The Shale Plays A Trial Lawyer s Perspective. General Litigation Issues. The Shale Plays From a Trial Lawyer s Perspective. Greg W.

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1 The Shale Plays A Trial Lawyer s Perspective BACKGROUND 1722 Routh Street, Suite 1500 Dallas, Texas The Role of Gas in the U.S. Economy General Litigation Issues In the past, shale production was minimal and helped stabilize overall production and off-set production declines with production generally from shallow developments (500 to 2,500 feet). The biggest difference today is technology, and the technical challenge is to release the gas from impermeable and very hard rock. 3 4 Economical horizontal drilling and new completion technology have made recovery possible and financially viable. Different from other tight gas plays, shale gas wells are expected to have production for 30 years or more. Domestic production from shale gas has more than quadrupled in the last 5 years. Although shale development was once a niche play dominated by small, independent producers, major oil and gas companies are now active in the sector (Exxon, BP, BG, Shell, Statoil, ConocoPhillips, etc.) 5 6 1

2 Geology Shale generally has very low permeability and releases gas very slowly. Shale is very rich in organic carbon and can hold enormous quantities of gas. Shale often forms a seal that retains oil and gas, and sometimes the oil and gas reservoir is located within the shale formation itself. Shale is found at a variety of different depths, though most are between 250 ft. and 8,000 ft. Some are deeper, such as the Haynesville. Most natural gas produced from shale is clean and dry, though some natural gas liquids (NGLs) are present as well. 7 8 Major U.S. Shale Gas Formations - Keys Each formation area presents unique challenges and unique opportunities. Major shale gas players are seeking a diverse portfolio. Technical experts, methodology and experience are the keys to successful shale gas development. The lessons learned from one shale gas formation have benefited activities in others. Technology improvements, technical expertise and know-how have resulted in increased efficiency, lower expenses and very high initial productivity rates Horizontal drilling became widely used during the 1990s. Most horizontal laterals extend for more than 4,000 feet. Many today are even greater. Rotary steerable systems allow the drill bit to be continually rotated while changing directions, allowing more accurate, economic and complex wellbores that can follow the contours of a shale bed. The well bore stays in direct contact with the shale along much of the distance. Horizontal wells typically cost twice as much as vertical wells. However, horizontal wells offset that higher cost with greater efficiency. When combined with hydraulic fracturing, a horizontal well can provide 5 to 10 times the flow capacity of a vertical well. In addition, horizontal wells reach a larger area. Six to eight horizontal wells, drilled from a single well pad, can access the same reservoir volume as sixteen vertical wells

3 Shale gas wells are hard to complete, normally requiring hydraulic fracturing before production is possible. Hydraulic fracturing is a well-stimulation treatment that perforates and stimulates various points along the lateral wellbore. It involves pumping large quantities of fluids through perforations in the wellbore: fluids are pumped at a very high pressure (up to 8,000 psi) Fluid can be water, oil, or acid based Process can require 2M to 8M of water for each job High-tech fracturing fluids are typically used for shale gas formations since they penetrate more deeply and allow solid materials ( proppants ) to flow more easily. Maintaining pressure on the well is difficult, and the solid proppants help prop the fractures open. The pressure causes the shale to fracture, preferably perpendicular to the well bore. Fractures can extend thousands of feet General Litigation Issues Sometimes, multiple fracturing treatments are required to produce fractures at different depths. This process is expensive, typically totaling up to 25% of the entire cost of the well. The BP factor Hire local counsel and any needed experts early on Consider self help: Lis pendens TRO / injunction Estoppel letter Develop discovery plan early The Economy Strikes the Patch Preserve everything I was under medication when I made the decision not to burn the tapes. President Richard Nixon. Generally, bad economics are not a defense. Creative lawyering is being utilized: Statute of Frauds Identify witnesses early Don t necessarily agree to arbitrate as it may not be your best forum No title Estoppel Etc., etc., etc

