The Oil and Gas Addendum

As more and more horizontal well bores are being drilled across Pennsylvania, landowners are now keeping a closer eye on the location of nearby wells. For example, imagine you own 100 acres in Tioga County. Your acreage is currently unleased but you have received lease proposals from two competing drillers: ABC Production and XYZ Drilling. The landman from ABC Production informs you that your neighbor’s parcel is already under lease and that three horizontal well bores will be drilled from a well-pad located on your neighbor’s tract. One of those well bores will run along the length of your property line and only 250 feet from the boundary. The landman further tells you that if you don’t accept their lease proposal “we’ll just take your gas anyway.” On the other hand, the landman from XYZ Drilling tells you not to worry because if you accept XYZ Drilling’s lease proposal, they will drill an “offset” well to negate any “drainage” from the ABC Production well bore. You are confused and frustrated. Will the ABC Production well drain gas from your unleased parcel? If you lease with XYZ Drilling, can they actually drill an “offset” well to mitigate this? Answering these questions has become more challenging and complex in the era of horizontal drilling and hydraulic fracturing. As illustrated by the Texas Supreme Court’s opinion in Murphy Exploration v. Adams, the traditional concept of “drainage” may not apply to horizontal well bores drilled in a tight shale formation such as the Marcellus Shale.

At issue in Adams was a 2009 oil and gas lease between Murphy Exploration and the Herbst family covering 302 acres in Atascosa County, Texas (the “2009 Lease”). The 2009 Lease obligated Murphy Exploration to drill an offset well, pay royalties or release certain acreage in the event a producing well was completed on an adjacent tract within 467 feet of the Herbst property boundary. Specifically, Paragraph 25 of the 2009 Lease provided that:

“It is hereby specifically agreed and stipulated that in the event a well is completed as a producer of oil and/or gas on land adjacent and contiguous to the leased premises, and within 467 feet of the premises covered by this lease, that Lessee herein is hereby obligated to, within 120 days after the completion date of the well or wells on the adjacent acreage, as follows:

(1) to commence drilling operations on the leased acreage and thereafter continue the drilling of such off-set well or wells with due diligence to a depth adequate to test the same formation from which the well or wells are producing from [sic] on the adjacent acreage; or

(2) pay the Lessor royalties as provided for in this lease as if an equivalent amount of production of oil and/or gas were being obtained from the off-set location on these leased premises as that which is being produced from the adjacent well or wells; or

(3) release an amount of acreage sufficient to constitute a spacing unit equivalent in size to the spacing unit that would be allocated under this lease to such well or wells on the adjacent lands, as to the zones or strata producing in such adjacent well.”

In November 2012, Comstock Oil & Gas drilled a horizontal well on the adjacent tract and began producing hydrocarbons from the Eagle Ford shale formation (the “Lucas Well”). The Lucas Well was 350 feet from the Herbst property boundary, thereby triggering the offset well covenant in Paragraph 25. Rather than pay royalties based on the Lucas Well production or release acreage, Murphy Exploration drilled a horizontal well on the Herbst property (the “Herbst Well”). Like the nearby Lucas Well, the Herbst Well also penetrated the Eagle Ford shale formation. The Herbst Well, however, was approximately 1,800 feet from the lease boundary and nearly 2,100 feet from the Lucas Well. Both the Herbst Well and the Lucas Well ran parallel to the property boundary in a north/south direction.

In May 2013, the Herbst family and other royalty owners under the 2009 Lease commenced a lawsuit against Murphy Exploration alleging a breach of Paragraph 25. The Herbst family contended that the Herbst Well was too far from the property boundary to qualify as a true offset well. In other words, because the Herbst Well was 1,800 feet from the boundary, the Herbst family argued that the well could not protect against the drainage caused by the Lucas Well. They further argued that since the Herbst Well was not protecting the leased premises from drainage, it did not operate as an offset well as required by Paragraph 25.

