OIL & GAS ALERT: The Texas Supreme Court’s Decision in Wagner & Brown, Ltd. et al v. Sheppard

    16 March 2009

    Normally, when a lessor signs a lease to an oil company, that lessor thinks he or she will never be liable for any of the costs related to drilling a well and producing oil or gas. Not any longer.

    Normally, when a lessor signs an oil and gas lease to an oil company, when that lease expires, he or she will get all of the minerals back, ready to lease again. Not any longer.

    The Texas Supreme Court threw a real curveball to the oil and gas industry when it delivered its opinion in Wagner & Brown Ltd. v. Sheppard.

    Jane Sheppard owned an undivided 1/8th mineral interest in a 62.72 acre tract of land. A company leased her 1/8th interest and assigned the lease to Wagner & Brown, Ltd. (“W&B”). W&B leased the remaining 7/8ths from the other mineral owners. Sheppard’s lease had a special addendum stating that if royalties were not paid within 120 days after the first sale of oil or gas, her lease would terminate the following month. The Sheppard tract was pooled with eight other adjacent tracts to form the Landers Gas Unit, covering 122.16 total acres.

    Two gas wells were completed on the Sheppard tract; none were completed on the rest of the Unit. Ms. Sheppard’s lease allowed pooling.

    W&B discovered that Sheppard had not been paid royalties within 120 days of the first gas sale and offered her a new lease, which she declined. The parties agree that Sheppard’s lease terminated and she became an unleased co-tenant. Sheppard sued W&B saying that she was entitled to 1/8th of 100% of the production from both wells located on her land. The Trial Court and the Court of Appeals agreed: Sheppard was a co-tenant and entitled to her share of production from wells on her land, reduced only by the costs incurred by W&B after her lease expired.

    The Texas Supreme Court held that:

    Termination of Sheppard’s lease did NOT terminate her participation in the Unit; and

    Sheppard should bear the costs of production incurred before her lease terminated as well as costs incurred after her lease terminated that relate to the unit but not her lease.

    The Court relied on the language in Sheppard’s lease (and unit agreement) which pooled the “premises” and “lands,” not just the “leased interests.” Reasoning that, while the lease expired, the lands themselves obviously did not; therefore, the unit agreement was not terminated. “Thus while the termination of Sheppard’s lease changed who owned the mineral interests in the unit, it did not cause the unit to terminate because it was a pooling of lands, not just leases.”

    The trial court and court of appeals applied the express language of the lease, which stated that the lessee was responsible for all production costs. The Court applied equitable principles regarding improvements to real property. “The principles will establish that in equity that a person who in good faith makes improvements upon property owned by another is entitled to compensation therefore.” “It is true that [the lessee] breached Sheppard’s lease, but a breaching party is not necessarily barred from reimbursement for improvements.” The Court reasoned that if a co-tenant undertaking operations without consent of another co-tenant and a good faith trespasser could both recover a share of operation costs then, “it is hard to see why one who obtains a lease and then loses it by mistake is entitled to less equity than one who by mistake never had a valid lease in the first place.”

    Most pooling provisions contain a reference to the lands because a pooling of the land has an impact on how those lands can be treated in the event of a proposed pooling by a third party of those same lands. In no cases or instances has the pooling of lands under a lease been construed as a pooling of the underlying minerals free of the lease – until this case. Your difficulty now is in knowing which units which were once thought dead may still be alive. It is difficult as well to know what the impact of Ms. Sheppard executing a lease to a third party would now have – and what if the new lease has no pooling clause? Is the new lessee in the unit? And to what extent is the pooling effective? Is it effective as to more minerals than the original? Is it effective as to all depths or only as to the pooled depths?

    Although the Court is distinguishing between expenses incurred in connection with the unit, for which Ms. Sheppard is liable, and those with respect to the lease, for which she is not liable, the liability was announced as an application to oil and gas of general real estate principles saying that a landlord must compensate the tenant for improvements made by the tenant. No distinction made between “production costs” and “improvements;” the court simply stated that oil wells were improvements on the land. As written, then, the obligation of the lessor to reimburse the lessee could be imposed on every lessor whose lease has expired. Must the lessor now pay for roads and fences and wellbores that were dry holes? No hint is given save that it will be determined on “equitable” grounds, i.e. a trial will be required in all cases.

    Numerous parties have filed amicus curie briefs within the time limit that would allow the Court to reconsider its decision. But with the original decision being 8-0 it seems rather unlikely that the Court will reconsider, which means that each of these issues will have to be tried and years of uncertainty will ensue.