Face Challenges Confidently

468 EnerQuest Oil & Gas, LLC v. Plains Exploration & Prod. Co.

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.
EnerQuest Oil & Gas, LLC v. Plains Exploration & Prod. Co., 981 F.Supp.2d 575 (W.D. Tex. 2013) held that surface facilities are not necessary for a well to be capable of producing in the context of a shut-in royalty clause.  In 2008, EnerQuest Oil & Gas, LLC and Chieftain Energy, LLC (collectively “EnerQuest”) obtained two oil and gas leases in Karnes County, Texas.  The leases were “paid up,” but on a form with a deleted delay rental clause.  The leases contained a shut-in royalty clause requiring payment of shut-in royalties within ninety days after a well was shut in or after the end of a rental period.  EnerQuest did not drill new wells or obtain production from existing, old, non-producing wells on the leases, but on June 2, 2010 (shortly before the expiration of the primary term), EnerQuest ran a production test on one of the old wells.  On September 10, 2010, the mineral owners informed EnerQuest that the leases had terminated for failure to produce.  On September 14, 2010, EnerQuest tendered shut-in royalty payments and contended that the old well was capable of producing in paying quantities.  In November of 2010, the mineral owners executed new leases, which EOG Resources, Inc. (“EOG”) and Plains Exploration and Production Company (collectively “Defendants”) acquired.  In April of 2011, EnerQuest paid $84,000 to connect the well to a pipeline and began producing gas.  In 2012, EnerQuest brought suit for trespass to try title and related actions, seeking a declaration of the leases’ validity; Defendants and mineral owners counterclaimed for lease termination, trespass, and conversion.  EnerQuest later amended its complaint to add claims against EOG for seismic trespass.  The parties brought cross-motions for summary judgment, and the trial court ruled that the lease terminated as a matter of law.
A shut-in clause allows lessees to avoid lease termination only if (1) the well was capable of producing in paying quantities when the shut-in royalties were tendered and (2) the shut-in royalties were tendered timely.  The court first examined the issue of capability of production under the established two-prong test:  (1) the well must be capable of producing, meaning that “if the well is turned ‘on,’ . . . it begins flowing, without additional equipment or repair, and (2) the well must be capable of producing in paying quantities, meaning facilities must be located near enough so that production could be marketed at a profit, even small, over operating expenses.
The parties disputed whether the first prong was met because the well at issue lacked surface facilities necessary for actual marketable production, such as a separator, meter run, and flowline.  Relying upon Blackmon v. XTO Energy, EnerQuest argued that surface facilities were not necessary because the test centers on whether the well itself, if turned on, would begin flowing raw gas in a marketable quantity, as opposed to marketable quality.  Defendants argued that the lack of surface equipment was relevant because the capability test requires the well to be “capable of capturing gas and reducing it to a marketable state.”
Siding with EnerQuest, following Blackmon, and confirming that “the relevant inquiry is whether the well is equipped to permit gas to flow from the wellhead,” the court held that “lack of surface facilities, or the fact that surface facilities may need repair, does by itself not render a well incapable of production.”  The court reasoned that the seminal Texas cases on the issue, Anadarko Petroleum Corp. v. Thompson and Hydrocarbon Management, Inc. v. Tracker Exploration, Inc., were focused on whether oil or gas would “flow” and did not discuss capturing marketable quantities.
Further, because Anadarko held the existence of a pipeline was not required for a finding of capability of production, and because a well cannot actually produce gas without a pipeline, the court found no difference between lack of a pipeline and lack of surface facilities.  The court doubted that the Texas Supreme Court in Anadarko intended that “if there were a failure at any of the many points in this complex chain, anywhere before the gas entered the pipeline, a well would be in need of ‘repair’ and would be declared incapable of production.”  The court also held that the “realities of gas production” supported its conclusion as it may be undesirable to leave certain surface equipment idle in the field or installed prior to securing a pipeline hookup.
