Liability for Damages to Reservoirs

In Hayes Fund for the First United Methodist Church of Welsh, LLC v. Kerr-McGee Rocky Mt., LLC, No. 13-1374, 2014 La. App. LEXIS 2342 (La. App. 3 Cir. Oct. 1, 2014), the Louisiana Third Circuit Court of Appeal concluded that oil and gas operators were liable for the damages to reservoirs, in the form of unrecoverable hydrocarbons, and owed lessors for lost production and royalty income for failing to follow industry-wide accepted protocol in the drilling of two wells.

The dispute arose from the drilling of two wells in southern Louisiana.  Id., at *2.  The first well was drilled in 1999 and produced from the Hackberry formation until the well ceased production in 2004 when allegedly water zones from the original wellbore mixed with oil and gas zones produced by a sidehole.  Id., at *3-4.  The Hayes Lumber well was also drilled in 1999 and ceased production in the lower zone of the Nodosaria formation in May 2007 due to sanding problems.  Production ceased in the upper zone of the formation on November 30, 2008 allegedly due to “extraneous water entering the well though casing leaks caused by prior sanding problems.”  Id.  The Plaintiffs (collectively “Hayes Fund”) entered into various oil and gas leases, whereby the Defendants (collectively “Kerr-McGee”) operated the above wells.

Hayes Fund filed suit against Kerr-McGee alleging that Kerr-McGee operated the wells imprudently in violation of Article 122 of the Louisiana Mineral Code and sought pecuniary damages in the form of lost royalties.  Id.

Article 122 of the Louisiana Mineral Code provides:

A mineral lessee is not under a fiduciary obligation to his lessor, but he is bound to perform the contract in good faith and to develop and operate the property leased as a reasonably prudent operator for the mutual benefit of himself and his lessor.  Parties may stipulate what shall constitute reasonably prudent conduct on the part of the lessee.

La. R.S. § 31:122. Hayes Fund’s argument focused on the assertion that Kerr-McGee acted in an imprudent manner when it allowed extraneous water and sand to enter into the reservoirs thereby leaving valuable hydrocarbons unrecoverable.  Kerr-McGee, at *4.  To determine if Kerr-McGee was liable to Hayes Fund for its improper actions, the Court examined provisions of the subject lease.  Id., at *50.  The lease provision provided, in pertinent part:  “The Lessee shall be responsible for all damages to timber and growing crops of Lessor caused by Lessee’s operations.”  Id., at *50.  The phrase, “to timber and growing crops of Lessor” was stricken from the lease, and therefore, the provision read, “Lessee shall be responsible for all damages caused by Lessee’s operations.”  Id., at *51.  The Court also reviewed Exhibit A to the lease, which provided that Lessee is responsible for all damages caused by Lessee’s operations “including, but not limited to damages to the surface of the land, timber, crops, pastures, … water wells and improvements.”  Id., at *52 (emphasis added).  Because the provision in Exhibit A was included and the phrase “to timber and growing crops of Lessor” was stricken from the lease, the Court concluded that Kerr-McGee’s responsibilities and liabilities were “expounded upon rather than limited.”  Id., at *53.  Therefore, Kerr-McGee was responsible for “all damages caused by [its] operations” rather than just to timber or growing crops.  Id.  Consequently, Hayes Fund was not required to prove Kerr-McGee acted imprudently, because, based on the language in the lease, Kerr-McGee was absolutely liable for damages it caused by its operations.  Id.

To determine the amount of damages sustained by Hayes Fund, the Court attempted to determine the amount of diminished royalties resulting from the reservoirs becoming unrecoverable.  Id., at *49. The Court used the Louisiana Commissioner of Conservation’s order establishing the boundaries of the reservoirs to determine the amount of lost production and royalty income.  Id., at *30.  Kerr-McGee alleged that the reservoirs were actually smaller than the dimensions set forth in the order.  Id.  However, the Louisiana Collateral Attack Doctrine, La. R.S. § 30.12, prohibited attacks on the Commissioner’s order except when a suit has been filed against the assistant secretary of the Office of Conservation for review of the order.  La. R.S. § 30.12(A)(1).  In this case, the Commissioner’s unit order setting the dimensions of the reservoir was binding on all parties because Kerr-McGee failed to challenge properly the Commissioner’s order.  Kerr-McGee, at *37-38.  Accordingly, Hayes Fund was entitled to damages for “lost profits,” which included losses attributable to the diminished overriding royalties from the reservoir sizes set forth in the unit order.  Id., at *38.

It is imperative for a lessee to examine carefully the language of its leases and confirm that the lease provisions do not expand the scope of the lessee’s liability for damages caused by the lessee’s operations.  Further, it is important that any orders granted by the Louisiana Commissioner of Conservation can only be challenged in a suit against the assistant secretary of the Office of Conservation in East Baton Rouge Parish.  Absent a proper challenge to a Commissioner’s order, the order and all of its terms are binding upon all parties.