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FuelFix reports that companies have drilled but not completed wells, in effect storing the reserves in the ground until oil prices rise and completion costs decline. FuelFix says that IHS Energy counts 3,000 uncompleted wells in the US, including 1,500 uncompleted wells in the Eagle Ford alone. It says that Apache, Anadarko and Cabot have 845 uncompleted wells in Texas, with a potential to produce 373,000 barrels of oil and 528 million cubic feet of gas a day.

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Last month I wrote about the Texas legislature’s efforts to limit cities’ authority to regulate drilling within their jurisdictions, after the City of Denton passed a ban on hydraulic fracturing. The bill that has emerged is House Bill 40, sponsored by Drew Darby, chairman of the House Energy Resources Committee. It passed out of committee, but yesterday was returned to committee on a technicality. A companion bill in the Senate, Senate Bill 1165, has also passed out of its Natural Resources committee.

The bill would greatly limit cities’ ability to regulate drilling. It provides that cities may only regulate “aboveground activity related to an oil and gas operation that occurs at or above the surface of the ground, including a regulation governing fire and emergency response, traffic, lights, or noise, or imposing notice or reasonable setback requirements.” Any ordinance must be “commercially reasonable,” defined as “a condition that would allow a reasonably prudent operator to produce, process and transport oil and gas, as determined based on the objective standard of a reasonably prudent operator and not on an individualized assessment of an actual operator’s capacity to act.”

The bill leaves may questions unanswered. For example, Fort Worth has an ordinance that regulates saltwater pipelines.  Are pipelines an “aboveground activity” that cities can regulate?

Last weekend, about 50 residents living close to a well being completed by Vantage Energy were evacuated because of a mechanical failure in the well during the fracing operation.  Well blow-out experts were called in to regain control of the well. The incident is being cited by opponents of House Bill 40 to argue against restrictions on municipal regulation. A Dallas Morning News editorial yesterday said that “Homeowners and cities should have the right to see events like what happened over the weekend in Arlington and determine for themselves whether drilling is in the best interests of their community.” Protesters planned an all-night vigil on the Capitol steps in opposition to the bill. And last week, the Environmental Defense Fund filed applications for rulemakings with the Texas Railroad Commission, requesting that it adopt rules replacing municipal regulations for pipeline, truck traffic and special safety measures needed in case of a natural disaster. The EDF applications were undoubtedly intended to impress the legislature on the lack of RRC regulation of drilling in urban areas.

 

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Yesterday the Energy Resources Committee of the Texas House of Representatives heard testimony on HB 1552, introduced by one of its members, Rep. Tom Craddick. The bill deals with “allocation wells,” of which I have written before. An allocation well is a horizontal well that crosses over two or more tracts without combining those tracts into a pooled unit or obtaining agreement from the royalty owners in the tracts on how production from the well will be allocated among the tracts.

Although the Texas Railroad Commission issues permits for allocation wells, there has been a lot of speculation about whether leases grant the authority to drill such wells. At the hearing, representatives of operators spoke in favor of the bill, and mineral owners spoke in opposition. I spoke in opposition on behalf of Texas Land and Mineral Owners Association.

A substitute for the original filed bill was introduced at the hearing.  HB 1552 substitute

Testimony at the committee hearing was taped and can be viewed here.

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Everyone knows this quote and that it is from Shakespeare. It is from Henry VI, Part 2. And it has generated some controversy.

Defenders of lawyers (mostly lawyers) say that it is misunderstood and was intended as a “complement to lawyers and judges who protect the people from tyranny and anarchy.” This argument stems from the identity of the character speaking, Dick the Butcher, a dastardly villain and follower of the rebel Jack Cade, a pretender to the throne and a sort of libertarian. Dick the Butcher was supporting Jack Cade’s campaign and encouraging him in his quest for anarchy.

But not so fast, say others.  In fact, Dick the Butcher is making a joke, as Shakespeare was wont to do, at the expense of lawyers.

