Airport Participation in Oil and Gas Development (2018)

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5 CHAPTER ONE INTRODUCTION PURPOSE OF THE SYNTHESIS In many areas of the country, airports supplement aeronautical revenue with proceeds from mineral extraction programs. Structuring a project that will be favorable to the airport sponsor and will comply with FAA and environmental requirements requires a nuanced approach. In 2016, the FAA published Advisory Circular (AC) No. 150/5100-20, which addresses FAA policies, regulations, and standards for oil and gas extraction at federally obligated airports. This document consolidates information about FAA requirements, reviews, and airport sponsor obligations. However, even with this guidance, an airport sponsor has to make important business and lease decisions while adhering to FAA protocols. This synthesis considers oil and gas development issues from the airport sponsor’s perspective, with attention to such questions as these: • Who owns the subsurface rights on an airport? • How does an airport sponsor establish a fair market value for its mineral reserves? • What are airport sponsor experiences with respect to fluctuations in prices for oil and gas? How do these fluctuations affect the feasibility of new projects and affect existing projects? • What are the options for various participation models and payment structures? • What are the issues and strategies involved with horizontal drilling under airport property from off-airport locations? • How should the airport sponsor manage and prevent revenue diversion? • For federally obligated airports, how do grant assurances, FAA policies, and regulations affect an airport mineral extraction program? HISTORICAL CONTEXT FOR OIL AND GAS DEVELOPMENT AT AIRPORTS Oil and gas development near or on airports is not new. When the City and County of Denver selected a site for its new inter- national airport, 71 oil and gas wells were operating on the property. However, in the 1980s and 1990s technological advances led to economically feasible ways to extract large amounts of natural gas from shale and other tight rock/sand formations. Mitchell Energy and Development Corporation began experimenting with hydraulic fracturing by drilling a mile or more below the surface, then turning horizontal and continuing several thousand feet more. In this way, a single surface site could support a number of wells. Mitchell Energy used this technology to extract gas from the Barnett Shale near Dallas/Fort Worth. As the new technology became commercially available to the petroleum industry, oil and natural gas extraction from shale expanded into Arkansas, North Dakota, Pennsylvania, and other regions. The industry was giddy about the potential opportunities. Today, hydraulic fracturing is applied to the majority of U.S. oil and natural gas wells to enhance well performance, minimize drilling, and extract otherwise inaccessible resources.1 However the process is not without controversy, including concerns about earth- quakes, water and soil contamination, air pollution, and compatibility with other land uses. The boom in oil and gas extraction from shale was supported in the United States by rising energy prices. Figure 1 illustrates the history of natural gas prices and leases signed by airport sponsors. In 2006, Dallas/Fort Worth International Airport (DFW) signed a lease with Chesapeake Oil. At the time, signing bonuses were high: DFW received a bonus pay- ment of $10,000 per acre plus a royalty of 25% of production, while Arlington Municipal Airport (GKY) in Arlington, Texas, signed a lease in 2008 with a bonus of $7,500 per acre and a royalty of 27%. Other airports negotiated leases at different price points.

6 FIGURE 1 U.S. Natural Gas Industrial Price (Dollars per Mbtu) Source: Prepared by KRAMER aerotek with synthesis research and U.S. Energy Information Administration data. Spot oil prices over the same period demonstrate similar patterns of volatility. Figure 2 shows the West Texas Intermedi- ate (WTI) spot price for barrels of oil. Here, as in Figure 1, the impact of the Great Recession is particularly evident, as is the precipitous decline in oil prices that began in December 2014. FIGURE 2 Cushing OK WTI Spot Price, January 1997–March 2017. Source: U.S. Energy Information Administration. Note: WTI = West Texas Intermediate. During the mid-to-late 2000s, several events converged to intensify airport interest in oil and gas extraction programs. • Among commercial airports, there were disruptions of service and tenant leases stemming from major carrier bankrupt- cies and mergers. • New airline/airport operating agreements tended to have shorter durations when the Great Recession hit in 2008 and travel demand plunged. • While the airlines demonstrated a nimble ability to respond by cutting capacity, airport aeronautical revenues declined. • With less revenue, reductions in Airport Improvement Program (AIP) funding, and a ceiling of $4.50 on passenger facility charges (PFCs), airport sponsors postponed long-term capital projects. At the same time, interest in alternative revenue streams accelerated.

