5 September 2008

    On August 29, 2008, the Texas Supreme Court issued its long-awaited opinion in Coastal Oil & Gas Corporation et al. v. Garza Energy Trust, et al. The decision was 6 - 3 with Justice Hecht delivering the majority opinion, with a 3-person dissent written by Justice Johnson. Justice Willett wrote a concurring opinion. Two justices – O’Neill and Wainwright –were not sitting, but were replaced by appointment by Judges Christopher and Pemberton.

    Summary of Holding. As long as the driller complies with applicable Texas Railroad Commission regulations, a hydraulic frac from a legally-located well that penetrates an adjoining tract is not actionable by an adjoining owner because the driller, based on the rule of capture, has caused no actionable damage. The adjoining owner can protect its minerals by drilling its own well.

    44 individuals (the “Share 13 Owners”) own the minerals under a 748 acre tract called “Share 13,” in Hidalgo County, Texas. Coastal is the mineral lessee under a lease on Share 13 that permitted pooling. Coastal owned the minerals under an adjoining 163-acre tract known as “Share 12.” Coastal has drilled wells on both Share 12 and 13. Production is from the Vicksburg T formation, a tight sandstone.

    Before 1983, Coastal drilled two producing wells on Share 13, one of which was the “2V.” In 1994, Coastal drilled the No. 3 well on Share 13, which was a strong producer. Later in 1994 Coastal drilled the No. 1 well on Share 12 – where it owned the entire mineral estate. The No. 1 well was located in the northeast corner, as close to Share 13 as Rule 37 permitted – 467 feet from the north and east lines.

    The No. 1 well on Share 12 was fraced. The fracing hydraulic length was designed to reach over 1,000 feet, however, its “propped” length (the distance the propant reached) and its effective length (how far out the frac will actually improve production) were progressively less.

    In 1997, Coastal formed an 80 acre unit of 73 acres from Share 13 and 7 acres from Share 12. The unit included the No. 2V well and the No. 4 well on Share 13 but no well on Share 12.

    In 1997, the Share 13 Owners sued Coastal and the court awarded the following to the Share 13 Owners:

    • for trespass on Share 13 caused by Coastal’s fracing of the No. 1 Well on Share 12, $1 million in lost royalties;
    • for breach of Coastal’s implied lease covenant to prevent drainage on Share 13, $1.75 million in damages for interest on lost royalties;
    • for breach of Coastal’s implied lease covenant to develop Share 13, $543,776 in damages for lost royalties;
    • for breach of Coastal’s duty to pool in good faith, $81,619; and
    • because Coastal had acted with malice, the jury awarded $10 million in punitive damages and found that, by permitting the frac to cross the lease line, Coastal had committed felony theft.

    The Corpus Christi Court of Appeals affirmed on all issues except on a point about attorneys’ fees. The Texas Supreme Court reversed and rendered in part and remanded in part.

    1. Trespass by Fracing. The first issue was whether the incursion of hydraulic fracturing fluid and proppants into another’s land two miles below the surface constitutes a trespass for which the minerals owner can recover damages equal to the value of the royalty on the gas thereby drained from the land.

    a. As to whether subsurface fracing can give rise to an action for trespass, Justice Hecht’s majority opinion said the issue had not been previously decided but it was not necessary to decide that broader issue. Instead, the majority held that the Share 13 Owners’ only claim of injury – that Coastal’s fracing operation made it possible for gas to flow from beneath Share 13 to the Share 12 wells – is precluded by the rule of capture. The rule of capture gives a mineral rights owner title to the oil and gas produced from a lawful well bottomed on the property, even if the oil and gas flowed to the well from beneath another owner’s tract. The Court said that the Share 13 Owners did not claim that the No. 1 well violates any statute or regulation: “Thus, the gas he claims to have lost simply does not belong to him. He does not claim that the hydraulic fracturing operation damaged his wells or the Vicksburg T formation beneath his property. In sum, [the Share 13 Owners] do not claim damages that are recoverable.”

