119 Abraxas Petroleum Corp. v. Hornburg

Richard F. Brown

 
The following is not a legal opinion. You should consult your attorney if the case may be of significance to you.
 
Abraxas Petroleum Corp. v. John H. Hornburg, 2000 Tex. App. Lexis 1748 (Tex. App. —El Paso 2000, no pet. h.) construes the provisions of a joint operating agreement regarding appointment of successor operators, authorization for expenditure letters, and the exculpatory clause applicable to the operator.
 
Abraxas Petroleum Corporation (“Abraxas”) purchased the leasehold interest of the majority owner of a prolific oil lease in September 1992. The seller was also the Operator under the terms of the Joint Operating Agreement (“JOA”) applicable to the lease. Abraxus assumed responsibilities as Operator, although there was no formal election of a successor Operator as provided in the JOA. There was an immediate and significant decline in production.
 
In November 1993, Abraxas informed the other working interest owners under the JOA that all production had ceased from the four producing wells located on the lease. Abraxas included in the mailing to the working interest owners an authorization for expense (“AFE”) letter which described the proposed workover procedures to restore the wells and included a cost estimate for each well. To participate in the proposed workover procedures, the AFE letter required the other working interest to pay their proportionate share of the expenses. If the working interest owners declined to consent to the AFE letter, Abraxas would invoke the 300% non-consent penalty under the JOA and seize the lease income of the non-consenting working interest owners until 300% of the non-consenting working interest owners’ proportionate share of the proposed workover operations had been paid. The estimated costs to workover all four wells totlaed $44,250.00, but no one well was estimated to require more than $30,000.00.
 
None of the working interest owners elected to proceed with work over operations within the 30 day window. Abraxas deemed the status of the working interest owners to be “non-consent” under the JOA as of December 1, 1993; therefore, Abraxas seized future “runs” of the working interest owners, that is, the income from the sale of the oil produced on the Lease. Although the AFE letter had listed work over procedures totaling $44,250.00 for all four wells, Abraxas actually performed only one small project in December 1993 at a cost of approximately $7,500.00. Abraxas did not notify any of the working interest owners that it had decided not to complete all of the proposed operations. Because of further problems with the wells on the Lease, Abraxas decided to shut down the Lease and produce only one barrel from one well per day each month in order to hold the Lease. Consequently, the Lease was reduced from a 1,000 barrel-per-month producer when Abraxas obtained the Lease, to producing only 30 barrels or less of oil per month.
 
Three working interest owners to the Lease, John H. Hornburg, Gwendolyn Hornburg Hauter, and Marian C. Guiberson (collectively referred to herein as the “Working Interest Owners”) filed suit against Abraxas alleging, among other things, negligence, gross negligence, willful misconduct, breach of contract and waste. Abraxas counterclaimed against the Working Interest Owners with a suit on a sworn account seeking to collect Lease operating expenses which had not been paid by the Working Interest Owners. The counterclaim also alleged a breach of contract action and sought attorney’s fees. Abraxas later amended its counterclaim to request a declaratory judgment and attorney’s fees.
 
The trial court determined that Abraxas had never been formallyselected as operator pursuant to the provisions of the JOA. The jury found that Abraxas had been grossly negligent in committing waste, but did not engage in willful misconduct and had breached the JOA by sending the AFE letter and by failing to perform all or substantially all of the work proposed under the AFE letter. The jury also found that the conduct of Abraxas caused damages to the Working Interest Owners and that Abraxas was not entitled to an offset for reasonable and necessary expenditures on the Lease. The jury also awarded exemplary damages in favor of the Working Interest Owners.
 
The El Paso Court of Appeals affirmed the judgment of the trial court except as to the award of exemplary damages, which it deleted. The court first addressed the trial court’s determination that Abraxas had never been formally selected as operator under the JOA. The Court ruled that the working interest owners waived the JOA requirement that Abraxas be formally selected as operator of the Lease. The Court based its holding on its prior decision in Purvis Oil Corp. v. Hillin, 890 S.W.2d 931 (Tex.App. — el Past 1994, no writ) in which it held that non-operating working interest owners could waive requirements of the JOA pertaining to selection of a successor operator by permitting another party to act as operator despite a failure to qualify as such and by accepting the benefits of that party’s performance. Although the trial court was in error regarding the selection of Abraxas as operator, the Court ruled that the trial court’s error was not sufficient to remand the case for a new trial.
 
Abraxas also contended that the Working Interest Owners were not entitled to maintain a waste cause of action because the liability of Abraxas arose out of its breach of the JOA, if any. The Court noted that waste included injury resulting from a failure to exercise reasonable care in the preservation of property; however, in this case, the JOA governed the conduct of the operator with respect to production of oil from the land. The JOA gave Abraxas the contractual right to produce oil from the Lease. Although no provision specifically prohibited Abraxas from committing waste, Article 5A of the JOA required that the operator “conduct all such operations in a good and workmanlike manner.” In other words, the operator was governed by the “reasonably prudent operator” standard. Therefore, the Court ruled that the liability of Abraxas for waste was premised on the jury’s determination that Abraxas did not act as a reasonably prudent operator. However, because the duty violated by Abraxas derived from its responsibilities as operator under the JOA, the Working Interest Owners were not permitted to maintain a common law waste cause of action.
 
