliminary discussions with potential applicants to address issues that may arise, and through the public hearings process involved in the project approvals process. Board orders and approvals may also include environmental conditions. Environmental regulation is also achieved through guidelines, information letters, interim directives and regulations issued by the AEUB.

The government of Alberta has recently announced new legislation which will separate the AEUB into two separate regulatory bodies: a new Energy Resources Conservation Board and the Alberta Utilities Commission. The Alberta Utilities Commission Act [is expected to come into force on January 1, 2008] [NTD: Update] and is intended to allow Alberta's regulatory authorities to effectively manage Alberta's growing natural resources sector. (ii) Alberta Environment Alberta Environment's central mandate is the protection of the environment and the protection and management of water resources. It also addresses climate change and waste management. Alberta Environment carries out its mandate under the authority of the Environmental Protection and Enhancement Act ("EPEA"), the Water Act and other legislation. (iii) The Alberta Environmental Protection and Enhancement Act The EPEA is a consolidation of various environmental statutes that were previously independent. Its purpose is "to support and promote the protection, enhancement and wise use of the environment" through sustainable development. The EPEA provides a comprehensive means of regulating activities which may impact the environment, including requiring that certain activities will be subject to the environmental impact assessment process. The EPEA deals with release of substances, which has been defined broadly and could refer to emissions, salt water, oil and other hydrocarbons. Regulations enacted under the EPEA prescribe limits upon the release of some substances. The EPEA also deals with the remediation of contaminated sites. (iv) The Water Act The Water Act focuses on managing and protecting Alberta's water and on streamlining administrative process surrounding the allocation of water licenses. The Water Act applies to any activity that can possibly disturb either ground or surface water, and includes the impoundment, storage, consumption, taking or removal of water for any purpose. Subject to certain exemptions provided for under the Act and its regulations, an approval or license under the Water Act will be required for such activities. Regulatory and policy initiatives are currently being implemented to improve the efficient industrial use of water. Further, under the Water Act, water management plans may be developed for major river basins in Alberta, including the Athabasca River which is located in the area of major oil sands development. Such plans could impact the right to divert water. 2. Conservation (a) Purpose

Each province has authority over property and civil rights and in respect of exploration for, and conservation and management of, non-renewable natural resources within such

province. In Alberta, the AEUB is mandated to ensure that the discovery, development and delivery of Alberta's energy resources and utilities services takes place in a manner that is fair, responsible and in the public interest. The purpose of such conservation efforts is to obtain the ultimate recovery of oil and gas reserves for the benefit of all Albertans. To that end, the AEUB regulates the safe, responsible and efficient development of Alberta's energy resources, including: oil, natural gas, oil sands, coal and electrical energy, along with pipelines and transmission lines that move the resources to market. (b) Waste

The prevention of waste and the conservation of resources are key elements of the AEUB's mandate. To this end, the AEUB has been granted a broad mandate under its enabling legislation to manage Alberta's energy resources. Means of preventing the waste of Alberta's oil and gas resources include regulating the concurrent production of gas and bitumen, and considering applications for reduced spacing units and applications for compulsory pooling requirements. (c) Mandated Requirements

The EPEA requires operators to plan for and employ effective conservation and reclamation measures. Conservation refers to the planning, management and implementation of the oil and gas activity with the objective of protecting the essential physical, chemical and biological characteristics of the environment against degradation. Reclamation refers to the removal and decontamination of equipment or buildings or other structures and the reconditioning of the land to a state fit for some future use. Conservation and reclamation measures are accomplished by issuing approvals for complex industrial activities, collecting security for activities with approvals, conducting inspections of conservation and reclamation activities, issuing reclamation certificates and undertaking compliance and enforcement actions when necessary. The Oil and Gas Conservation Act and regulations are also intended to address conservation issues by conserving resources to maximize the benefit therefrom for all Albertans, to promote the economic, orderly and efficient development of oil and gas resources, to observe safe and efficient oil and gas practices, and to control pollution. B. 1. Intra-provincial & International Gas Transportation Provincial (a) Pipeline Construction & Operation

