On June 2, 2017 the Louisiana Second Circuit Court of Appeal affirmed a trial court’s judgment cancelling a mineral lease under Mineral Code article 140 and provided further clarity on a production in paying quantities analysis under Louisiana Mineral Code article 124.[1]  The dispute in Gloria’s Ranch, L.L.C. v. Tauren Exploration, Inc., arose from a 2004 mineral lease covering nearly 1,400 acres in Sections 9, 10, 15, 16, and 21, Township 15 North, Range 15 West, in Caddo Parish.[2]  The lease was granted by Gloria’s Ranch, L.L.C. (“Gloria’s Ranch”) to Tauren Exploration, Inc. (“Tauren”) and contained a three year primary term as well as a horizontal and vertical Pugh clause.[3]  Tauren subsequently assigned a 49% interest in the lease to Cubic Energy, Inc. (“Cubic”).[4]

In 2007, Fossil Operating, Inc. (“Fossil”), with whom Tauren contracted to conduct operations on the property, drilled and completed wells on the leased property in Sections 9, 10, and 16.[5]  Chesapeake Operating, Inc. (“Chesapeake”) drilled Cotton Valley wells in Sections 15 and 21 on lands that were unitized with the leased property.[6]  On September 1, 2009, Gloria’s Ranch executed a top lease to Chesapeake on the property in Section 21.[7]  In November of 2009, Tauren assigned the deep rights (all depths below the base of the Cotton Valley formation) to EXCO USA Asset, Inc. (“EXCO”) for $18,000 per acre.

By December of 2009, Gloria’s Ranch believed that the lease granted to Tauren had expired either in whole or in part for lack of production in paying quantities.  Gloria’s Ranch sent a letter dated December 3, 2009 to Tauren, Cubic, EXCO, and Wells Fargo.[8]  After some investigation, Tauren responded by stating that it had incorrectly calculated revenues and operating expenses of the wells drilled in Sections 9, 10, and 16, and that after the correction, the lease was operating at a profit.[9]  Unsatisfied with the response, Gloria’s Ranch sent a letter on January 28, 2010 demanding a recordable act evidencing the expiration of the lease, to which the defendants refused.

Gloria’s Ranch ultimately filed suit against Tauren, Cubic, EXCO, and Wells Fargo for their failure to provide a recordable instrument evidencing the expiration of the lease.  Gloria’s Ranch’s petition alleged that the lease expired in 2009 due to lack of production in paying quantities and alleged that it suffered damages for lost-leasing opportunities.[10]  Gloria’s Ranch amended its petition to include a claim for failure to pay royalties on production in Section 15 (from the unit well drilled by Chesapeake).  After a four-day bench trial, the trial court found that the lease had expired as to all depths in Sections 9, 10, 16, and 21 due to lack of production in paying quantities, and awarded Gloria’s Ranch $18,000 per acre as damages for lost-leasing opportunities.[11]  The trial court also found that defendants failed to pay royalties in Section 15 and awarded Gloria’s Ranch the royalties owed plus punitive damages.[12]  The trial court’s judgment cancelled the lease as to Sections 9, 10, 15, 16, and 21.  The defendant’s appealed.

After setting forth the proper level of deference owed to the trial court’s judgment, the Second Circuit turned its attention to the production in paying quantities issue.  Louisiana Mineral Code article 124 provides for lease maintenance beyond the primary term by production in paying quantities.  According to the Second Circuit, one of the “prime motivations” for this requirement is to prevent a lessee from maintaining a lease “for speculative or other selfish purposes.”[13]  In evaluating whether a lease is producing in paying quantities, courts have traditionally looked to whether “a reasonably prudent operator would, for the purpose of making a profit or minimizing loss, continue to operate a well in the manner in which the well in question was operated.”[14]  The Second Circuit iterated that this standard implicitly requires production income to exceed operating expenses, and that Louisiana courts generally look to a 12 or 18 month period in determining whether a lease is producing in paying quantities.[15]