Turning to production in paying quantities, the court restated the Texas rule that “to terminate a lease, a lessor must demonstrate both that the well has not produced in sufficient quantities to yield a profit over a reasonable period of time and ‘that a reasonably prudent operator would not have continued under the circumstances in the attempts devoted to obtaining such production.’”  The court held the relevant time period was the end of the primary term, and that EnerQuest must have “a reasonable expectation of profitable returns from the Well at that time, based solely on the information available to it at the end of the Leases’ primary terms” in order for the shut-in royalties to be effective.  The court found material fact issues concerning what a reasonable time period would be to determine profitability and what a reasonably prudent operator would have done, therefore, the court denied both sides’ summary judgment motions as to production in paying quantities.  The lengthy discussion of facts suggests some interesting issues as to the treatment of hookup costs and the recovery of other marketing costs in the context of a profitability analysis at the moment a well is shut in.  It also suggests that there will never be a summary judgment on production in paying quantities.
Nevertheless, in this case, the court did hold that the leases had terminated because, even if the well was capable of production in paying quantities, the shut-in royalties were not timely tendered.  The shut-in clause provided for payment within 90 days after the well was shut in or “following the end of the rental period.”  The parties agreed that tender took place after the primary term and 103 days after the well was shut in.  EnerQuest argued that it had an additional ninety days after the expiration of the primary term (end of a rental period) under the shut-in clause because the leases were held by payment of delay rentals.  EnerQuest claimed it prepaid all delay rentals when the leases were executed.  The court found no evidence that the leases provided for the payment of delay rentals, as the delay rental clause was struck and the leases contained no recital that EnerQuest paid delay rentals in advance.  EnerQuest argued that the notation of “Paid Up” at the top of each page of the leases indicated that the delay rentals were paid in advance.  The court held “(1) [T]he term ‘paid up’ simply means that the lessee has no drilling obligations during the primary term and (2) that a paid-up lease without a drilling/delay rental clause is maintained during its primary term by a bonus payment, not by ‘prepaid rentals.’”
The court compared a delay rental, which is a payment constituting an alternative to drilling, with a bonus, which is cash consideration for executing the lease.  Without a drilling clause, there is no alternative to drilling, meaning there may be no delay rental payment, and “increasing a bonus payment by ‘an amount equal to delay rentals’ does not transform that bonus into a delay rental.”  The court rejected EnerQuest’s cited treatises that claimed the advance payment in a paid-up lease was for delay rentals, citing its own treatises stating the payments were for bonuses.  The court also found that the references throughout the leases to “rentals” were the result of a drafting oversight, the leases being based on a form with a drilling clause, and when the clause was struck, the drafters failed to also remove these references, which were meaningless without the clause.  Because the well was shut in, but shut-in royalties were not timely paid, there was no actual or constructive production, and the leases therefore terminated on the expiration of their primary terms.
The court also granted EOG’s summary judgment motion barring EnerQuest’s seismic trespass claims under the statute of limitations.  Noting “Texas courts’ aversion to applying the discovery rule to trespass claims involving oil and gas operations,” the court held the general discovery rule did not apply to delay the accrual of claims involving seismic trespass.  That EOG’s seismic operations in this case may have been less evident than usual was “beside the point” because discovery of the particular injury is irrelevant; the relevant inquiry is discoverability of the type of injury.  EnerQuest argued that seismic operations did not involve continuing surface activities and did not cause visible physical injuries.  The court rejected this argument, finding that seismic operations, as a class, are not “inherently undiscoverable” as they “involve significant surface activities that are sufficient to alert a reasonably diligent lease holder of the possibility of a seismic trespass.”
This case is significant for a number of reasons.  First, it thoroughly examines capability of production in paying quantities in the context of shut-in clauses, finding that surface equipment is not necessary for a well to be capable of production.  Second, it holds that the initial payment made by lessees on “paid up” leases lacking a drilling/delay rental clause will generally be construed as bonus only; because the lease will be held through the primary term regardless of a failure to drill.  Third, it finds that claims for seismic trespass are not inherently undiscoverable, and therefore seismic trespass plaintiffs may not rely on the discovery rule to delay the accrual of the cause of action.