COPAS AND THE 2OO5 COPAS ACCOUNTING PROCEDURE_SIGNIFICANT GHANGES FOR GHANGING TIMES

By Jonathan D. Baughman.and

J. Derrick Price..

McGinnis, Lochridge & Kilgore, L.L.P.

2005 Jonathan D. Baughman, McGinnis Lochridge & Kilgore, L.L.P.All Rights Reserved-Reproduction with Attribution Permitted

I. PREFACE

It is believed that most attorneys overlookthe importance of the various exhibitsattached to the Model Form Joint OperatingAgreements used in the oil and gasindustry. These exhibits form part of theagreement concerning the joint operationsand in many cases can limit the parties'rights to recover under the joint operatingagreement. As discussed below, theaccounting procedure, usually attached asexhibit uC" to the Model Form JointOperating Agreements, not only determinesthe manner in which the operator maycharge the non-operators for the jointoperations, but can, among other things,create evidentiary presumptions, toll thestatute of limitations, and require that theparties mediate their disputes. Accordingly,this paper is intended to focus the attorney'sattention on the Council of PetroleumAccountants Societies, the organizationresponsible for creating the model formaccounting procedures and the majorchanges that have been made to the 2005COPAS Accounting Procedure.

II. INTRODUCTION

The Council of Petroleum AccountantSocieties (COPAS)..* is an organization ofregional petroleum accountant societies thatprepares and publishes the COPASaccounting procedure forms commonlyattached to joint operating agreements.These forms are usually attached to theModel Form Joint Operating Agreementspromulgated by the American Association ofProfessional Landmen (AAPL). Theaccounting procedure is just one of severalattachments contemplated in the ModelForm Joint Operating Agreements. Forinstance, the 1989 Model Form JointOperating Agreement contemplates thefollowing exhibits:

A.) Description of the Contract Area(Exhibit "A")

B.) Form of Lease (Exhibit "B")

C.) Accounting Procedure (Exhibit "C")

D.) lnsurance Requirements (Exhibit

E.) Gas Balancing Agreement (Exhibit'E")

'.Jonathan D. Baughman is a partner in the Houston office of McGinnis, Lochridge & Kilgore, L.L.P.J. Derrick Price is an associate attorney in the Austin office of McGinnis, Lochridge & Kilgore, L.L.P.

'.' The writers would like to acknowledge the assistance and cooperation of COpnS ãnd its currentPresident Mr. Howard Blunk in contributing to this article.

F.) Non-Discrimination and Certificationof Non-Segregated Facilities (Exhibit'F")

G.) Tax Partnership (Exhibit "G").

The accounting procedure is arguably oneof the most important exhibits for disputesthat commonly arise between the parties inconducting joint operations.

Currently, the 1984 COPAS AccountingProcedure is the most commonly used formÍn the industry for onshore operations, whilea 1986 version is most commonly used inoffshore operations. However, COPAS hasprepared a 2005 COPAS AccountingProcedure, which is scheduled to be votedon by the Council of the COPAS at itsspring meeting on April 29,2005. The 2005COPAS Accounting Procedure discussed inthis paper is the version that has beenapproved by various internal committeeswithin COPAS and is expected to beformally approved by COPAS at its springmeeting. The 2005 COPAS AccountingProcedure is a single form intended toreplace the 1984 Onshore AccountingProcedure and the 1986 OffshoreAccounting Procedure.

This paper discusses the history andevolution of COPAS and the accountingprocedure forms. Also, this paper highlightsthe major changes and modificationscontained in the proposed 2005 COPASAccounting Procedure, with an emphasis onhow the proposed form differs from the mostcommonly used form in the industry, the1984 COPAS Accounting Procedure.

III. COPAS - AN OVERVIEW

A. History

Although COPAS was created in 1961 andpublished its first accounting procedure formin 1962, the move to create petroleumaccountant societies and to developaccounting procedure forms to be used injoint operating agreements started much

earlier.l The first society of accountantsdedicated exclusively to the petroleumindustry-the Petroleum AccountantSocieties of Los Angeles-was formed in1926 and subsequently developed what iscommonly thought to be the first "standard"form accounting procedure, the PAS No. 1.2

