What Surface Interest Owners Should Know Before Acquiring Oil and Gas Interests-part Ii

• Jurisdiction: Colorado,United States
• Citation: Vol. 23 No. 1 Pg. 73
• Pages: 73
• Publication year: 1994

23 Colo.Law. 73 Colorado Lawyer 1994.

1994, January, Pg. 73. What Surface Interest Owners Should Know Before Acquiring Oil and Gas Interests-Part II

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Vol. 23, No. 1, Pg. 73

What Surface Interest Owners Should Know Before Acquiring Oil and Gas Interests---Part II

by John D. Seidel

Part I of this article, published in the November 1993 issue of The Colorado Lawyer, analyzed a typical oil and gas lease with an eye to advising surface owners whose surface use on oil- or gas-producing properties is disrupted by oil or gas production. This Part II focuses on the covenants implied in oil and gas leases.

Implied Covenants in Oil and Gas Leases

Colorado, like other jurisdictions, has taken the position that

[t]he fundamental purpose of an oil and gas lease is to provide for the exploration, development, production, and operation of the property for the mutual benefit of the lessor and lessee. . . . [W]here the purpose of the lease is thus disclosed, but the lease does not itself contain express provisions creating duties in the lessee to do such acts as are necessary for the accomplishment of that purpose, the law implies them.(fn1)

Davis v. Cramer describes four distinct covenants: (1) to develop a given lease; (2) to produce (and market the product from) a given lease; (3) to protect the lease against drainage from wells drilled on surrounding land; and (4) to explore the lease for possible further production.(fn2) In each case, whether a lessee has met the implied obligation depends on whether the lessee operated in the same manner that a reasonably prudent operator would under similar circumstances.(fn3)

Duty to Protect Against Drainage

Drainage occurs when wells surrounding the lessor's lease pull oil or gas from a reservoir underneath the lessor's lease. A cause of action for protection against drainage requires the lessor to prove that (1) substantial drainage has taken place, and (2) an offset well---a well drilled on the lessor's lease close to the well or wells draining the oil or gas from beneath the lessor's land---would produce oil or gas in paying quantities.(fn4)

In drainage cases, "paying quantities" means a quantity of oil or gas"... equal to the cost of administrative expenses, drilling or reworking and equipping a protection well, producing and marketing the oil, and [which] yields the lessee a reasonable expectation of profit."(fn5) [Emphasis supplied.]

It is not easy to be a reasonably prudent operator in drainage cases. For example, in Amoco Production Co. v. Alexander,(fn6) the lessor alleged that the lessee developed wells on nearby leases which produced greater quantities of oil faster than the lessor's wells. The lessee countered that government well-spacing rules prohibited it from drilling more wells on the lessor's property, but those same rules allowed Amoco to get permission to drill more wells when "necessary to prevent. . . confiscation of property."(fn7) The court held that if drilling such wells would be profitable, Amoco had a duty to seek administrative relief.(fn8)

The cases are split on whether cancellation, an equitable remedy or damages is the appropriate remedy for a lessee's failure to prevent substantial drainage. In Sinclair Oil & Gas Co. v. Bishop, the appeals court reversed the trial court's cancellation of the lease, holding that

although the rights of the parties are strictly legal and the ultimate remedy of a kind that can be granted by a court of law[,]. . . [w]here equity has assumed jurisdiction of the subject matter it may do complete justice between the parties by retaining the cause and ordering recovery of compensatory damages....(fn9)

Duty to Reasonably Develop

Colorado recognized the covenant to reasonably develop in Clovis v. Pacific Northwest Pipeline Corp.(fn10) There, the lessee drilled a producing well on that portion of the lessor's tract which was within a unit.(fn11) The court held that simply drilling a well inside the unitized portion

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of the lessor's tract was not sufficient by itself to satisfy the duty to develop. Instead, the lessee must develop all of the lease, as would any ordinary prudent operator

To state a cause of action for failure to reasonably develop, the lessor must allege that the lessee failed to drill a well that would have produced oil or gas in paying quantities.(fn12) Most jurisdictions hold that "paying quantities" in these cases means sufficient oil or gas to recover well operating, drilling and administrative expenses.(fn13) However, Colorado law has not explicitly defined the term "paying quantities" in this context. The leading case states only that the covenant of reasonable development requires that additional development be "profitable."(fn14)

Under Colorado decisions, the factors bearing on whether a lessee developed the premises as a reasonably prudent operator (under similar circumstances) are: (1) the period of time since the last well was drilled, (2) the size of the tract, (3) the number and location of existing wells, (4) favorable geological inferences, (5) the attitude of the lessee toward further testing, (6) the feasibility of further drilling and (7) the willingness of someone else to drill.(fn15)

In Graefe & Graefe v. Beaver Mesa Exploration,(fn16) six years of production from a single well on 2,880 acres justified cancellation of the entire lease. Similarly, in Mountain States Oil Corp. v. Sandoval,(fn17) the lessees drilled four wells on a 6,000-acre lease. The lessor sought cancellation for failure to reasonably develop. The Colorado Supreme Court held that given (1) the size of the lease, (2) the length of time the lessee failed to drill and (3) the presence of a ready market for lease production,(fn18) the trial court had properly canceled the lease.(fn19) As the Supreme Court stated:

[I]nstruments of this character are construed most favorably to development, ... time is the essence of the contract, and the real motive for the giving of such instruments is the development of the leased property. Therefore, such a lease or option is properly construed strongly against the lessee, so as to secure such speedy development.(fn20)

In Mountain States, the lessee claimed it could not conduct further development operations because it would ruin the company. Many lessees complain that because development is so expensive, a reasonably prudent operator cannot profit from new wells at this time. Therefore, the argument goes, the lessee has no duty to drill now, but can still hold the lease. In Colorado, the lessor has an answer:

[A]... lessee may not hold the land merely for speculation in the hope that non-viable mineral holdings will become economic at some unknown time in the future. . . . [I]f the exploration of the surrounding area shows very poor potential for profitable wells, then the lessee must surrender the lease rather than hold it on the mere speculative and remote hope that the economics might change in favor of profitable drilling.(fn21) [Emphasis supplied.]

The concept that the lessee must either find development economical and "just do it" or give up its lease is especially useful to surface owners who "[desire] to develop the land for purposes other than for production of oil and gas."(fn22) "The implied covenant to act as would a reasonably prudent operator is not limited just to production ...