7 • For general aviation airports, high fuel prices and the recession temporarily extinguished demand for recreational and personal flying. These factors made on-airport energy development particularly attractive to airport sponsors, and many airports with oil and gas reserves explored extraction programs. At the time, bonus and royalty payments were lucrative; however, in hindsight, the economic viability of oil or gas extraction from shale depended on a relatively high price of natural gas.2 The case studies prepared for this synthesis serve as a cautionary tale—they show a choppy record of royalty payments and drilling activity in a volatile market. Most of the airports studied for this synthesis experienced variable royalty payments and sometimes multiple lease assignments during the course of oil and gas development and production. Oil and gas extraction can provide airport sponsors with additional non-aeronautical revenue, but sponsors must under- stand levels of acceptable risk and timing, and should be prepared with a business plan to develop oil and gas on airport prop- erty as well as assistance from legal counsel with experience in airport land development and oil and gas leases. OIL AND GAS BASICS Like the aviation industry, the oil and gas industry has its own terms, technology, and participation models. This section provides a very brief overview of industry basics intended to enrich the discussion in the next chapters. Mineral Deposits, Reserves, and Estates (Rights) A mineral deposit is a concentration of naturally occurring solid, liquid, or gaseous material, in or on the Earth’s crust in such form and amount that its extraction and conversion into useful materials or items are profit- able now or may be in the future. Mineral resources are nonrenewable and include metals such as iron, copper, and aluminum, and nonmetals such as salt, gypsum, clay, sand, and phosphates. Oil and gas deposits are types of mineral deposits. Oil and gas reserves are deposits known to exist that are economically and technologically recoverable. An oil and gas reserve takes on value when it can be identified and extracted from the ground, processed into usable products, and delivered to market at a competitive price. Determination of the value of a reserve is complicated; it involves estimating (1) the price of the oil or gas at the wellhead; (2) extraction, processing, and delivery costs; (3) the unit value of the processed commodity delivered to market; (4) the value of reserves in the ground today; and (5) the value of reserves in the future. Given the volatil- ity of oil and gas prices, valuation of future reserves is highly speculative, which explains why oil and gas wells are started and then shut in or abandoned. Ownership of mineral rights in real property is referred to as a mineral estate. The owner can exploit, mine, or produce any or all of the minerals lying below the surface of the property. Ownership of mineral estates involves two distinct rights: the surface estate and the mineral (subsurface) estate. These two estates may be owned together by one entity or they might be divided, or severed, and owned by separate entities. Ownership defines the use and availability of the estates, including the following permutations: • Fee ownership – complete mineral and surface rights • Surface only – ownership of surface rights • Mineral only – ownership of mineral rights • Surface lease – control by lease of surface rights • Mineral lease – control by lease of mineral rights Airport sponsors own the surface rights of airport property, and these are subject to FAA grant assurances, rules, and regu- lations. Often—but not always—airport sponsors also own mineral estates. State statutes typically determine the rules for estate ownership of subsurface rights. In Texas, the Texas Railroad Commission is the state administrative agency responsible Mineral Deposits • Coal—anthracite, bituminous, lignite • Clay • Crushed stone • Dimension stone (granite, limestone, slate) • Gypsum • Iron ore • Natural gas • Oil • Phosphate • Sand and gravel • Other mineral commodities

