Oil & Gas Law Chapter 6: Implied Covenants Professors Wells

Presentation:

October 19, 2016

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Overview: Covenants versus Conditions

It is essential to understand the difference between the two in an oil and gas lease. 1.  Conditions are not covenants. Conditions are rooted in property law, not contract law. Conditions

determine how long an interest in property endures. E.g., an oil and gas lease is granted “for 3 years and as long thereafter as oil and gas are produced.” No production occurs at the end of 3 years, the lease ends. The condition was not met. The Lessee never promised to obtain production.

2.  Covenants are promises or obligations. Failing to satisfy a covenant generally represents a breach of contract.

E.g., Lessee promises to pay a 1/6 royalty on production. Breach of a covenant is like breach of contract. Damages as a remedy. The lease does not end because of breach of contract.

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Implied Covenants: Brewester v. Lanyon Zinc. Co

Brewster v. Lanyon Zinc Co, 140 F. 801: 1.  Facts

2.  Court reasoning

“The subject was, therefore, rationally left to the implication, necessarily arising in the absence of express stipulation, that the further prosecution of the work should be along such lines as would be reasonably calculated to effectuate the controlling intention of the parties as manifested in the lease, which was to make the extraction of oil and gas from the premises of mutual advantage and profit. * * * Whatever, in the circumstances, would be reasonably expected of operators of ordinary prudence, having regard to the interests of both lessor and lessee, is what is required.”

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Implied Covenant to Develop: Waggoner Estate v. Sigler Oil Co

Waggoner Estate v. Sigler Oil Co, 19 S.W.2d 27: 1.  Facts

2.  Court reasoning

“The usual remedy for breach of the lessee’s implied covenant for reasonable development of oil and gas is an action for damages, though, under extraordinary circumstances– where there can be no other adequate relief– a court of equity will entertain an action to cancel the lease in whole or in part.”

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Model Lease Agreement: Implied Covenant to Develop

Paragraph 9 The breach by Lessee of any obligation arising hereunder shall not work a forfeiture or termination of this lease nor cause a termination or reversion of the estate created hereby nor be grounds for cancellation hereof in whole or in part. In the event Lessor considers that operations are not at any time being conducted in compliance with this lease, Lessor shall notify Lessee in writing of the facts relied upon as constituting a breach hereof, and Lessee, if in default, shall have sixty (60) days after receipt of such notice in which to commence the compliance with the obligations imposed by virtue of this instrument. After the discovery of oil, gas or other mineral in paying quantities on said premises, Lessee shall develop acreage retained hereunder as a reasonable prudent operator but in discharging this obligation it shall in no event be required to drill more than one well per forty (40) acres of the area retained hereunder and capable of producing oil in paying quantities and one well per 640 acres plus an acreage tolerance not to exceed 10% of 640 acres of area retained hereunder incapable of producing gas or other mineral in paying quantities.”

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Implied Covenant to Develop: Sauder v. Mid-Continent Petroleum Corp.

Sauder v. Mid-Continent Petroleum Corp, 292 U.S. 272: 1.  Facts

2.  Court reasoning

“It is conceded that a covenant on respondent’s part to continue the work of exploration, development and production is to be implied from the relation of the parties and the object of the lease. * * * * The dissenting judge in the court of appeals thought that a decree should be entered cancelling the lease as to the 320 acre tract (the E1/2 of the Section) unless within a reasonable time an exploratory well should be drilled therein to the Mississippi lime, and that the 40 acres embaraced in SE ¼ of the SW ¼ of Section 16 should remain under the lease. We are of the opinion that such a decree would recognize and protect the equities of both parties.”

SE¼

160 acres 40

acres 40

acres

40 acres

SW¼

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Implied Covenant to Develop: Clifton v. Koontz

Clifton v. Koontz, 325 S.W.2d 684: 1.  Facts

2.  Court reasoning

“[Y]et it is equally true that the burden rests upon the lessor to prove that the producing stratum required additional wells, or that strata different from that form which production is being obtained, in reasonable probability, exist, and that by the drilling of additional wells there would be a reasonable expectation of profit to the lessee. Under such circumstances, the lessee’s obligation as to development is measured by the rule of reasonable diligence or what an ordinarily prudent and diligent operator would do, and he is not required to continue in the performance of these duties or to engage in the performance

of such implied duties unless there is a reasonable expectation of profit, not only to the lessor, but also the lessee.”

350 acres

Sipes Well

Strawn

Ellenberger & Marble Falls

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Implied Covenant to Develop: Post-Clifton v. Koontz Issues

Notes to Clifton v. Koontz 1.  Elements Necessary for Lessor to Prevail

2.  Measure of Damages

3.  How should damages be measured in a development covenant lawsuit?

4.  Clifton exceptions.

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Implied Covenant to Develop: Sun Oil v. Jackson

Sun Oil v. Jackson, 783 S.W.2d 202: 1.  Facts

2.  Court reasoning

“This court has held that no implied covenant of further exploration exists independent of the implied covenant of reasonable development. In Clifton, the court held that the covenant of reasonable development encompassed the drilling of all additional wells after production on the lease is achieved. By “additional wells” the court meant both additional wells in an already producing formation or stratum, or additional wells in “that strata different from that from which production is being obtained. The critical question was whether the lessor could prove a reasonable expectation of profit to lessor and lessee. Therefore, under Clifton if a party could prove that a reasonably prudent operator would have drilled the well, that well fell within the implied covenant of reasonable development, without regard to whether the well was classified as exploratory or developmental.”