The AEUB regulates the construction and operation of pipelines within Alberta pursuant to the Alberta Pipelines Act. This Act applies to all pipelines in the province except those on plant property and those subject to an order or certificate of the National Energy Board. Pipelines require a construction permit from the AEUB as well as an operating license from the AEUB upon completion. When reviewing an application for a


construction permit, the AEUB will consider various public interest matters including resource conservation, correlative rights of well owners, and potential environmental issues. After construction and completion, the AEUB also supervises and enforces licence and statutory requirements for pipeline operation. (b) Energy Exports

The AEUB also regulates the removal of natural gas from the province pursuant to the Gas Resources Preservation Act. This Act requires that the AEUB shall not grant a permit for export unless it is, in its opinion, in the public interest to do so. While the AEUB may authorize the removal of smaller quantities of gas with the approval of the Minister of Energy and Natural Resources, long term sales applications also require the approval of the Lieutenant Governor in Council. 2. National Energy Board & Legislation (a) Intra-provincial Transportation

The federal government has authority to make laws regarding the regulation of trade and commerce in inter-provincial and international trade, including the import and export of natural resources. The federal government also has authority to regulate pipelines and other means of transportation that cross provincial and international boundaries under the Constitution Act, 1867. This authority is exercised through the National Energy Board (NEB), an independent federal agency that reports to Parliament through the Minister of Natural Resources, Canada. The NEB has authority to regulate traffic, tolls and tariffs of companies operating extra-provincial pipelines. It is the NEB's responsibility to ensure that tariffs and tolls are just and reasonable and that there is no undue discrimination in tariffs or services. The NEB also requires that pipeline companies operate according to the principle of "open access". This means all parties must have access to transportation on a nondiscriminatory basis. (b) Pipeline Construction

When a company proposes to construct a pipeline that crosses a provincial boundary or extends beyond the international boundary, or to extend existing pipeline systems under federal jurisdiction, a Certificate of Public Convenience and Necessity must be obtained from the NEB. Before issuing the certificate, the NEB must "be satisfied that the line is and will be required by the present and future public convenience and necessity." In determining whether a pipeline project should proceed, the Board considers its economic, technical and financial feasibility and the environmental and socio-economic impact of the project.


VII. A. 1.

Acquisition, Disposition & Anatomy of an Oil & Gas Property Transaction Due Diligence Title Review

Title review is the process of investigating a vendor's ownership of assets to confirm the individual or company in fact holds title to the assets they have represented to hold. This may result in a law firm preparing and providing a title opinion in respect of the vendor's interests in some or all of the assets, or lawyers, landmen or other professionals conducting investigations and preparing non-opinion title reports. Typically, full title opinions are more extensive than title reviews, involve more comprehensive investigations and, in practice, are not completed as often as title reviews. A title review will provide the purchaser with a reasonable degree of comfort with respect to the vendor's title to and ownership of the target reserves. During this review, all documents (including correspondence; lease, contract summary sheets and agreements contained in the mineral contract files; mineral lease files; and all relevant titles, search letters and registered encumbrances) are reviewed. In some instances, a title review is conducted on selected properties. This often occurs when most of the value associated with the transaction is concentrated on specific assets. In some cases, the scope of the review might be narrowed to simply conduct relevant searches, review land summary sheets and review the key documents relating to such interests. Title review is necessary for a number of reasons. One such reason stems from the lack of a registry of working and other interests on which prospective purchasers can rely to ascertain a vendor's ownership of reserves. Another stems from the fact vendors are typically not prepared to provide an adequate warranty and indemnity in respect of its ownership of reserves and, consequently, the risk of title failure is passed on to the purchaser. Both the crown and freehold land systems have limitations in ensuring the current and proper beneficial owners of the interests have recognized, registered and accurate interests in the relevant lands or leases. Accordingly, it is necessary to examine all title documents relevant to a vendor's chain of title in order to ensure the vendor has acquired the interest that it purports to have as disclosed in its property reports and land schedules. In addition, these reviews are designed to determine that the encumbrances on such interests are also as stated, that the leases and other title and operating documents on which such interests are based or derived are in good standing and that there are no other defaults or issues existing under the leases or other title documents including material terms of an adverse nature, such as an ongoing area of mutual interest covenant. This due diligence examination is designed to determine the vendor's ownership of reserves subsurface but does not address surface assets, activities and operations. 2. Corporate Searches