The Court rejected the next contention of Abraxas that its mailing of the AFE letter could never violate the JOA. While Abraxas was correct that an AFE was an estimate or budget of proposed expenses, the budgetary function of the letter was not its sole or even primary function. When Abraxas mailed the AFE letter, that action triggered the consent/non-consent provisions of the JOA and put the working interest owners to an election of participating in the proposal or suffering a substantial penalty in the event that the proposed work resulted in a producing well. The Court ruled that if an AFE was unjustified under the facts, then it could constitute a breach of the JOA to send the AFE letter to the Working Interest Owners and put them to the consent/non-consent election.
 
The Court next considered the contentions of Abraxas that the evidence was legally and factually insufficient to support the jury’s findings that it had breached the JOA by sending the AFE letter. The Court found that the expert testimony at the trial constituted sufficient evidence to support the finding that sending the AFE letter breached the JOA. Abraxas asserted that the work proposed in the AFE letter constituted “reworking” within the meaning of Article 6 of the JOA, therefore, the AFE letter was proper.
 
An expert for the Working Interest Owners testified at trial that the projects proposed by Abraxas in the AFE letter were not subject to Article 6 because none of them involved a reworking, deepening, or plugging back of the four wells on the Lease. Instead, the proposed work concerned routine, normal repairs to the wells which Abraxas had an obligation as operator to undertake without sending the AFE. In fact, evidence produced at trial showed that a few months before Abraxas sent the AFE letter to the Working Interest Owners, Abraxas had done identical work on the wells and had billed the working interest owners for the respective shares of their expenses through joint interest billings. Abraxas had billed this prior work as part of the ordinary operating expenses rather than treating it as a “rework” under the non-consent provisions. Based on the testimony of the expert for the Working Interest Owners, the Court concluded that the jury’s findings were not so contrary to the great weight and preponderance of the evidence as to be manifestly unjust.
 
Abraxas also contended on appeal that the evidence was legally and factually insufficient to show that its sending of the AFE letter caused damages to the Working Interest Owners. However, the Court noted that sending the AFE letter triggered the contractual obligation of the Working Interest Owners to elect whether to participate in the cost of the proposed operations or suffer the 300% penalty specified in the JOA. When the Working Interest Owners did not respond to the AFE letter, Abraxas seized the interest of the Working Interest Owners in the Lease and began appropriating their earnings. Abraxas continued to withhold the earnings even though it did not complete the operations specified in the AFE letter. Abraxas retained the interest of the Working Interest Owners until the Lease had no more value. Consequently, the Court ruled that the evidence was both legally and factually sufficient to establish that sending the AFE letter caused damages to the Working Interest Owners.
 
Abraxas next asserted that the jury’s failure to make a finding of gross negligence or willful misconduct in connection with its sending of the AFE letter precluded a finding of liability for breach of contract. Abraxas relied on Article 5A of the JOA which contained the following exculpatory clause:
 

“[Operator]. . .shall conduct and direct and have full control of all operations on the contract area as permitted and required by and within the limits of this agreement. It shall conduct all such operations in a good and workmanlike manner, but it shall have no liability as operator to the other parties for losses sustained or liabilities incurred except such as may result from gross negligence or willful misconduct.”

 
The Court noted that exculpatory clauses in a contract are utilized generally to exempt one party from future liability for negligence; however, the Court found no cases discussing exculpatory clauses exempting a party from liability for breach of contract. As some evidence that Abraxas and the Working Interest Owners did not intend that the exculpatory clause apply to any and all claims, the Court noted that the exculpatory clause was found in an article concerning the operator’s authority to conduct operations in the contract area. The Court also noted that the operator’s limitation on liability imposed on the operator a duty to act as a reasonably prudent operator concerning the manner in which the operator conducted drilling operations on the Lease. Therefore, the Court concluded that the exculpatory clause was limited to claims based upon an allegation that Abraxas had failed to act as a reasonably prudent operator and did not apply to a claim that it breached the JOA. Because the exculpatory clause did not apply to a breach of contract, and the Working Interest Owners were not entitled to exemplary damages for the breach of contract, the Working Interest Owners were not obligated to prove gross negligence or willful misconduct.
 
Abraxas also contended that the trial court instructed the jury on the wrong measure of damages because the proper measure was lost profits rather than a decrease in the value of the working interest owner’s interest. Expert testimony offered by the Working Interest Owners explained that a working interest in an oil and gas lease is a stream of anticipated income burdened by a stream of expenses. The projected future income stream could be anticipated and estimated with some certainty because an oil and gas reservoir becomes depleted over time in a predictable manner known as a decline curve. When that income stream expires, the working interest expires with it. Because the breach of contract resulted in a decrease in the income stream of the Working Interest Owners, the Court ruled that it was appropriate to inquire into the value of the income stream before and after the breach of contract in order to determine the actual damages.
 
The Court overruled other challenges of Abraxas regarding the trial court’s rulings on its counterclaim for suit on a sworn account and its attorneys fees.
 
The model form operating agreements published by the American Association of Petroleum Landmen are the forms most commonly used by the industry. These forms have express provisions regarding AFE letters and exculpation clauses. This case is significant for operators because they should review for what expenses they should submit AFE letters, and it is significant for non- operators because they should understand that they may waive requirements of the JOA pertaining to selection of a successor operator by permitting another party to act as an operator despite a failure to qualify when they accept the benefits of the party’s performance. This case is significant for both operators and non-operators in determining what actions are exempted by exculpatory clauses. An exculpatory clause that is limited to claims based upon an allegation that a party failed to act as a reasonably prudent operator does not apply to a claim that the party breached the JOA.