“Far from “eliminating those who might stand in the way of a contemplated revolution” or portraying lawyers as “guardians of independent thinking”, it’s offered as the best feature imagined of yet for utopia. It’s hilarious. A very rough and simplistic modern translation would be “When I’m the King, there’ll be two cars in every garage, and a chicken in every pot” “AND NO LAWYERS”. “

Perhaps Shakespeare was not taking sides, but commenting on the ambiguous status of lawyers in his own day. And perhaps it is so popular today because it still evokes the same ambiguity. The legal industry was growing in Shakespearian England. According to David Riggs, a retired Stanford University professor of English, Shakespeare may have been dramatizing social divisions within Elizabethan society while keeping an ironic distance from lawyer-haters.

The line was even commented upon by former Supreme Court Justice John Paul Stevens in a 1985 dissent: “As a careful reading of that text will reveal, Shakespeare insightfully realized that disposing of lawyers is a step in the direction of a totalitarian form of government.”

So take your pick. If nothing else, this debate speaks of the Bard’s lasting influence.

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Struggles over fracking bans have been in the news for some time in Pennsylvania, Colorado, Ohio, New Mexico and other states. The State of New York has had a moratorium on fracking for several years. But until recently, cities and oil and gas companies in Texas had been able to get along. Until, that is, the City of Denton, Texas passed a referendum banning fracking with in its city limits. Since then, as we say in Texas, all hell has broken loose.

The day after Denton’s referendum passed, two suits were filed challenging its ordinance, one by the Texas General Land Office and one by the Texas Oil and Gas Association. In the Legislature, several bills were filed to limit municipal authority to regulate drilling. One bill would require cities to reimburse the state for lost revenue from any drilling ban.  Another would require cities to get approval from the Attorney General before putting any referendum on the ballot.

The two bills that appear to have the most legs are HB 2855, introduced by Drew Darby, and SB 1165, introduced by Troy Fraser. SB 1165 has been favorably reported out of the Senate Natural Resources Committee. HB 2855 remains pending in the House Energy Resources Committee after a lengthy hearing at which representatives of the industry and municipalities testified late into the night.

HB 2855 would prohibit a city from enacting an ordinance that “prohibits or has the effect of prohibiting an operation under the jurisdiction of the” Texas Railroad Commission. And it delegates to the RRC “exclusive jurisdiction to determine whether the adoption or enforcement of an … ordinance … prohibits or has the effect of prohibiting an operation under the jurisdiction of” the RRC.

SB 1165 prohibits ordinances that “ban, limit or otherwise regulate an oil or gas operation” except for ordinances that “regulate only surface activity that is incident to an oil and gas operation, is commercially reasonable, does not effectively prohibit an oil and gas operation, and is not otherwise preempted by state or federal law.”

Cities claim that both bills would effectively eliminate the ordinances that they have carefully crafted, with input from industry, to regulate drilling within their municipal limits.

In 2011, the Texas Supreme Court decided Railroad Commission of Texas and Pioneer Exploration, Ltd. v. Texas Citizens for a Safe Future and Clean Water and James G. Popp, No. 08-0497. It held that the RRC’s authority to issue permits for injection wells, which requires the RRC to find that the permit will be “in the public interest,” does not give the RRC authority to consider traffic safety in deciding whether to grant the permit. The RRC strenuously argued that it had no jurisdiction to consider public safety issues in granting injection well permits. I was reminded of this case in relation to the debate over municipal authority, because, like injection wells, the RRC never considers public safety issues in deciding whether to grant drilling permits. Indeed, I suspect that the RRC would say, as it did in Popp, that it has no jurisdiction to consider such issues when granting a drilling permit. In municipal jurisdictions, issues of public safety are principally delegated to the municipality. City drilling ordinances address those issues – traffic, noise, emissions, etc. The City of Fort Worth’s drilling ordinance, considered a model for other cities, addresses those issues in great detail.

