Face Challenges Confidently

177 Wagner & Brown, Ltd. v. Sheppard

Wednesday, September 2nd, 2015

Richard F. Brown

The following is not a legal opinion. You should consult your attorney if the case may be of significance to you.
Wagner & Brown, Ltd. v. Sheppard, 282 S.W.3d 419 (Tex. 2008) (Termination of producing wellsite lease in a pooled unit), holds that (1) lands pooled under a lease pooling clause (which pools “lands”) continue to be pooled after lease termination, (2) the former royalty owner thereafter received only the tract allocation (diluted) share of production attributable to the former royalty owner’s mineral interest, and (3) costs incurred by the former lessee prior to lease termination may be recoverable on equitable grounds. Sheppard owned 1/8 of the minerals in a 62.72-acre tract included in a 122.15945-acre unit. One well was drilled on Sheppard’s lease prior to lease termination, and one well was drilled on Sheppard’s lease after lease termination. The lease termination was not discovered until Wagner & Brown assumed the duties of operator. Wagner & Brown offered Sheppard a new lease, but Sheppard declined. Sheppard insisted on payment based on the unpooled (or undiluted) interest, and Sheppard contended that Sheppard was not obligated to bear any of the drilling costs incurred on the first well prior to lease termination. The fact of lease termination and accounting on a well-by-well basis were uncontested.
The lease pooling clause provided that “Lessee shall have the right . . . to pool . . . the leased premises or interest therein with any other lands or interests . . . .” “The Designation of Unit signed by the lessees of the various ‘leases and lands’ included in the pool provided that they ‘hereby pool and combine said leases and lands . . . into a single pooled unit or unitized area for the development of said production. . . .” Wagner & Brown generally argued that the termination of a lease should never terminate a pool. Sheppard generally argued that no pooling can extend longer than the lease itself. The court declined to rule on broad principles, but rather confined its opinion to the particular provisions of this contract and specifically the lease pooling clause. The court was able to dodge the broader question because this particular lease happened to have in it a provision which read: “Pooling hereunder shall not constitute a cross-conveyance of interests.” A sentence like this is not commonly found in oil and gas leases, and there is a broad concept that pooling results in a cross-conveyance of interests between the owners of the pooled unit.  The resolution of those issues will have to wait for another case.
The court concluded that under this particular lease the lessee pooled the “lands.” Termination of the lease did not somehow terminate the “lands,” and therefore the “lands” were still pooled. Ownership of the “lands” reverted to Sheppard, but the “lands” were still pooled. Sheppard was therefore entitled to only the diluted or tract allocation share, which was 1/8 of 62.72/122.15954 of the proceeds of production. The opinion is in obvious tension with settled case law that an oil and gas lease creates a fee simple determinable, with the lessor retaining the possibility of reverter. That is, the provisions expressed in the lease pooling clause granting to lessee the right to pool the “leased premises” arguably do not include the reversionary estate under the possibility of reverter, which was never granted to the lessee. However, again focusing on the specific lease language, the court said that what was pooled was Sheppard’s land – not just the leasehold interest.  “If the parties want pooling to expire (or not) upon termination of one lease, they should be free to say so.”
Note that this lease pooling clause granted the right to pool the “leased premises” with “other lands.” Lessor did not grant the right to pool lessor’s “lands.” Without saying so, the Texas Supreme Court read “leased premises” as meaning “lands,” i.e., a tract, not whatever interest in that tract is leased or continues to be leased. In fact, in summarizing its holding, the court said that “[t]he lease here allowed the Sheppard tract (rather than just the lease) to be pooled . . . .” The court cited with approval the similar case of Ladd Petroleum Corp. v. Eagle Oil & Gas Co. The leases in the Ladd opinion also apparently authorized lessee to pool “leased premises” with “other lands.” The Texas Supreme Court in Wagner & Brown, Ltd. expressly recites that “Sheppard’s reverter was certainly an interest in the leased premises.” In a stretch of logic, the Texas Supreme Court also reasons that the effect of a proper pooling on the possibility of reverter has some relevance to the question of whether the pooling was proper.
Similarly, the opinion seems to assume that the Designation of Unit, executed by the lessee and not the lessor, can somehow be read as including “lands” in the rights lessor authorized to be pooled. The reasoning is circular, because it assumes the answer to the question:  lessee pooled “lands,” therefore lessee could pool “lands.”
The case sets up monumental uncertainties as to the many issues which will now arise under leases with depth severances and Pugh Clauses. Because these issues exist across thousands of existing properties, a blizzard of litigation may follow. This is particularly true because no firm principles are announced, and every case will turn on specific lease language.
Although the first well was drilled while the lease was in force and effect, and lessee was clearly obligated to bear all costs and expense of drilling, the court held that the lessee may be entitled to recover on equitable grounds the costs of improvements to the extent they enhanced the value of the estate. This conclusion appears to be broadly based on intent to do equity for the lessee which lost its lease by mistake. However, the lease specifically provided that it terminated if royalties were not paid within 120 days after first gas sales. That was an express term of the agreement, and it is unclear why the court would read into that clause the possibility that lessee’s failure to perform would somehow transfer to the lessor the obligation to pay drilling costs incurred prior to the date of termination.
The opinion is significant first for all the controversy that will surely follow. This is a complex opinion on some very basic oil and gas concepts. Generations of oil and gas lawyers will parse its language to find support or distinctions relevant in future litigation. The significant points are (1) that upon termination of a pooled lease, the specific pooling clause in the terminated lease will determine the effect of the termination on the unit, and (2) a lessee may, under certain circumstances, as a matter of equity, recover drilling and production costs incurred while a lease was in force and effect. The broadening of the right to recover costs on equitable grounds is likely to be urged as grounds to extend such recoveries into other circumstances common in the industry. For example, what should happen if the lessee fails to make the first shut-in royalty payment on a $5,000,000.00 horizontal well?  Those questions could be intense, but it will be far more contentious and uncertain as to how to account for pooled and unpooled interests upon lease terminations.