Following on the heels of the Los Angelesgroup, several other regional accountingsocieties were formed, including the Tulsa,Oklahoma Society in 1929, the Wichita,Kansas society in 1936 and the Dallas,Texas society in 1944.3 This processcontinued until the 24 regional societies thatmake up COPAS today were formed in themajor energy areas of North America.aThese societies also produced accountingprocedure forms, the most influential ofwhich was the PASO-1949 authored by thePetroleum Society of Oklahoma-Tulsa.5Obviously, the existence and use of somany different forms caused disagreements

t See generatty John E. Jolly, The COPASAccounting Procedures Demystified, 34 RocKyMrru. Mrr.r L. lNSr. S 21.02 (1988).2 See id. at $$ 21 .02, 21.04 (explaining that theexact date of the first publication of the PAS No.1 is not known because the form was revisedseveral times, making it difficult to determine thedate it was first written); see a/so Hownno G.Blu¡¡r, NRroruRl Accou¡¡rlruo R¡¡o Auotll.lcScnoor- roR Jontr lrureResr Opennrrorus 50(Professional Development lnstitute, Universityof North Texas 2003).t Jolly, supra note 1 at$ 21.02.o td. (noting that COPAS had almost 4,000individual accountants as members in 19BB). Asof 2004, COPAS has approximately 2,524members representing 947 companies. SeeCOPAS Website About Membership, afhttp ://www. copas. org/Mem bersh i pAbout. aspx#Societies (last visited Jan. 29, 2005) (listing 24local societies comprising COPAS).u td. at S 21.04. Prior to the formation ofCOPAS, the PASO-1949 was the most commonform used throughout the mid-continent and gulfcoast areas. This form was ievised and becamethe PASO-T-1955 once some of the Texassocieties accepted its use. /d.

a

between the industry operating areas.u ln1961, representatives of the 12 existingregional petroleum accounting societies metin an effort to resolve these differences.TThe result of this meeting was theestablishment of the Council of PetroleumAccounting Societies, and the subsequentpublication of the 1962 COPAS AccountingProcedure, which was merely a revision of aPASO form pedormed by an ad hoccommittee of COPAS.8

Since 1962, COPAS has periodicallyadopted new versions of accountingprocedures, with each succeeding versionreplacing the prior version as the COPASrecommended form.e COPAS 1962,COPAS 1968, COPAS 1974, and COPAS1976 Offshore Operations are now out ofprint and no longer available from COPAS.10 However, many of the Joint OperatingAgreements to which these older COPASforms were attached are still in force andeffect and therefore, the forms are still partof legally binding contracts.ll The practiceof replacing the older form with the newerform continued until 1995 when COPASissued the COPAS 1995 Model FormAccounting Procedure as an alternative tothe COPAS 1984 Onshore and the COPAS1986 Offshore Accounting Procedures.l2The 1995 COPAS Accounting Procedurewas not well received by the industry and isnot widely used. Similarly, the COPAS1998 Project Team Accounting Procedurewas designed for deepwater and otherresource-sharing projects, and was not

u td. atS21.o2.

' td.

" td. at SS 21.02, 21.04.s See Blunk , supra note 2, at 49.t'

rd.

tt rd.

" ld.; see a/so John Burritt McArthur, A Twelve-Step Program for COPAS fo Sfrengthen Oil andGas Accounting Protections, 49 SMU L. Rev.1447 , 1448 (1 996).

intended as a replacement for previousCoPAS forms.13 The 200s CopASAccounting Procedure is intended to replaceboth the COPAS 1984 and 1986 OffshoreAccounting Procedures. 1a

B. Purpose

The various COPAS accounting procedureshave served several purposes. lnitially, thepurpose of any accounting procedure is toprovide the framework for the obligationsand responsibilities of each party to theagreement.l5 One commentator recentlyobserved that "[t]he COPAS AccountingProcedure was developed to set theguidelines for the charging of costs by theoperator to the non-operators."16 TheAccounting Procedure also provides the"rules" by which the non-operator conductsaudits of the joint account.lT Perhaps moreimportantly though, the COPAS AccountingProcedures served the purpose ofstandardizing the accounting proceduresused in joint operations to alleviate theproblems caused by having no standard setof terms and conditions which were

tt See Blunk, supra note 2, a|49.to

2OO5 COPAS Accounting Procedure, ModelForm lnterpretation, MFI-SX,Publication/Revision Date - October 6, 2004[hereinafter 2005 COPAS MFI-sX].15 Blunk, supra note 2, at 54.tu Susan R. Richardson, Wiil Stapting CreateHarmony? or The Añ of Reconciling the JOAand COPAS, State Bar Section Report, Oil, Gasand Energy Resources Law, Dec. 2004,Yol.29,No. 2, at 22; see a/so Michael E. Smith & RobertD. McCutcheon, Joint Operating AgreementExhibit: A Suruey,47 RocKy Mr¡¡. Mrru. L. lrusr. $14.04 (2001) (stating that "[t]he principle functionof the accounting procedure is to serve as theexpense basis upon which the operator is tocharge each party with its proportionate share ofcosts incurred").17 Richardson, supra note 16, at 22. (noting thatvarious COPAS publications also provideguidance to auditors).