Typically, a purchaser conducts or has its legal or other representatives conduct due diligence searches against the vendor. Regardless of what other due diligence is being conducted in connection with the transaction, a purchaser should always conduct such searches although, in some cases, depending upon the nature of the assets involved, certain searches may not be

necessary. These searches do vary by jurisdiction and, accordingly, a lawyer or other professional familiar with such searches should be contacted to determine what searches are appropriate with respect to the specific transaction. The types of searches that can be conducted include the following: Corporate: To determine the current status of the vendor: ensuring the proper corporate name, valid corporate existence and determining the registered office and current directors of the corporation; Courthouse: To determine whether there are any actions commenced against the vendor which might impact the assets or the ability of the vendor to complete the transaction; Personal Property Registry: To determine whether or not there is any general or specific security granted against the assets of the vendor; these searches are typically only province-wide, so they must be conducted separately for each province in which assets exist; Bank of Canada: To determine whether or not there is any Bank Act (Canada) security granted by the vendor which would attach to the assets; Workers' Compensation Board: To determine whether there are any statutory liens in existence under the applicable statute; Employment Standards: To determine whether there are any statutory liens in existence under the applicable statute; Bankruptcy: To ensure the vendor has not committed an act of bankruptcy and, therefore, could not complete the transaction; this search covers all of Canada; and Environmental: To determine whether there are any environmental breaches or occurrences that may affect the assets or the ability of the vendor to complete the transaction. Reserve Ownership


The information contained in a reserve report or a property report is a critical component in establishing the bid price. Accordingly, it is important that the purchaser ensure the information that forms the basis of the reserve report or property report is accurate. A key element of such information is the vendor's stated ownership of the evaluated or stated petroleum and natural gas rights (for purposes of this discussion, we use reserves and petroleum and natural gas rights interchangeably) and the lessor royalties and other encumbrances thereon. In establishing the value of the reserves attributable to the vendor, evaluators will utilize the property reports and information provided by the vendor. Accordingly, the purchaser must ensure that those property reports and information are accurate. In addition, in reviewing the reserve report, the purchaser should consider whether it agrees with the manner in which the evaluator has arrived at the vendor's net interest in such reserves pursuant to the evaluator's process of evaluating working


interests, convertible interests, net profits interest, carried interests, gross overriding royalties, lessor royalties, regulatory or other limitations on production and other encumbrances. It is obvious that there would be a material negative effect on the purchase price model if the vendor's stated ownership of reserves associated with a particular well is overstated, or if the encumbrances on such interest are payable on a higher percentage of production or paid at a higher rate than stated. For example, if the vendor's interest in a well is evaluated as a 100% working interest, but such interest is subject to conversion to an undivided 50% working interest upon payout of the well and the reserve report does not reflect this, this may amount to a significant difference in value notwithstanding that an associated overriding royalty may have been factored in. It may be an even more significant difference in value if the well is very close to paying out. Accordingly, any examination conducted in respect of the vendor's ownership of such reserves must be directly linked to the information used in the evaluation of such reserves. 4. Operations

Where the asset profile warrants it and where such matters are strategic to the purchaser's goals, the purchaser should conduct at least some due diligence investigations into operatorship issues, location, capabilities, contractual terms and other aspects of gathering, processing, disposal and transportation facilities, transportation and marketing arrangements, third party contract operating arrangements, third party service arrangements and other aspects of the operations. Such a review can be broken into the following components: identification and examination of surface rights; identification and examination of facilities; identification and examination of material contractual arrangements, including agreements for the gathering, processing, disposal, transportation and marketing of production, construction, ownership and operating agreements, contract operating agreements and other service arrangements; review of accounts, books and records; and equipment, field and site inspections and environmental audit. Surface Rights