8 for regulating oil and gas development; in Colorado, it is the Colorado Oil and Gas Conservation Commission. In Pennsyl- vania, the Department of Environmental Protection, Office of Oil and Gas Management is the state regulatory agency. (See Appendix A for a review of state laws concerning the ownership of mineral estates.) Oil and Natural Gas Extraction Methods The oil and natural gas extraction industry includes four distinct phases: (1) exploration, (2) well development, (3) production, and (4) well abandonment and land restoration. Each of these phases is briefly described.3 Permits and regulatory require- ments are discussed in chapter two. Exploration Exploration is the search for oil and natural gas deposits in rock formations on land and under the ocean. Exploration involves geophysical prospecting and exploratory drilling to identify and locate exploitable reserves. These activities also estimate the size and extent of the reserves and determine the groundwater conditions in the area. Well Development Once a deposit is located and determined to be economically recoverable, development begins with a surface lease that allows for preparation of the well site. The operator clears the area of trees and obstacles to build a well pad. If access roads are insuf- ficient, the operator will improve existing roads or build new ones. The next step is to bring a drilling rig to the location. Trucks (maybe 20 or 30 loads) transport the rig in pieces, and the operator assembles it on site. The first well is drilled straight down into the ground beneath the pad to a depth 100 ft below the deepest known aquifer and about 1,000 ft above the underground area where oil and gas exist. Then the operator lowers and cements a steel casing in the long hole to prevent contamination of the aquifer. In the past, the standard approach was for operators to drill oil and gas wells vertically. If hydrocarbons were found, the wells were developed to completion; if not, they were abandoned. Today, advanced drilling technologies allow the drilling rigs to turn horizontally and continue 1 or 2 mi following the same rock bed, so that multiple horizontal legs can originate at one surface drilling location. Once the target distance is reached, the operator removes the drill pipe, inserts a steel pipe, cements it in place along the entire area drilled, and tests to make sure the pipe is impermeable. Before oil or gas production begins, the operator lowers a perforating gun into the deepest part of the well and fires into the rock formation, creating holes that connect the oil and gas reserves to the wellhead. This is when fracking begins. Fracking fluid—primarily composed of water and sand (99.5%) and chemicals (0.5%)—is pumped at high pressure through the perforations to create paper-thin cracks in the shale rock, releas- ing the oil and natural gas trapped in the reservoir (Pearson 2016). The process of firing the perforating gun and pumping the fracking fluid is repeated 20 or 30 times over a few days (see Figure 3). Production Once the operator completes the fracking, oil and natural gas flow up the well bore. Production is the process of separating the mixture of liquid hydrocarbons, gas, water, and solids; recycling the fracturing fluid; and selling the oil and gas. Oil is nearly always sent by pipeline to a refinery for processing. Natural gas may be processed in the field to remove impurities or at a natural gas processing plant. Well Abandonment and Land Restoration After the operator has recovered all the oil and gas that is economic to produce, the operator will either shut in the well for future production or permanently plug it. Most state laws require that when a well is permanently plugged, the land must be restored to its condition before drilling operations began.

9 FIGURE 3 Oil and Gas Well Development. Source: Pearson 2016. Participation Models Airport sponsors participate in oil and gas development in a variety of ways that influence their specific regulatory responsi- bilities. Figure 4 shows three basic participatory models. The case studies in chapter five describe these participatory models in action. FIGURE 4 Airport Sponsor Participatory Models for Oil and Gas Development. Source: Prepared by KRAMER aerotek, 2016. Off-Airport Royalty Interest In the first participatory model, well sites and infrastructure are located off airport and horizontal drilling (under the fence) provides subsurface access to oil and gas reserves underneath airport property. No access or use of surface airport property is required; consequently the FAA would not require changes to the airport layout plan (ALP), review of oil and gas leases, or approval of on-airport construction or operations. However, airport revenue use, preservation of adequate land title, and compatible land use controls per AC No. 150/5100-20 do apply. Some airports choose this option, using pooling or unitiza- tion agreements with off-airport landowners if the state permits them. This approach involves fewer sponsor reporting and approval requirements and still allows for bonus4 and royalty5 payments (see Elmira, Williston, and Arlington case studies). On-Airport Royalty Interest In the second model, an airport sponsor can solicit an oil or gas company to develop well sites on airport property. The sponsor negotiates a lease with the company and manages the lease for compliance with its terms. Payment is in the form of a bonus and a royalty interest. The bonus is typically set as a fee per acre leased, and the royalty rate is based on the amount of oil or gas sold from the drilling operations on airport land. When the lease is on federally obligated airport property and involves surface access to the well site, FAA policies, guidance, standards, and obligations apply (see Dallas/Fort Worth International, Denton, Greeley-Weld County, and Pittsburgh International case studies).

