The Texas Supreme Court issued two opinions in mid-April of this year that finally settled some confusion over the retained acreage clauses in leased. Specifically, what role do the rules and regulations of the Texas Railraod Commission play in determining what is retained? This article covers one of the cases: Endeavor Energy Resources, LLC, et al. v. Discovery Operating Inc., et al.

Over a 3 year period, Endeavor leased two tracts of land totaling 960 acres. We will refer to the tracts as “Section 4” and “Section 9”. Section 4 contained 640 acres. Adjoining Section 4 to the south was the north half of Section 9, being 320 acres. Endeavor completed four wells on the lands: two wells in Section 9’s northeast corner, and two wells in Section 4’s southeast corner. After completing the wells, Endeavor filed certified proration plats with the Texas Railroad Commission. The plats filed for Section 9 designated proration units of 81.21 acres. The two units were wholly contained in the northeast quarter of Section 9. Endeavor’s certified plat designated 81.0 acres for each of the proration units in Section 4, which were both located in the southeastern quarter of the Section.

When the leases’ primary terms were over, Patriot Royalty and Land, LLC, leased the southwest quarter of Section 4 and the northwest quarter of Section 9. Patriot assigned the leases to Discovery Operating, Inc., who drilled two wells in each quarter. After Discovery’s wells were drilled, Endeavor claimed that it owned the leasehold interest in those quarter sections by virtue of the language in the leases. Obviously, Discovery did not agree, and a lawsuit was filed.

Parties to a contract are generally free to make whatever agreements they want, so long as they are not outside the bounds of the law. Mineral leases are contracts that affect real property, and are therefore subject to “construction rules that apply particularly to agreements governing property rights.” Mineral leases are also “subject to legal and regulatory restrictions” as promulgated by the Texas Railroad Commission to prevent waste and to conserve our natural resources.

Operators are familiar with several of the RRC’s general rules applicable statewide, such as Rule 37 spacing requirements, or Rule 38 pertaining to well density. The RRC also sets out “production allowables” based upon the proration unit assigned to a particular well to help prevent waste and conserve resources. The Texas Supreme Court defined both:

‘Production allowables refer to the maximum amount of hydrocarbons a well may recover as prescribed by the applicable field rules’ and ‘are designed to limit production from a well in order to control the rate of production from the field.’ A proration unit is the ‘acreage assigned to a well for the purpose of assigning [production] allowables and allocating allowable production to the well.’ Generally, ‘an operator must first designate [a well’s] proration unit and the acreage assigned to it, then certify that the acreage is productive before receiving the well’s production allowable.’

The designation, when required, is made by filing a certified plat of the proration unit and Form P-15 (a Statement of Productivity of Acreage). After review, the RRC will assign to the well a maximum allowable, which is “the largest allowable that can be assigned under applicable rules.”

In mineral leases, separate clauses address the “duration and expiration” of leases. In this particular case, the Court had to analyze three: the habendum clause, the continuous development clause and the retained acreage clause.

You will usually find a lease’s habendum clause in the first few provisions of a lease, since it defines the duration of a lease (e.g. “this Lease shall be in force for a term of three (3) years”), i.e. the “primary term”. The habendum clause can also set forth a “secondary term” which “continues the lease after the primary term expires, for ‘as long thereafter as oil, gas or other mineral is produced.’” As the Court pointed out, this term, by itself, could continue a lease indefinitely “[a]s long as one portion of the leased tract—even a small portion—is producing oil or gas.” Therefore, parties typically choose to modify this provision.

One way the parties modify the habendum clause is through continuous-development clauses. Continuous development clauses preserve a lease “even though there is no production after the expiration of the primary term during continuous drilling operations,” as long as the operations continue “with no gap.” The Court noted that:

[w]hile a habendum clause generally extends the entire lease so long as some production is occurring on the lease, and a continuous-development clause further extends the entire lease so long as the operator remains engaged in the required development efforts, a retained-acreage clause typically divides the leased acreage such that production or development will preserve the lease only as to a specified portion of the leased acreage.