In conducting a surface rights review, the purchaser will examine the existing surface leases, surface access agreements, easements and rights-of-way to ensure such rights are sufficient for all existing facilities and wells, there has been material compliance with such arrangements, there are no instances of trespass and there are no arrangements in respect of which there is a current default. In addition, if relevant, the purchaser will wish to examine such documents (and often the existing leases and title and operating documents associated with the hydrocarbon rights) with respect to any surface access restrictions that might otherwise apply. Examples of areas where surface access restrictions will apply include military facilities, animal habitats and mating grounds, historical sites, cemeteries and populated areas. In addition, such review will

assist the purchaser in determining whether the costs of access are consistent with the assumptions which the purchaser has made in establishing its bid price. As an added bonus, surface files are often a helpful source of determining whether or not any environmental issues currently exist or have ever existed in respect of the assets. In addition to the file review, a surface review can include physical site inspections, obtaining road ban information and the conduct of searches with Alberta Energy and the Land Titles Office. 6. Facilities

In connection with a facilities review, a purchaser will attempt to learn the means by which production is gathered, processed, disposed, transported and ultimately brought to market from the wellhead through to the sales point and confirm that the results are consistent with the data and assumptions that went into its purchase price model. Such an examination will typically include a review of all of the vendor's relevant files and obtaining publicly available information, either directly from public sources (i.e. Energy and Utilities Board) or from available third party sources (such as AccuMap), which is then synthesized with other pertinent information gathered from other investigations that can then be mapped for visual reference. 7. Material Contracts

In connection with the review of material contracts, the purchaser may wish to review all gathering, processing, disposal, transportation and marketing arrangements and CO&O agreements, contract operating agreements and service arrangements to confirm the information provided to it in the data room. In some cases, written contracts may not have been entered into and, accordingly, the purchaser will have to rely upon whatever accounting or other information that is available to it. In conducting such a review, the purchaser will take into account: 8. confirming financial terms and ownership interests are as assumed; assessing the credit risk of counterparties; assessing the market value of fees and terms of arrangements; assessing the stranded production risk (if behind third party facilities); assessing competitor/counterparty issues; and assessing general business terms and conditions of arrangements. Accounts

An examination of the vendor's accounts will help to confirm much of the financial and other information provided to the purchaser and could disclose material issues such as the nonpayment or late payment of royalties, other encumbrances, AFEs, trade creditors and other cost items having a bearing on the assets.



Equipment, Field & Site Inspection

During equipment, field and site inspections, purchaser will assess the condition, capability and suitability of the assets and will conduct an inventory of equipment. In connection with the foregoing, the purchaser may also find it valuable to review the following: 10. minutes of meetings of any operating committees of common facilities of properties; equipment leases; government licences and permits; equipment warranties; utilities agreements; equipment schedules; maintenance records of significant equipment; fuel contracts and related agreements; equipment service agreements; and equipment purchase agreements. Environmental

Environmental due diligence is conducted with a view of identifying risks, quantifying those risks and allocating liabilities. There are several aspects to environmental due diligence which will vary depending upon the type and scope of transaction. Common types include: B. 1. Site Specific: Soil, surface water, groundwater contamination and other identifiable environmental conditions; Regulatory Compliance: Proper permits and licenses, compliance with applicable environmental legislation and regulations, health and safety concerns; and Legal: Absence of claims or threatened claims, governmental orders, prior indemnification agreements. The Bidding Process Data Room

In many cases when a vendor has committed itself to disposing assets, it will wish to proceed with the marketing of such assets through a formal process and to a broader spectrum of potential purchasers. In connection with the marketing process, the vendor will work with marketing professionals to prepare an actual and/or virtual data room containing information, documentation and evaluations relevant to the assets and the valuation of the assets and a confidential information memorandum and/or a data book summarizing such information. On the basis of the information provided in the confidential information memorandum and the data room, the bidders will be requested to make bids on the assets on or before a specified date. Typically, the vendor will specify that it is under no obligation to accept the highest bidder's offer (or any offer) in respect of the assets. It is common for the vendor to request non-binding


bids, indications of interest or letters of intent wherein the purchaser is asked to provide the basic terms of its proposed purchase, such as purchase price, effective date (if not already set by the vendor) and specifically required conditions. In some cases, the vendor may provide a copy of the form of sale agreement to be entered into among the parties. It is not unusual for such form of sale agreement to undergo drafting amendments during negotiations and, as such, the purchaser may be required to provide all such comments in respect of same by submitting them alongside the purchaser's bid. Once the vendor has received such bids, it will then narrow down the bids and meet with the leading prospective purchasers with a view to finalizing the terms of each bid and ultimately selecting the winning bid. The vendor will control access to the data room, the form of bid letter and the process by which a purchaser is selected. It is important both the vendor and the prospective purchaser understand the rules of the bidding process and the terms of the form of bid letter to ensure they understand what obligations, if any, derive from the offering of the assets, bidding on the assets and the execution and delivery of a letter of intent. 2. Letter of Intent