10 On-Airport Working Interest The third participatory model involves the airport sponsor taking a working interest6 in the extraction of oil and gas. In this model, the airport sponsor owns a portion or all of the oil and gas leasehold. Instead of receiving a royalty interest, the spon- sor earns revenue based on its ownership share of production. When oil and gas prices are on the high side, net revenue to the airport sponsor can be much higher than a royalty interest; however, there is also substantially more financial risk with exposure to operating expenses and environmental liabilities (see Denver International Airport case study). Revenue Terms Bonus Oil and gas operators provide bonus payments to airport sponsors for exclusive rights to drill under airport land. The bonus payment typically is calculated on an amount per acre. It is paid upfront and is not part of the lease. The amount of the bonus payment is highly variable and depends on the estimated value and size of the oil and gas reserves and competition for the opportunity. Royalty When an airport sponsor has an on- or off-airport royalty interest in oil or gas wells, the sponsor receives a percentage share of production or the value of production, paid from a producing well. Since the royalty payment is determined by the value of oil or gas produced, royalties fluctuate with changes in hydrocarbon prices. Gross Versus Net A royalty is paid on a gross or net basis. Payment on a net basis means that the amount paid to the airport will be calculated after deducting costs of production, which could be substantial depending on what is included. Market conditions will drive whether a bidder will offer to pay on a net or gross basis. Negotiating payment on a gross basis protects airports from ques- tionable deductions. RESEARCH SCOPE AND REPORT ORGANIZATION To gain a greater understanding of oil and gas extraction on airport property, the synthesis focused on U.S. airports with exist- ing oil and gas leases. The research team interviewed airports identified by the panel as case studies to gain an understanding of each airport’s experience with oil and gas development and to collect sample lease agreements, well permits, and other documents that would illuminate various ways airports manage oil and gas activity. The synthesis also delved into FAA policy, guidance, compliance requirements, federal regulations, and other documents important for an airport sponsor to consider. AC No. 150/5100-20 was an important resource to identify these areas of federal purview. Variations in state law were also considered as they affect ownership of oil and gas estates, opportunities to pool or unitize leaseholds, environmental cleanup, and well reclamation. Research team expertise and documents from case study airports provided the basis to discuss elements of oil and gas leases, how airports determine fair market value of mineral estates, how they solicit and evaluate bids, and how they structure lease terms. Figure 5 shows the report organization beginning with the overview, which contains a summary and this introduction. Chapter two presents a discussion of the regulation of oil and gas from the airport sponsor’s perspective. Chapter three addresses key elements of an oil and gas lease. Chapter four addresses how airports manage revenue accounting for oil and gas royalties and bonus payments. Chapter five reports on the case studies, and chapter six presents conclusions. Appendix A contains an overview of mineral estate ownership in various states. Appendix B provides a sample of insurance requirements to be included in a mineral extraction lease. Appendix C contains a bibliography. The report concludes with a glossary of terms and a list of acronyms.

11 FIGURE 5 Report Organization. Source: KRAMER aerotek, 2016. OTHER TRB RESOURCES There is very little published research about mineral extraction programs at airports. However, TRB has published a number of studies and syntheses that complement this research. Table 2 lists relevant studies that might be of interest. TABLE 2 RELATED ADDITIONAL ACRP AND TRB PUBLICATIONS Project Number Project Title ACRP Legal Research Digest 14 Achieving Airport-Compatible Land Uses and Minimizing Hazardous Obstructions in Navigable Airspace ACRP Report 47 Guidebook for Developing and Leasing Airport Property ACRP Report 114 Guidebook for Through-the-Fence Operations ACRP Report 121 Innovative Revenue Strategies—An Airport Guide ACRP Report 131 A Guidebook for Safety Risk Management for Airports ACRP Report 145 Applying an SMS Approach to Wildlife Hazard Management ACRP Report 166 Interpreting the Results of Airport Water Monitoring ACRP Report 169 Clean Water Act Requirements for Airports ACRP Synthesis 19 Airport Revenue Diversification ACRP Synthesis 77 Airport Sustainability Practices TRB Research Record No. 1257 Land Use Controls and Policy for Airport Development Source: Compiled by KRAMER aerotek, 2017. ENDNOTES 1 See American Oil & Gas Historical Society, “A Fracking History,” and EnergyfromShale.org, “What Is Hydraulic Fracturing?” 2 For example, Chesapeake Energy, which had the DFW leasehold, originally planned to drill 330 wells, but as of 2016 it had drilled only 110 wells. For new drilling to cover development costs, the price of gas would have to be above $10/Mcf (Weijermars 2013). Mcf = 1,000 ft3 of natural gas.

12 3 See Pearson (2016) and EPA (n.d.) profile. 4 The bonus is the amount paid to the lessor as consideration for the execution of the lease. The amount of the bonus is almost never set forth in the lease itself. It is paid when the lease is signed by the lessor and delivered to the lessee. 5 A royalty interest owner has the benefit of sharing in production revenue without exposure to the capital costs, operating expenses, or environmental liabilities associated with oil and gas production. 6 Investors own participating, or lessee, interests in land. Working interest owners pay capital expenses, operating costs, and royalties to the mineral estate title owner. They incur all the costs and liabilities but share only part of the revenue. The working interest owner (lessee) drills for the oil and gas. If the drilling is successful, the lessor receives a share of the revenues based on that production. If the drilling is unsuccessful, however, the working interest owner receives no revenues but is still responsible for 100% of the costs of drilling and subsequently plugging an abandoned well.