The proposed bills will leave a lot of open questions. When does a municipal ordinance “have the effect of prohibiting an operation”? When is a municipal ordinance “commercially reasonable”? Senate bill 1165 defines “commercially reasonable” as “a condition that permits a reasonably prudent operator to fully, effectively, and economically exploit, develop, produce, process and transport oil and gas.” It appears to me that these bills are licenses for operators to litigate with cities over their ordinances, in expensive litigation that some cities will be unable or unwilling to fight.

These bills were filed in response to Denton’s drilling ban. It seems to me that the most reasonable response, if any is needed, is simply to prohibit cities from enacting a drilling ban. The industry appears to be using the drilling ban as an opportunity to try to severely limit municipal authority over drilling.

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The Energy Information Administration shows oil production from the Niobrara, Eagle Ford and Bakken fields dropping for the first time, by 24,023 bbl/d — much sooner than some predicted. Production from the Permian Basin is still rising. Operators may be delaying completion of wells already drilled, in effect storing their reserves in the ground. (Click image below to enlarge.)

 

EIA production graph

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Last November, the Texas General Land Office lost its appeal in Commissioner v. SandRidge Energy, Inc., in the El Paso Court of Appeals. For the first time, a court has ruled that a lessee can deduct post-production costs under the Texas General Land Office’s Relinquishment Act lease form, citing Heritage Resources v. NationsBank, 939 S.W.2d 118 (Tex. 1996).

The case actually involves several oil and gas leases owned by SandRidge in Pecos County, some covering lands owned by private parties, some covering Relinquishment Act lands. (The State owns the minerals under Relinquishment Act land; the surface owner is agent for the state in granting oil and gas leases, for which the surface owner receives ½ of bonuses and royalties. The lease must be approved by the GLO and be on the approved GLO lease form.) The most interesting part of the case is the court’s interpretation of the GLO’s Relinquishment Act lease form. There are somewhere between 6.4 million and 7.4 million acres of Relinquishment Act lands in Texas, principally in West Texas, in and around the Permian Basin.

SandRidge’s wells on the leases in dispute produce mostly carbon dioxide, mixed with some natural gas. Originally, SandRidge paid the GLO royalties on its sales of natural gas and carbon dioxide. More recently, SandRidge made an agreement with Oxy USA; SandRidge built a plant, the Century Plant, to extract the CO2 from SandRidge’s gas. Oxy owns and operates the plant and gets the CO2 extracted; SandRidge gets the natural gas. Oxy doesn’t charge SandRidge for separating the gas from the CO2. Oxy uses the CO2 in secondary recovery projects. The plant reportedly cost a billion dollars.

When the Century Plant was up and running, SandRidge stopped paying royalties on CO2 under its Relinquishment Act leases. The State sued, and the parties filed motions for partial summary judgment. The trial court ruled in favor of SandRidge.

The GLO relied on the following provisions of the Relinquishment Act leases:

4(B).  NON PROCESSED GAS. Royalty on any gas (including flared gas), which is defined as all hydrocarbons and gaseous substances not defined as oil in subparagraph (A) above, produced from any well on said land (except as provided herein with respect to gas processed in a plant for the extraction of gasoline, liquid hydrocarbons or other products) shall be 25% part of the gross production or the market value thereof, at the option of the owner of the soil or the Commissioner of the General Land Office, such value to be based on the highest market price paid or offered for gas of comparable quality in the general area where produced and when run, or the gross price paid or offered to the producer, whichever is the greater ….

 7.  NO DEDUCTIONS. Lessee agrees that all royalties accruing under this lease (including those paid in kind) shall be without deduction for the cost of producing, gathering, storing, separating, treating, dehydrating, compressing, processing, transporting, and otherwise making the oil, gas and other products hereunder ready for sale or use. Lessee agrees to compute and pay royalties on the gross value received, including any reimbursements for severance taxes and production related costs.