Once the vendor has settled on the basic terms of a proposed transaction with a purchaser, the parties will likely execute some form of letter of intent which will form the basis of the formal purchase and sale agreement. Typically, the letter of intent will express the basic terms of the transaction, including: description of the assets and any specifically excluded assets; purchase price with an allocation; effective date; and special conditions.

It is always a concern whether or not a letter of intent constitutes a binding agreement and is therefore enforceable. Generally speaking, there are three possible scenarios: Non-enforceable: Provided that a letter of intent is properly drafted with the inclusion of conditions which prevent the formation of a contract, it is possible to prevent an agreement from arising. The distinction between a condition which prevents the formation of a contract and a condition to an obligation arising under a contract is very important. If it is the intention of the vendor and purchaser to prevent an agreement of purchase and sale to arise, or to prevent any other contractual obligations flowing from the letter of intent, the parties may wish to include express language which states that the letter of intent is not intended to be binding and there is no agreement between the parties until a formal agreement is executed. There are other less obvious circumstances where it is possible that an agreement has not been formed, such as where there is a condition requiring negotiation, execution and delivery of a mutually satisfactory agreement of purchase and sale (i.e. "an agreement to agree"). Fully Enforceable: A binding agreement can come into effect if the essential terms of the contract have been agreed to and no conditions precedent are preventing the formation of the contract. As noted above, the simple existence of conditions will not necessarily


prevent a contract from coming into effect, as such conditions may simply suspend the obligation to perform under the contract until such condition is satisfied (this is illustrated by the numerous conditions found in binding formal agreements of purchase and sale). For example, the vendor may have agreed to sell to the purchaser subject to the purchaser having obtained all required regulatory approvals. This type of condition does not prevent the formation of a contract. Partially Enforceable: It may be that the letter of intent does not represent an agreement of purchase and sale (i.e. it is simply an agreement to agree) but does contain enforceable obligations. Short of a letter of intent actually forming a contract to sell and to buy between the vendor and the purchaser, there are a number of covenants which a purchaser may want a binding commitment from the vendor. For example, letters of intent almost always provide that the obligation to sell and to purchase is subject to the execution of a formal agreement and, therefore, will likely not be binding. However, the purchaser may want a binding obligation imposed on the parties to negotiate, execute and deliver the agreement of purchase and sale in good faith. In addition, the purchaser will likely wish to obtain an exclusivity or no shop provision whereby the vendor is prohibited from offering the assets to third parties until a reasonable negotiation period has passed. Accordingly, the purchaser may wish to take care that key provisions of the letter of intent are in fact enforceable even though no agreement respecting a transaction has been reached.

Once the letter of intent has been finalized, the vendor and the purchaser will proceed to negotiate and execute the agreement of purchase and sale. C. Purchase & Sale Agreement

The asset purchase and sale agreement is the means by which the purchase and sale of assets takes place. It documents the respective rights and obligations of the parties to each other, the process by which the assets are to be sold and transferred, and the pre-closing and post-closing rights, obligations and liabilities of the parties. Typically, this arrangement is documented in a formal agreement of purchase and sale (the "Sale Agreement") which will be discussed below in fairly broad terms. 1. Clauses & Considerations (a) (i) Clauses Defined Terms One key element of the Sale Agreement is the defined terms section and specifically those defined terms which identify the assets to be sold and purchased thereunder. Too often vendors and purchasers rely upon conventional definitions without careful consideration of this issue, resulting in the Sale Agreement failing to adequately address the inclusion or exclusion of specific assets. This is particularly important in circumstances where shallow or deep petroleum and natural gas rights or facilities are being retained and where there are assets to be


