CHAPTER 7 IMPLIED COVENANT LAW AND HORIZONTAL DEVELOPMENT
Jurisdiction | United States |
(Nov 2012)
IMPLIED COVENANT LAW AND HORIZONTAL DEVELOPMENT
Washburn University School of Law
Topeka, KS
DAVID E. PIERCE is a professor at Washburn University School of Law in Topeka, Kansas where he teaches Oil & Gas Law, Advanced Oil & Gas Law, Energy Regulation, Mineral Title Examination, Property, and Drafting Contracts and Conveyances. Prior to entering law teaching, Professor Pierce was an in-house oil and gas attorney for Shell Oil Company in Houston, Texas, and before that he engaged in the private practice of law in Neodesha, Kansas. He has also worked Of Counsel with the Tulsa-based law firm of Gable & Gotwals, and with the Kansas City-based law firm of Shughart Thomson & Kilroy. Professor Pierce has a B.A. from Pittsburg State University, a J.D. from Washburn University School of Law, and a Masters of Law (LL.M.-Energy Law) from the University of Utah College of Law. Professor Pierce is the author of the Kansas Oil and Gas Handbook, a co-author of Cases and Materials on Oil and Gas Law, a revision and upkeep co-author of Kuntz on the Law of Oil and Gas, a co-author of Hemingway Oil and Gas Law and Taxation, and an editor of the Oil and Gas Reporter. Professor Pierce served as RMMLF president from 2008-2009 and is the 2012 recipient of RMMLF's Clyde O. Martz Teaching Award.
I. Introduction
II. What Did the Parties Intend?
III. Is My Lessee a Prudent Operator?
IV. Prudent Operators Have Only One Lease
V. Analysis: Covenant First, Prudent Operator Second
VI. Must I Drill a Test Well Under My "Paid-Up" Lease?
VII. Do I Really Need to Drill Another Gas Well At This Time?
VIII. Can I Hold My Lease With Vertical Wells?
IX. Shale is Different
X. Conclusions
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"[B]ecause of the complexity of the oil and gas industry, and changes in technology, the courts cannot list each obligation of a reasonably prudent operator which may arise." 1
I. Introduction
Horizontal development technology and techniques are being used successfully to extract oil and gas from rock structures previously thought to be of no economic value. As with anything new, once something is proven to work, there will be varying degrees and rates of acceptance by industry participants. Within the oil and gas reservoir, the rate at which production-enhancing technology and techniques are employed can have a direct economic impact on parties owning the oil and gas.2 This impact is a product of the rule of capture and the ability of oil and gas to migrate, within the reservoir, toward areas of lower pressure created by connection to a wellbore. Horizontal drilling and hydraulic fracturing act in concert to maximize these reservoir/wellbore connections. The better the connection, the more likely the formation will give up the oil and gas it contains.
The law is devoid of a legal mechanism that allows competing tracts overlying an oil and gas reservoir to "catch up." Oil and gas jurisprudence has never accepted a concept of correlative rights that requires the equitable apportionment of reservoir contents among reservoir owners. Instead, an owner's correlative rights consist of the "opportunity" to develop its portion of the reservoir.3 Owners that fail to fully exercise
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their opportunity, or that are slow in exercising their opportunity, will lose out to the more diligent reservoir owners. These physical and legal facts, along with the lessor's desire to maximize royalty income, form the foundation of implied covenant law.
This article examines the role of "implied covenant law" when a formation is being developed, or is susceptible to being developed, using horizontal drilling and hydraulic fracturing. The label "implied covenant law" is used to describe the body of case law where courts have found an implied obligation that necessarily compliments, and supplements, the express terms of an oil and gas lease. Commentators have tended to treat implied covenants as a given adjunct to the express terms of the oil and gas lease.4 They have developed theories of "cooperation"5 and "relational contract"6 that tend to obscure the true function and proper role of the implied covenant. Implied covenants are more accurately described as interpretive tools to be applied, when necessary, to ascertain and give effect to the intent of the parties by supplying an omitted term they would have provided had they chose to address the matter.7 The existing body of implied covenant law is a collection of factual situations where courts were seeking, or at least purporting to seek, to give effect to the terms of the parties' oil and gas lease. The ultimate goal is to ascertain the parties' intent.
