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February 27, 2015 Articles

Litigation Update on Select Oil and Gas Contract Disputes

A rundown of several cases impacting the industry.

By Mark D. Christiansen – February 27, 2015

PNP Petroleum I, LP v. Taylor

Court determines whether the special provisions of the oil and gas lease required that a well be “capable of producing in paying quantities” before the payment of shut-in royalties could extend the term of the lease.

In PNP Petroleum I, LP v. Taylor, 438 S.W.3d 723 (Tex. Ct. App.—San Antonio 2014, petition filed), the parties to an oil and gas lease dated June 1, 2009, had included the following special savings clause:

ii. SHUT-IN ROYALTY (Savings) If, at the expiration of the primary term there is located on the lease premises a well or wells not producing oil/gas in paying quantities, Lessee may pay as royalty a sum of money equal to Twenty ($20) dollars per proration acre associated with each well not producing. The shut-in well royalty payment will extend the term of this lease for a period of one (1) year. . . .

Id. at 727.

At the time the oil and gas lease was negotiated and signed, 13 wells that were not actually producing oil or gas were already located on the leased premises. Those wells had been drilled by a prior lessee whose lease had expired.

On May 12, 2010, PNP sent the mineral owner-lessors payment under the above savings clause with the stated purpose of extending the term of the lease. The mineral owners rejected the tendered payment and took the position that no well located on the leased premises was “capable” of producing oil or gas in paying quantities, and that a “shut-in royalty” payment would extend a lease under Texas law only if the well that was shut in was “capable” of producing in paying quantities. At the time the payment was rejected, the only wells located on the leased premises were the same 13 preexisting wells that had been drilled by the prior lessee, and those wells were not producing in paying quantities.

PNP filed suit seeking a declaratory judgment that its tender of payment extended the term of the lease. On cross-motions for summary judgment, the trial court granted partial summary judgment in favor of the mineral owners.

Seven months later, PNP filed a motion to reconsider the earlier summary-judgment ruling. In support of that motion, PNP attached an affidavit providing details of the negotiations between the parties preceding the signing of the lease. Exhibits to the affidavit included email correspondence and drafts revealing changes made to the lease form, and the savings clause in particular, during the negotiations. The mineral owners objected to the affidavit and attached exhibits on the ground that those documents were “extraneous, parol evidence offered ‘to vary, contradict, and/or create ambiguity in the unambiguous PNP Leases.’” Id. at 728. Hearsay and relevancy objections were also made. PNP responded that the affidavit and its exhibits should be considered as “surrounding circumstances” that could be properly considered by the court.

The trial court sustained the mineral owners’ objections and struck the affidavit and exhibits from the record. The court then denied PNP’s motion to reconsider. No. 10-05-00167, 2010 WL 10912006 (Tex. Dist. Ct. Nov. 22, 2010). PNP appealed.

In reversing the trial court’s ruling in favor of the mineral owners and rendering judgment in favor of PNP, finding that the term of the oil and gas lease was extended by PNP’s tendered payment, the Texas Court of Appeals found in part as follows:

1. It noted that the mineral owners’ primary objection to the affidavit and exhibits offered in support of the motion to reconsider was that those documents were alleged to be inadmissible extrinsic, parol evidence offered to contradict or create ambiguity in the lease. The court further observed that one of the primary propositions PNP sought to establish with this evidence was that the red-lined drafts of the lease and savings clause showed (a) that an earlier draft of the savings clause was expressly worded to provide that a well had to be capable of producing oil or gas in paying quantities for the lease to be extended by the payment of the shut-in royalties, and (b) that wording was modified by the parties to replace the phrase “capable of producing oil/gas in paying quantities” with the phrase “not producing oil/gas in paying quantities” in describing the type of well that would give rise to a right to extend the lease with such payments.

2. The appellate court reviewed prior decisions of the Texas Supreme Court and concluded that trial courts are allowed to consider contract negotiations as surrounding circumstances in construing an oil and gas lease. The court also cited its own prior decision in BP America Production Co. v. Zaffirini, 419 S.W.3d 485 (Tex. App.—San Antonio 2013), in which the court held:

“[N]egotiations prior to or contemporaneous with the adoption of a writing are admissible in evidence to establish . . . (c) the meaning of the writing, whether or not integrated.” . . . In BP Am. Prod. Co., this court considered evidence of the parties’ negotiations, including the offers and counter-offers made. 419 S.W.3d at 500–01.