sold which are not directly related to the petroleum and natural gas rights or tangibles. For example, the parties should specifically address whether or not proprietary seismic, vehicles, loose equipment, materials, and production sales and transportation contracts form part of the assets or do not. (ii) Deposits A typical Sale Agreement will require the purchaser to deliver a deposit as security for its obligations thereunder and provide that, if the purchaser wrongfully fails to close, the vendor shall be entitled to retain the deposit and interest accrued thereon "as a genuine pre-estimate of liquidated damages and not as penalty". Some recent Alberta judicial decisions have revisited the question of the enforceability of such deposit forfeiture mechanisms in circumstances where a purchaser of assets has repudiated the Sale Agreement by wrongfully not closing the transaction. This case law confirms that, notwithstanding such wording, the courts will examine whether or not the circumstances of the deposit constitute a penalty. If it is determined to be a penalty, such provision will be deemed unenforceable and the vendor will be entitled to collect only the actual proven damages it suffered from the purchaser's repudiation. Accordingly, while it is prudent for a vendor to ensure that such wording is included in the Sale Agreement, it will not necessarily be definitive of the issue. Conversely, a purchaser may wish to expressly provide that it is not liable for any damages over and above the deposit and wording to this effect should be effective to prevent any such additional damages. (iii) Adjustment Clauses Sale Agreements often provide for two separate dates: the "effective date", on which title passes but the contract is not executed until the conditions have been fulfilled; and the "closing date", which occurs after the conditions have been completed or waived and the deal becomes complete. Often there are extended periods of time between striking the deal and closing due to extensive due diligence, numerous conditions precedent and required third party consents. The vendor is accountable for the benefits and obligations in the interim period between the effective and closing date. Adjustment clauses provide for this adjustment, making the purchaser accountable as of the effective date. Petroleum substances produced but not sold as of the effective date are credited to the vendor. (iv) Conditions Precedent Conditions precedent utilized in a Sale Agreement are conditions to an obligation; the obligation being that of vendor to close on the sale of the assets or that of purchaser to close on the purchase of the assets. Typically, each party will attempt to minimize the other party's conditions thereby minimizing its risk that


other party will abort the transaction. However, this is somewhat limited by the fact that it has become customary that such conditions largely be reciprocal. In some cases, distinct from any expressly provided for title and due diligence mechanisms, the purchaser may be able to negotiate in conditions in respect of its satisfaction with material contracts, the condition of tangibles, surface rights, and environmental damage or contamination. (v) Due Diligence Mechanisms In addition to conditions to close, a Sale Agreement will typically contain due diligence mechanisms with respect to reserve ownership and, sometimes, environmental due diligence. Rarely does a Sale Agreement contain mechanisms in respect of the other due diligence components such as surface rights, facilities, material contracts, accounts review, and equipment and facility inspections. Accordingly, should a purchaser require such due diligence, it should either ensure that it has completed its review prior to executing the Sale Agreement or obtain some means whereby it can ensure that it is satisfied with such review prior to being obligated to close. To a certain extent, the purchaser may be able to obtain comfort in respect of these matters (in addition to or in lieu of conducting actual due diligence) by obtaining appropriate representations and warranties from the vendor. (vi) Representations & Warranties Representations and warranties are a means of allocating some of the risk to the vendor, however, the purchaser should be very cautious about substituting due diligence on the assets for representations and warranties. It is important to note that representations and warranties will not cover all of the issues to be addressed by a due diligence review, and are of limited value once closing has occurred in that they merely give the purchaser a cause of action, but no guarantee of a judgment and successful collection on such judgment; unless relied upon, there is no cause of action. If utilized properly, representations and warranties can provide the purchaser with a useful condition to close in that, where its review in respect of a represented matter indicates that the representation is materially inaccurate, the purchaser can utilize the non-satisfaction of the condition that the vendor's representations be true at closing to terminate closing or threaten such termination in order to renegotiate the terms of the sale with the vendor. This will be valuable in circumstances where the misrepresentation is significant and affects the purchaser's goals for the transaction. However, this is of limited value given that the purchaser will have made significant expenditures, including time, money and energy, and may have issued a press release regarding the existence of the pending transaction. Accordingly, it will not wish to waste such efforts or incur negative publicity by terminating the transaction for anything less than a significant discrepancy. Post-closing, the purchaser may claim damages for breaches.


