1989 model form operating agreement

Co-author Alexandra Crawley

In Elm Ridge Exploration Co., LLC v. Engle we are reminded of a little-used provision in the 1989 Model Form Operating Agreement. Article VI.D.1 allows the operator to use its own equipment, but his charges may not exceed prevailing rates in the area, and the rates must be agreed to in writing before drilling commences.

Breach of the JOA?

A New Mexico Operator sued the majority working interest owner/non-operator for recovery of well costs. The AFE for the well specified a 24-hour rig.  The majority owner alleged that Operator breached the Operating Agreement by drilling the well with a more expensive daylight rig of Operator’s affiliate, instead of a 24-hour rig. He claimed that the excess cost of the daylight rig should reduce the amount he owed for his share of well costs.  Use of the daylight rig was without the majority owner’s consent. A 24-hour rig would have cost less to operate than the daylight rig.

Operator argued that the BLM drilling permit would have expired had it waited, leading to an even costlier re-permitting process to finish drilling the well and that by not waiting, Operator saved money.

The Testimony

Operator testified that they were lucky to get the rig they did because another rig was not available. However, he also testified that the permits were satisfied when the Operator spudded some time between October and January, and that an Application for Permit to Drill (“APD”) that was extended to November 2008 meant that Operator had until then to spud the well. Nevertheless, he went ahead and spudded the well in August 2008.

In testimony likely to negatively impact his chances for career advancement, Operator’s district superintendent testified that an APD deadline no longer matters once surface pipe has been set to 250 to 300 feet or, at the very least, the well has been spudded by setting a conductor pipe. Possibly seeking another reason to dust off his resume, he then testified that Operator would initially use smaller rigs (like the one used) on deep wells to put pipe down to 250 or 300 feet to “hold [the] wells, or get them where the permits would be good,” and they could come back later, when a larger rig was available, to finish drilling.  The court noted that 24–hour rigs were available by the beginning of 2009.

The Result

The jury found, and the appellate court agreed, that a reasonably prudent operator would have used the less expensive rig and reduced the defendant’s share of costs by the amount attributable to the breach. Operator was not entitled to judgment for the more expensive rig. The permit would not have been jeopardized by waiting for a less expensive rig. Problem for the non-operator:  Operator was entitled to foreclose because other costs the non-operator failed to pay were justified.

Enough About Extravagance 

My wife and I drink “affordable” wine during the week. That way, when we drink good wine on the weekend we appreciate it more. And so it is with music. Today’s musical interlude is not one but two of the most vapid, lame and treacly musical offerings ever. Quaff a little Phantom 309 and Teen Angel and  you will be blown away by just about any tune you will ever hear from this moment forward.  Don’t laugh. Patches is next.

Co-author Andrew Neal

Non-operators have had a lot in common with Br’er Rabbit ever since 2006, when the Texas Supreme Court surprised the industry in Seagull Energy E & P, Inc. v. Eland Energy, Inc. Their tar baby is the ruling that, absent a release from the operator a working interest under a JOA who assigns his interest to a third party remains automatically liable for costs not paid by his successor. Indian Oil Company, LLC v. Bishop Petroleum, Inc. is a step to clarify the extent of the automatic liability prescribed in Seagull.

Bishop, operator and working interest owner, and Trotter, non-operating working interest owner, signed a 1989 Model Form 610 JOA. Trotter assigned his interest to Indian Oil in 2002 and informed Bishop about the assignment. In 2007 the well ceased to produce. Indian Oil and the other working owners approved an AFE for a workover costing $1.6 million to restore production. The workover was unsuccessful and the well was plugged at a cost of $243,300. When Indian Oil refused to pay, Bishop sued Trotter claiming under Seagull that he was automatically liable for all costs not paid by Indian Oil.

The 1989 model form states, “[N]o assignment or other disposition of interest by a party shall relieve such party of obligations previously incurred by such party.” Trotter was held liable for costs which he “previously incurred” prior to assigning his interest in the well to Indian Oil in 2002, such as his pro rata share of P&A costs, but not for costs of reworking operations approved by Indian Oil and not by Trotter. In other words, under the 1989 model form, a working interest owner will not be held liable for expenses which he did not agree to pay.

Indian Oil isn’t a roadmap for all disputes over the automatic liability prescribed in Seagull, but it does establish some relief for former working interest owners. 

Takeaways

  •  Working interest owners who assign their interests continue to be automatically liable for unpaid costs that they agreed to pay.
  • Texas courts appear to be reluctant to force working interest owners who sold theirinterests to pay for costs approved after they sell their interest in the well.

Maybe now this plea from a former owner won’t be so desperate.

It’s deju vu all over again in Chesapeake Operating, Inc. v. Sanchez Oil & Gas Corp. More accurately, it is a variation of Reeder v. Wood County Energy, LLC, et al. applied to Louisiana operations. For the impact of the exculpatory clause protecting the operator from liability in the 1989 Model Form JOA, see my post (co-authored by Marty Averill), “Operator Not Liable for Breach of 1989 Model Form Operating-Agreement, Part Two”. 

