CHAPTER 2 THE COVENANT OF FURTHER EXPLORATION—THIRTY YEARS LATER

• Jurisdiction: United States

Implied Covenants
(Nov 1986)
CHAPTER 2
THE COVENANT OF FURTHER EXPLORATION—THIRTY YEARS LATER
Charles J. Meyers and Steven M. Crafton
Gibson, Dunn & Crutcher
Denver, Colorado

I. INTRODUCTION

In 1956 the senior author published an article in the Texas Law Review entitled: The Implied Covenant of Further Exploration.¹ The purpose of that paper was to provide a rationale for a line of implied covenant cases that did not appear to fit into orthodox analysis. Thirty years have passed and a reconsideration of that work is in order. In doing so, the authors update and review subsequent judicial and scholarly developments and consider the theory of implied covenants from a new perspective, viz., the relationship of oil and gas law both to general contract law and to recent scholarly writing in the field of law and economics. Specifically, we are concerned with the concepts of relational contracting and opportunistic behavior.

To accomplish these goals, we first review three drilling covenants implied in oil and gas leases, viz., the offset well covenant, the reasonable development covenant, and

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the further exploration covenant. Special attention is then given to the developments pertaining to the exploration covenant. These covenants are then explained as being paradigmatic judicial responses to problems inherent in relational contracts with examples from recent cases supporting our theory.

II. THREE IMPLIED DRILLING COVENANTS COMPARED

A review of oil and gas jurisprudence reveals three categories of dispute between lessor and lessee over the drilling of wells. The first dispute is clear and the rules governing its resolution are straightforward and relatively easy to apply. That dispute deals with drainage, and the covenant that grew out of the dispute is called the protection covenant or the offset well covenant. The other disputes over drilling are less straightforward. It was the confusion found in the disparate and conflicting drilling cases that prompted the earlier effort to make an analytical distinction between the duty to reasonably develop and the duty to explore.

A. Offset Well Covenant ²

The dispute here concerns drainage: the permanent loss of hydrocarbons. Ordinarily, the lessee's interest is consonant with the lessor's interest, because both are losing

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hydrocarbons. The only dispute about drilling an offset well would seem to lie in the economics. Obviously, bearing no costs, the lessor finds the economics simple. The lessee, who does bear the costs, must be slightly more sophisticated, but the return on investment only need cover his opportunity cost of capital because the risk is slight. Thus, we have the black letter rule: an oil and gas lessee, as an ordinary prudent operator, is under an obligation to drill a protection well where (a) drainage is taking place and (b) the offset well would cover operating costs, recover capital expenditures, and would return a "reasonable", or what economists call a "normal", profit. While this rule is easy to understand, and relatively easy to apply, a problem arises when the lessee's interest is not consonant with the lessor's — where the lessee owns an interest in the adjoining land and benefits from the drainage. In the language we adopt later in the paper, the lessee has an economic incentive to act opportunistically, i.e. maximize his welfare to the detriment of his lessors. In this case of drainage caused by the lessee, the offset well covenant serves to reduce the lessee's incentive and ability to act opportunistically by arbitrating the dispute between the lessor and lessee over the obligation to drill a protection well.

B. Reasonable Development Covenant ³

Analytically, the reasonable development covenant is easily distinguished from the offset well covenant and the

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further exploration covenant. In practice it gets much more complicated. In theory the development well the lessor wants is another well to be drilled in a known, established and reasonably well-defined reservoir. Before spacing and other conservation regulations, courts rather than regulatory agencies were the arbiters of drilling density, if any regulation existed at all. It is apparent that as to drilling density the incentives are such that the lessor will prefer tighter spacing than the lessee, since the latter bears the costs. The standard required to resolve a dispute over development drilling is again economic: the difference between 40-acre spacing and 80-acre spacing in an oil field involves roughly doubling the drilling costs without necessarily doubling the present discounted value of the increased rate of production. Since the discount rate reflects the preference for "present over future", the higher the discount rate, the greater value placed on more rapid production. The prudent operator rule requires the lessor to establish that the additional drilling will be "profitable," but that rubric does not solve the real problem, unless it considers the tradeoff between increased drilling and operating costs on the one hand, and the possibly higher present worth values of more rapid production on the other.