After receiving Gloria’s Ranch’s December 3, 2009 letter, Tauren and Fossil’s attorney provided operating statements showing that the wells in Sections 9 and 16 made a net income of $16,265 and $25,383, respectively, and the well in Section 10 operated at a loss of $28,239.[16]  Based on these figures, the attorney opined that the lease was operating at a profit and satisfied the production in paying quantities requirement of Mineral Code article 124.  But, according to the Second Circuit’s opinion, during discovery, Gloria’s Ranch discovered that the operating statements had been altered to exclude administrative costs ($1,025 per month), ad valorem taxes, contract labor, and routine chemical charges.[17]  The operating statements also reduced the monthly charge for the use of Tauren’s processing facility to a flat rate of .035 cents per mcf.[18]  Expert testimony during trial revealed that the wells in Sections 9, 10, and 16 operated at a cumulative net loss of $216,507.59 for the 18 month period prior to Gloria’s Ranch’s letter in December of 2009.[19]  Another expert testified that the well in Section 21 was operated at a cumulative net loss of $115,248.74 between May 2007 and February 2010.[20]

Tauren argued that despite the wells unprofitability, Tauren had a legitimate business plan to develop the Haynesville Shale formation.  Tauren’s expert testified that Tauren’s business plan to develop the lease satisfied the requirement of Article 124 as he interprets the language therein.[21]  The Second Circuit rejected Tauren’s business plan argument.  The Second Circuit reasoned that “the existence of an ongoing business plan to develop the Haynesville Shale does not exempt the defendants from [the production in paying quantities] requirement.”[22]  Finding that the defendant’s plan was clearly speculative and “a textbook example of what the legislature intended to prevent,” the court affirmed the trial court’s judgment finding that the lease expired as to Sections 9, 10, 16, and 21 for lack of production in paying quantities.[23]

The next issue before the Second Circuit on appeal was the calculation of damages for lost-leasing opportunities.  At trial, several experts testified as to the bonus and rentals Gloria’s Ranch could have received had it been able to execute a new lease.  Two experts testified that the $18,000 per acre paid by EXCO was the best evidence of the value of the lost-leasing opportunities.[24]  Defendants’ expert testified that the property was outside the core Haynesville Field and, therefore, less valuable.[25]  The Second Circuit held that based on the evidence presented at trial, the trial court did not err in finding that the $18,000 per acre paid by EXCO was the best evidence of the value of Gloria’s Ranch’s lost-leasing opportunities claim.[26]

Lastly, the Second Circuit addressed the trial court’s judgment ordering punitive damages and lease cancellation under Mineral Code article 140.  Mineral Code article 140 provides, in pertinent part, that “[i]f the lessee fails to pay royalties due or fails to inform the lessor of a reasonable cause for failure to pay in response to the required notice, the court may award as damages double the amount of royalties due. . . ” On appeal, Tauren argued that the damages permitted under Article 140 does not entitle Gloria’s Ranch to treble damages, only the value of the unpaid royalties plus a damage award equal to the value of the unpaid royalties, i.e., twice the value of the unpaid royalties.

The Second Circuit rejected this argument, following its decision in Wegman v. Cent. Transmission, Inc., 499 So. 2d 436, 451 (La.App. 2 Cir. 1986).[27]  In Wegman, the Second Circuit held that the damages permissible under Article 140 is the value of the unpaid royalties plus an additional damage award of twice the amount of the unpaid royalties.[28]  The court reasoned that the punitive damages under Article 140 are discretionary and are distinct from the award of the unpaid royalties themselves since the legislature could not have intended to allow the court discretion on awarding the unpaid royalties.[29]  Thus, the Second Circuit found that the discretionary award of damages equal to double the amount of unpaid royalties is separate and distinct from the required damages of the unpaid royalties themselves.

