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San Antonio Court of Appeals’ Decision Applying RPO Standard to Offset Well Provision in Horizontal Drilling Dispute Now Final

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On October 11, 2017, the San Antonio Court of Appeals issued a mandate, making its June 28, 2017 unanimous decision in favor of Murphy Exploration & Production Co.—USA final. On June 28, 2017, the court of appeals issued an opinion affirming summary judgment in favor of Murphy in an oil and gas lease dispute involving the proper interpretation of an offset well clause in the context of horizontal drilling. In affirming the trial court’s ruling, the court of appeals interpreted the “drill, pay, or release” offset well clause as implicating the traditional reasonably prudent operator standard regarding offset wells and rejected the plaintiffs’ interpretation that Murphy owed them over $11 million dollars in compensatory royalties for failing to offset shale production on adjacent land in Karnes County, Texas.

Lessor’s claim for breach of offset well clause and trial court rulings

In 2014, Murphy’s lessor, Helen Mzyk, and related entities sued Murphy for over $11 million in compensatory royalties after an adjacent operator drilled horizontal wells on an adjacent lease tract. The laterals on the horizontal wells drilled on the adjacent tract ran perpendicular to and away from Murphy’s lease, and because there was no concern that they were draining Murphy’s lease, Murphy decided not to offset the wells. There was also evidence of unfavorable geology for horizontal wells beneath Murphy’s leasehold.

Plaintiffs sued Murphy under an offset well clause in the lease requiring Murphy, upon the drilling and completion of a well on adjacent land within 467’ of the lease line, to either drill an offset well as a “reasonably prudent operator” would, or, in lieu of drilling, either pay compensatory royalties or release leased acreage. Murphy responded that by expressly incorporating the reasonably prudent operator standard into the offset well provision, Murphy was only required to offset the adjacent wells if they were substantially draining the lease and it would be economic to do so.

Murphy moved for summary judgment on its interpretation that a reasonably prudent operator would not have drilled an offset well in these circumstances. The trial court granted Murphy’s motion, construing the lease to require an offset well only when: (1) the productive portion of the horizontal lateral on the adjacent lease is within 467’ of the lease; (2) substantial drainage was occurring from the neighboring wellbore in question; and (3) a reasonably prudent operator would have a reasonable expectation of producing gas and condensate in paying quantities from the prospective offset well. After Mzyk failed to present evidence meeting each of these three elements, the trial court granted Murphy’s no-evidence motion for summary judgment.

Court of appeals applies reasonably prudent operator standard to reject lessor’s interpretation of offset well clause as a “deemed drainage” provision

Plaintiffs appealed, arguing that the offset well clause was a “deemed drainage” provision that did not require proof of any drainage, much less substantial drainage, or proof that a well would be economic if drilled in order to establish a breach of the lease. Under their theory, plaintiffs argued that the RPO standard in the offset well clause only applied to the question of how Murphy should have drilled an offset well, not the threshold question of whether a reasonably prudent operator would drill an offset well in the first instance. The court of appeals rejected plaintiffs’ arguments and held that the reasonably prudent operator standard, as previously interpreted by Texas courts in the context of offset well provisions involving vertical wells, required the lessor to prove both substantial drainage and that a reasonably prudent operator would have drilled a commercial well. Plaintiffs conceded they had made no attempt to present evidence of either of these factors. Because Murphy was not required to drill an offset well, the court of appeals also agreed that Murphy was likewise not obligated to pay compensatory royalties.

Takeaways

While Texas courts have applied the “substantial drainage” standard in the context of offset well clauses and vertical drilling, the Mzyk decision is the first time that a Texas court of appeals has expanded the substantial drainage standard to a so-called “deemed drainage” clause in the context of horizontal shale drilling. In doing so, the court confirmed that the RPO standard in an offset well clause applies to whether the lessee must drill, not how the well is to be drilled. This is important where lessors seek compensatory royalties in the context of wells running perpendicular to and away from the lease—wells that present no risk of drainage.

Jason Newman and Meghan McElvy represented Murphy before the trial court and assisted Macey Stokes on the appeal, with additional support from Ben Gonsoulin.

To read the full opinion, click here.

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