CHAPTER 2 COMMON LAW ORIGINS OF THE DUTY TO PROTECT AGAINST DRAINAGE
| Jurisdiction | United States |
(Mar 1994)
COMMON LAW ORIGINS OF THE DUTY TO PROTECT AGAINST DRAINAGE
Texas Tech University School of Law
Lubbock, Texas
I — Introduction
The development of implied covenant jurisprudence and the development of oil and gas jurisprudence has gone hand in hand. Oil and gas production has been occurring in the United States since the 1850's. Major developments in oil and gas law developed some 30-40 years later and were reasonably mature by the mid-1920's. Implied covenant law followed that same chronological pattern. The earliest cases arose in the 1890's but after the landmark decision in Brewster v. Lanyon Zinc Co.,1 the basic parameters of implied covenant jurisprudence were laid out. This was especially true of the implied covenant to protect against drainage.2 The law relating to the implied marketing covenant is not as well developed, but generally follows the basic principles of implied covenant law.
Because the federal government, for itself as well as for Indian tribes, has adopted the basic "private" or "fee" lease form, the implied covenant doctrines would be just as applicable to the federal or Indian leases as to "fee" leases. The jurisprudence of implied covenants, however, has largely developed in the private sector and not with federal oil and gas leases. This paper will review the relevant statutes, regulations, administrative decisions and judicial opinions that relate to the application of implied covenant law to federal and Indian oil and gas leases.
II — Historical Background
A — The Underlying Rationales
1 — Lanyon Zinc
Although the dispute involved an express development covenant, the Pennsylvania Supreme Court in Stoddard v.
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Emery,3 in dictum concluded that even in the absence of an express clause:
[t]here would of course have arisen an implication that the property should be reasonably developed, and evidence of a custom of reasonable development by boring a given number of wells in a certain space of time would have been competent and perhaps controlling.4
Many of the early cases dealing with implied covenants combined the concepts of development and protection from drainage in dealing with the lessor's claim that not enough wells were being drilled. Thus in Harris v. Ohio Oil Co.,5 the Ohio Supreme Court the court described the lessor's claim as follows:
His only complaint is that the company has failed to drill the number of wells necessary to develop the lands, and so protect the lines as to prevent wells on adjoining lands from draining the oil from under his lands.6
After admitting that there was no express covenant or agreement as to the extent to which the lands should be developed, the Ohio Supreme Court clearly found that an implied covenant to develop and to "reasonably protect the lines" should be found. The basis for this implication was "principle and authority" along with the notion that the law implies other covenants in commercial transactions, such as a reasonable time to perform if none is expresses and performance of a contract in a "workmanlike manner."7
The courts' eagerness to find implied obligations between the parties to an oil and gas lease was not universally accepted. A dissenting judge in Kleppner v. Lemon,8 concluded that the majority's conclusion that the lessee was impliedly obligated to drill additional wells to develop and protect the lease from drainage was: "a flagrant violation of the liberty and sanctity of contracts, by raising a purely factitious equity to enable the complainant now to make a better bargain,..."9 This dissenting view, however, was silenced by Judge Van Devanter in Lanyon Zinc provided the theoretical support for the implication of covenants in an oil and gas lease.
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Lanyon Zinc is a classic example of a drainage case. The lessor executed a lease covering 3 separate tracts of land which totalled 312.5 acres in size. It provided that the lessee should "drill or pay rental" within two years. Rentals were duly paid. The lease contained a 5 year primary term with a 1/10 royalty reserved for oil production and a $ 50/well royalty for gas production. Two months prior to the end of the primary term the lessee drilled a producing well and paid the lessor $ 50.00. No further drilling activities were begun when the lessor filed suit seeking to terminate the lease. There were no express leasehold provisions relating to the number of wells that were to be drilled or to the prevention of drainage to adjoining tracts. Judge Van Devanter provided the following rationale for implying covenants in oil and gas leases:
It is conceded ... that the lease contains no express stipulation as to what, if anything, should be done in the way of searching for and producing oil or gas after the first five years; but it does not follow from this that it is silent on the subject, or that the matter is left absolutely to the will of the lessee. Whatever is implied in a contract is as effectual as what is expressed.... Oil and gas are usually found in porous rock at considerable depth under the surface of the earth. Unlike coal, iron, and other minerals, they do not have a fixed situs,... but are capable of flowing from place to place and of being drawn off by wells penetrating their natural reservoir at any point. They are part of the land, and belong to the owner so long as they are in it, or are subject to his control; but when they flow elsewhere, or are brought within the control of another,... the title of the former owner is gone....