 The State argued that SandRidge was paying for the cost of treating the natural gas by giving the CO2 to Oxy, and that this cost is not deductible under the Relinquishment Act lease form. SandRidge argued that the cost of treating the gas is deductible, based on Heritage v. NationsBank.  In Heritage, the Texas Supreme Court held that, where a lease provides for royalties based on “market value at the well,” a lessee may deduct post-production costs even if the lease prohibits such deductions. According to the Court, “from SandRidge’s perspective, Heritage stands for the principle that a market value at the well clause trumps any other provision that conflicts with it.” SandRidge argued that the paragraph 4(B) of the Relinquishment Act lease is in effect a market-value-at-the-well royalty provision. The El Paso Court of Appeals agreed. It said that the clause provides for royalties based on the wellhead measurement of gas volume. “The royalty is therefore owed on the substance so measured: raw gas, including all of its components. ‘When there is a wellhead measurement, payment is due for gas in its natural state, not on the liquid hydrocarbons which are later extracted.’ ConocoPhillips Co. v. Incline Energy, Inc., 198 S.W.3d 377, 381 (Tex.App.–Eastland 2006, pet denied)(citing Carter v. Exxon Corp., 842 S.W.2d 393 (Tex.App.–Eastland 1992, writ denied)).”

To my knowledge, this is the first appellate decision applying the Heritage rationale to a royalty clause that does not contain “market-value-at-the-well” language.

The GLO intends to appeal to the Texas Supreme Court. The Supreme Court has already agreed to hear Chesapeake’s appeal in the Hyder case, which also implicates Heritage.

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Betty Lou Bradshaw’s parents owned 1773 acres in Hood County. In 1960, they sold the land and reserved 1/2 of the royalty on oil, gas and other minerals. Betty Lou inherited her parents’ royalty interest.

In 2005, Steadfast Financial (subsequently renamed KCM Financial) acquired the right to purchase the land. In 2006, KCM made a deal with Range Resources by which it simultaneously (1) exercised its right to purchase the land, (2) sold the land to Range, reserving all minerals, and (3) leased the mineral estate to Range. The lease provided for 1/8th royalty, and the bonus was $7,505 per acre.

Betty Lou sued KCM and Range. She alleged that they conspired to limit her royalty on production from the lease to 1/16 (1/2 of 1/8), whereas it should have been 1/8 (1/2 of 1/4), since the going rate for lease royalties in Hood County at the time was 1/4. She alleged that Steadfast had agreed to a lower royalty in order to receive an above-market bonus.

The trial court dismissed Betty Lou’s claims, holding that KCM and Range had not breached any obligation to Betty Lou.

The Supreme Court remanded Betty Lou’s case against KCM for trial, but it dismissed her case against Range.

It has long been known in Texas that the owner of minerals whose mineral estate is subject to a royalty interest owned by another has a duty of “utmost good faith” to the royalty owner. The Supreme Court held that Betty Lou had presented sufficient evidence that KCM had breached its duty to her to entitle her to a jury trial on the issue.

The Court said that the holder of the “executive right” – the right to grant oil and gas leases – has a duty “to acquire for the non-executive [the royalty owner] every benefit that he exacts for himself,” but that “the executive is not required to grant priority to the non-executive’s interest.” Evidence that the holder of the executive right is guilty of self-dealing “can be pivotal.” “Self-dealing has most commonly been observed in situations where the executive employs a legal contrivance to benefit himself, a close familial relation, or both.” “The controlling inquiry is whether the executive engaged in acts of self-dealing that unfairly diminished the value of the non-executive interest.”

In Betty Lou’s case, “the allegation is that the executive [KCM] has misappropriated what would have been a shared benefit ( market-rate royalty interest) and converted it into a benefit reserved only unto itself (an enhanced bonus), with the intent to diminish the value of Bradshaw’s royalty interest. If proved, such conduct is the essence of self-dealing.”