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generally accepted by the industry.18Although some of the problems associatedwith the earliest joint operating accountingprocedures, which were internallydeveloped by companies or negotiatedbetween the parties to the joint venture,were alleviated by the initial regionalsocieties that eventually collaborated toform COPAS, these regional societies couldnot provide a set of accounting practicesthat would be accepted industry-wide.leToday, the various COPAS AccountingProcedures forms, and the A.A.P.L. Form610 Joint Operating Agreements to whichthey are commonly attached,2o govern amajority of oil and gas investments, andCOPAS accounting procedures serve as theprimary source of oil and gas accountingstandards.2l

COPAS issues several publications to assistthe industry in addition to issuing the formaccounting procedures. COPAS issuesAccounting Guidelines (AGs) to assist inestablishing industry standards and ModelForm lnterpretations (MFls) to assist theindustry in interpreting the various modelform accounting procedures. Thesepublications are updated by COPAS on aregular basis and provide recommendationsand guidelines for joint account issues thattend to arise in practice. lnterestingly,COPAS considered providing the parties an

'u See Blunk, supra note 2, at71.t"

rd.

'o "The 1956,1977,1982 and 1989 printed formoperating agreements provide for the accountingprocedure to be attached as a separate exhibit,usually Exhibit'C."' Smith & McCutcheon, supranote 16, at $14.04. Additionally, each of theA.A.P.L Form 610 Operating Agreementscontain a provision stating that in the event of aconflict between the terms of the operatingagreement and the accounting procedure, theterms of the operating agreement prevails. See,e.9., A.A.P.L. Form 610 Model Form OperatingAgreement-1956, 1T B and A.A.P.L. Form 610-1989 Model Form Operating Agreement, Art. ll.

" McArthur, supra note 12, at 1449,1451.

option of making the MFls expressly part ofthe 2005 COPAS Accounting Procedure.However, COPAS decided not to includesuch an option in the 2005 COPASAccounting Procedure due to concerns that,instead of increasing standardization, onlyvariations would result as MFls wererevised over time. ln addition, concernsexisted over which MFI would be relevant ina dispute: the MFI in existence at the timethe agreement is signed or when thedispute arises?

Realizing that the 1984 and 1986 COPASAccounting Procedures have been the mostcommonly used forms "for onshore Lower48 and offshore shelf propedies" for the last20 years, COPAS proposes "to updatethese forms-to clarify gray areas, and toreflect current industry practices andchanges in technology. At the same timethe goal [is] to minimize exceptionaccounting that might be caused by usingthe model form [and] to help [the 2005COPAS Accounting Procedurel gainwidespread acceptance and usage by theindustry."22 Because the 1984 and 1986forms will no longer be available fromCOPAS, it is important to understand howthe 2005 form differs from these priorversions. This paper points out the majorchanges embodied by the 2005 form andaddresses the impact these changes willhave on joint accounting disputes in thefuture-

IV. A FEW WORDS ABOUT WHAT DIDNOT CHANGE IN THE 2OO5ACCOUNTING PROCEDURE

Like prior versions, the 2005 COPASAccounting Procedure attempts to spell outwhat the operator can and cannot chargethe non-operators for operating the jointproperty. ln doing so, the 2005 COPASAccounting Procedure sets forth what theoperator may directly charge the non-

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" 2oos coPAS MFt-sx, supra note 14.

operators and what types of charges fallunder overhead. Typically, there is aconstant struggle in the industry betweenthe operator and the non-operator onwhether certain types of costs should becovered by the overhead provision set forthin the accounting procedure or directlycharged by the operator. This is where themost significant disputes occur between theoperators and the non-operators. The 2005COPAS Accounting Procedure has notchanged this framework, thus the strugglestill continues to exist. The overheadoptions previously available under the 1984Onshore COPAS Accounting Procedure aregenerally available in the 2005 COPASAccounting Procedure. Nevertheless, theseprovisions are still vital in evaluating theaccounting procedure for the contemplatedjoint operations. As a result, the attorneyshould still review these provisions with akeen eye on the contemplated operationsso that any obvious disputes can beavoided.