4 Do We Have an Agreement? Several operators in the Haynesville Shale and Marcellus Shale backed out of nearly every agreement that they had not closed in October 2008 resulting in a number of lawsuits. Principal defense no agreement satisfying the statute of frauds. Statute of frauds requires contract in writing, including a description of what is conveyed. Several parties attempted to enforce binding letters of intent. Examples: Cheetah sought enforcement of Agreement to Purchase Oil and Gas Leases. Agreement purported to convey all of Cheetah s right, title and interest below the depths of producing formations in certain leases. The parties failed to attach an exhibit describing the leases to be assigned even though they included information such as net acres and working interest. Court did not enforce the agreement In Preston Exploration, Preston sought enforcement of PSA. Court noted that the PSA included Lessor name Effective date of lease Gross acres leased Royalty of lease Net revenue interest Court found that PSA Joint Ownership Agreement Issues Did not comply with statute of frauds. However Court found fact questions based upon whether assignments were finalized Joint Ownership Issues Texas Law on Exercise of a Preferential Right Many JOAs (including 1989 form) have a preferential right to purchase provision. Probably covers both operating and nonoperating interests. Strike it. Sales are taking place. Most litigated area involving JOA, other than lack of performance or poor performance

5 Other Areas of Dispute Payment of joint interest billings Audit Suspend rights Foreclosure Drill a partner out Performance by operator JOA is not ideally drafted for horizontal wells need to change definition of deepen You only get to elect once can t change your mind. Comply with statute of frauds Exhibit A is your contract. Gross negligence standard Does not protect from contractual issues Liability for Hydraulic Fracturing Two years ago, the Texas Supreme Court decided the case of Coastal Oil & Gas Corp. v. Garza Energy Trust Primary Issue: Whether subsurface hydraulic fracturing of a natural gas well that extends into another s property is a trespass for which the value of gas drained as a result may be recovered as damages? No. But does that solve all of the operator s problems? No

6 Garza sued Coastal for: Breach of the implied covenant to develop Garza s tract; Trespass, alleging that the fracing invaded beneath their tract causing substantial drainage; Breach of the implied covenant to protect against drainage; and At trial, Garza won on all counts and the jury awarded over $15 M in total damages. The trial court reduced some of the damages. The court of appeals reversed and remanded the attorney s fee award, but affirmed in all other respects. Bad-faith pooling The Texas Supreme Court, Justice Hecht delivering the opinion: Reversed the award of damages for drainage resulting from the trespass (fracing) Remanded the issues of breach of the implied covenant to develop and bad-faith pooling While not deciding the broader issue of whether fracing in and of itself is a trespass, the Court held that the rule of capture disallowed any damages where the only claim of injury was that the fracing allowed gas to flow from one tract to another The rule of capture gives a mineral rights owner title to the oil and gas produced from a well, even if the oil and gas flowed to the well from another owner s tract. Given this rule, the Court said that the gas [Garza] claims to have lost simply does not belong to [Garza]. Id. at *5. Accordingly, because there were no other claims of injury, Garza had no recoverable damages. Garza argued that the rule of capture should not apply to fracing, comparing the practice to slantwell drilling. The Court rejected this argument, contrasting the fact that slant-well drilling took minerals in place while fracing only allowed minerals to drain

7 37 The law already gives a drained owner full recourse An owner who claims that her minerals are being drained can: Drill an offset well; Sue the lessee for violation of the implied covenant to protect against drainage; Offer to pool; or Apply for forced pooling if the offer to pool is denied. 38 Changing the rule would usurp the power of the RRC The rule of capture allows the commission to protect correlative rights by governing spacing, density and allowables of wells while also preventing waste and conserving natural resources. Changing the rule would give a right to specific minerals and would limit the RRC s power to regulate production. Determining the value of the drained minerals is not a decision best left to litigation. Given the subsurface nature of the litigation, the facts are almost impossible to determine. Courts would also have to take into account the social policies, industry operation, and greater good of permitting fracing. While these factors could be considered, changing the rule would disrupt one of the foundational principles of the industry. Nobody in the industry wants it to change. The Court received amicus curiae briefs from regulators, landowners, royalty owners, operators, and hydraulic fracturing service providers all opposing liability for hydraulic fracturing What does this all mean? The Court left unanswered the larger question of whether fracing in and of itself is a trespass. Still liable for negligence even if it was during fracing. The future: Liability for Horizontal Drilling House probe on fracing and EPA investigation

