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The Texas Supreme Court Provides Guidance on Retained-Acreage Clauses

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On April 13, 2018, the Supreme Court of Texas issued two unanimous opinions on retained-acreage clauses in oil and gas instruments with divergent results. The clauses at issue in each opinion set the size of the retained acreage by reference to a Texas Railroad Commission ("Railroad Commission") rule or regulation, which is very common in Texas oil and gas leases. As these decisions demonstrate, the particular words used in retained-acreage clauses, and the Railroad Commission rules or regulations they incorporate, make all the difference when it comes to preserving rights in a mineral lease.

Both cases presented the same question: to what extent does a lessee–operator retain acreage upon the termination of the primary term of the lease after drilling on some parts of the leased acreage but not others? In Endeavor Energy Resources, L.P. v. Discovery Operating, Inc., --- S.W.3d ---, No. 15-0155, 2018 WL 1770290 (Tex. Apr. 13, 2018), the Court construed a retained-acreage clause to preserve only the roughly 81 acres per well that the lessee–operator (Endeavor) had designated as proration units in its plat filings with the Railroad Commission, even though the applicable field rules permitted operators in that field to assign up to 160 acres per well, and Endeavor claimed it mistakenly assigned less than 160 acres for each well. In XOG Operating, LLC v. Chesapeake Exploration Limited Partnership, --- S.W.3d ----, No. 15-0935, 2018 WL 1770506 (Tex. Apr. 13, 2018), the Court held that the retained-acreage clause was not limited to the operator’s (Chesapeake) designation but rather was controlled by the applicable field rules, which resulted in Chesapeake retaining more acreage than what it designated in the proration plats that it filed with the Railroad Commission.

Recognizing the importance of Endeavor and XOG to the oil and gas landscape, please see below for a more in-depth analysis of the cases and takeaways from both a litigation and a transactional perspective.

The Court's decisions.

The two cases involved different oil and gas instruments with differently worded retained-acreage clauses, but presented the same core issue—the amount of acreage preserved by a retained-acreage clause. A retained-acreage clause typically works in conjunction with other lease-preservation measures: “While a habendum clause generally extends the entire lease so long as some production is occurring on the lease, and a continuous-development clause further extends the entire lease so long as the operator remains engaged in the required development efforts, a retained-acreage clause typically divides the leased acreage such that production or development will preserve the lease only as to a specified portion of the leased acreage.” Endeavor, 2018 WL 1770290, at *6. To distinguish between the acreage that is kept by the lessee–operator upon termination and the acreage that is returned to the lessor, retained-acreage clauses are often drafted to refer to a Railroad Commission designation, such as a proration unit, to identify the acreage that is retained by the lessee–operator. The Railroad Commission’s field rules may affect how a proration unit is designated. For example, some field rules refer to operators “assigning” acreage in a proration unit, while others “prescribe” proration units—a distinction that affected the two cases before the Court.

Retained-acreage clauses are “contractual and vary widely because parties are free to contract in any way they choose not prohibited by law.” XOG, 2018 WL 1770506, at *3. “Each retained-acreage clause must be construed on its own, under governing principles of contract interpretation.” Endeavor, 2018 WL 1770290, at *6. “[A]s with any contract, the parties to a retained-acreage provision are presumed to know the law and to have stated their agreement in light of it.” XOG, 2018 WL 1770506, at *3.

According to the Court, what distinguished the Endeavor and XOG cases were the terms of the retained-acreage clauses and the Railroad Commission’s applicable field rules. The retained-acreage clause in Endeavor stated that, at the end of the lease’s primary term or “upon the cessation of the continuous development . . . whichever is later,” the

lease shall automatically terminate as to all lands and depths covered herein, save and except those lands and depths located within a governmental proration unit assigned to a well producing oil or gas in paying quantities and the depths down to and including one hundred feet (100’) below the deepest productive perforation(s), with each such governmental proration unit to contain the number of acres required to comply with the applicable rules and regulations of the Railroad Commission of Texas for obtaining the maximum producing allowable for the particular well.

Id. at *8 (emphases in original). Focusing on the phrase “governmental proration unit assigned to a well,” the Court held that the only reasonable construction was that it referred to an “operator’s assignment of a proration unit through its filing of a proration plat with the Railroad Commission,” because “operators, and only operators, ‘assign’ acreage to proration units.” Id. at *9 (first emphasis added, second emphasis in original). Although the Railroad Commission’s field rules for the area permitted proration units of up to 160 acres, Endeavor did not designate or assign 160 acres to the proration units for its wells. Instead, Endeavor designated roughly 81-acre proration units, which was sufficient to obtain the maximum producing allowable for those wells. As a result, the Court affirmed the lower court’s summary judgment ruling that Endeavor had lost any interest in acreage outside the 81-acre proration units under the retained-acreage clause.