The Second Circuit also upheld the trial court’s judgment cancelling the lease as to Section 15 for failure to pay royalties under Article 140.  The court noted that lease cancellation under Article 140 is only proper where “the remedy of damages is inadequate to do justice.”[30]  Gloria’s Ranch, after contacting Chesapeake (the operator of the Section 15 well), sent notice to defendants as required by Article 140.  Defendants then failed to pay the royalties or provide a response as to why royalties were not being paid or were not due.[31]  According to Cubic’s vice president, defendants decided that a response was not necessary because they were already being sued.[32]  The Second Circuit found that because the well drilled in Section 15 produced for nearly two years prior to the instigation of the suit and approximately four years prior to the notice sent by Gloria’s Ranch, and because Defendants failed to respond to Gloria’s Ranch’s notice, the trial court had a factual basis to conclude that damages were not sufficient to remedy the injustice.  Notably, this is the first case in which dissolution of the lease was awarded under Article 140 since the Second Circuit’s ruling in Wegman v. Cent. Transmission, Inc., 499 So. 2d 436, 451 (La.App. 2 Cir. 1986).

There are two important points to take away from the Second Circuit’s decision in this case.  First, the court further clarified some of the costs and expenses courts will consider when determining whether a well or lease is producing in paying quantities, including administrative charges, ad valorem taxes, contract labor, and chemical charges.  Second, the court’s judgment makes clear that courts will award dissolution of a lease for failure to pay royalties, and that the fact that a lawsuit has been filed does not relieve a lessee from responding to a notice of unpaid royalties.

The Second Circuit’s decision also addressed issues involving lender liability for damages under the Louisiana Mineral Code, and a detailed discussion of those issues is also located on The Energy Law Blog. If you would like additional information on this case and its potential implications, please contact Caleb J. Madere (cjmadere@liskow.com), Brittan J. Bush (bjbush@liskow.com), or Jamie D. Rhymes (jdrhymes@liskow.com).

* Caleb J. Madere and Brittan J. Bush are Associates, and Jamie D. Rhymes is a Shareholder in Liskow & Lewis’ Lafayette, Louisiana office. Any views expressed herein are those of the authors and do not necessarily reflect the views of Liskow & Lewis and/or its clients. Furthermore, it is the authors’ intention to provide the information contained herein in an objective fashion that presents the practical effects of particular legal decisions without any commentary as to whether a particular decision is legally correct or sound policy. In the interest of full disclosure, Liskow & Lewis served as appellate counsel for Cubic Louisiana, L.L.C. in this matter.

[1] Gloria’s Ranch, L.L.C. v. Tauren Exploration, Inc., et al., 51, 077 (La. App. 2 Cir. 6/2/17). A copy of the Second Circuit’s decision is available at http://www.la2nd.org/archives/docs/410ecc.pdf. As of the posting of this blog entry, the delays for appeal have yet to expire.

[2] Id. at p. 1.

[3] Id.

[4] Id. at p. 2.

[5] Id.  The wells drilled in Sections 9 and 10 were completed to the Cotton Valley formation.  The well in Section 16 was drilled to the Haynesville Shale formation, but only completed to the Cotton Valley formation.

[6] Id. at p.3.

[7] Id.

[8] Id. at p. 4.

[9] Id.

[10] Id. at p. 5.

[11] Id.

[12] Id.

[13] Id. at p. 8 (citing La. R.S. § 31:124, cmt.).

[14] Id. (citing La. R.S. § 31:124, cmt.; Middleton v. EP Energy E&P Co., L.P., 50,300 (La.App. 2 Cir. 02/03/16), 188 So. 3d 263; Wood v. Axis Energy, Corp., 2004-1464 (La.App. 3 Cir. 04/06/05), 899 So. 2d 138, 143).

[15] Id. at p. 9.

[16] Id. at p. 9.

[17] Id. at p. 10.

[18] Id.  The wells were originally charged using a throughput method, which resulted in an average yearly cost of $1.457 per mcf in 2009.

[19] Id. at p. 11.

[20] Id.

[21] Id. at p. 12.

[22] Id.

[23] Id. at p. 13.

[24] Id. at pp. 14-15.

[25] Id. at p. 15.

[26] Id. at p. 16.

[27] Id. at p. 17.

[28] Id.

[29] Id. at p. 18.

[30] Id. at p. 20 (citing La. R.S. § 31:141).

[31] Id. at p. 21.

[32] Id.