The implication necessarily arising from these provisions—the intention they obviously reflect—is that if, at the end of the five-year period prescribed for original exploration and development, oil and gas, one or both, had been found to exist in the demised premises in paying quantities, the work of exploration, development, and production should proceed with reasonable diligence for the common benefit of the parties, or the premises surrendered by the lessor. That this was the very essence of the contract is shown by the extensive character of the grant....
Considering the migratory nature of oil and gas, and the danger of their being drawn off through wells on other lands if the field should become fully developed, all of which must have been in the minds of the parties, it is manifest that the terms of the lease contemplated action and diligence on the part of the lessee. There could not well have been an express stipulation as to the number of wells to be drilled,
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as to when the wells, other than the first, should be drilled, or as to the rate at which the production therefrom should proceed, because these matters would depend in large measure upon future conditions, which could not be anticipated with certainty .... [such as] the presence of wells on adjacent lands capable of diminishing or exhausting the supply in the natural reservoir. The subject was, therefore, rationally left to the implication, necessarily arising in the absence of express stipulation...10
The above excerpt reflects the position held by A.W. Walker, Jr. that implied covenants are implied in fact.11 A covenant is implied in fact if it is derived from the written instrument and the circumstances which surround its execution. Clearly, the Lanyon Zinc rationale with its references to the intent of the parties and the nature of oil and gas development is supportive of the implied in fact doctrine. Professor Merrill, on the other hand, believed that implied covenants were a creation of the courts in order to impose a regime of fair dealing between the lessor and lessee.12 As suggested by Williams & Meyers, there is a kernel of truth in both positions.13 Courts have been willing to add to the express obligations of the lessee both because of equitable considerations and because of the nature of the oil and gas lease. Both doctrines have influenced the development of implied covenant law and it is difficult, if not impossible, to say which has been more predominant notwithstanding the widespread judicial acceptance of the implied in fact rationale.
2 — The Relational Contract and the Need to Control Opportunistic Behavior
In the 1980's Dean Charles Meyers, "borrowed" the concept of the relational contract as an way of explaining the growth of implied covenant law.14 A relational contract "involves a situation in which an asset (or something of value) is managed by the performing party, with the income
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(or return on capital) of the passive party solely dependent on the performing party's actions. Clearly this is the situation faced by the lessor of an oil and gas lease."15 Relational contracts also involve the lack of definitive, written obligations because of the nature of the subject-matter of the agreement. Parties cannot predict with certainty all of the variables that will affect oil and gas operations over a potentially lengthy period of time.
Another aspect of relational contracts is the possibility of "opportunistic behavior." It occurs "when a performing party behaves contrary to the other party's understanding of their contract, but not necessarily contrary to the explicit terms of the agreement, leading to a transfer of wealth from other party to the performer..."16
Dean Meyers saw implied covenants as a response to the lessee's opportunistic behavior which would inevitably arise out of the leasing transaction when the interests of the lessor and lessee would diverge. Lanyon Zinc recognized the potential for opportunistic behavior and understood the difficulty of requiring the lessor to expressly state all of the duties that were to be performed by the lessee. The lessor is protected by requiring the lessee to act in a way which benefits both the lessor's and lessee's interests.
B — The Reasonable and Prudent Operator Standard
Along with the imposition of implied...
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