8 Liability for Horizontal Drilling 43% of all wells in 2009 were horizontal. Need permission to use the surface of adjoining tract for horizontal drilling. Do you need permission of mineral lessor on lands which you will pass through? Unanswered question. Liability for Horizontal Drilling Currently cases go both ways. Garza has language that supports both positions. Policy of Garza would seem to support operators. But what is the harm? Also, subsequent Court of Appeals decision cited Garza finding no trespass occurred when fluids were injected under RRC-authorized process does same rationale apply to horizontal drilling if the RRC approves? But will a court stop a knowing and intentional tort if asked to do so? Lease Termination Issues Pennsylvania has pending litigation Lease Termination Issues In areas like Panola and Harrison, I don t see how there is anything left to lease. Those counties have been leased up for years because of the Cotton Valley and Travis Peak formations. Walter Priddy, Geologist Henderson, Texas. Haynesville Shale Generates Attention, Marshall News Messenger, August 19, Lease Termination Issues The typical habendum clause extends an oil and gas lease, after it begins producing, so long as there is continued production. (Note: Some leases may only require capability of production.) Courts have interpreted production in these provisions to mean production in paying quantities. So what do courts consider PPQ?

9 Lease Termination and PPQ The Texas standard for PPQ was established in Clifton v. Koontz, 325 S.W.2d 684 (Tex. 1959). This test also serves as the basis for the Louisiana Mineral Code s definition of PPQ, so there is overlap between the states. La. Rev. Stat. Ann. 31:124. Under the test in both states, the lessor carries the burden to show that there has been no PPQ. PPQ in Texas Part 1 Production Less: Operating Expenses Less: Marketing Expenses Profit to Lessee? Measured over a reasonable period of time. If there is a profit, then the well is PPQ and there is no need to go to part 2. Expert intensive PPQ in Texas Part 1 PPQ in Texas Part 2 Note that this calculation does not include drilling and equipment costs. It does include: Taxes Overhead charges Labor Repairs Depreciation on salvageable equipment Other out-of-pocket lifting expenses Evans v. Gulf Oil Corp., 840 S.W.2d 500 (Tex. App. Corpus Christi 1992, writ denied) (considering production over two separate periods, one 15 months and the other 18 months). If there is no profit, then the court asks whether a reasonably prudent operator would continue to operate with an expectation of profit, and not just for speculation. If so, the lease continues. If not, the lease terminates. Again, this is measured over a reasonable period of time PPQ in Texas Part 2 In determining whether a reasonably prudent operator would continue with the well, a court will consider all relevant circumstances, including: Ability to market the minerals (including pipeline availability and general market conditions) Relative profitability of other wells in the area Operating and marketing costs of the lease Net profit Lease provisions Period of time that the well has been marginally producing Lease Termination and PPQ Always consider equitable defenses, including quasi-estoppel. Cambridge v. Geodyne. Termination of a lease does not necessarily mean termination of a pooled unit. Wagner & Brown v. Shepard. Cessation-of-Production Clauses May allow recovery of expenses

10 The Next Wave of Cases Difference between total physical cessation of production and cessation of production in paying quantities. If there is total physical cessation of production, then the cessation-of-production clause controls. If there is only a cessation of production in paying quantities, then the Clifton v. Koontz standard controls. Shut-in Clauses Still require PPQ when shut in. Focus on quantity not quality. Bad faith pooling No power to pool without express authorization, which is usually contained in the pooling clause RRC Rule 40 recognizes ability to pool Must be done in the method and for purposes specified in the lease Decision will be upheld unless done in bad faith Beyond terms of the lease, lessor should not be able to dictate Surface Owner Issues Clean, freshwater, is the lifeblood of rural Texas. Douglas Beveridge, Vice President, King Ranch Minerals Surface Owner Issues Water will be a concern in the Haynesville Water will be needed for fracturing process Texas (and Louisiana) are already concerned about water shortages Surface Owner Issues Controlling the fracturing process to keep water table safe EPA is currently studying (as of 03/18/10) fracturing effects on water supplies Development in urban areas 1000 wells in the City of Fort Worth

