Face Challenges Confidently

187 Coastal Oil & Gas Corp. v. Garza Energy Trust

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.
Coastal Oil & Gas Corp. v. Garza Energy Trust, 268 S.W.3d 1 (Tex. 2008), holds that damages for drainage by hydraulic fracturing are precluded by the rule of capture, when the only result of the operation is that the oil or gas migrates more easily to another tract. However, if the operation results in actual injury (damage to the reservoir or to an offsetting well), there may be liability, and the rule of capture will not shield misconduct without commercial justification. The case is also important for its holdings on the standing of mineral owners in trespass and drainage cases and the measure of damages in drainage cases.
Lessor owned the mineral interest in a 748 acre tract in  Hidalgo  County  called “Share 13.” Coastal was the Lessee in Share 12, Share 13, and Share 15, which were adjoining. Coastal eventually acquired the fee interest in Share 12, so that Coastal also owned the royalty interest in that tract. From 1978 to 1983, Coastal drilled three wells on Share 13, and two of them were productive; the M. Salinas No. 1 and M. Salinas No. 2V.  In 1994, Coastal drilled the Salinas No. 3 on Share 13, which was an exceptional producer.
The M. Salinas No. 3 was located approximately 1,700 feet from Share 12. The Pennzoil Fee No. 1 was the closest well on Share 12 to the M. Salinas No. 3. In 1996, Coastal drilled the Coastal Fee No. 1 on Share 12 as close to Share 13 and the M. Salinas No. 3 as the Texas Railroad Commission’s statewide spacing rules permitted. Coastal then shut-in the Pennzoil Fee No. 1, but later drilled the Coastal Fee No. 2 on Share 12 close to Share 13. Lessor believed that Coastal was allowing gas to be drained from Share 13, on which Coastal owed Lessor a royalty, to the wells on Share 12, where Coastal was entitled to the gas unburdened by any royalty obligations. Lessor sued Coastal for breach of its implied covenant to develop Share 13 and prevent drainage. Coastal promptly drilled eight wells on Share 13 within fourteen months. When Coastal formed a gas unit including parts of Share 12 and Share 13, Lessor added a claim for bad faith pooling to Lessor’s lawsuit for breach of the implied covenant to develop and protect.
The Vicksburg T formation was the productive formation under both Share 12 and Share 13. It is a “tight” sandstone formation from which natural gas cannot be commercially produced without hydraulic fracture stimulation (“fracing”). All the wells on Shares 12 and 13 were completed in the Vicksburg T formation and fraced. Lessor also added a claim for trespass to its lawsuit, which alleged that Coastal’s fracing of the Coastal Fee No. 1 on Share 12 invaded the reservoir beneath Share 13, resulting in substantial drainage of gas from Share 13. There was evidence that the frac job on the Coastal Fee No. 1, when compared to the other wells, was massive. The parties agreed that the hydraulic and propped lengths of the frac crossed the lease line, but they presented conflicting expert opinions on whether the effective length of the frac crossed the lease line.  Lessor won a jury verdict on all of its claims.
The supreme court had not previously decided whether subsurface fracing can give rise to an action for trespass, and its opinion in this case did not fully resolve the issue. For many years, Hydraulic fracture stimulation has been a very common practice. The trial court judgment against Coastal of approximately $15,000,000, combined with the fear in the industry that this very common industry practice would now be subject to a significant legal risk, generated intense interest and a blizzard of amicus briefs. For the past several years, this case has probably been the most visible oil and gas case working its way through the judicial system.
The general expectation was that the supreme court would have to decide whether subsurface fracing was or was not a trespass. However, the court determined it did not have to decide this broad issue. Actionable trespass requires an injury, but Lessor’s only claim of injury was that Coastal’s fracing operation made it possible for gas to flow from beneath Share 13 to the Share 12 wells. Under the rule of capture, there are no damages, because the gas Lessor claimed to have lost simply did not belong to Lessor. “That rule gives a mineral rights owner title to the oil and gas produced from a lawful well bottomed on the property, even if the oil and gas flowed to the well from beneath another owner’s tract.” Therefore, Lessor did not prove any recoverable damages (such as actual damage to Lessor’s wells or to the reservoir) caused by the frac operation.
This case does not completely remove the risk of trespass by subsurface frac, because the court carefully distinguishes potential liability attributable for actual damages to an offsetting well or to the reservoir. Furthermore, the rule of capture will not “shield misconduct that is illegal, malicious, reckless, or intended to harm another without commercial justification. . . .” Although not clearly foreclosed, the remaining risks of liability for subsurface trespass by frac appear to be based on conduct causing actual damages, not the nominal damages of a trespass, and those risks fall within conventional existing tort theories of liability, such as negligence.
