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Texas Supreme Court Recognizes Realities of Horizontal Drilling in Key Lease Clause Ruling

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On Friday, June, 1, the Texas Supreme Court issued an opinion holding that as a matter of law, Murphy Exploration & Production—USA complied with an express offset lease clause by drilling the offset well in the optimal location on the lease tract. The 5-4 opinion recognized important differences between horizontal drilling in tight shale formations where there is little to no drainage, and vertical drilling in more traditional reservoirs where migrating hydrocarbons lead to drainage.

Under the provision at issue, if a well was drilled within 467 feet of Murphy’s lease line (a “triggering well”), Murphy was required, within 180 days, to drill a well adequate to test the same formation, pay compensatory royalties as if an equivalent amount of production was obtained from an offset well on the lease, or release sufficient acreage to constitute a spacing unit as if the triggering well had been drilled on the leased premise. After a neighboring operator drilled a triggering well, Murphy drilled a horizontal well on the lease (“Herbst well”) to counter production. The Herbsts sued Murphy for breach of the offset provision, alleging that the Herbst well, which was located approximately 1800 feet from the lease line, was too far away from the triggering well to be an offset well. Murphy, however, contended that the plain language of the provision contained no distance requirement for the offset well. Murphy argued that the provision was drafted with horizontal drilling in mind, and therefore it only required Murphy to counterbalance production from the triggering well. Murphy further contended that there was little to no drainage in the Eagle Ford formation where Murphy completed the well, and therefore no reason to locate the well an arbitrary distance from the lease line.

The trial court agreed with Murphy’s interpretation of the provision. On appeal, however, the San Antonio Court of Appeals implied drainage requirements into the provision, despite its lack of any reference to drainage, and reversed the trial court’s ruling because Murphy had not met its summary judgment burden “to conclusively prove the Herbst well was protecting the [leased] tracts from drainage by the [triggering] well.” At the Texas Supreme Court, Murphy contended that the plain language of the provision did not include any distance requirement or limitation on the location of the offset well, and that the well Murphy drilled, which was undisputedly adequate to test the same formation where the triggering well was completed, was, by definition, “such off-set well” as used in the lease. The Herbsts did not defend the court of appeals’ implied drainage requirement, but instead continued to urge that the well must be located closer to the lease line.

In siding with Murphy, the Texas Supreme Court began by discussing the context in which the lease was negotiated – horizontal drilling in the Eagle Ford shale. Citing prior precedent, the Texas Supreme Court recognized that the term “offset well” could describe a vertical well drilled to prevent drainage, but also noted that this provision was drafted in a different context, one where production from tight shale presented little risk of drainage.

The court then examined the three interpretations proffered by Murphy, the Herbsts, and the San Antonio Court of Appeals, and determined that Murphy’s interpretation was the only reasonable one. The Herbsts interpretation was unreasonable, the court explained, because the arbitrary distance requirement they advocated for was not supported by either the lease provision or the lack of drainage in the shale formation where both wells were completed. The court found that the court of appeals’ holding that Murphy could prevail only by demonstrating that the Herbst well was protecting against drainage, despite the absence of a significant possibility that drainage was in fact occurring, was simply not logical. The court further noted that if the triggering well’s surface location was within the triggering distance, but the triggering well ran perpendicular to the lease line, protecting against drainage would be a logical impossibility. After rejecting these two interpretations as unreasonable, the court adopted Murphy’s interpretation that the term “offset well” is internally defined within the lease provision as a well drilled “to a depth adequate to test the same formation from which the well or wells are producing from on the adjacent acreage.”

The court’s decision is important for several reasons. First, it represents a recognition by the court that common law built on vertical wells drilled in non-shale formations does not always apply to horizontal drilling, and a willingness by the court to recognize important differences between the two, such as the lack of drainage in tight shale formations. Second, it recognizes the need to focus on the productive portions of a horizontal wellbore for purposes of analyzing lease provisions such as offset well clauses. The court recognized that “the points along the horizontal wellbore that are ‘perforated and fractured’ are the points at which oil and gas is drained from the surrounding rock,” and that “the locations of both the vertical portion of a horizontal well and the perforated portions of the horizontal wellbore are essentially irrelevant for production purposes.” The court’s focus in this regard may prove useful in future disputes involving the proper allocation of production from horizontal wells drilled across two or more lease tracts without pooling.

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