In Bell v. Chesapeake Energy Corporation, No. 04-18-00129-CV, the San Antonio Court of Appeals heard a permissive accelerated appeal of an issue addressed by the trial court in a multi-district litigation brought by many royalty owners in the Eagle Ford against Chesapeake, In re: Chesapeake Eagle Ford Royalty Litigation, involving multiple claims against Chesapeake for breach of the plaintiffs’ oil and gas leases. The Court issued its opinion last week. The issue addressed by the Court was the interpretation of clauses in two oil and gas leases requiring the lessee to either drill and offset well or pay compensatory royalty.
The trial court in the multi-district litigation was asked to construe offset clauses in several oil and gas leases, among them the Bell and Ward leases. Those two leases contain similar clauses regarding protection against drainage by wells drilled on adjacent leases. I will quote the Bell lease here:
In the event a well (“Adjacent Well”) producing Oil or Gas in Paying Quantities is drilled and completed after the date of this Lease on land under which Lessor does not own the quantity of minerals or royalty as under the lands covered by this Lease, and such Adjacent Well is draining the Leased Premises or is deemed draining if the adjacent Well is located within three hundred thirty (330) feet of the Leased Premises, or, when Lessee has an economic interest in said Adjacent Well and said Adjacent Well is located within four hundred sixty seven (467) feet of the Leased Premises (in the case of a Vertical Well, distance will be measured from the surface location or bottom hole location of the Adjacent Well, whichever is closer; in the case of a Horizontal Well distance will be measured from the surface location or the subsurface path of a horizontal drainbore, from its point of entry into the productive horizon to its terminus, whichever is closer), then Lessee agrees to drill such offset wells which is[sic]reasonably designed to protect the Leased Premises from drainage, or at the option of Lessee, shall pay to Lessor the Compensatory Royalties set forth below, or execute and deliver to Lessor a release in recordable form releasing acreage in an amount equivalent to the number of acres required or permitted by the Texas Railroad Commission to drill an offset well to the formation of such Adjacent Well. Lessee shall have ninety (90) days from the date of first production of such Adjacent Well within which to Commence Actual Drilling Operations of an offset well or release offsetting acreage, and thereafter, Lessee’s sole obligation shall be to pay Compensatory Royalties as set forth herein. …
In lieu of Drilling an Offset well required hereunder or releasing acreage as provided above, then Lessee shall pay to Lessor as a Compensatory Royalty an amount equal to the Royalty Share of Gross Proceeds of production from the Adjacent Well.
The plaintiffs sought compensatory royalties for horizontal wells drilled on adjacent tracts. Although the facts are not fully described in the opinion, it is apparent that, for some of the wells on adjacent tracts, only a portion of the horizontal wellbore was within 330 feet of the leased premises.
Chesapeake made three arguments in an effort to avoid paying compensatory royalty to the lessors based on production from the offending well. First, it argued that the leases should be construed to incorporate the requirements that the lessors show “substantial drainage” by the offending well and that a prudent operator would drill an offset well to protect the leased premises against that drainage. Second, Chesapeake argued that, if it was required to pay compensatory royalty, that royalty should be based only on a share of production from the offending well equal to that percentage of the wellbore within 330 feet of the leased premises. Third, Chesapeake argued that, if the clause is interpreted as the plaintiffs contend, the compensatory royalty is an unenforceable penalty for breach of the offset clause.
The trial court ruled that the leases did not require the lessor to prove substantial drainage or that a prudent operator would drill an offset well in order to trigger the lessee’s obligation to drill an offset well. But the trial court sided with Chesapeake on the amount of compensatory royalty Chesapeake should pay. The court did not rule on Chesapeake’s penalty argument.
The Court of Appeals affirmed the trial court’s ruling that the lessors need not prove substantial drainage or that a prudent operator would drill an offset well. The clause “does not incorporate the reasonably prudent operator standard and, in fact, negates the ‘substantial drainage’ element of that standard ….” But the Court reversed the trial court on the amount of compensatory royalty Chesapeake must pay, holding that Chesapeake’s obligation is to pay compensatory royalty based on the total production from the triggering well.
Chesapeake’s argument that only take points are relevant is, in effect, an argument that take points within the Leases’ Trigger Distances and take points outside of those distances should be treated as separate wells for purposes of applying Paragraph 18. In fact, Chesapeake states in its brief that ‘[e]ach take point essentially functions as a separate underground well.” Chesapeake also states that the central aspect of its position on interpreting Compensatory Royalty is that production from a horizontal well is not from the entire length of the well, but only from take points where the horizontal wellbore is perforated.
The Court disagreed. “Had the parties intended that a horizontal well be treated as a series of ‘take point’ wells rather than one integrated well, they could easily have said so. They did not, and we may not say so for them.”
Chesapeake urged the Court to “look beyond the language of the Leases and consider the ‘realities’ of horizontal drilling as surrounding facts and circumstances that inform the court’s construct of that language,” citing the Supreme Court’s recent opinion in Murphy Explor. & Prod. Co.-USA v. Adams, 560 S.W.3d 105 (Tex. 2018). The Court distinguished Murphy on its facts.
The difference … is that the Murphy leases did not expressly address the issue presented to the court for construction–whether a required offset well may be drilled anywhere on the leased premises or whether there was an implied requirement of proximity to the lease boundary. … It was in the context of answering that question that the supreme court considered sources outside the four corners of the lease (0rimarily law journal articles) concerning how a horizontal well produces minerals and the unlikelihood of drainage between tracts. …
In the present case, the Leases expressly address the issue presented. Compensatory Royalty is computed based on ‘production from the Adjacent Well.’ And, in the context of a horizontal well deemed to be draining the Leased Premises, an Adjacent Well is one whose surface location or subsurface path ‘from its point of entry into the productive horizon to its terminus’ is within the Trigger Distances. This language clearly demonstrates that the parties were aware of the realities of horizontal drilling and made provision for those realities. Chesapeake may not now assert those ‘realities’ to alter or contradict the unambiguous contract language.
Finally, the Court refused to consider Chesapeake’s argument that the clause imposed an unenforceable penalty, because the question was not certified by the trial court and had not yet been addressed by the trial court. That issue will certainly arise in future appeals.