10,000 acres

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Implied Covenant to Protect: Amoco Production Co. v. Alexander

Amoco Production Co. v. Alexander, 622 S.W.2d 563: 1.  Facts

2.  Court reasoning

“A lessor is entitled to recover damages from a lessee for field-wide drainage upon proof: (1) of substantial drainage of the lessor’s land; and (2) that a reasonably prudent operator would have acted to prevent substantial drainage from the lessor’s land.”

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Model Lease Agreement: Offset Well Clause

Paragraph 6 In the event a well or wells producing oil or gas in paying quantities should be brought in on adjacent land and within three hundred thirty (330) feet of and draining the lease premises, or acreage pooled therewith, Lessee agrees to drill such offset wells as a reasonable prudent operator would drill under the same or similar circumstances.”

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Empire Oil and Refining Co. v. Hoyt, 112 F.2d 356: 1.  Facts: Acid job causes well to water out. Lessor sues Lessee for damages for lost royalty due to loss of

the well.

2.  Who wins?

Implied Covenant to Administer Leasehold: Empire Oil and Refining Co. v. Hoyt

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Baldwin v. Kubetz, 307 P.2d 1005: 1.  Facts: Well hazards and safety violations by Lessee prevented Lessee from being able to obtain permits

to drill further wells. Lessor sues to terminate lease, claiming that Lessee failed to fulfill implied duty to manage the lease.

2.  Who wins?

Implied Covenant to Administer Leasehold: Baldwin v. Kubetz

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Waseco Chemical Supply Co. v. Bayou State Oil Corp, 371 So.2d 305: 1.  Facts: Lessee operated marginally producing wells. Fire flooding would increase recoverability from 5%

to 60% and could increase production one hundred fold. Other operators were using this technique in adjacent tracts. Lessor sued for termination of lease.

2.  Who wins?

Implied Covenant to Administer Leasehold: Waseco Chemical Supply Co. v. Bayou State Oil Corp.

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HECI Exploration v. Neel, 982 S.W.2d 881: 1.  Facts

2.  Court reasoning

“Because we conclude that the discovery rule does not apply and that the Neels' claims are barred, we do not reach the issue of whether an implied covenant to notify of the need to sue exists under Texas mineral leases. * * * As demonstrated in this case, the information that the Railroad Commission maintains regarding fields in which there is competing production indicates that injury to a common reservoir by an adjoining operator is not inherently undiscoverable.”

Implied Covenant to Administer Leasehold: HECI Exploration v. Neel

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Adverse Possession: Discovery Rule BP America Production Co. v. Marshall

BP America Production Co. v. Marshall, 342 S.W.3d 59:

1.  Facts

2.  Court Reasoning:

While the J.O. Walker No. 1 well log contained highly technical information regarding the resistivity, conductivity, and spontaneous potential at various intervals in the formation, it was this information regarding the reservoir’s geology that led the Marshalls’ expert to conclude that BP’s continued activities on the well were not in good faith. * * * Although technical, the public documents concerning BP’s operations were available to the Marshalls. While the Marshalls did not examine them until internal BP documents put this publicly available log information in context with BP’s efforts to keep the lease alive by continued operations, they could have. It is not significant that BP’s internal documents helped the Marshalls discover the injury in this case, as the information was otherwise discoverable. Because the Marshalls had a duty to exercise reasonable diligence in protecting their mineral interests, and since the low probability of success of BP’s continued operations could have been dis- covered with the exercise of reasonable diligence, the injury was not inherently undiscoverable.

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Adverse Possession: Discovery Rule Samson Lone Star Ltd. Partnership v. Hooks

Samson Lone Star Limited Partnership v. Hooks, 389 S.W.3d 409:

1.  Facts: Lessee was found to have engaged in fraud, misrepresentations, and bad-faith pooling and had concealed all of these actions and lied to its lessors.

2.  Houston 1st Dist. Appellate Court: Lessee wins due to the statute of limitations and inapplicability of the discovery rule Justice Sharp’s Concurring Opinion:

This burden the Court imposes upon lessors is severe. It is now a lessor's duty to presume that any statement made by its lessee is false and to ransack the esoteric and oft-changing records at the Railroad Commission to discover the truth or falsity of its lessee's statements.

I believe the Texas Supreme Court has placed an unnecessary and very heavy burden on lessors by its ruling in BP America, one that will result either in much money being spent unnecessarily on prophylactic forensic review of Railroad Commission records or in many viable claims being lost to limitations. As we are, however, bound to follow the Court's rulings, I reluctantly concur in that part of the opinion that finds the Hooks' fraud, fraudulent inducement, and statutory fraud claims barred by limitations as a matter of law.

3.  Supreme Court: Reversed and remanded, holding that it was a fact question whether the discovery rule could apply. The Court distinguished BP America v. Marshall because “the public record itself was not tainted” in BP America v. Marshall while the public record was tained in the Hooks case. “We cannot say that, as a matter of law, Hooks should have discovered the accurate information when the more recent

filing falsely conveyed that the well had been completed outside the protected zone.”

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Coastal Oil & Gas Corp. v. Garza, 268 S.W.3d 1: 1.  Facts

2.  Court reasoning

“We have held that one measure of damages for breach of the implied covenant of protection is the amount of royalties that the lessor would have received from the offset well on its lease. But this would overcompensate the lessee if production from the offset well exceeded the drainage. Another measure of damages is the value of the royalty on the drained gas, but this, too, would overcompensate the lessee if not all of the drainage could have been prevented, either because of the nature of the field, or the regulatory system, or for whatever reason. The correct measure of damages for breach of the implied covenant of protection is the amount that will fully compensate, but not overcompensate, the lessor for the breach– that is, the value of the royalty lost to the lessor because of the lessee’s failure to act as a reasonably prudent operator.”

Implied Covenant to Administer Leasehold: Coastal Oil & Gas Corp. v. Garza