In response, Murphy Exploration argued that Paragraph 25 imposed no such location or minimum distance requirements and only mandated that the offset well be drilled “on the leased acreage” and “to a depth adequate to test the same formation” as the triggering well (i.e., the Lucas Well). Murphy Exploration further argued that the 2009 Lease was drafted with “horizontal well bores in mind” and such well bores, when drilled through a tight shale formation such as the Eagle Ford, create little or no drainage. Given this context, Murphy Exploration argued that Paragraph 25 did not require the Herbst Well to actually protect against drainage, so the location of the well bore itself was irrelevant and immaterial.

Murphy Exploration moved for summary judgment and the trial court agreed and entered judgment in favor of Murphy Exploration. On appeal, the San Antonio Court of Appeals reversed the trial court and held that Murphy Exploration had not proved that the Herbst Well was protecting against drainage. The Court of Appeals opined that the offset well required by Paragraph 25 had to operate and perform like a typical offset well: it had to prevent or negate drainage from an adjacent well. Murphy Exploration then appealed to the Texas Supreme Court.

Before we address the substance of the Supreme Court’s opinion, a brief primer on the concepts of drainage and offset wells is warranted. For almost 120 years, courts have recognized that the conduct of a driller may be governed by certain implied obligations that are not expressly stated in the parties lease. One of these implied covenants is the covenant to protect against drainage.

The implied covenant to protect against drainage requires the lessee to protect the leasehold from “drainage” that may be caused by nearby wells. See, Krug v. Helme rich & Payne, Inc., 320 P.3d 1012, 1019 (Okla. 2013) (“[T]he lessee has a duty to protect the land from drainage by adjoining wells so long as the drilling of a protection well or wells will, in the judgment of a reasonably prudent operator, be a profitable undertaking”); Croston v. Emax Oil Company, 464 S.E.2d 728, 733 (W.Va. 1995)(“….there is an implied covenant in the lease that the lessee will protect lessor’s property against substantial drainage”); HECI Exploration Co. v. Neel, ·982 S.W.2d 881, 889 (Tex. 1998)(“[O]ne of the implied covenants imposes a duty to protect the leasehold from local and field-wide drainage”). Because gas is fugitive and will migrate from one part of the common reservoir to another, drainage can be mitigated by drilling an offset well. See, Thoroughbred Association LLC v. Kansas City Royalty Co. LLC, 308 P.3d 1238, 1245 (Kan. 2013) (“…the duty to drill an “offset” well to prevent or protect against drainage …. is a contractual duty, either express or implied, in an oil and gas lease”); Kerr-McGee Corp. v. Helton, 133 S.W.3d 245 (Tex. 2004) (“Drainage may be prevented by drilling an offset well”); Brown v. Humble Oil Co., 83 S.W.2d 935 (Tex. 1935) (“an adjoining landowner cannot complain if wells are drilled near his boundary” as that the landowner can “protect himself by drilling offset wells”); See also, William & Meyers, Manual of Oil and Gas Terms, p. 63 (14th Ed. 2009)(defining an offset well as “a well drilled on one tract of land to prevent the drainage of oil or gas to an adjoining tract of land, which a well is being drilled or is already in production”).

Pennsylvania has long recognized the duty to protect the leasehold from drainage. In Kleppner v. Lemon, supra., the Pennsylvania Supreme Court observed that a lessee has an implied obligation to mitigate the effect of nearby wells. The Kleppner Court opined that, if left unchecked, drainage from nearby wells will “defeat the very purpose of the contract, and [will] drain from the land of the lessor the oil underlying it, and yield him nothing in return.” Kleppner, 35 A. at 109. Likewise, in Barnard v. Monongahela Natural Gas, 65 A. 801 (Pa. 1907), the Pennsylvania Supreme Court noted that because “oil and gas are fugitive in their nature and will by reason of inherent pressure seek any opening,” a lessee has a duty to protect the leasehold from drainage. Barnard, 65 A. at 802. And in Hamilton v. Foster, 116 A. 50 (Pa. 1922), the Pennsylvania Supreme Court re-affirmed the protection covenant by stating that:

“[I]t is a well-known fact that oil and gas can be readily drawn from one part of the underlying field to another…and therefore a lessee in such cases must act with great promptness in sinking and due-care in selecting the place to bore a well, lest others are drilled on adjacent property …which will exhaust the gas to the detriment of the lessor.”

