March 2009 Archives

March 31, 2009

Exxon v. Emerald

On March 27, the Texas Supreme Court issued its opinions in two related cases, both styled Exxon Corporation v. Emerald Oil & Gas Company. The cases were argued before the court more than two years ago, and the decisions were awaited with much anticipation. The Court reversed a judgment against Exxon for $8.6 million in actual damages and $10 million in punitive damages.

The facts in the case are remarkable. In the 1950's Exxon's predecessor Humble Oil & Refining Company obtained oil and gas leases covering several thousand acres in Refugio County owned by the O'Connor family. The leases were quite unusual;  among other things, they provided for a 50% landowners' royalty. Exxon drilled 121 wells and produced more than 15 million barrels of oil and 65 billion cubic feet of gas from the O'Connor lands. In the 1980's Exxon asked the O'Connors to reduced their royalty, claiming that the leases were becoming uneconomical.  Those negotiations failed, and in 1989 Exxon notified the O'Connors that it intended to start plugging wells and abandoning the leases. Negotiations for the O'Connors to take over operation of the wells were not successful, and Exxon began plugging wells and abandoning the leases.

 

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March 23, 2009

Use of Bank Drafts for Bonus Payment in Oil and Gas Leasing

Exploration companies have traditionally used bank drafts to pay bonuses for oil and gas leases.  Since drafts look a lot like a check, they can be misleading to mineral owners.  Some mineral owners' recent experiences with dishonored drafts have highlighted the problems with use of these financial instruments.

 A draft is like a check, but different.  It is an order issued to a bank to pay a party, conditioned on the happening of a specified event.  As used by exploration companies, it is an order issued by a company or its landman to the company's bank to pay the bonus to the mineral owner.  Typically, the draft provides that the company has a period of time - 30 to 90 days - from the date its bank receives the draft to "honor" the draft - that is, to tell the bank to pay the bonus to the mineral owner.  The draft typically has language like the following:

On approval of lease or mineral deed described herein, and on approval of title to same by drawee not later than 30 days after arrival of this draft at collecting bank.

In other words, the company has 30 days to approve the oil and gas lease being paid for and to approve the mineral owner's title to the minerals being leased.  If the company does not approve the lease, or if it determines that the mineral owner does not have good title to the minerals being leased, it can refuse to pay the draft.

 Use of drafts to pay for leases would seem to be a good way, in theory, to facilitate the lease transaction.  And in fact, drafts are used every day in hundreds of lease transactions, without incident.  But there are problems with its use, and those problems can put landowners at risk.  My advice to landowners is to avoid using drafts if possible.

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March 18, 2009

Oil and Gas Lease Termination Clauses

Last week I discussed Wagner & Brown v. Sheppard, a recent Texas Supreme Court case that involved a lease termination clause.  Sheppard's lease in that case provided that, if royalties were not paid to her within 120 days after first production, the lease would automatically terminate.  That is exactly what happened.

Landowners are usually surpriesed to learn that, under a "standard form" oil and gas lease, the lessee's failure to pay royalties does not give the lessor the right to terminate the lease.  The lease remains in effect, and the lessor's only remedy is to sue for the unpaid royalties.  Landowners often seek to negotiate a clause like Sheppard's that gives the lessor the right to terminate the lease for failure to pay royalties.  Exploration companies of course do not like such a provision.  It puts them at risk that, if royalties are not timely paid for some inadvertent reason, they can lose the lease even though they are willing and able to pay the royalties. 

First, I think it is not a good idea to include a provision that a lease terminates automatically if royalties are not paid within a specified time.  Depending on the circumstances, it may not be in the lessor's best interest to terminate the lease, even though royalties have been delayed.  A better provision is that, if royalties are not paid by a specified date, the lessor has the option to terminate the lease.

Second, I think that the lessee has a good point as well.  The lessor should not be able to terminate a lease because of inadvertence, or an innocent mistake, in paying royalties.  A well-drafted termination clause should provide that, if royalties are late, the lessor must give written notice to the lessee and an opportunity to cure the problem.  Only if the late payment is not rectified should the lessor have the right to terminate the lease.

March 13, 2009

What happens to a pooled lease when the lease terminates?

