Face Challenges Confidently

114 HECI Exploration Co. v. Neel

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.
HECI Exploration Co. v. Neel, 982 S.W.2d 881 (Tex. 1998), is probably the most significant oil and gas case for oil and gas royalty owners in the past decade. It is a very important case on the discovery rule, particularly in oil and gas cases, and it is a very important case on implied covenants.
This was a suit by royalty owners, “Neel,” against their lessee, “HECI.” Neel sued HECI in 1993, because HECI did not earlier notify Neel that HECI had sued and obtained a judgment against the operator of an adjoining lease, AOP Operating Corporation (“AOP”). There was a common reservoir under the HECI and AOP leases. AOP’s operations damaged the reservoir. The injury was not the result of drainage, but reservoir damage. Production at excessive rates caused oil to migrate into the gas cap which diminished the recoverable reserves. HECI sued AOP in 1988, and obtained a judgment for actual damages in the amount of $1,719,956 and $2,000,000 in punitive damages. In 1989, the case was settled and a release of judgment was filed in September 1989.
Neel did not learn of the suit until May 1993 and did not sue HECI until December 1993, more than four years after the damage to the reservoir occurred. The causes of action alleged included breach of contract, negligent misrepresentation, breach of the implied covenant to protect against drainage, and unjust enrichment for retaining compensation from AOP that was attributable to Neel’s interest. HECI relied on limitations, and Neel contended the discovery rule should apply. For the discovery rule to apply (tolling the statute of limitations), the injury complained of had to be inherently undiscoverable and objectively verifiable.
The Supreme Court held that any cause of action to notify Neel that Neel had a claim would arise at the same time the cause of action against AOP arose. Because AOP’s illegal overproduction had ceased by December 1988, that was the latest possible date a cause of action could arise against HECI for failure to notify. Therefore, all of the causes of action alleged were barred by limitations, unless the discovery rule applied.
The court ruled that the applicability of the discovery rule is categorical, not case specific. That is, the rule may not be available in a particular type of case, regardless of whether on the specific facts of that case the injury was inherently undiscoverable and objectively verifiable. The court concluded that “damage to the reservoir from illegal production is not the type of injury that is inherently undiscoverable.”  Thus, the discovery rule was not applicable to the Neel case.
The court noted that there were several potential sources of information available to Neel, including neighbors, other operators, Neel’s lessee HECI, and the Railroad Commission. The court would not adopt HECI’s position that the Railroad Commission records were constructive notice, but concluded that the Commission’s records were a ready source of information that contributed to the fact that injury to a common reservoir by an adjoining operator was not inherently undiscoverable. The court ruled that “[a]ny failure of a lessee to monitor activities of operators in a common reservoir or to notify royalty owners of a cause of action against those operators is not an inherently undiscoverable breach.” The court stated that the same reasoning would apply to drainage claims.
The court ruled that the Neels, as royalty owners, had some obligation to exercise reasonable diligence to protect their oil and gas interests in determining whether adjoining operators had inflicted damage. The court stated:

Royalty owners cannot be oblivious to the existence of other operators in the area or the existence of a common reservoir. In some cases, wells visible on neighboring properties may put royalty owners on inquiry. In any event, a royalty owner should determine whether a common reservoir underlies its lease because it knows or should know that, when there are other wells drilled in a common reservoir, there is the potential for drainage or damage to the reservoir.

Even if the royalty owner lives thousands of miles from his royalty interest, the royalty owner now has an affirmative obligation to determine whether a common reservoir underlies his property and whether wells on adjacent properties have been drilled.
The court of appeals had found that there was an implied covenant in the lease to notify the lessor of the need for suit. Because the Supreme Court found that, if such an implied covenant existed, the cause of action for breach was barred by limitations, the court refused to consider whether there was such an implied covenant.
The court of appeals also found that there was an implied covenant in the lease to notify the lessor of lessee’s intent to sue. The Supreme Court ruled there was no such implied covenant. To reach this conclusion, the Supreme Court gave a lengthy explanation of the types of covenants implied in oil and gas leases and the reasons why covenants were implied. An implied covenant had to arise from the presumed intention of the parties as gathered from the instrument, and implied covenants were justified only on the ground of necessity.
Broadly categorized, we have recognized implied covenants to (1) develop, which means to drill an initial well and to reasonably develop the lease, (2) protect the leasehold,  which  includes  protection  from  local  and  field-wide  drainage,  and (3) manage and administer the lease.
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The extent of each lessee’s implied duties is governed by the concept of what a reasonably prudent operator would do “to carry out the purposes of the oil and gas lease.”
Having considered the fundamental nature of implied covenants in general, the court held that Neel and HECI were owners of concurrent interests in land, each had their own interest, each had their own cause of action, and each had to protect its own rights.
The court of appeals had struggled with Neel’s unjust enrichment claim, because the record was unclear as to whether HECI had recovered a judgment for all the reserves, or just HECI’s interest in the reserves. The Supreme Court concluded that it did not matter. A cause of action for unjust enrichment by Neel against HECI had to be based upon an unjust enrichment at Neel’s expense. The fact that HECI may have recovered more than it was entitled to recover did not give rise to a cause of action for unjust enrichment in favor of Neel.
The application of the discovery rule in this case and other cases has been strictly limited. The significance of this case is that it holds the discovery rule to be inapplicable in a case concerning damage to a reservoir from illegal production and in a case for breach of the implied covenant to protect against drainage. The Supreme Court intends to determine the applicability of the discovery rule as a categorical rather than case-by-case basis. Therefore, this case bars the use of the discovery rule in reservoir damage and drainage cases.