438 S.W.3d at 734.

The court concluded that the parol evidence rule did not bar the introduction of the evidence showing the deletions and changes made in the drafts of the oil and gas lease during the parties’ negotiations, and that the trial court erred in ruling otherwise.

3. In likewise finding that there was no valid hearsay objection, the court stated that an out-of-court statement, offered to show what was said, rather than the truth of what was said, is not hearsay. Because the deletions and revisions made in the course of negotiating the oil and gas lease were offered to show what was said, the appellate court ruled that the trial court also abused its discretion in sustaining the hearsay objections to the lease drafts.

4. With regard to the final evidentiary objection made by the mineral owners to the proposed consideration of the redline drafts of the lease on the grounds that the evidence was not relevant, the court found that the lease drafts have a logical connection in determining the intent of the parties in selecting the language used in the savings clause. Accordingly, the trial court abused its discretion in sustaining the relevancy objection.

5. With regard to the heart of the oil and gas lease interpretational dispute, the appellate court recognized the general rule that “[i]f a lease term has a generally accepted meaning in the oil and gas industry, we use its generally accepted meaning.” Id. at 736. The mineral owners asserted that the term “shut-in royalty” has a special meaning in the oil and gas industry that requires that the underlying well be “capable” of producing in paying quantities before shut-in royalty payments will extend the lease. However, the court found that the general meaning had no application in this case because the parties had expressly stricken from earlier drafts of the lease a requirement that the wells be “capable” of commercial production.

6. Taking into consideration the parties’ negotiations as reflected in the various drafts of the lease and the plain language of the lease, the court concluded that the parties did not intend to apply the oil and gas industry’s generally accepted meaning of the term “shut-in royalty” in the savings clause of the lease. “Quite simply, the parties could not have intended for the law to engraft into their agreement the very language they removed.” Id. at 737.

This case remained the subject of appellate proceedings at the time of this writing.

Black Diamond Energy, Inc. v. Encana Oil and Gas (USA) Inc.

Wyoming court finds that party first committing a substantial breach of contract cannot complain that the other party fails to perform.

The analysis of the Wyoming Supreme Court in Black Diamond Energy, Inc. v. Encana Oil and Gas (USA) Inc., 2014 WY 64, 326 P.3d 904, concerning disputes that arose under a multi-well farmout agreement, will be of interest to the many who have been presented with complex contractual disputes that involve disagreements as to which side first breached the underlying agreement. The applicable farmout agreement contemplated the drilling of a series of wells, with the rights earned being dependent on certain factual variables. As occurs with some regularity in the oil and gas industry, disputes arose regarding the payment of joint-interest billings, the issue of when and if assignments had been earned, and similar issues. Both parties arguably owed layers of performance to the other as the oil and gas activities proceeded forward on multiple fronts.

A variety of arguments were raised in the ensuing litigation between the parties, with each party asserting certain claims against the other. The trial court disposed of some of the issues through summary-judgment rulings, and the remainder of claims and defenses proceeded to a jury trial. The jury returned a verdict finding that Black Diamond (BDE) breached the farmout agreement but Encana proved no damages. BDE appealed. In affirming the ruling of the trial court, the appellate court made the following findings:

1. BDE’s primary argument on appeal was that the trial court erred in instructing the jury that if a party materially breaches a contract, the non-breaching party is no longer required to continue to perform. While BDE agreed that this is a correct statement of the law generally, it argued that the circumstances of the present case gave rise to the qualifying principal of law that

a victim of a breach must either declare the breach or move ahead with the contract; it cannot continue to receive benefits under the contract and then refuse to perform its part of the bargain. As applied to this case, BDE contends the jury should have been instructed that if BDE breached the FOA by failing to remit payments due, Encana either had to declare the breach and terminate the FOA at the time or continue to accept payments from BDE and perform Encana’s part of the bargain by assigning the leasehold interests BDE had earned. Because Encana continued to accept payments, BDE argues, Encana was obligated to complete the wells and assign the leasehold interests.

326 P.3d at 910.

However, the court concluded that the instruction to the jury was consistent with Wyoming law because the party first committing a substantial breach of contract cannot complain that the other party fails to perform.