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II. What Did the Parties Intend?
Courts imply covenants to fill in the details of what the parties left unsaid in the oil and gas lease. When a lease is silent regarding the timing, extent, and nature of development, the court must extrapolate, from the parties' express agreements, what they intended regarding development. The issue is purely contractual. If the parties have expressed their intent in the oil and gas lease, that intent will govern. If the parties chose not to address the matter, or failed to address it adequately, their presumed intent will be gleaned from the terms of the contract and their general purpose and goals for entering into the contract. The test is would a reasonable person expressly agreeing to terms a, b, and c, logically have intended to include term d as well. If so, then term d will be implied as part of the contract the parties intended to create. If not, then the contract will be interpreted and applied without term d.8
Under this analysis, contracts are supplemented only with implied terms that are consistent with the parties' contractual purpose and intent. The goal of the judiciary in some cases, however, has not been to ascertain and give effect to the parties' contractual purpose and intent. Usually these cases look more like an exercise in re-interpretation to achieve a desired result. The cases that suffer the most from this aberrant judicial policymaking are the royalty calculation cases purporting to apply an implied covenant to market.9
Once it is determined a covenant should be implied, the next step is to define and apply the standard used to evaluate the lessee's actions or failure to act. The lessee's conduct will be measured by the prudent operator standard.10
III. Is My Lessee a Prudent Operator?
The Williams & Meyers treatise likens the prudent operator to the "reasonable man" of tort law: "The prudent operator is a reasonable man engaged in oil and gas operations."11 The standard, in the vast majority of producing jurisdictions, is objective.12
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The prudent operator is a hypothetical operator, not the real operator. The real operator may be short on cash. The real operator may have other obligations, under other leases, that demand more immediate attention. The real operator may want to spend its money developing oil prospects instead of further developing the lessor's lease, which is producing dry gas.13
An area not fully explored by courts to date is whether a real operator's unique capabilities can increase its obligations under the prudent operator standard. Although it is clear a real operator's individual limitations cannot lower the bar of the hypothetical prudent operator,14 can a real operator's unique capabilities raise the bar?15 Put another way, will Shell Oil Company be held to the same standard as Mom & Pop Oil Company? The implied covenant cases and commentary rightly assume the answer is "yes." There is
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only one standard. The same hypothetical prudent operator standard will be applied to Shell and Mom & Pop regardless of their individual capabilities or limitations. This means a lessee that owns its own horizontal drilling company, or hydraulic fracturing service company, will be treated the same as a company that has no special relationship with the drilling and completion side of the industry.16
This seems logical, particularly when it is recognized that oil and gas leases, since the inception of the industry, have been freely assignable.17 A lease today with Mom & Pop could end up with Shell. Also, the lease is often taken by an individual or entity that has no capability to develop the leased land. In those cases the plan, at the inception of the transaction, is to ultimately transfer the lease to a developer.
IV. Prudent Operators Have Only One Lease
The hypothetical nature of the prudent operator standard is best illustrated by asking "how many oil and gas leases does a prudent operator own"? The answer provided by courts that have addressed this issue is clear: a prudent operator has one lease. Not two, not a hundred, not a thousand. The Texas Supreme Court, in Amoco Production Co. v. Alexander,18 applied this "single-lease analysis" to limit both the rights and the obligations of the lessee. First, the rights of Amoco were limited by the court's holding that Amoco's obligations to other lessors in the field could in no way reduce its hypothetical prudent operator obligations to the Alexanders under their oil and gas lease.19 On the other hand, Amoco's obligations as a hypothetical prudent operator could
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not be increased because it owned the surrounding oil and gas leases causing drainage from the Alexander lease. Amoco's obligations, instead, must be based on its hypothetical status as the owner of only one lease in the field, the Alexander lease.20 Therefore, the single-lease analysis cuts both ways: Amoco's hypothetical prudent operator status cannot be affected, positively or negatively for either party, by the fact Amoco owns other leases in the field. The existence of other leases in Amoco's inventory did not matter, because a prudent operator owns only one lease.
In Coastal Oil & Gas Corp. v. Garza Energy Trust,21 the...
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