Breach of covenant to administer lease — must the operator use the latest drilling and completion technology?
Today Blawgletter continues our seven-part series from the 66th Annual Oil & Gas Law Conference in Houston with part 2. We turn now to an issue that had more resonance when high prices dominated and made a call for using high-cost drilling and completion techniques more plausible. Those claims may remain economic for look-back periods in spite of the recent drop in prices, but those who have them ought to act promptly to avoid statute of limitations concerns.
The lessee under an oil and gas lease has a duty “to manage and administer the lease”, and within that broad charge arises an obligation to “use successful modern methods of production and development.” Amoco Prod. Co. v. Alexander, 622 S.W.2d 563, 567 & n.1 (1981) (quoting R. Hemingway, The Law of Oil & Gas § 8.1 (1971)). These days, “successful modern methods of production and development” plainly include unconventional techniques like horizontal drilling and hydraulic fracturing.
Indeed, a half-century ago, the Oklahoma Supreme Court held that an operator’s failure to use “sandfracing” on wells in part of a 90-acre tract supported cancellation of the lease as to that acreage. Crocker v. Humble Oil & Refining Co., 419 P.2d 265, 274 (Okla. 1965) (“The defendant cannot offer any reasonable excuse in its failure to utilize the sandfracing process for further development of the cancelled portion of the lease.”).* And “the tight, homogeneous nature of shale rock makes development somewhat like a mining operation” that involves far less geological risk than in other kinds of formations. David E. Pierce, Implied Covenant Law and Horizontal Development 7-14 (Nov. 9, 2012). An operator who fails to employ these and other potentially gainful methods may thus face a claim for breach of the implied covenant. But how far does the duty go?
Because all implied lease covenants stem from a single duty of the lessee to act in good faith as a reasonable and prudent operator, Krug v. Helmerich & Payne, Inc., 320 P.3d 1012, 1022 (Okla. 2012) (quoting Owen L. Anderson, Oil and Gas Law and Taxation 402 (4th ed. 2004)), the reasonably prudent operator test will determine whether or not a lessee’s failure to use unconventional methods complied with its duty to administer the lease.
A strong claim for failure to use the latest drilling technology would include some or all of these circumstances:
- Large reserves, preferably the proved and producing kind, within the lease area;
- Successful use of production-maximizing techniques in the relevant formation on or near the acreage;
- Pipeline access from the tract to points of sale; and
- High wellhead prices during the relevant look-back period (e.g., the length of the statute of limitations) and into the future.
* The Supreme Court of Texas held in Coastal Oil & Gas Corp. v. Garza Energy Trust, 268 S.W.3d 1, 14 (2008), that a landowner cannot sue another landowner “for oil and gas drained by hydraulic fracturing that extends beyond lease lines” into the first landowner’s property. The ruling lowered the risks of, and therefore had the effect of encouraging, aggressive horizontal drilling campaigns.