2. Related to the preceding issue, BDE further argued that the trial court erred in giving the jury a verdict form that asked it to determine which party breached the contract and the damages proven by the non-breaching party. BDE asserted that the effect of that verdict form and the instruction discussed above was to erroneously instruct the jury that there could be only one breaching party and only one party entitled to damages. BDE urged that the trial court should have instead given the jury BDE’s proposed verdict form, which asked the jury to determine, first, whether Encana breached the farmout and, if so, what BDE’s damages were and, second, whether BDE breached the farmout and, if so, what Encana’s damages were. For the same reasons as the court rejected BDE’s foregoing complaint about the jury instructions, it rejected these complaints regarding the verdict form.

3. BDE additionally emphasized paragraph 16 of the farmout agreement, which provided in detailed terms that BDE could earn certain leasehold rights in some circumstances even if some of the minimum requirements of the agreement had not been met. BDE urged that the effect of this paragraph was to require Encana to assign certain acreage to BDE even if BDE had failed to meet its financial obligations. However, the court found that, while BDE interpreted paragraph 16 in that manner, the jury may have interpreted the farmout agreement to mean that BDE was entitled to partial assignments only if it had satisfied the requirement that eight test wells be drilled and completed (which had not occurred under the evidence presented at trial).

4. The appellate court noted that, in interpreting the disputed issues under the farmout agreement, the trial court ruled that the phrase “completed as a producer” meant “a well capable and ready to produce gas, including perforation and fracking, but did not require that the well be hooked up to the pipeline.” 326 P.3d at 909, ¶ 15.

Those who encounter these issues in their trial work may want to note that the opinion of the court includes a detailed discussion regarding the trial court’s (a) exclusion of certain expert testimony and reports, and (b) exclusion of evidence offered at trial that Encana was holding funds BDE had paid toward a separate well under a separate contract, and that BDE had asked Encana to apply those funds to the amounts owed to Encana under the subject farmout agreement.

First Tennessee Bank National Association, as Trustee v. Pathfinder Exploration, LLC

Court holds that lessee had the right to surrender the oil and gas lease before its primary term and avoid liability under separate lease clause that required the drilling of five wells.

In First Tennessee Bank National Association, as Trustee v. Pathfinder Exploration, LLC, 754 F.3d 489 (8th Cir. 2014) (applying Arkansas law), the plaintiff trusts had granted an oil and gas lease to Pathfinder, which provided for a bonus consideration of $2,300,433.49 and a primary term of five years. Pertinent to the controversy in the present lawsuit, the lease also included the following provisions:

3. During the primary term hereof [five years] or any extensions as provided for herein, Lessee shall have the obligation to drill or cause to be drilled five (5) oil & gas wells on the leased premises. . . . In the event that Lessee fails to drill the obligated wells. . . . Lessee will pay to Lessor the sum of $100,000 per well not commenced, due immediately upon the expiration of the primary term or any extension as provided for herein.

Id. at 490.

The oil and gas lease further provided that “[Pathfinder] may at any time and from time to time surrender this lease as to any part or parts of the leased premises. . . .” Id.

Pathfinder surrendered the lease before the expiration of its primary term and before drilling any wells. Pathfinder asserted that the amounts specified in the above-quoted paragraph 3 of the lease were not due because it surrendered the lease before the primary term expired. The trusts sued Pathfinder for the amounts they contended were owed under paragraph 3. The district court granted summary judgment in favor of Pathfinder. The trusts appealed.

In affirming the ruling in favor of Pathfinder, the Eighth Circuit agreed with the district court that the prior decision in Frein v. Windsor Weeping Mary, LP, 2009 Ark. App. 774, 366 S.W.3d 367 (2009), supported the position of Pathfinder. In Frein, the court found that the mutuality doctrine was not violated. The appellee paid the landowners a large signing bonus in addition to committing to drill two wells within 18 months, and then properly exercised its option to cancel the leases before the 18-month period expired.


Keywords: energy litigation, oil and gas, PNP Petroleum, Black Diamond Energy, Encana, First Tennessee Bank National Association, Pathfinder


Mark D. Christiansen is with McAfee & Taft in Oklahoma City and Tulsa, Oklahoma.

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