V. THE MAJOR CHANGES OF THE 2OO5COPAS ACCOUNTING PROCEDURE

The 2005 COPAS Accounting Procedurewas significantly changed from priorAccounting Procedures published byCOPAS. While the body of this paper doesnot describe each and every change indetail, it does discuss the most significantchanges in the view of the authors. For amore detailed analysis, see the morecomprehensive line-by-line comparisonof the 2005 COPAS Accounting Procedureand the 1984 Onshore AccountingProcedure attached as an Appendix to thispaper. The authors have chosen the 1984Onshore Accounting Procedure forcomparison purposes primarily because the1984 Onshore Accounting Procedure is themost widely used form in the industry. Themost notable changes occurred in thefollowing sections of the AccountingProcedure:

A. Statements and Billings [Section l, No. 2of the Accounting Procedurel

B. Advances and Payments by Non-Operators [Section l, No. 3]

C. Adjustments [Section l, No. 4 of theAccounting Procedure]

D. Audits [Section l, No. 5 of theAccounting Procedurel

E. Labor [Section ll, No. 3 of theAccounting Procedurel

F. Affiliates [Section ll, No. 7 of theAccounting Procedurel

G. Other Expenditures [Section ll, No. 15 ofthe Accounting Procedurel

H. Amendments [Section l, No. 6 B of theAccounting Procedurel

l. Failure to Elect Provision [Section l,General Provisions of the AccountingProcedurel

A. Statements and Billings.

The 2005 COPAS Accounting Procedurestill requires that the Operator provide thenon-operators with a bill on or before thelast day of each month for the precedingmonth. However, the 2005 COPASAccounting Procedure has been revised toreflect the change in technology that hasoccurred in the last decade. ln particular,the 2OO5 COPAS Accounting Procedureallows the operator to make available tonon-operators its statements and bills via"email, electronic data interchange, internetwebsites or other equivalent electronicmedia in lieu of paper copies." For timingpurposes, the accounting procedureprovides that a "statement or billing shall bedeemed as delivered twenty-four (24) hours(exclusive of weekends and holidays) afterthe Operator notifies the Non-Operator thatthe statement or billing is available on thewebsite and/or sent via email or electronicdata interchange transmission." The 2005COPAS Accounting Procedure still allows

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the non-operator to elect to receive papercopies of bills instead of electronic copies.

B. Advances and Payments by Non-Operators

This section has been revised for the firsttime to allow the non-operator in very limitedcircumstances to "short pay" or reducepayment for bills that it receives from theoperator. The non-operator can only "shortpay" to the extent the payment is reducedfor

1) an incorrectworking interest; or

2) a project or AFE requiring approvalof all parties under the jointoperating agreement that has notbeen approved by the non-operator;or

3) a property in which the non-operatorno longer owns a working interest,provided the non-operator hasfurnished the operator a copy of therecorded assignment or letter in lieu;or

4) Charges outside the adjustmentperiod.

To substantiate these limitedcircumstances, the non-operator mustfurnish the operator with documentation andan explanation at the time the payment ismade.

G. Adjustments

The Adjustments section, in conjunctionwith the Audit Section of the 2005 COPASAccounting Procedure discussed below,contains probably the most significantchanges to the accounting procedure from alegal and accounting perspective.

From a practical standpoint, theAdjustments section of prior versions of theCOPAS accounting procedures can havethe most significant legal effect on a non-

operator's ability to obtain adjustments tothe joint interest account. ln particular, evenbefore the inception of COPAS in 1962,many joint operating agreements oraccounting procedures attached to theseoperating agreements had a provision thatprovided that the joint interest bills issued bythe operator were deemed correct unlessthe non-operator objected in writing within aspecified time period.

Since the creation of COPAS, eachpublished version of Accounting Proceduresdistributed by COPAS since 1962 hascontained such a provision. For instance,the 1984 Onshore Accounting Procedureprovides that "[a]ll bills and statements arepresumed to be correct unless within a 24month period following calendar year ofcharge, a Non-Operator takes writtenexception to and makes claim on Operatorfor adjustment. No adjustments favorable tothe Operator shall be made unless they aremade wíthin a 24 month period, with theexception of adjustments resulting frominventory of Controllable Material."

The 2005 Accounting Procedure pertainingto Adjustments has been reworded inseveral respects.

First, just as initially set forth in the seldomused 1995 COPAS Accounting Procedure,the 2005 COPAS Accounting Procedurerequires that the non-operator's "writtenexception" be a "specific detailed writtenexception" in order to be entitled to claim anadjustment to the bills or statements. While"specific detailed written exception" is not adefined term in the accounting procedure,one can surmise that, in most situations, anon-operator must do more than lodge ageneral objection without some specificparticularized complaint.

