Diamonds May Not Be the Only Things That Are Forever

The Texas Supreme Court announces its decision in Wagner & Brown v. Sheppard[1]

On November 21, 2008, the Supreme Court of Texas decided that a mineral owner’s participation in a validly pooled unit did not cease simply because the lease of that interest terminated.  Because the unit continued, it was proper to account for production and costs on a unit-wide basis, and termination of the lease did not necessarily extinguish the equitable right of reimbursement for improvements on the premises.

The Facts

The lease of Jane Turner Sheppard’s one-eighth mineral interest contained the following language:

Lessee shall have the right but not the obligation to pool all or any part of the leased premises or interest therein with any other lands or interests. . . . Production, drilling, or reworking operations anywhere on a unit which includes all or any part of the leased premises shall be treated as if it were production, drilling or reworking operations on the leased premises, except that the production on which Lessor’s royalty is calculated shall be that proportion of the total unit production which the net acreage covered by this lease and included in the unit bears to the total gross acreage in the unit. . . .  In the absence of production in paying quantities from a unit, or upon permanent cessation thereof, Lessee may terminate the unit by filing of record a written declaration describing the unit and stating the date of termination.  Pooling hereunder shall not constitute a cross-conveyance of interests.

The lease was pooled under a unit designation that provided that the lessees “hereby pool and combine said leases and lands . . . into a single pooled unit.”  Two successful wells were then drilled on the lease, and proceeds and costs were allocated to all the interests in the unit.  

After taking over as operator of the unit, Wagner & Brown discovered that Sheppard had not been paid in accordance with a provision requiring payment within 120 days of the first gas sales, resulting in the termination of her lease according to that provision. 

Sheppard claimed that she was owed her full one-eighth interest, undiluted by any other unit interests, and she contested the deduction of expenses from her share of production.  She also contended that she was not bound by the pooled unit after termination of the lease, and she claimed that the operator must account to her on a well-by-well basis.

Decisions by the Lower Courts

The trial court entered summary judgment that:

• termination of the lease had ended Sheppard’s participation in the unit;
• Sheppard was not responsible for any costs incurred before termination, and
• Sheppard was responsible for only those post-termination costs associated with her interest.

The court of appeals affirmed the judgment in all respects.[2]

The Texas Supreme Court Saw It Differently

The Supreme Court addressed the case on contract construction, rather than public policy, grounds, noting that the lease was silent as to what happens to the unit when a single lease terminates, and “the unit agreement pooled certain ‘premises’ and ‘lands,’ not just their leased interests.” Termination of the Sheppard lease, therefore, did not terminate the unit, which the Court described as “a pooling of lands, not just leases.”

This was admittedly a case of first impression for the Court, which looked to a court of appeals decision (the Ladd case) construing a lease that allowed pooling with “other lands”[3] and where that court had determined that termination of a single lease did not destroy the unit, because “the continuing validity of any such pooling was not dependent upon a subsisting leasehold estate in the adjacent land.”  The Supreme Court found Ladd to be “precisely” on point, stating that “there cannot be one rule of contract interpretation for small mineral interests and a different rule for large ones.”

Another court of appeals had held that termination of two of three pooled leases terminated the entire unit,[4] which the Wagner & Brown Court distinguished on the basis that the lease before that court authorized pooling only “with the gas leasehold estate” of adjacent lands. Thus, the Supreme Court said, that unit terminated with the leasehold estate.  But in contrast, the Sheppard lease allowed for the pooling of lands, with the result that “a unit formed by pooling lands” does not necessarily “terminate on the same basis as one formed by pooling only leases.”  Also, because the Sheppard lease allowed pooling of “all or any part of the leased premises or interests therein,” Sheppard’s reversionary interest was also affected.

Thus, the Court held that Sheppard was entitled to one-eighth of the proceeds allocable to the mineral interest owners of her tract, and was not entitled to one-eighth of the proceeds allocable to the mineral owners of the other tracts by the terms of the pooling agreement.  As a result, Wagner & Brown had properly accounted to Sheppard for production and expenses on a unit basis, but because the trial court had awarded no costs to Wagner & Brown, the case was remanded for a reassessment of damages.

The Court was also asked to determine whether Sheppard should have to pay drilling and other costs incurred prior to termination of her lease.  The court of appeals had held that Sheppard was not liable for pre-termination costs “because at the time they were incurred (during the term of the lease), she had no liability for them.”  But the Supreme Court ruled otherwise, relying on the equitable principle that one who makes improvements in good faith on property owned by another is entitled to compensation.  Oil and gas wells are improvements to real property and “one who drills a well in good faith is entitled to reimbursement.”  Similarly, co-tenants must account to fellow co-tenants, but are entitled to deduct “the reasonable and necessary costs of production and marketing.”

The Court noted that expiration of a lease does not change these principles and it declined “to read Texas law as establishing that drilling costs are always or never recoverable when a lease expires.”  While the Court indicated that the equities here might rest with Wagner & Brown, it recognized that neither party’s summary judgment evidence focused on the equitable issues involved.  The Court thus reversed the judgment denying recovery of pre-termination costs and remanded the case for a determination of whether Wagner & Brown was entitled to pre-termination costs and determination of the reasonable and necessary amount of the costs.

1 Wagner & Brown v. Sheppard, No. 06-0845, 2008 WL 4958501 (Tex. Nov. 21, 2008). The Court has extended until January 7, 2009, the time for filing a Motion for Rehearing. The Wagner & Brown decision is the subject of a more detailed article by Mr. Marseglia, to be published in the December Report of the State Bar of Texas Oil, Gas and Energy Resources Law Section.

2 Wagner & Brown v. Sheppard, 198 S.W.3d 369 (Tex. App.—Texarkana 2006). Wagner & Brown did not appeal the trial court’s judgment that operating expenses be deducted from production on a well-by-well basis.

3 Ladd Petroleum Corp. v. Eagle Oil & Gas Co., 695 S.W.2d 99, 106 (Tex. App.—Fort Worth 1985, writ ref’d n.r.e.).

4 Texaco, Inc. v. Letterman, 343 S.W.2d 726, 730 (Tex. Civ. App.—Amarillo 1961, writ ref’d n.r.e.).