A. Purchaser: The purchaser typically prefers broad representations and warranties and should ensure such representations and warranties address any assumptions made by the purchaser and any knowledge sought about the vendor and the assets that is not convenient or readily obtainable. B. Vendor: The vendor typically prefers narrow representations and warranties on an "as-is" basis, which provides for future risks to be assumed by the purchaser. (vii) Third Party Rights & Consents Third party rights and consents provide a third party to a Sale Agreement with an opportunity to pre-emptively purchase the assets on the same terms as the purchaser. The vendor must serve the required notices promptly and in strict compliance with the Right of First Offer or consent provision, as defects can void notice and lead to liability for the vendor. The purchaser is required to submit a "good faith estimate" of the value of the assets and, in connection with this, the vendor will often require indemnification from the purchaser. (viii) Indemnities A. Purchaser: The typical practice in Sale Agreements is for the purchaser to provide the vendor with a broad indemnity with respect to the assets and anything pertaining thereto from and after the effective date (or alternatively the closing date) of the transaction. In addition, the purchaser will assume responsibility for and indemnify the vendor in respect of any and all reclamation and abandonment obligations and any environmental liabilities, regardless of whether they existed or accrued before, on or after the effective (or closing) date. The purchaser indemnity is typically unlimited by time and in quantum of damages that could be suffered by the vendor. B. Vendor: There are basically two approaches to vendor indemnities. (1) The more common approach today is for the vendor to only indemnify the purchaser for any liabilities as a result of the inaccuracy or untruthfulness of any of its representations and warranties and the purchaser will provide a reciprocal indemnity for its representations and warranties. This type of indemnity likely does not give either the vendor or the purchaser significantly greater rights or remedies than it already had at common law by virtue of a breach of representation and warranty cause of action. However, depending upon how it is worded, it may have some benefits in terms of the breadth of remedies or damages which the indemnified party can seek and as to whether or not such party may have to prove reliance upon the inaccurate representation or warranty. (2) The second approach is for the vendor to indemnify the purchaser with respect to any liabilities accruing in respect to the assets prior to the effective date, excluding anything relating to vendor's title to the assets

and excluding liabilities in respect of land reclamation obligations and environmental matters. Conceptually, this is potentially broader than the indemnity given by the vendor in respect of the representations and warranties and may provide the purchaser with some additional recourse against the vendor in the event that it suffers some loss in respect of a matter not covered by the vendor's representations and warranties. In most circumstances, vendor indemnities will be limited by time (12-month survival), by quantum (amount not more than purchase price) and by type of damages (excluding consequential and punitive damages and business losses). A vendor may seek two additional means by which to reduce its potential liability for losses suffered by the purchaser. Firstly, the vendor may attempt to require a threshold be reached before the purchaser can make a claim for any losses. Secondly, the vendor may attempt to make the amount of such threshold a deductible so it is only liable for amounts of losses over and above the threshold amount. These matters are often negotiable and will depend upon the existing transaction climate (vendor or purchaser favourable) and how significant the issue is relative to the vendor's retention value and the purchaser's price model. (ix) Arbitration Arbitration is a method of dispute resolution that involves a neutral third party who hears the dispute and makes a binding decision. Parties to arbitration have greater control, the procedures are more flexible than in court litigation and parties can select arbitrators that have specific expertise. Arbitration is often less costly and more timely than litigation and is more likely to preserve the relationship between the parties. Parties typically share the costs of the arbitrator's fees. (x) Governing Law Governing law determines which laws are to govern the Sale Agreement. Typically, parties expressly state which law applies in the event of a dispute, however, if this is not specified, courts will apply the system of law that has the closest, most substantial and real connection to the contract by considering issues such as the place of contracting, the place of performance, the place of residence or business of the parties and/or the nature and subject-matter of the contract. (xi) Considerations Negotiation of Sale Agreement: What is an effective and useful Sale Agreement in one transaction will not necessarily be effective in another, given disparities in material elements of such transactions and the assets involved. Obtaining a reasonably thorough understanding of the assets and elements of the transaction is extremely valuable when effectively negotiating the terms of the Sale Agreement. It will assist in assessing the relative importance of various issues and in ensuring that vulnerabilities under the Sale Agreement are limited to the less important