Second, the 2005 COPAS AccountingProcedure states that the presumption ofcorrectness is to apply "with respect only toexpenditures." Therefore, the issuance ofbills or statements with incorrect revenue

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information is not subject to the samepresumption.

Third, the Adjustment provision nowexpressly applies to "payout statements."Fourth, subject to a few exceptions, theAdjustments provision is enforceableagainst the operator. The AccountingProcedure identifies those circumstanceswhen an operator can still makeadjustments outside of the 24-monthperiod. These include adjustments for thefollowing: 1) physical inventory 2) offsettingentries that are the direct result of a specificjoint interest audit exception granted onanother property; 3) a governmental/regulatory audit; or 4) a working interestownership oradjustment.

participating interest

The Adjustments provision should be readtogether with the Statements and Billingssection discussed above. The Statementand Billings section describes the level ofdetail required in the statements issued bythe operator. For instance, the sectionstates, among other things, that "intangibledrilling costs, audit adjustments, andunusual charges and credits shall beseparately and clearly identified." This isimportant because courts have held that inorder for the operator to be entitled to takeadvantage of the 24-month presumptionattached to statements rendered and notobjected to by the non-operator, thestatements rendered must satisfy the levelof detail required for the statements issuedby the operator. ln Exxon v. Crosby-Mrssrssþpi Resources, Lfd. the Fifth CircuitCourt of Appeals held that several of theoperator's monthly statements did notsatisfy the level of detail required under the1974 COPAS Accounting Procedure, andas a result, those monthly statements werenot entitled to the presumption affordedother statements that were rendered by theoperator. 40 F.3d 1474, 1488 15th Cir.1995). Therefore, in determining theapplicability of the 24-month provisioninitially one must determine whether the billsand statements satisfy the level of detail

required under the applicable accountingprocedure.

D, Audits

From a legal standpoint, the most significantchange to the entire 2005 COPASAccounting Procedure is the Audits section.ln particular, following the concept firstintroduced in the 1995 COPAS AccountingProcedure, the statute of limitations isexpressly tolled under this provision as longas the parties comply with the specificsubstantive and procedural requirementsset forth in this section. ln addition, theAccounting Procedure for the first timerequires that the parties submit their auditdisputes to mediation.

Before addressing the specific languageconcerning the tolling of the statute oflimitations, one needs to understand thespecific procedural timelines for filingexceptions and conducting audits, as wellas the significance of their impact on thetolling of the limitations period.

First, as in prior versions of the COPASAccounting Procedure, the non-operatorshave a "right to audit the Operator'saccounts and records relating to the JointAccount within the twenty-four (24) monthperiod following the end of such calendaryear in which such bill was rendered." lnother words, for joint interest bills renderedin 2002, an audit can only be conductedduring 2003 or 2004. However, from apractical standpoint, in order to comply withthe 24 month adjustment period, the auditmust be pedormed sufficiently in advance ofthe end of 2OO4 so that the non-operatorsatisfies its obligation to provide "specificdetailed written exceptions."

Second, once an audit is completed, thenon-operator must issue an audit reportwithin 90 days after the completion of theaudit testing and analysis. Once in receiptof the audit report, the operator mustrespond in writing to all exceptions in thenon-operator's audit report within 180 days.

n

The operator's denial of exceptionssubmitted by the non-operator must beaccompanied by a "substantive response."lf the operator does not provide asubstantive response to an exception withinthis time period, the operator will oweinterest on that particular exception ifultimately granted.

An interesting optional provision is includedin the 2005 COPAS Accounting Procedurethat provides severe penalties for delays inthe audit process by either the operator orthe non-operators. ln particular, thisoptional provision provides that if the non-operators fail to reply to an operator'sresponse to an audit report within 90 daysof receipt, any unresolved exceptions thatwere not addressed by the non-operatorswithin one year following receipt of the lastsubstantive response of the operator shallbe deemed to have been withdrawn by thenon-operators. Likewise, if the operatorfails to respond to an audit report within 180days, any unresolved exceptions that werenot addressed by the operator within oneyear following receipt of the audit report orreceipt of the last substantive response ofthe non-operators, whichever is later, shallbe deemed to have been granted by theoperator and adjustments shall be made,without interest, to the joint account.

As set forth below, in the event the non-operator timely files written exceptions or anaudit report, the statute of limitations istolled in relation to those specific claims.However, through inadvertence or neglect,the non-operator may undo this tolling byfailing to comply with the remainingprocedural deadlines set forth in the auditprovision. ln particular, the 2005 COPASAccounting Procedure provides:

"A li4gly filed written exception oraudit report containing writtenexceptions (hereinafter "writtenexceptions") shall, with respect to

,

preclude the Operator fromasserting a statute of limitations

defense against such claims, andthe Operator hereby waives itsright to assert any statute oflimitations defense against suchclaims for so long as any Non-Operator continues to comply withthe deadlines for resolvingexceptions provided in thisAccounting Procedure."