This one is a bit different.  Chesapeake and Sanchez entered into a JOA to operate leases in Louisiana. Chesapeake sued Sanchez for failing to pay its proportionate share of drilling and completion costs. Sanchez asserted the defense that Chesapeake had breached the  JOA in, as the court put it, “several ways”,  and did not perform its work in a good and workmanlike manner.

The key issue was the scope of the exculpatory clause, and whether Sanchez was required to prove that Chesapeake acted with gross negligence when it breached the JOA. The clause mirrors Article V.A of the 1977 and 1982 Model Form JOA’s (I assume one of those forms was at issue, but the court didn’t say):

 Chesapeake  . . .  shall be the Operator  . . .  and shall conduct and direct and have full control of all operations on the Contract Area . . .  . It shall conduct all such operations in a good and workmanlike manner, but it shall have no liability as Operator to the other parties for losses sustained or liabilities incurred, except such as may result from gross negligence or willful misconduct.

Sanchez argued that the clause only applied to claims that Chesapeake had not conducted the operations in a good and workmanlike manner; Chesapeake responded that the exculpatory clause also applied to allegations that it breached the JOA.

The court noted that the Fifth Circuit construed an identical clause in Stine v. Marathon Oil Company, and held that protection of the exculpatory clause extended to breaches of the JOA and that the operator was not liable unless its actions were grossly negligent or willful. The court also noted that three Texas appellate courts had reached the opposite conclusion, holding that the clause only applied to claims that the operator failed to act as a reasonably prudent operator.

The court stated that clause would apply to Sanchez’s defenses if Stine controlled but would not apply if the Texas appellate decisions controlled. The court stated that it could only rely on the appellate decisions if they “comprised unanimous or near-unanimous holdings from several—preferably a majority—of the intermediate appellate courts of the state in question.”Here, although the appellate courts were unanimous, they were not a majority of the Texas appellate courts. Thus, the court deemed itself bound to follow Stine.

The clause applied to Sanchez’s affirmative defenses. Because Sanchez had not presented evidence that Chesapeake’s breaches resulted from gross negligence or intentional misconduct, the court dismissed Sanchez’s defenses.

Big and Important Caveat: Chesapeake is a Texas case ostensibly applying Louisiana law. It is not from a Louisiana court.  The parties agreed that Louisiana and Texas law would be identical, so the court looked to Texas cases. I’m sure there are Louisiana non-operators who would (and will) take issue with this result.

Co-authored by Marty Averill

If you are a non-operator under the 1989 Model Form Operating Agreement, pay close attention to Reeder v. Wood County Energy, LLC, et al.  The Texas Supreme Court ruled that the operator is not liable to non-operators for breach of the agreement except in the cases of gross negligence or willful misconduct.

 This is a departure from Texas decisions which historically have held that the exculpatory language at the heart of the case extends only to claims that the operator failed to act as a reasonable prudent operator in connection with operations, but not for breaches of the JOA.

 The Decision

 The question before the court: What is the standard for resolution of a breach of contract claim against the operator? Article V.A.1. requires the operator to “ . . . conduct its activities under this agreement as a reasonable prudent operator, in a good workmanlike manner, with due diligence and in accordance with good oil field practice, …”. So far so good. But then comes the exculpatory clause: “. . . but in no event shall it have any liability as Operator to the other parties for losses sustained or liabilities incurred except such as may result from gross negligence or willful misconduct.”

 The difference between the forms is, “its activities under this agreement …” (‘89 form) and “… all such operations …” (’77 and ’82 forms). The court concluded that there is a substantial difference between those terms.

 The Litigation

 The parties were not getting along on major operations decisions. Reeder, the operator, sued Wood County Energy (in which he was a 45% partner) and the other non-operators alleging that as operator he had the exclusive right of possession of certain well bores and for other claims. The defendants counterclaimed that he illegally produced oil, fraudulently reported oil from one formation as being produced from another, and failed to sustain production in the quantities required by the JOA. All parties alleged conversion, violations of the Texas Thief Liability Act, and a host of other misdeeds.

 The jury found that Reeder breached his duties as operator. The non-operators were awarded damages and a declaration that Reeder owned no interest in the two formations at issue. The Court of Appeals agreed, but the Supreme Court reversed.

 The Takeaway

 It will be more difficult for non-operators under te 1989 form to recover against the operator for any claim, including breach of the contract, unless the non-operator can prove that the operator is guilty of gross negligence or willfulness conduct. Those are difficult burdens to meet.

 The court also discussed the legal sufficiency of the evidence necessary to support a jury verdict for gross negligence or willful conduct.

Stay tuned for a more thorough analysis of the case, including how the court could have resolved it in favor of the non-operators, why that result might have been better for the industry, how the ruling can be addressed when negotiating future agreements, and the sufficiency of evidence in this kind of  case.