A recent decision of the Texas Supreme Court, Wagner & Brown, Ltd. v. Sheppard, has caused quite a stir in oil and gas legal circles.  The court was faced with a question never before answered by a Texas appellate court, what is known as a "case of first impression."  Such cases are always interesting to oil and gas lawyers, so I thought I would weigh in on the arguments.

The facts in the case are these:  Jane Sheppard owns a 1/8th mineral interest in 62.72 acres in Upshur County.  She leased her 1/8th interest, and her lease - along with leases of the other 7/8ths interest in the 62.72 acres and leases of other lands- was pooled to form the W.M. Landers Gas Unit, containing 122.16 acres.  Two wells were drilled on Sheppard's tract, both producing gas. 

Sheppard's lease contains a provision requiring payment of royalties within 120 days of first sales of gas, failing which the lease would terminate.  She was not paid on time, and her lease terminated.

Texas law is clear that, if there had been no pooled unit, upon termination of her lease Sheppard would become what is known as a "non-consenting co-tenant" in the two wells on her tract.  She would be entitled to receive her 1/8th share of proceeds of sale of gas from the wells, less 1/8th of the costs of production and marketing.  But Wagner & Brown contended that Sheppard's tract was still bound by the pooled unit, even though her lease had expired.  Under the pooling clause in Sheppard's lease, her royalty would be calculated based on the number of acres of her tract compared to the total number of acres in the unit - in this case, 62.72/122.16, or 51.34% of the wells' production.  Wagner & Brown contended that Sheppard should receive 1/8th of 51.34% of production from the wells, less that same fraction of the cost of production and marketing.  The Supreme Court agreed with Wagner & Brown, holding that "the termination of Sheppard's lease did not terminate her participation in the unit."

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March 2, 2009

Surface Damages for Oil and Gas Activities in Texas

Landowners in Texas are often surprised to learn that oil companies have no obligation to compensate them for use of their lands, or to restore the lands after their use, absent a contractual requirement to do so in their oil and gas lease.  The typical oil-company form lease provides only that the lessee will pay for damages "caused by its operations to growing crops and timber on the land."  Under such a lease, the company does not have to compensate the surface owner for use of or damage to the surface caused by its operations.

Most exploration companies do compensate the surface owner for surface use.  The usual practice is for the company to agree with the surface owner on a single lump-sum payment for each well location, with its attendant roads and flow line easements.  The company pays this compensation for two reasons: first, to maintain good relations with the surface owner, and second, to obtain from the surface owner a release, which is presented to the surface owner at the time of the payment.  The release typically contains language absolving the company from any and all damages caused by the company's operations on the property for the well.  In other words, part of the consideration for the payment is the landowner's release of the company from further liability.

 Absent a contractual obligation in the lease, the oil company has no obligation to compensate the landowner unless it negligently or intentionally causes damages in excess of the reasonable and necessary damages resulting from its operations.  The mineral estate is the "dominant estate," which means that the mineral owner and his/her lessee have the right to use so much of the surface estate as is reasonably necessary to explore for and produce oil and gas.  Texas courts have historically been very careful to protect the rights of the mineral lessee.  After all, the oil and gas industry was the principal source of wealth and revenue in Texas for decades, and courts obligingly crafted legal principles designed to facilitate oil and gas exploration and production.

Even where the oil company has negligently or intentionally caused excess damages, it is very difficult to recover for those damages absent express contractual authority.  A good example of the difficulty faced by landowners suffering surface damages is Primrose Operating Company v. Senn.  In that case, the Senns bought a large ranch in West Texas that had extensive oil and gas activity at the time of their purchase, with 500-600 producing wells.  After their purchase, the Senns had particular problems with one of the operators, Primrose, which had more than 86 spills of oil and salt water.  Testimony at trial showed that it would cost more than $2 million to clean up the spills.  The Senns obtained a judgment, after a jury verdict, for $2,110,000 in actual damages and $880,000 in punitive damages.  But the court of appeals reversed and held that the Senns were entitled to no compensation.  It ruled that, because it was not "economically feasible" to remediate the spills, the damages were limited to the reduction in market value of the ranch caused by the spills, and that, since the value of the ranch had increased since the time of the spills, there was no evidence that the Senns had been damaged.

Any lease by a mineral owner who owns the surface of the leased premises should therefore address the rights of the lessee to use the surface estate and the lessee's obligation to pay compensation for use of or damage to the surface of the lands.