,,

complv with the additionaldeadlines in Section 1.5.8

[Operator responding to auditreport within 180 daysl or 1.5.C

[Non-Operator replying toOperator's response within 90days], the Operator's waiver ofits riqht to assert a statute oflimitations defense aqainst theclaims brought bv the Non-Operators shall lapse, and suchclaims shall then be subject to theapplicable statute of limitations;provided that such waiver shall notlapse in the event that theOperator has failed to comply withthe deadlines in Section 1.5.8 or1.5.C.' (Emphasis added).

Finally, the 2005 COPAS AccountingProcedure maintains the concept that beganwith the 1995 COPAS AccountingProcedure providing that a party may call anaudit resolution meeting after a certain timeperiod has elapsed. However, instead of the18 month period used in the 1995 COPASAccounting Procedure, the 2005 COPASAccounting Procedure provides that eitherparty may call for an audit resolutionconference if any audit issues areoutstanding 15 months after the operatorreceives the audit report. Significantly,COPAS added a dispute resolutionprocedure that either the operator or thenon-operators can invoke if the audit issuescannot be resolved by negotiation. lnparticular, the 2005 COPAS AccountingProcedure provides:

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'lf the Agreement contains nodispute resolution procedures andthe audit Íssues cannot beresolved by negotiation, thedispute shall be submitted tomediation. ln such event, promptlyfollowing one Party's writtenrequest for mediation, the Partiesto the dispute shall choose amutually acceptable mediator andshare the costs of mediationservices equally. The Parties shalleach have present at themediation at least one individualwho has the authority to settle thedispute. The Parties shall makereasonable efforts to ensure thatthe mediation commences withinsixty (60) days of the date of themediation request. Notwith-standing the above, any Party mayfile a lawsuit or complaint (1) if theParties are unable afterreasonable efforts, to commencemediation within sixty (60) days ofthe date of the mediation request,(2) for statute of limitationsreasons, or (3) to seek apreliminary injunction or otherprovisional judicial relief, if in itssole judgment an injunction orother provisional relief isnecessary to avoid irreparabledamage or to preserve the statusquo. Despite such action, theParties shall continue to try toresolve the dispute by mediation."

Based on this language, a party can initiatelitigation over an audit dispute withoutcompleting the mediation process for"statute of limitations reasons" or if in theparty's sole judgment it is necessary toavoid irreparable damage or to preserve thestatus quo. lnterestingly, COPASconsidered including a mandatoryarbitration provision in the 2005 COPASAccounting Procedure. However, notenough votes could be garnered to pass themandatory arbitration provision.

E. Definition of "First Level Supervision"and "On-Site"

The exploration, development, andproduction of oil and gas has changedtremendously over time. ln the early days,many operators conducted operations inremote locations where supervision andoffice support was closer to the fieldoperations. ln most cases, these facilitiesand related expenditures were not directlychargeable under the accounting procedureunless there was a "district expense"election exercised by the parties. Sincethen, the nature of oil and gas exploration,development and production has beenconsolidated and become more efficientthrough technological advances. As aresult, the 2005 COPAS AccountingProcedure appears to take these changesinto account. For instance, the 2005COPAS Accounting Procedure permits theJoint Account to be directly charged for theOperator's expenditures related to "FirstLevel Supervision" based on the function ofthe supervisor instead of merely whetherthe supervisor is "in the field."

The 1984 Onshore Accounting Proceduredefined "First Level Supervisors" as those"employees whose primary function in JointOperations is the direct supervision of otheremployees and/or contract labor directlyemployed on the Joint Property in a fieldoperating capacity." This provision wasgenerally interpreted as requiring that theFirst Level Supervisor be "in the field" inorder to be chargeable. The 2005 COPASAccounting Procedure appears to havechanged this requirement by deleting the "inthe field" language. "First LevelSupervision" is defined in the 2OO5Accounting Procedure as meaning "thoseemployees whose primary function in JointOperations is the direct oversight of theOperator's field employees and/or contractlabor directly employed On-Site in a fieldoperating capacity." Several examples ofwhat may constitute First Level Supervisionfunctions are included in the definition ofFirst Level Supervision. One example

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includes the "responsibilÍty for employmentdecisions and performance appraisals forfield personnel."

ln a related issue about the location ofemployees, COPAS has attempted to clarifyinstances when technical labor can bechargeable. The 2005 COPAS AccountingProcedure introduces for the first time thedefinition of the term "On-Site," in what onemight consider to be an attemptedclarification that the chargeability of anemployee is not limited to the boundaries ofthe joint property. "On-Site" means

"orì the Joint Property when indirect conduct of Joint Operations.The term 'On-site' shall alsoinclude that portion of OffshoreFacilities, Shore based Facilities,fabrication yards, and stagingareas from which Joint Operationsare conducted, or other facilitiesthat directly control equipment onthe Joint Property, regardless ofwhether such facilities are ownedby the Joint Account."

