CHAPTER 10 THE NEXT NEW THING: THE DUTY TO DEVELOP AND COMPELLED CAPITAL EXPENDITURE IN A TIME OF FISCAL RETRENCHMENT
| Jurisdiction | United States |
(Dec 2008)
THE NEXT NEW THING: THE DUTY TO DEVELOP AND COMPELLED CAPITAL EXPENDITURE IN A TIME OF FISCAL RETRENCHMENT
Hosie Rice LLP
San Francisco, California
Spencer Hosie, an attorney for Hosie Rice LLP in San Francisco, is a nationally recognized top-ranked trial lawyer for complex commercial cases. In his 20+ year career, he has won or settled cases worth almost $2 billion for his clients. In June 2005, the National Law Journal profiled Mr. Hosie as one of the 10 most successful trial lawyers in the country. Mr. Hosie's practice covers the spectrum of complex commercial cases, with particular focus on intellectual property and energy litigation. He currently is an advisor to the Alaska, Louisiana, and Hawaii state governments. Mr. Hosie began his legal career with the San Francisco law firm of Heller, Ehrman, White & McAuliffe, with an antitrust and securities defense practice. He started his own firm in 1985, ultimately named Hosie, Wes, Sacks & Brelsford, which specialized in intellectual property, energy, and complex litigation. In 1993, he was named one of the "Top 25 Attorneys in the State of California Under 45 Years of Age" by California Lawyer.
I. INTRODUCTION.
Several successive waves of litigation have rolled through the oil and gas sector in the past fifteen years. First came oil royalty underpayment cases, filed en masse in the early to mid-1990's. For the most part, these cases turned on allegations that the producers set field prices (posted prices) artificially low and used interaffiliate transfers and other means to undervalue oil. All-in, these cases resulted in billions of dollars in trial verdicts and settlements, including a very significant (plus $500 million) settlement with the Department of Justice on behalf of the federal government. See, e.g., United States of America, ex rel., J. Benjamin Johnson, Jr., et al. v. Exxon Company USA, et al., No. 9:96CV66; In re Lease Oil Antitrust Litigation (No. II), 186 F.R.D. 403 (1999); Chevron U.S.A. v. State of Louisiana, 857 So. 2d 505 (2003); Exxon Corporation v. Harold C. Heinze, 32 F.3d 1399 (9th Cir. 1994).
The many oil royalty cases were followed by natural gas and natural gas processing matters. Several of these gas and gas processing cases are still being litigated, but many have been resolved and the remainder should resolve shortly. See, e.g., In re Natural Gas Royalties Qui Tam Litigation, MDL 1293; Shockey v. Chevron, No. 98,063 (Okla. Ct. App. 4/4/03).
So, what's next? From the perspective of this practioneer, given the current economic climate, the next big wave of energy litigation will likely turn on the producers' perceived failure to develop and invest. These cases will go to a core conflict inherent in the uneasy relationship between landowner and oil company - the royalty owners' desire for immediate development as against the producers' incentive, at least in many instances, to warehouse the resource, hold cash, and wait for a better day.
A producer can have many reasons to wish to defer investment, all perfectly legitimate from the producer's unilateral viewpoint. Perhaps a project elsewhere promises a higher rate of return, or an opportunity elsewhere will be lost if not developed. Or perhaps the producer is long on the resource in question, or wants cash more than additional reserves, or instead prefers to prop up its stock price by buying back its shares.2 These are all perfectly rational justifications for a producer to defer development, but delaying development does nothing for the royalty owner who gets paid when the resource is produced and sold. This inherent tension can lead to disputes, and increasingly, litigation.
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In fact, these cases have already begun, with one significant case presently underway in Alaska, turning on lease termination for failure to develop the massive Point Thomson field. (Nine trillion feet of gas; 200 million plus barrels of oil). Other cases are sure to follow.
After a brief summary of the implied duties, including the duty to develop, this note uses the pending Alaska case as an exemplar of what one may expect in the coming duty to develop cases.
II. THE IMPLIED DUTY TO DEVELOP.
The basic rule is that a lessee has a duty to develop known reserves, if a reasonably prudent operator would do so. This question, in turn, depends upon whether there is an objectively reasonable expectation of profit from the development. One of the rationales for this rule is that because the lessee controls the exclusive operating rights, the lessor cannot itself legally develop the land and so this should heighten the lessee's duty to do so. See HOWARD WILLIAMS & CHARLES MEYERS, OIL AND GAS LAW § 831, at 217-19 (2001) (using this explanation for duty of further exploration). The expectation of profit need only be reasonably certain, not absolutely certain.