As part of KCM’s agreements with Range, KCM promised “to honor and uphold any interest Betty Lou Bradshaw is determined to be entitled to in” the leased property. It is evident that Range knew that Steadfast was bargaining for a below-market royalty in order to get a higher bonus, and it was concerned that it might have some liability to Betty Lou. But the Supreme Court held that Range had no duty to protect Betty Lou’s interest. “Evidence that Range knew the [mineral] estate was burdened with Bradshaw’s non-participating royalty interest, may have known about tensions between Bradshaw’s and Steadfast’s interests, and agreed to a one-eighth royalty and an eight-figure bonus payment to Steadfast are simply insufficient to impute Steadfast’s liability, if any, to Range.” “[I]n negotiating with the executive, a lessee should not fear liability for doing nothing more than getting a good deal closed.”

After KCM granted its lease to Range, it transferred its reserved lease royalty to third parties. Betty Lou included those third parties in the suit and asked for a “constructive trust” on those royalty interests, on the theory that she should have received a 1/8 royalty, and since the lease provides for only 1/8 royalty, all of the royalty should go to her. A constructive trust is a remedy courts will grant where (1) there has been a breach of a special trust or fiduciary relationship or fraud, (2) the wrongdoer has been unjustly enriched, and (3) as a result the injured party has lost identifiable property that can be returned. The remedy is that the wrongdoer is found to be holding the property in “constructive trust” for the injured party.

The Court refused to accept Betty Lou’s constructive trust remedy. It said she had failed to show that she had lost “identifiable property” that could be returned to her. The Court’s logic was: Betty Lou owned an interest equal to 1/2 of the royalty. Her parents had sold the other 1/2 of the royalty when they sold the land. The royalty interest Steadfast had transferred to the other defendants was the royalty Betty Lou’s parents had sold, not part of the royalty she owned. “The royalty payments on which Bradshaw seeks a constructive trust emanate from [the mineral interest her parents had sold], which Steadfast retained when it conveyed [leased] the mineral rights to Range, and not from the one-half of royalty interest reserved by [Betty Lou’s parents] in the 1960 deeds.”

What if KCM had not transferred it reserved royalty interest to third parties, but still owns it? Would the Supreme Court say that Betty Lou could not claim that royalty interest? I think another way to analyze the case is that KCM traded its royalty interest to Range for an increased bonus, so, to make Betty Lou whole, she should receive the royalty reserved in the lease.

If Betty Lou wins her case before the jury, she can get a judgment against KCM but not against Range or the persons to whom KCM transferred its royalty interest. It is not clear to me what the measure of damages for Steadfast’s breach of duty should be. One way to approach the problem: suppose that a market bonus rate for the lease would be $3,000/acre. Steadfast got $7,505/acre. For 1773 acres, the part of the bonus above the market rate would be $7,996,375. That is the additional bonus Steadfast received for lowering its royalty from 1/4 to 1/8. Another way to look at it is that the additional 1/8 royalty was worth $8 million to Range. Betty Lou should have received 1/2 of that additional 1/8 royalty, so she should get 1/2 of that $8 million.

To my knowledge, the question of the lessee’s potential liability to a royalty owner like Betty Lou has not previously been addressed by the Supreme Court. This case seems to shut the door on that issue. But suppose a slightly different set of facts. Suppose that, instead of paying KCM a higher bonus, Range had agreed to assign to KCM’s sole shareholder a 1/8 overriding royalty on lease production, as part of the lease deal. If the additional 1/8 royalty is worth $8 million, the result is the same economically to Range. But under these facts, it seems to me that Range might have some liability. It looks more like Range  is conspiring with KCM to deprive Betty Lou of her rights.  Not Betty Lou’s facts, but a case can be made that, under some circumstances the lessee could be held liable for conspiring with its lessor.

The Court’s opinion can be found here.

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