Based on this language, "On-Site" wouldinclude charges for Technical Employeeswho may not be physically located on theJoint Property but may be working at afabrication yard or staging area. While the2005 COPAS Accounting Procedurepreserves the traditional definition of "JointAccount," "Joint Property," and "JointOperations," the addition of this definition of"On-Site" appears to have cleared up anygray areas in this regard.

F. Affiliates

The 2005 COPAS Accounting Procedureaddresses the use of affiliates of theoperator in performing work for the jointaccount. "Affiliate" is defined in theAccounting Procedure as a

"person, another person thatcontrols, is controlled by, or is undercommon control with that person. ln

this definition, (a) control means theownership by one person, directly orindirectly, of more than fifty percent(50%) of the voting securities of acorporation or, for other persons, theequivalent ownership interest (suchas partnership interests), and (b)'person' means an individual,corporation, partnership, trust,estate, unincorporated organization,association, or other legal entity."

The parties are given options in the 2005COPAS Accounting Procedure for selectingrates and services to be charged foraffiliates. For instance, one option that theaccounting procedure provides is for theparties to specify a monetary threshold thatpermits the operator to use an affiliate toperform work as long as the affiliate isidentified and the work is specificallydetailed in an approved AFE. For workperformed by an affiliate not requiring theissuance of an AFE, the accountingprocedure allows the pafties to specify thata designated percentage of the partiesowning an interest must approve the use ofthe Affiliate for such work. Finally, as in the'1995 COPAS Accounting Procedure, the2005 COPAS Accounting Procedure makesit clear that in no event shall the cost ofaffiliate goods or services exceed theaverage commercial rates prevailing in thearea of the joint property. This is importantsince arguably under the Audit provision ofthe 2005 COPAS Accounting Procedure, aswell as prior versions, the non-operators areonly entitled to audit the operatolsaccounts and records related to the jointaccount. lt is commonly understood in theindustry that the non-operators do not havethe right to audit the affiliates' records butdo have the right to audit the books andrecords of the joint account. This is animportant distinction. Having the right toaudit the operator's records in the jointaccount would allow the non-operator toinspect the documentation kept by theoperator for charges incurred. Thispresumably would include invoices fromaffiliates. However, generally, the non-

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operator would not be able to inspect theaffilíates' records supporting such invoices.Nevertheless, the costs charged by theaffiliate must not exceed the "averagecommercial rates prevailing in the area ofthe Joint Property."

G. "Other Expenditures"

The 1984 COPAS Accounting Procedureprovides that the operator may directlycharge the joint account for "[a]ny otherexpenditure not covered or dealt with in theforegoing provisions of this Section ll [DirectChargesl, or in Section lll [Overhead] andwhich is of direct benefit to the JointProperty and is incurred by the Operator inthe necessary and proper conduct of theJoint Operations." The 2005 COPASAccounting Procedure left this languageintact but added language that expresslyrequires non-operator approval for suchcosts. As a result, this revision to a largeextent closes the door to the operatorclaiming that costs not clearly addressed inthe operating agreement or in theaccounting procedure are chargeable underthis provision unless the operator has gottenapproval by the non-operators. However,the 2005 COPAS Accounting Proceduredoes not mention whether the non-operators'approval must be in writing. As aresult, one can still foresee situations whennon-operators who remain silent may bedeemed to have consented to the operatorincurring and charging the joint account forsuch costs.

H. Amendments

Another substantial change appears inSection 1.6 of the 2005 COPAS AccountingProcedure, which deals with the approvalnecessary by the parties to the jointoperating agreement to change theaccounting procedure. The 1984 COPASAccounting Procedure merely requires theoperator to notify the non-operators of theproposed change and approval by amajority in interest of the non-operators to

make the change effective. The 2005COPAS Accounting Procedure keeps thisprovision intact, but limits its application to"specific situations of limited duration wherea Party proposes to change the accountingfor charges from that prescribed in thisaccounting procedure." This provision doesnot, however, cover amendments to theAccounting Procedure.