Hamilton, 116 A. at 53. For over a century, the drainage covenant was typically triggered only in connection with vertical wells in conventional reservoirs.

The plaintiffs in Adams, however, argued that the danger and threat of drainage is the same whether the well is vertical or horizontal. The Texas Supreme Court disagreed. The Adams panel rejected the Herbst family’s interpretation of Paragraph 25, opining that the clause must be construed in light of the context of the unconventional nature of the Eagle Ford shale formation. The majority opinion noted that “[C]ommentors have recognized that hydrocarbons in the tight reservoirs developed by horizontal drilling…are not susceptible to migration in the same fashion as found in formations traditionally targeted by vertical drilling.” Given the non-migratory nature of shale gas and the corresponding low risk of drainage from such formations, the majority concluded that the offset well required by Paragraph 25 did not actually have to protect against drainage. In short, it would be “illogical” for Paragraph 25 to require the offset well to protect against drainage that simply does not exist in the context of the Eagle Ford shale. Since mitigating against drainage was not the purpose of the Paragraph 25 offset well, the court concluded that Murphy Exploration did not breach the clause by drilling the Herbst Well some 2,100 feet away from the Lucas Well. The location of the offset well was not relevant or dispositive under the majority’s interpretation of Paragraph 25. Finally, the court observed that:

“As noted, Herbst contends an offset well is necessarily one that protects against drainage and that proximity to the draining well is necessary to effectuate that purpose. This is a reasonable premise in the context of vertical drilling, where placement of an offset well is an important factor in minimizing the amount of oil and gas being drained. But the same principal does not apply in the context of horizontal drilling and hydraulic fracturing in the Eagle Ford shale.”

In reversing the intermediate appellate court, the Adams panel rejected the commonly understood definition of an offset well and simply concluded that horizontal wells drilled in shale formations should be treated differently than vertical wells drilled in conventional reservoirs. The distinction made by the Adams panel could have far reaching consequences. For example, if horizontal wells drilled in and through tight shale formations, such as the Marcellus Shale, do not “drain” hydrocarbons from adjacent parcels, should the “rule of capture” even apply to horizontal drilling? [1] The “rule of capture” essentially provides that a driller may extract hydrocarbons from a common reservoir, even if those hydrocarbons flow from that portion of the reservoir located underneath an unleased, adjacent tract. In other words, naturally occurring drainage will not impose liability on the driller, so long as the wellbore is lawfully drilled within the footprint of the leased premises. If horizontal wells drilled in tight shale formations do not create a drainage risk, it raises a legitimate question as to whether such wells (and their operators) should be afforded the liability protection of the rule.

As many readers are aware, the nature and scope of the “rule of capture” is currently pending before the Pennsylvania Supreme Court in Briggs v. Southwestern Energy Production Company (443 MAL 2018). The question in Briggs is whether the frac fissures created by hydraulic fracturing should be considered a subsurface trespass if those fissures extend beneath an unleased neighboring parcel. Southwestern Energy has defended the suit on the grounds that the “rule of capture” immunizes a driller from a subsurface trespass claim even if the fissures cross property boundaries. In essence, Southwestern Energy has argued that the “rule of capture” applies because the fissures are simply draining hydrocarbons from the adjacent tract, which is expressly sanctioned by the rule itself. Adams, however, suggests that horizontal shale wells do not drain. If Adams is correct, then the applicability of the “rule of capture” to such horizontal shale wells is suspect.

It is unclear whether the Pennsylvania Supreme Court will adopt the logic and rational espoused by the Adams majority and conclude that horizontal shale wells should be treated differently in Pennsylvania. While some may argue that the Adams court went too far, it is clear that advances in drilling technology are forcing courts across the United States to revisit and re-examine historic principles of oil and gas law which developed in the era of vertical drilling.

[1] The applicability of the “rule of capture” was not at issue in Adams and the Texas Supreme Court expressly noted that its holding was limited to the definition of an offset well “which involve(s) unconventional production in tight shale formations.” Nevertheless, the court’s conclusion that horizontal shale wells pose little or no drainage risk could impact other areas of oil and gas law.