Oil and Gas Lawyer Blog
Lawyers for royalty owners have filed multiple suits against Chesapeake Energy in Dimmit County seeking damages for breach of Chesapeake’s leases. These cases were consolidated for discovery and case-management purposes into a single matter, In re: Chesapeake Eagle Ford Royalty Litigation, Cause No. 2016CI22098, in the 224th District Court in San Antonio.
In addition to claims for underpayment of royalties, the plaintiffs in the Dimmit County cases allege that Chesapeake has breached clauses in the leases requiring the lessee to protect the lease against drainage from adjacent wells – sometimes called an express offset clause. Chesapeake has filed a motion for summary judgment arguing that these clauses are unenforceable because they impose a “penalty.”
One of the implied covenants in all oil and gas leases is the covenant to protect the lease against drainage from wells on adjacent tracts. The implied covenant requires the lessee to drill an “offset well” to the draining well if a reasonable and prudent operator would do so. Damages for breach of the implied covenant are the value of the royalty lost to the lessor, based on the amount of drainage that would have been prevented by the drilling of the offset well. Liability and damages for breach of the implied covenant are difficult to prove, so lessors have come up with an alternative – the express offset clause.
Under an express offset clause, if a well is drilled within a specified distance from the lease, the lessee must either drill an offset well, release sufficient acreage from the lease to allow the lessor to drill and offset well, or pay to the lessor the amount of royalties the lessor would have received had the draining well been located on the leased premises. Such clauses typically provide that, if a draining well is drilled, it will not be necessary for the lessor to prove that the draining well is actually draining oil or gas from the leased premises. Many of the oil and gas leases in the Chesapeake Dimmit County cases have express offset clauses.
In Texas, parties to a contract can agree on the amount of damages that will be payable in the event of a particular breach – known as “liquidated damages.” But Texas courts impose a limit on the parties’ ability to contract for liquidated damages. A liquidated damages provision will be enforceable only if the actual harm caused by the breach is difficult to estimate and the amount of liquidated damages called for in the contract is a reasonable estimate of the actual damages. Chesapeake argues that the express offset clauses in its leases are unenforceable penalties because the amount of liquidated damages called for – the royalty that would have been paid to the lessor if the draining well had been located on the leased premises — is not a reasonable estimate of the actual damages caused by the draining well. Chesapeake says that the amount of royalty that would be paid if the draining well had been on the leased premises will always exceed the royalty on the amount of oil that would not have been drained from the leased premises had an offset well been drilled, so the liquidated damages cannot be a reasonable estimate of the actual damages.
Chesapeake is making a similar argument in another case, RaeMay v. Chesapeake, Cause No. D-1-GN-15-005015, in the 345th District Court of Travis County. Our firm is representing the royalty owners in that case, a suit for additional royalties due. The lease in RaeMay provides for two methods for valuing production for payment of royalty: if the lessor sells production to a third party who is not affiliated with the lessee, then royalties are based on the proceeds of the sale; if the lessor sells production to an affiliated entity, the royalties are based on the average of the three highest prices paid during the calendar year in the Railroad Commission district. Chesapeake sells production to its affiliate, Chesapeake Energy Marketing Company, but has refused to pay royalty based on the average of the three highest prices in the district. It argues that the lease royalty clause is a disguised liquidated damages clause, that the requirement to pay royalties based on the three highest prices is really liquidated damages for breach of the lease, and that such liquidated damages are an unenforceable penalty because the amount of royalty due will always exceed the lessors’ actual damages for the breach.
One might question why courts will refuse to enforce liquidated damages provisions in commercial contracts between sophisticated parties. Courts in some states do not follow Texas in refusing to enforce liquidated damages provisions that impose agreed “penalties” for a breach. It may be reasonable to impose limits on liquidated damages clauses in consumer contracts where there is not equal bargaining power. For example, a court should not enforce a provision in the contract we “sign” when we create a Facebook account, if the Facebook contract would require the consumer to pay liquidated damages of $10,0000 for any breach of the contract’s provisions. But there seems to be little or no justification for refusing to enforce agreed liquidated damages provisions in commercial contracts that were a bargained-for consideration for the agreement.