Amendments to the 2005 COPASAccounting Procedure for situations lastingmore than a "limited duration" are coveredby the new Section 1.6.8 of the AccountingProcedure. Under this section, amendmentof the accounting procedure will require anaffirmative vote of a selected number ofparties, one of which must be the operator,owning a predetermined percentage of theworking interest. The form provides blanksfor the parties to fill in the number of partiesthat will be required to vote and thepercentage of working interest that will benecessary to be represented. However,approval of at least one non-operator isrequired to amend.

A second new provision, Section 1.6.C.,deals with affiliates. lf any of the parties tothe agreement are affiliates of one another,they shall be treated as one pafty having acombined working interest for purposes ofvoting under Sections 1.6.4. and 1.6.8.Additionally, if one of the non-operators isan affiliate of the operator, votes underSection 1.6.4. will require a majority ininterest of the non-operators exclusive ofthe operator's affiliate. This provision doesnot apply to votes for amendments underSection 1.6.8.

Regardless of these formal procedures foramending and changing the accountingprocedure, parties should be aware that theaccounting procedures might be modified bytheir conduct. Hondo Oil & Gas Co. v.

Texas Crude Operator, lnc., 97Q F.2d 1433,1437-38 (Sth Cir. 1992). ln Hondo, AtlanticRichfield Company ("ARCO') entered intoseveral operating agreements in 1962 and1965 with Texas Crude Operator, lnc.

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("Texas Crude") as Operator. ld. at 1435 -36. The PASO-T-1955-2 AccountingProcedure was attached to each of theseagreements. ld. at 1436. ln 1978, TexasCrude decided to begin charging Non-Operators using a COPAS accountingprocedure, rather than the PASO-T-1955-2.ld. Although Texas Crude did not notifyARCO that it was changing accountingprocedures, ARCO paid Texas Crude for sixyears in accordance with the COPASbillings, after making a complaint as to thenew rate in October 1978. /d The issuebefore the Fifth Circuit was whether ARCOand Texas Crude had modified theiroperating agreements. ld. at 1437. Thecouft concluded that because ARCO knewof the change and apparently consented toit, ARCO and Texas Crude had modified theaccounting procedures to be used under theoperating agreements. /d. at 1437-38.

l. Failure to Elect Provision

Probably from experience, COPAS hadenough foresight to insert language in the2005 COPAS Accounting Procedure thatprovides a mechanism for when the partiesfail to select an option in the accountingprocedure or the parties inadvertently selecttwo competing options or alternatives thatare inconsistent. ln particular, the 2005COPAS Accounting Procedure states at theoutset that "if the parties fail to select eitherone of competing "alternative" provisions, orselect all the competing "alternative"provisions, alternative 1 in each suchinstance shall be deemed to have beenadopted by the parties as a result of anysuch omission or duplicate notation."

Nevertheless, it is possible that thisprovision may be overridden by the expressterms of the joint operating agreement if thealternative is somehow inconsistent with thejoint operating agreement. For instance, the1982 and 1989 A.A.P.L. Form 610 - ModelForm Operating Agreements reference"Accounting Procedure" as exhibit "C." The1982 Model Form Joint OperatingAgreement states that if "any provision of

any exhibit, except Exhibits uE" [Gas

Balancing Agreementl and uG" [Tax

Partnershipl is inconsistent with anyprovision contained in the body of thisagreement [Model Form OperatingAgreementl, the provisions in the body ofthis [Model Form Operating Agreement]shall prevail." The 1989 Model Form JointOperating Agreement includes an almostidentical provision. Therefore, assuming theparties do not modify this provision,situations may arise when the terms of thejoint operating agreement may control overthe terms of the attached COPASaccounting procedure even when theFailure to Elect Provision has becomeoperative.

VI. CONCLUSION

The 2005 COPAS Accounting Procedureappears to be an improvement over the1984 COPAS Accounting Procedure. lt hasre-introduced some of the better conceptsfirst developed in the 1995 COPASAccounting Procedure that were neverreally adopted by the industry due to overallproblems with the 1995 version. From this,COPAS appears to have developed amodel form that is more clear andcomprehensive than prior forms. Theinclusion of language in the accountingprocedure that places severe penalties onboth the operator and non-operator in theaudit process should encourage the partiesto focus on their disputes and attempt toresolve them in a timely fashion. COPASshould be commended for including amandatory mediation process in the modelform accounting procedure. While it will notbe a cure for all disputes, the new 2005COPAS Accounting Procedure will providea framework for the parties to attempt towork out their differences.

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