    The Share 13 Owners said that stimulating production through hydraulic fracturing which sends fractures beyond one’s property is just like a slant well. The Court distinguished the slant well by saying that the gas migrates to the producing well bore in a fracing situation whereas gas from a deviated well does not migrate to the wellbore from another’s property – it is already on another’s property. The Court recognized that its rule “is a rule of expedience.”

    The Court held that the rule of capture is justified because (i) the drained owner can drill his own well; (ii) allowing recovery for gas drained by fracing “usurps to courts and juries the … authority of the Railroad Commission to regulate oil and gas production …,” (iii) determining the value of oil and gas drained by fracing is the kind of issue the litigation process is least equipped to handle due to the uncertainty of proof and the fact that judges and juries cannot “take into account social policies, industry operations, and the greater good …,” and (iv) the law of capture should not be changed to apply differently to hydraulic fracturing because “no one in the industry appears to want or need the change” [citing numerous amicus curiae briefs].

    b. A sub-issue was whether the Share 13 Owners had standing to maintain a trespass action. The Share 13 Owners only had a royalty interest and the possibility of reverter and had no right to possess the minerals. Some cases have stated that trespass involves “the injury to the right of possession”; the Court said the statement was too broad. The Court explained that, of the several common law trespass actions, only quare clausum fregit required a physical invasion of a possessory interest, while trespass on the case did not. The Share 13 Owners had standing to sue but had to show actual injury.

    2. Implied Covenant to Protect Against Drainage. The Court described the correct measure of damages as “the amount that will fully compensate, but not overcompensate, the lessor for the breach – that is, the value of the royalty lost to the lessor because of the lessee’s failure to act as a reasonably prudent operator.” Since the trial court had instructed the jury that the measure of damages was “the value of the royalty on the gas drained from Share 13 by the subsurface trespass…” the Court held that the jury instruction “was therefore incorrect.” Since there was no proof submitted on the amount of drainage a reasonably prudent operator should have prevented, the Share 13 Owners cannot recover on the claim for breach of the protection covenant.

    3. Implied Development Covenant. The Share 13 Owners said that Coastal’s delay in drilling additional wells breached the covenant. Coastal argued that any delay was offset by higher prices that prevailed when additional wells were drilled. The Court was unable to determine from the record whether Coastal established that the Share 13 Owners were not damaged nor whether those Owners offered no evidence of the amount of the damages.

    4. Repudiation. Coastal argued that, by filing suit, the Share 13 Owners had repudiated the lease and had therefore absolved Coastal of its obligation to develop the lease. Since Coastal did not cease operations (it drilled 8 more wells on Share 13) and Coastal did not ask the Court to resolve the issue, the repudiation argument was rejected.

    5. Bad Faith Pooling. The Share 13 Owners argued that Coastal had improperly exercised the pooling authority in the lease. They argued that Coastal should have included only one Share 12 acre in the 80 acre unit and the decision not to include the No. 1 well in the unit was bad faith as was the decision to include the No. 4 well in the unit. They also claimed that the location of the No. 4 and No. 6 wells in less favorable positions to prevent drainage was bad faith. The Court agreed that the jury’s findings were supported by the evidence.

    The Court reversed the judgment, rendered judgment that the Share 13 Owners take nothing on the trespass claim and the claimed breach of the implied covenant to protect against drainage, and remanded the remainder of the case for a new trial.

    Dissenting Opinion. Justices Johnson, Medina, and Chief Justice Jefferson, relying on case law applicable to the rule of capture which emphasized that the flow must occur “solely through the operation of natural agencies in a normal manner,” concluded that such fracing constituted a trespass and would have upheld the judgment of the court of appeals.

    Concurring Opinion. Justice Willett concluded, in part because of the importance of the oil and gas industry to Texas, that suits over fracing would subvert the rule of capture and would have instead followed the conclusion in Railroad Commission of Texas v. Manziel (decided in 1962) that subsurface fluid injection was no trespass at all. Justice Willett would have addressed whether the fracing was wrongful to start with: “this case should turn not on the absence of injury but on the absence of wrongfulness.”