The duty to develop applies to each formation, not just to particular surface areas. If, for example, a lease has separate oil formations and gas formations, the lessee will have a duty to develop each if the elements of the duty otherwise are satisfied, as discussed within. The most common remedy for a failure to develop is damages. Courts generally have rejected lessee efforts to limit damages to the time-value of the delayed production, and instead have awarded the full value of the estimated production - the reserves that a prudent operator would have produced. Courts have also entered conditional decrees that the lease will be cancelled unless the lessee follows a prescribed drilling schedule. Immediate cancellation has been the least common remedy, as one would expect.
A. The General Duty.
The basic rule is that when reserves are reasonably known, an operator has a duty to develop the property by drilling such additional wells that a reasonably prudent operator would drill - even if the lease is silent on additional drilling, as it is in the great majority of duty-to-develop cases.3 This old rule is most often traced to a case that is also the leading case on the right to imply covenants generally, Brewster v. Lanyon Zinc Co., 140 F. 801 (8th Cir. 1905). In Brewster, the lease contained express terms requiring an initial well within two years (which could be expanded by five years by paying a delay rental) and certain pricing terms, including paying $50 for "every" well whose gas production was used off the premises. The lease had no express provision or requirement for drilling subsequent wells. Id. at 810. The lessee claimed
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that it had complied with the lease and could hold it "indefinitely" by drilling what it claimed was the one mandated well. Id. at 815.
The Eighth Circuit disagreed. Looking at the lease terms in the context of the overall relationship, it held that the "implication necessarily arising from these provisions - the intention which they obviously reflect" was that if any oil or gas was found in the original exploration period, "the work of exploration, development, and production should proceed with reasonable diligence for the common benefit of the parties, or the premises be surrendered to the lessor." Id. at 810.4 That this was "of the very essence of the contract" was shown by the "extensive character of the grant, which was without limit as to time and included all the oil and gas in or obtainable through the demised premises...." Id.
The court added that there could not have been an express stipulation on the development program because, by definition, the parties could not set the number or rate of development of wells when they entered the lease. The development program would depend "in large measure upon future conditions, which could not be anticipated with certainty," such as the extent of reserves, "the existence of a local market or demand therefore or the means of transporting them to a market," and drainage by adjoining properties. Id. (emphasis added).
The court treated the implied duty to develop as co-equal with express lease terms. "[A] covenant arising by necessary implication is as much a part of the contract - is as effectually one of its terms - as if had been plainly express." Id. at 812 (citations omitted). Given the lessee's attitude, which made the breach "a continuing one," and given the migratory nature of oil and gas, the breach entitled the Brewster lessor to lease forfeiture. Id. at 815-16.
A characteristic listing of the elements of the duty to develop, all of which the plaintiff has the burden of proving, is as follows:
(1) that the lessees failed to measure up to the standards of the prudent operator;
(2) that the producing strata or horizons, which the lessor contends should have been further explored or drilled, required additional wells;
(3) that the strata or horizons other than those from which production is being obtained (on which further exploration or drilling is sought) exists in reasonable probability; and
(4) that by the drilling of additional wells, there would be a reasonable expectation of profit, not only to the lessor, but also to the lessee.
Young v. Amoco Production Co., 610 F.Supp. 1479, 1486 (E.D. Texas 1985), aff'd, 786 F.2d 1161 (5th Cir. 1986).5
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This rule has remained the law in all major oil and gas jurisdictions ever since. See, e.g., Clifton v. Koontz, 325 S.W.2d 684 (Tex. 1959); Freeport v. American Sulphur Royalty Co., 6 S.W.2d 1039 (Tex. 1928); Texas Pacific Coal & Oil Co. v. Barker, 6 S.W.2d 1031 (Tex. 1928); see generally WILLIAMS & MEYERS, §§ 831-35.6. The duty is an objective one under the reasonable prudent operator test, so that it is not a defense that the lessee operator decided in subjective "good faith" not to drill more wells. See Texas Pacific Coal & Oil Co. v. Barker, 6 S.W.2d 1031, 1036 (Tex. 1928)(adopting objective test in what has become the general rule); see also Brewster...
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