elements of the transaction. Accordingly, a seasoned negotiator will take advantage of his or her knowledge of the transaction and assets to ensure the Sale Agreement contains the provisions necessary to achieve his or her side's key goals while sacrificing position on less relevant terms. (xii) Pre-Closing Consents and Approvals There are a number of pre-closing governmental or quasi-governmental approvals the parties may be required or otherwise wish to obtain prior to closing, including: A. Competition Act (Canada): Required for "notifiable" transactions which is based upon: (1) Size of the Parties: If the parties and their affiliates have combined Canadian assets or combined gross annual revenues from sales greater than $400 million; and (2) Size of the Transaction: If the aggregate value of Canadian assets being acquired or gross annual revenue from sales therefrom is greater than $50 million. Both must be exceeded in order for a transaction to be notifiable. The Competition Act creates two aspects of merger review in Canada. First, it establishes pre-merger notification obligations and mandatory waiting periods with respect to the above transactions. Second, it empowers the Competition Tribunal to block, in whole or in part, or make other remedial orders against mergers that are likely to substantially lessen or prevent competition in any market in Canada. Unless the Commissioner of Competition (the "Commissioner") makes an advance ruling confirming there are no substantive concerns, the Commissioner maintains the right to challenge a merger at any time within three years following its completion. Typically this would only occur if the Commissioner receives complaints from outside parties that the merger was affecting market power. B. Investment Canada Act (Canada): A transaction is reviewable or notifiable when it involves the acquisition of control of a Canadian business by a "non-Canadian" if it is a "direct acquisition" (i.e. acquisition of all or substantially all of the assets or majority of the shares of an entity carrying on business in Canada) and it meets the relevant threshold. If the purchaser is a non-World Trade Organization ("WTO") investor, the threshold value is $5 million for review; if the purchaser is a defined WTO investor, the value of such assets is [$281 million (2007 threshold)] [NTD: Update]. An indirect acquisition of a non-WTO investor's threshold is $50 million, while an indirect acquisition of a WTO investor is not reviewable by Investment Canada but is still subject to the requirement to file a post-closing notification. Reviewable investments require the Minister to determine if the transaction is of "net benefit" to Canada.


C. Third Parties: In addition to the foregoing, approvals, consents and any applicable rights of first refusal, the parties may wish to attempt to obtain third party consents to the proposed assignment of material contracts. Typically, consents in respect of standard industry agreements are not obtained until after closing, however, certain particularly material contracts and certain circumstances may warrant addressing this consent issue in advance of closing. (xiii) Interim Operations Sale Agreements typically have provisions which address how the vendor is to maintain the assets from the execution of the Sale Agreement until closing. The parties will need to consider how much discretion and influence each has with respect to: 2. notices, operations and approval of operations including associated expenditures and expenditure limits; rights of first refusals that accrue to the vendor during such period; emergency situations; and contract continuation, renewal amendment and termination.

Closing & Post-Closing Matters (a) Specific Conveyances

Typically, it is the vendor's responsibility to prepare all specific conveyances and, in an ideal situation, table such conveyances to the purchaser for execution and delivery at closing. In very large transactions where numerous specific conveyances are required, this is not always practically possible and, accordingly, conveyances are sometimes prepared and delivered post-closing. As a rule, registration and circulation of such conveyances is for the account of the purchaser and it is a matter of negotiation between the vendor and the purchaser as to which party will be responsible to carry out such registration and circulation. The vendor often wishes to control all or part of this process to ensure it is completed in a timely fashion. In part, this will depend upon the respective abilities of the vendor and the purchaser to complete such matters. (b) Post-Closing Transition

Similar to the interim operations, the vendor will typically be required to provide agency services until such time as the purchaser is properly novated into the title documents and accordingly hold such assets as trustee for the purchaser. More often than not, the purchaser will provide the vendor with an indemnity for acting in such capacity and, in turn, the vendor will carry out the lawful instructions of the purchaser. In some cases, the vendor may provide additional accounting, administrative and operational services and these services may be provided for an additional fee to be paid by the purchaser for a specified period of time beyond closing.