By contrast, in XOG, the Court deemed significant the references to a “prescribed” proration unit in the retained-acreage clause and field rules. See XOG, 2018 WL 1770506, at *4 (“In Endeavor, neither the retained-acreage provision nor the field rules refer to a “prescribed” proration unit.”). The retained-acreage clause in XOG provided that the acreage assigned to Chesapeake would revert to XOG after the primary term,

save and except that portion of [the leased acreage] included within the proration or pooled unit of each well drilled under this Assignment and producing or capable of producing oil and/or gas in paying quantities. The term “proration unit” as used herein, shall mean the area within the surface boundaries of the proration unit then established or prescribed by field rules or special order of the appropriate regulatory authority for the reservoir in which each well is completed. In the absence of such field rules or special order, each proration unit shall be deemed to be 320 acres of land in the form of a square as near as practicable surrounding[ ] a well completed as a gas well producing or capable of production in paying quantities ....

Id. at *1 (emphases in original). Chesapeake had drilled 6 wells during the primary term of the lease. Five of the wells were in the Allison-Britt Field, and one was in the Stiles Ranch Field. Based on the retained-acreage clause, the Court concluded that the proration unit for each of the six wells was 320 acres (for a total of 1,920 acres), even though Chesapeake had designated much less acreage in the proration plats it filed with the Railroad Commission. Because the Railroad Commission’s field rules for the Allison-Britt Field stated that, “[f]or allowable assignment purposes, the prescribed proration unit shall be a [320] acre unit,” the Court concluded that the proration unit for each of five wells in the Allison-Britt Field rules was 320 acres. Id. at *3 (emphasis added). Because no field rules applied to the sixth well in the Stiles Ranch Field, the Court concluded that the “deemed” proration unit for that well was 320 acres under the retained-acreage clause. Id. The Court affirmed the lower court’s summary judgment ruing that Chesapeake retained all of the acres under the retained-acreage clause, and none reverted to XOG.

Litigation Takeaways.

Endeavor and XOG make clear that retained acreage clauses are unique contractual provisions, and courts will not take a one-size-fits-all approach when interpreting them. The specific language used in the lease will be examined to determine the parties’ intent. And while parties often focus on the text within their lease, consideration should also be given to the statutes and regulations that may affect how that text is interpreted due to being incorporated by reference in the lease. For example, knowing the field rules that may apply when drilling in different formations is important, given how common disputes have become over whether retained acreage determined by reference to proration units is “fixed,” i.e., set at the time the well is originally completed, or “floating,” i.e., capable of increasing or decreasing when a well is re-completed in another formation with different field rules. As the Texas Supreme Court emphasized, parties to a contract “are presumed to know the law and to have stated their agreement in light of it.” XOG, 2018 WL 1770506, at *3. That is true even if “the contracting parties may not fully understand the ramifications of including a regulatory term in the typical mineral lease.” Endeavor, 2018 WL 1770290, at *6.

Also significant is the Court’s discussion of special limitations. “A special limitation in an oil and gas lease provides that the lease will automatically terminate upon the happening of a stipulated event.” Id. at *13. Examples of special limitations include “the cessation of production in contravention of the lease’s terms, failure to commence drilling or reworking operations within the time the lease required, or an operator’s failure to timely pay a shut-in royalty the lease required”—terms that commonly come into dispute, given their potential to end a lease. Id. The Court reaffirmed that courts “will not find a special limitation ‘unless the language is so clear, precise, and unequivocal that [courts] can reasonably give it no other meaning.’” Id.

In Endeavor, the Court determined that the lease language clearly and unequivocally imposed a special limitation: “The plain, grammatical language of Endeavor’s leases shows that the parties intended the leases to continue only as to acreage that had been assigned to a well as reflected in the certified plats Endeavor filed with the Railroad Commission, and that the leases ‘shall automatically terminate’ as to all acreage not assigned to those proration units.” Id. at *13. But in XOG, the Court held that the contract language was not sufficient to revert acreage back to XOG: “we cannot read it to do so unless it is so ‘clear, precise, and unequivocal that we can reasonably give it no other meaning.’” XOG, 2018 WL 1770506, at *4.

Thus, we expect that special limitations will continue to be an issue ripe for disputes. A lessor would likely argue that the special limitation is sufficiently clear, precise, and unequivocal to cause a lease termination, while a lessee would argue the opposite to avoid lease termination. But in a toss-up situation, this rule should favor the lessee.

Transactional Takeaways.

The cases also highlight the need to devote special attention to retained-acreage clauses, especially where significant valuations are placed on the expectation for long-term production from large amounts of acreage under lease. In the context of an acquisition, the due diligence activities of a prospective buyer or assignee should include an analysis of the wording of the retained-acreage clause contained in any oil and gas instrument affecting any oil and gas lease with significant value.

It should be noted that many instruments beyond oil and gas leases include retained-acreage clauses. For example, in XOG, the agreement that contained the disputed retained-acreage clause was a farmout agreement between XOG and Chesapeake. Thus, the importance of properly assessing and drafting retained acreage clauses arises in the context of any number of oil and gas instruments, including joint development agreements, drillcos, conveyances, and joint operating agreements—not just oil and gas leases and farmouts.

The courts permit parties to have significant leeway in drafting provisions in oil and gas instruments. Endeavor and XOG once again provide evidence that “words matter” in drafting or interpreting these types of agreements.

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