In the age of horizontal drilling, it happens more and more often that operators take oil and gas leases on interests in property that do not cover the entire undivided interest. In those cases, the remainder of the undivided interest may already be leased by one or more other operators. Questions that are posed in those situations involve the rights and responsibilities of each operator to one another, and also to the lessors involved. While I once thought these were straightforward issues in which the answers were understood, a recent case evidences the exact opposite.
Apache Corporation leased an undivided one-third (1/3) of a tract of land, while Devon Energy Production Company, L.P. leased the remaining two-thirds (2/3). In most cases like this one, the operators will negotiate a joint operating agreement. Although Apache and Devon tried, they were unable to agree to the terms.
Apache drilled seven oil and gas wells. Apache did not distribute any revenue to Devon or to Devon’s Lessors while the wells produced until Apache recovered its costs for the drilling and completion of the wells (“pay out”). In the meantime, Devon did not distribute any royalty revenue to its Lessors. When the wells paid out, Apache paid Devon it’s two-thirds (2/3) share of the net revenue.
Devon’s Lessors filed suit against bot Devon and Apache alleging that Devon failed to pay “all royalties due” under their leases and that Apache failed to pay them royalties as required under the Texas Natural Resources Code. Devon claimed that Apache was required to pay the royalty directly to the Lessors pursuant to the Texas Natural Resources Code. Each party filed partial summary judgments asking the trial court to determine which party was responsible for paying the royalty to the Lessors. The trial court determined that “‘Apache is not obligated under the Texas Natural Resources Code to pay royalties to [the Lessors] on oil and gas proceeds’ from the wells that Apache drilled.”
Devon appealed claiming that the trial court erred when it determined that Apache had no duty to pay Devon’s Lessors any royalty revenue. In examining the issue, the Court of Appeals noted that Devon and Apache were cotenants in the mineral estate. As such, they looked to the rules of equitable accounting. The Court pointed out that “[i]t has long been the rule in Texas that a cotenant has the right to extract minerals from common property without first obtaining the consent of his cotenants; however, he must account to them on the basis of the value of any minerals taken, less the necessary and reasonable costs of production and marketing.” As to the issue of Apache’s liability to Devon’s Lessors, the Court acknowledged that it had not been definitively determined by case law.
Citing a recent law review article, the Court noted that Apache is a stranger to Devon’s contract with Devon’s Lessors and has made no covenants to either party. Moreover, because cotenants owe each other “‘nothing until [they have] recouped [their] reasonable and necessary expenses, it would strain credulity to argue that [one] now owes [the other] royalty merely by virtue of the fact that the cotenant has leased to a third party. Each owner in a cotenancy acts for himself and no one is the agent for the other nor has any authority to bind the other merely because of the relationship[.]” On the other hand, “Apache set out to legally bind itself to [Apache’s Lessor] and, therefore, ‘undertook’ to distribute a portion of the proceeds of its wells to her.” The Court went on to hold that because Apache did not “enter into a legally binding relationship with [Devon’s Lessors], such that [Devon’s Lessors] were then ‘legally entitled to payment’ from Apache[,]” Apache was not legally bound to distribute any royalty revenue to Devon’s Lessors.
What this means for Devon is that, under its contract with its Lessors, Devon was required to pay its Lessors the appropriate royalty within the required timeframe, even though Devon was not yet receiving any revenue from the production. Although this concept is not new, it may be news to some operators. Therefore, be aware that if there is no joint operating agreement or other contract between two operators who have leases covering the same tract of land, each operator still has made promises to the party it does have a contract with and must fulfill those covenants or face being in breach of contract (which could lead to loss of the lease). Even if the operator must come out of pocket to pay the royalty on revenue it has not yet received.