Retained acreage clauses are negotiated and specific to each lease, and therefore cannot be interpreted by referring to any one general rule. These clauses had their start in protecting lessees and their productive acreage, but have evolved to “‘include clauses that require the release of all acreage that, at the end of the primary term, is not within a drilling, spacing, or proration unit.’” Reference to the RRC proration unit designation (or what is permitted or prescribed by the RRC) is common place in today’s leases, and therefore the RRC rules and regulations become important to examine when courts have to construe mineral leases.

In this case, these wells were filed in the Spraberry Trend Area, which sets the standard proration unit at eighty (80) acres. “[O]perators may elect to assign a tolerance of not more than EIGHTY 980) acres of additional unassigned lease acreage to a well on an EIGHTY (80) acre unit and shall in such event receive allowable credit for not more than ONE HUNDRED SIXTY (160) acres.” The field rules also require filing a certified plat that is required to “set out distinctly all of those things pertinent to the determination of the acreage credit claimed for each well[.]” Endeavor’s leases provided that:

the lease shall automatically terminate as to all lands and depths covered herein, save and except those lands and depths located within a governmental proration unit assigned to a well producing oil or gas in paying quantities and the depths down to and including one hundred feet (100’) below the deepest productive perforation(s), with each such governmental proration unit to contain the number of acres required to comply with the applicable rules and regulations of the Railroad Commission of Texas for obtaining the maximum producing allowable for the particular well.

Endeavor argued that even though it mistakenly assigned smaller proration unit plats, it still retained 160 acres per well because the field rules allow for 160 acre proration units to achieve the maximum allowable for a well, and the lease allowed for the proration unit sizes to comply with the appropriate field rule’s permissive size to obtain the maximum producing allowable. This is so, according to Endeavor, because the leases’ language that states that the lease terminates except as to lands “located within a governmental proration unit assigned to a well” (emphasis added) could reasonably be construed to mean lands that the RRC “‘assigned to’ the wells through the field rules.” The Court, however, held that “the only reasonable construction of that reference is to the operator’s assignment of a proration unit through its filing of a proration plat with the Commission.” The field rules require operators to assign acreage to proration units, and to file the plat of the proration unit.

Endeavor also contended that because “the leases provide that ‘each [assigned] governmental proration unit’ must ‘contain the number of acres required to comply with’ the Commission’s rules for obtaining ‘the maximum producing allowable for the particular well,’” every unit had to be 160 acres, “because that amount will result in the ‘maximum producing allowable.’” Discovery argued that “the retained-acreage clauses require[d] the operator to file a plat assigning only the amount of acreage necessary to obtain the maximum producing allowable as determined by the applicable field rules for the particular well at issue. According to Discovery, Endeavor required only 80 acres per well to obtain the maximum producing allowable for each of its wells.” (Emphasis added).

The Court agreed with Discovery, holding that Endeavor was required to “include in its certified plats only ‘the number of acres required to comply with the applicable rules and regulations of [Commission] for obtaining the maximum producing allowable for the particular well.’” The Spraberry field rules’ maximum allowable for an 80 acre proration unit is 515 barrels per day. The evidence showed that “‘the 81.0 acre allowables [allowed Endeavor’s] wells to produce an amount of oil far in excess of the amount of oil the wells are currently capable of producing.’” Therefore, Endeavor’s assignment complied with the field rules, and, based upon the production of the wells, would not have qualified for an assignment of the additional eighty (80) tolerance acres.

Interestingly, the Court went on to not only say that “[t]o retain 160 acres per well, Endeavor needed to actually assign 160 acres to each well,” but that “the operator must ‘verify[] that additional acreage is actually necessary or required to achieve the maximum allowable.’” (Emphasis added). In other words, if an operator claims more acreage than it is draining, “‘the operator may open itself up to claims that it is not acting in good faith in purporting to retain a substantially greater amount of acreage.’” A warning to operators and a signal to landowners? Only time will tell, but we could see a new wave of litigation challenging claimed tolerance acreage.