In his concurring opinion, Justice Willett wrote that he would find that there was simply no trespass, rather than there are no damages. In his opinion, trespass is a court-defined doctrine, and the court should refine that definition to hold that a frac is not a trespass. He found the issue to be indistinguishable from the secondary recovery water flood which the court permitted in R.R. Comm’n of Tex. v. Manziel, except that the water flood was arguably more invasive and inflicted greater and more irreversible damage than fracture stimulation. The dissent would not consider whether the rule of capture precluded damages, until it was first determined whether hydraulically fracturing across lease lines is a trespass. The dissent found that the gas did not migrate naturally to Coastal, and that a frac was essentially indistinguishable from a slant hole trespass. In any event, until the trespass issue is decided, Coastal’s frac must be illegal, because the jury found it was a trespass. Therefore, given that the production was illegal, the rule of capture did not apply, because the rule only applies to gas which can be legally produced.
The supreme court characterized the Lessor’s claim that the rule of capture did not apply as an argument that the rule should be changed. The court found four reasons not to change the rule of capture to allow one property owner to sue another for oil and gas drained by hydraulic fracing that extends beyond lease lines. First, the law already affords an owner who claims drainage full recourse (self-help drilling, counter-fracture stimulation, offer to pool, force pool, Commission regulations).  Second, allowing recovery for the value of gas drained by hydraulic fracturing usurps to courts and juries the lawful and preferable authority of the Railroad Commission to regulate oil and gas production. The Commission’s role should not be supplanted by the law of trespass. Third, determining the value of oil and gas drained by hydraulic fracturing is the kind of issue the litigation process is least equipped to handle. When litigating recovery for drainage resulting from fracing, trial judges and juries cannot take into account social policies, industry operations, and the greater good, which are all important factors in deciding whether fracing should or should not be against the law. Also, material facts are hidden below miles of rock, thus making it difficult to ascertain what might have happened. Fourth, the law of capture should not be changed to apply differently to hydraulic fracturing, because no one in the industry appears to want and/or need the change.
The court did support the Lessor’s claim of standing. Coastal sought to defeat the Lessor on jurisdictional grounds, because trespass is ultimately an injury to the right of possession, and a royalty owner like Lessor has no right of possession. The court held that this definition of trespass was over-simplified. Assuming Lessor can show more than a mere trespass – meaning actual, permanent harm to the property to affect the value of the royalty or the reversion – then the Lessor has standing.
The supreme court also reviewed the proper measure of damages on Lessor’s claims for breach of the implied covenant to protect against drainage. Coastal had an implied obligation to act as a reasonably prudent operator to protect Share 13 from drainage. The jury found that Coastal failed to meet this obligation, but was instructed to find as damages “the value of the royalty on the gas drained from Share 13 by the subsurface trespass” by the Coastal No. 1 fracing operation. In prior cases, the court had held that the correct measure of damages was the “offset royalty formula,” i.e. the amount of royalties the drained lessor would have received from the offset well. However, the lessor would be overcompensated if production from the offset well exceeded the drainage. There is also a line of cases holding that the correct measure of damages is a royalty on the “amount drained away.” However, this measure would also overcompensate the lessor if not all of the drainage could have been prevented. “The correct measure of damages for breach of the implied covenant of protection is the amount that will fully compensate, but not overcompensate, the lessor for the breach – that is the value of the royalty lost to the lessor because of the lessee’s failure to act as a reasonably prudent operator.” The court also cited with approval the statement that “The measure of damages for breach of the drainage covenant was the royalty interest on the production lost by the producer’s failure to prevent drainage.” Absent any evidence in this case of the proper measure of damages, Lessor could not recover against Coastal on Lessor’s claim for breach of the protection covenant.
The significance of the case is that now there are only a few unusual circumstances which might support liability for subsurface trespass by hydraulic fracture stimulation. The rule of capture generally trumps trespass. Operators can continue to do business as usual. If the frac operation damages the neighbor’s well, or the reservoir, then the operation will result in liability. A royalty owner has standing to sue for this kind of claim. The measure of damages in a drainage case has now been clarified as “the amount that will fully compensate, but not overcompensate, the lessor for the breach – that is, the value of the royalty lost to the lessor because of the lessee’s failure to act as a reasonably prudent operator.”