Co-author Rusty Tucker
As Humpty Dumpty would have said to Alice if he were Justice Dumpty of the Texas Supreme Court, the term means whatever the parties to an oil and gas lease say it means, neither more nor less. In Sundown Energy LP, et al. v. HJSA No. 3, Ltd. P’ship the term “drilling operations” meant that activities other than spudding-in new wells were sufficient to satisfy a continuous operations clause.
In a lease in Ward County, 19,570 acres from the surface to the base of the Pennsylvanian formation were “Producing Areas”. The remainder covered all depths as to 10,880 acres plus depths in the Producing Areas below the Pennsylvanian. During the primary term, production in paying quantities from anywhere on the leased premises would maintain the entire lease. At the end of the primary term lessee Sundown was required to reassign its rights in each tract not then held by production unless Sundown was engaged in a “continuous drilling program.” The continuous drilling clause in Paragraph 7(b) read:
The obligation . . . to reassign tracts not held by production shall be delayed for so long as Lessee is engaged in a continuous drilling program on that part of the Leased Premises outside of the Producing Areas. The first such continuous development well shall be spudded-in on or before the sixth anniversary of the Effective Date, with no more than 120 days to elapse between completion or abandonment of operations on one well and commencement of drilling operations on the next ensuing well.
Sundown spudded-in three development wells prior to the end of the primary term and then spent over $40 million drilling 14 more wells from 2006 to 2015.
Paragraph 18 defined “drilling operations”:
…  actual operations for drilling, testing, completing and equipping a well (spud in with equipment capable of drilling to Lessee’s object depth):  reworking operations, including fracturing and acidizing; and  reconditioning, deepening, plugging back, cleaning out, repairing or testing … .
Lessor HJSA sued in 2016 for a declaration that the lease had terminated in 2007 as to non-producing tracts because Sundown failed to engage in a “continuous drilling program.” HJSA argued that Sundown was required to spud-in a new well every 120 days but for six specified periods had failed to do so. Sundown countered that pursuant to the lease’s plain language, “drilling operations” included activities other than spudding-in a new well.
The parties disputed whether the definition of “drilling operations” applied to Paragraph 7(b) or whether 7(b)’s context required a different definition that meant only spudding-in a new well. The trial court agreed with Sundown, but the court of appeals sided 2 to 1 in favor of HJSA.
The Supreme Court’s view
“Drilling operations” was a defined phrase that included, but was not limited to, well-spudding. If the parties intended to limit “drilling operations” to well-spudding, they could have done so as they did in regard to the first continuous development well. Although words must be construed in the context in which they are used, in interpreting a contract courts can’t ignore clearly defined terms.
The principle of freedom of contract – an enduring favorite of this court – recognizes that sophisticated parties have broad latitude in defining terms of their business relationship, and courts are obliged to enforce the parties’ bargain according to its terms. HJSA argued that Sundown could stymie production if the broader definition of “drilling operations” controlled. The court responded that nothing in the lease relieved Sundown from its implied duty to reasonably develop the leased premises.
The court distinguished Exxon Corp. v. Emerald Oil & Gas Co., in which “[w]henever used in this lease,” manifested the parties’ intent to use that definition whenever “drilling operations” was used. Unlike Emerald Oil, this lease did not have conflicting definitions or incompatible obligations.
Because there was no dispute that Sundown timely engaged in “drilling operations” as defined in the lease, Sundown was engaged in a continuous drilling program. The Court rendered judgment that Sundown was not obligated to reassign the contested acreage and remanded to the trial court for further proceedings.
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