This category of cases also includes the problem of the edge well where the lessor believes that drilling ought to be undertaken, but the lessee, who pays the bills, thinks

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otherwise. Analytically the solution is reasonably easy: the step-out well ought to be drilled if it will recover capital and operating costs and pay a "reasonable" profit. In practice, of course, there are risks that must be accounted for in determining a "reasonable" profit, especially where the geology is tricky and it is uncertain whether there is enough oil at the edge of the reservoir to justify additional drilling.

C. Further Exploration Covenant⁴

Analytically and conceptually the dispute over exploratory drilling is quite different from those involving reasonable development and drainage. In this case, the lessor concedes that neither he nor his experts nor the lessee and its experts "know" whether or not oil or gas is present in commercial quantities. What the lessor asserts is that an ordinary prudent operator would explore. In other words, the lessor believes that further exploration will be for the common advantage of both lessor and lessee.

The recognition of this form of dispute was a consequence of research that determined that the law reports contain a large number of cases in which a court did not require the lessor to prove that drilling would be profitable. It is obvious that an ordinary prudent person — the rational economic man in the oil business — does not drill an offset well or a development well with the expectation that it will lose money, or develop a field with an excessive number of

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wells with the expectation that the overall project will either lose money or have drastically reduced profits. But it is also true that ordinary prudent operators — economically rational oilmen — drill exploratory wells. They do so on the basis of extensive seismic programs, other geophysical studies, geological mapping, core sampling, etc. But they do undertake risky exploratory programs because these are risks worth taking. Wealth maximization is of course the object of the game, and clearly profit on any particular test well is not how ordinary prudent operators judge exploration programs.

Thus, the lack of ex ante knowledge with regard to the outcome of exploration makes it apparent that a dispute over exploration will be much more difficult to resolve. Moreover, while all three disputes, and the resulting covenants, involve conflicts between the lessor and the lessee over drilling more wells, the lessee's duty under the exploration covenant, unlike the duty under the drainage and development covenants, is more problematic given the lessor's and court's difficulty in ascertaining why the lessee has failed to explore.

III. EXPLORATION COVENANT: THEORY AND PRACTICE

A. Elements of the Cause of Action

Unlike the offset well covenant and the reasonable development covenant, the elements of the cause of action for

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breach of the covenant of further exploration are not easy to state clearly and crisply. Breach of the covenant depends on a number of factors that bear on the overall reasonableness of lessee's conduct with regard to the further search for oil and gas. Clearly it is the lessee's conduct vis a vis the lessor which is the key. One must be able to ascertain by considering those factors whether the lessee who holds the lease by production is considering the lessor's interest in making his exploration decisions or is acting "opportunistically" by maximizing his own wealth at the expense of his lessor. Those factors can have varying weights; the greater the gravity of one factor the less importance that may be ascribed to another. A word that describes this set of factors is "congeries: A collection of particles, parts or bodies into one mass."

The more important factors that constitute the congeries of breach of the exploration covenant are the following:

1. How much land is in controversy?

2. Has a substantial amount of time gone by since the last well was drilled?

3. During that period has lessee undertaken operations which, while short of drilling, indicate a continued interest in further prospecting? Such operations include running seismic lines, contributing dry hole

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or bottom hole money to nearby tests, or farming out a portion of the leasehold for a test well.

4. Have other operators indicated an interest in exploring the leasehold by requesting farmouts?

5. Has the lessor shown concern by requesting or demanding exploratory drilling?

6. How favorable are the prospects for successful exploration? What is the profit potential of the area?

The interrelation of these elements is worth noting: if the leasehold is small, say 160 acres, the profit...