On January 5, 2013, the Pennsylvania Public Utility Commission (“PUC”) issued a Clarification Order1 (“Order”) regarding what constitutes “spudding” under the Unconventional Gas Well Impact Fee Act (“Act 13”)2. The Order is significant for operators that set conductor pipe for horizontal unconventional wells without drilling a well and commencing production. As enacted, Act 13 imposes impact fees on unconventional wells once “spud” but exempts so-called “stripper wells”3 that have de minimis production. This has led to an interpretation that only the drilling and completion of unconventional wells that produced in excess of the de minimis levels would trigger the imposition of the impact fee. However, in the Order, the PUC made its position clear that any “piercing of the ground” would likely trigger the impact fee for horizontal unconventional wells. On February 9, 2013, the PUC published the schedule of impact fees for the calendar year 2012. Under Act 13, the amount of the impact fee for 2012 for a horizontal well where conductor pipe was installed prior to December 31, 2011 is $35,000, while the amount of the impact fee for a horizontal well “spud” during calendar year 2012 – through setting of conductor pipe or otherwise – is $45,000.

The Order highlights, among other things, that the PUC’s interpretation of the term “spudding” is different than the industry’s conventional use of the term. While Act 13 defines “spud” as “the actual start of drilling of an unconventional gas well,” the PUC determined that setting conductor pipe, an activity that some in the industry would view as more preparatory in nature, constitutes the “start of the drilling process.” In the Order, the PUC essentially adopted the Pennsylvania Department of Environmental Protection’s (“DEP”) pronounced interpretation of the term “spudding” verbatim. The PUC’s and the DEP’s interpretation of the term “spudding” differs from the industry’s use of the term in its traditional sense, and, in some instances, from the interpretation espoused by other governmental agencies in other contexts. As the PUC begins to exercise its powers in implementing Act 13, the Order underscores how important it will be for producers to closely monitor the regulatory process in Harrisburg.

Background

On September 28, 2012, Anadarko E&P Company, LP (“Anadarko”) filed a Petition for Amendment and Clarification (“Anadarko Petition”) with the PUC seeking, among other things, clarification on whether the setting of conductor pipe constitutes “spudding,” which would trigger the impact fee. Other industry members and representatives filed comments generally supporting the Anadarko Petition. The DEP filed comments opposing arguments made by Anadarko in the Anadarko Petition.

PUC and DEP

The PUC found that setting conductor pipe into the ground constitutes spudding a well and triggers the impact fee under Act 13. However, as espoused by Anadarko in its Petition, and others in their supporting comments, setting conductor pipe is commonly viewed by producers as site preparation work, often done months or years in advance of any actual drilling. The PUC aligned itself with the DEP’s position, which argued that its position, prior to Act 13, has long been that spudding occurs as soon as a drill bit penetrates the ground or when a conductor pipe is set by being driven into the ground. Citing the permitting requirements of 58 Pa.C.S. § 3211(a), the DEP further argued that if setting conductor pipe does not constitute drilling a well, no permit would be required for this activity and a well site could be commenced without a permit from the DEP.

Given what the PUC and the DEP regulate and administer, it may not be surprising they have taken an expansive view of the term “spudding.” The DEP is responsible for permitting and, thus, will want to limit those activities which producers can engage in without a permit. Even if setting conductor pipe or certain other site preparatory work is not “spudding” or drilling in the traditional sense, the DEP will want to ensure that producers obtain permits as early in the process as possible and prior to establishing a well site. Similarly, the PUC is responsible for administering impact fees under Act 13 and, given that the purpose of the fee is to reimburse the Commonwealth for the impacts of drilling activities, apparently wants to capture a broad spectrum of activities that may impact the land.

IRS

In contrast, and in a very different context, the IRS and the United States Tax Court have used the plain meaning rule of construction in determining when the drilling process begins, and what constitutes spudding. In Caltex Oil Venture et al, 138 TC 18, Code Sec(s) 461 (2012), the taxpayer (using the accrual method of accounting) sought to fully deduct certain intangible drilling costs in a year in which only certain site preparation was done. The taxpayer was relying on Section 461(i)(2)(A) of the Internal Revenue Code that provides as follows:

In the case of a tax shelter, economic performance with respect to amounts paid during the taxable year for drilling an oil or gas well shall be treated as having occurred within a taxable year if drilling of the well commences before the close of the 90th day after the close of the taxable year. [Emphasis added.]

The taxpayer, for the purpose of taking the deduction, sought to establish that certain preparatory activities constituted the commencement of the drilling process. In holding in favor of the IRS, the Tax Court cited Webster’s Dictionary: …to “drill” means “to make (a rounded hole or cavity in a solid) by removing bits with a rotating drill”; to “commence” means “to begin”; and to “spud” means “to begin to drill (an oil well) by alternately raising and releasing a spudding bit with the drilling rig.” Id. The Tax Court concluded that “the plain language of section 461(i)(2)(A) dictates that, as a matter of law, ‘drilling of the well commences’ when the drill bit penetrates the ground to start the hole for the well [and] that a well is ‘spudded’ when the drill bit penetrates the ground for purposes of drilling an oil or gas well.” Id.

The Tax Court’s interpretation of the terms “drilling” and “spudding” within provisions of the Internal Revenue Code are not binding on the PUC for the purposes of Act 13. However, the holding in Caltex illustrates how, depending on the purpose of the statute or regulation in question, courts and governmental agencies can reach very different conclusions when evaluating what seem to be very similar drilling-related activities.

Contractual Drilling Commitments

Finally, another context in which producers may find themselves having to evaluate whether certain activities constitute spudding, drilling or commencement of a well is the interpretation of drilling obligations imposed by leases, farmout agreements or other similar contracts. In fact, opposing comments cited by the PUC in the Order offered the argument that operators would take the position that setting conductor pipe satisfies drilling deadlines in gas leases. This argument is overly simplistic. A producer’s obligations with respect to drilling or spudding wells or other related activities vary from agreement to agreement and very much depend on the language in the agreement. Fortunately for producers, in the contractual context at least, they have some ability to control what thresholds have to be met when.

Conclusion

The bottom line is that there is no “one size fits all” definition of what constitutes spudding or the commencement of drilling that would apply for all industry purposes. Words that might have one meaning in one context might be defined very differently in another context. Please contact us if you have any questions with regard to impact fees under Act 13 and how your agreements may be structured to work efficiently within the current regulatory environment.

___________________________

1 43 Pa.B. 115.

2 Adopted in February of 2012, Act 13 recodified the Oil and Gas Act, 58 P.S. 601.101 et. seq., as Title 58 of the Pennsylvania Consolidated Statutes, Pa Con. Stat. Chs. 23, 25, 27, 32, 33 and 35. Act 13 provides for the imposition of impact fees on unconventional gas well producers. The Order addresses issues related to Chapter 23 of Act 13 which sets forth, inter alia, certain of the PUC’s administrative responsibilities for implementing the provisions of Act 13.

3 “Stripper well” is defined as “an unconventional gas well incapable of producing more than 90,000 cubic feet of gas per day during any calendar month, including production from all zones and multi-lateral well bores at a single well, without regard to whether the production is separately metered.”