11 Primarily an issue when the mineral rights are severed from the surface... but has become more of an issue in where the oil fields are meeting the cities. Hostile surface owners get off my land... what part of my double barrel shotgun do you not understand? Play nice, negotiate compromise, surface damage agreement... Never take matters into your own hands... Injunctive relief and possibly damages related to delay/interference... Same rights to access surface exist even if minerals and surface are not severed, subject to terms of the lease. Scope of mineral owner s right to use surface Where mineral estate is severed from surface, mineral estate dominant. Legal privilege and enforceable right to use and have priority over servient estate to extent reasonably necessary to explore, develop, and transport minerals. When conflict of use arises, and no reasonable alternative, mineral estate s right to use surface trumps

12 In Texas, mineral owner not required to pay surface damages provided use is not excessive, negligent, or in violation of lease but as a practical matter most oil companies do so. Scope of mineral owner s right cont d... Many surface owners may not know that mineral owner may be entitled to damages and injunctive relief for improper interference. Right to use surface includes right to construct roads, tanks, pits, flow lines, utilize surface water, conduct seismic, etc., as reasonably necessary to explore, develop, and transport minerals and giving due regard to rights of surface owner. Rights may also be expressly defined by lease language (often overlooked or forgotten until too late) Limitations on right to use surface May use only amount of surface as reasonably necessary to explore, develop, and transport minerals giving due regard for the rights of the surface owner. Accommodation Doctrine : Are there reasonable alternative means to producing minerals which will permit surface owner to continue existing use of surface? must substantially impair existing surface use; and reasonable alternative must be available. Despite implied doctrine, express terms of lease or mineral reservation may trump. Limitations on right to use surface cont d... Whether reasonably necessary is fact question; surface owner has burden of proof to show surface use not reasonably necessary e.g., mineral owner may be required to directionally drill, even if increased costs, if directional drilling is viable economic alternative Surface use generally limited to exploration, development, and transport of minerals underlying lease/mineral estate must secure easement or right of way to transport off-lease or off-premise production or to access lease or premise to explore adjacent acreage (unless pooled) Surface use must comply with terms of lease and with applicable statutes, rules, and regulations e.g., drilling permits, statutory notice requirements, etc Surface damages Custom becomes the perceived law of the land. Many surface owners believe they are entitled to surface damages as a matter of law. However, absent express lease language to the contrary or statute, mineral owner/lessee generally only exposed to damages to the surface that are considered not reasonably necessary to explore and develop minerals. Existence of drill site, roads, pits, even noise, etc that are reasonably necessary, for example, and with due regard to the rights of the surface owner do not give rise to surface damages per se. Injury to livestock within reasonably necessary area to conduct operations does not give rise to surface damages, unless injury the result of intentional acts or gross negligence. However, what is reasonably necessary is often debated. Surface damages cont d... Exposure to damages for operations outside the reasonably necessary area used to explore and develop minerals. Pollution is not reasonably necessary. Lessee cannot negligently damage surface. Violations of RRC rules may result in negligence per se finding

13 Surface damages cont d... Don t forget the lease! Lease language may contain express provisions concerning surface damages: liable for damages, for example, to agricultural crops or structures regardless if operator is acting reasonably or within a justified area necessary for exploration and production lease may also cap or waive surface damages express provisions concerning fencing operations or restoration of the surface Surface damages cont d... Surface owner may seek breach of contract damages (e.g., breach of lease provisions), decreased market value, interference with peace and enjoyment of surface ( nuisance damages), physical damage to land, loss of crops or livestock, etc predicated on excessive or unreasonable use of surface If not covered by the lease (and not required by state statute), most operators will attempt to negotiate a surface damage agreement upfront In Texas, notice to landowner from tax roll is necessary for registry of existing wells