In Stewart Estate v TAQA North Ltd (Stewart Estate), (found here)1 the Alberta Court of Appeal reversed the decision of Justice Romaine in Stewart Estate v TAQA North Ltd (found here);2 and made findings on a number of significant oil and gas issues.
This case has something for everyone interested or involved in freehold oil and gas development, including academics, lessors, lessees, top-lessees, working interest owners, well operators and gross overriding royalty interest (GORR) holders. In a lengthy decision with each Justice issuing separate reasons, the Court of Appeal addressed these important issues:
- The general principles and standard of review applicable to the interpretation of oil and gas leases, in light of the Supreme Court of Canada decision in Sattva Capital Corp. v Creston Moly Corp, 2014 SCC 53 (see our earlier blog posts about this case (found here and here);
- The application of provisos in oil and gas leases which allow lease termination to be avoided where production is “interrupted or suspended” as a result of a lack of or an intermittent market or any cause whatsoever beyond the lessee’s reasonable control, in circumstances where the operator had determined that the relevant well had become uneconomic and then ceased producing the well for over five years;
- The application of the torts of trespass and conversion to sub-surface mineral rights;
- The range of potential remedies for trespass and conversion, including the (i) royalty approach; (ii) the “mild” compensatory or disgorgement of benefits approach, or (iii) the “harsh” compensatory or disgorgement of benefits approach.
- The date from which the accounting for trespass and conversion should be calculated, having regard to limitations as well as the possibility that the acceptance of royalties or shut-in payments constitute consent or leave and licence to continue production after lease termination;
- The obligation of GORR owners to account where the GORR holders receive a portion of production revenues after lease termination;
- The nature of the interests of top-lessees, including whether they have a direct claim against working-interest owners who continue production after lease termination, and whether litigation funding by top-lessees constitutes champerty and maintenance; and
- The ability or desirability of the Court making in rem declarations relating to interests in land and the validity of leases where there is a dispute as to who is the lessor.
Each of these items is summarized below.
The lessees of natural gas underlying section 25-27-1W5M (section 25) pooled their interests to form a one section production spacing unit and the 7-25-27-1W4M well (7-25 Well) was drilled during the primary term of the leases. The 7-25 Well produced until July 1995 when it was shut-in and production suspended for over five years. At the time of the shut-in, much of the infrastructure was removed. The 7-25 Well was placed on production again in February 2001 in a different formation and continued producing until January 2011, when it was shut-in by a court order unrelated to the issues in this case.
A number of factors affected the economics and production of the 7-25 Well, including that it was a sour gas non-unitized well close to Calgary and other production in the area was preferentially nominated under long term sale contracts in order to deplete the reserves in advance of urban growth. Further, the primary processing facility had capacity restraints and the lessees had no working interest in the processing facility and paid a premium for processing. The plaintiffs/appellants maintained the shut-in terminated the leases and the top-leases were the valid leases.
At trial, Justice Romaine concluded that a five-year cessation in operations and production of the 7-25 Well did not terminate the leases. Justice Romaine found three of the five leases valid, notwithstanding the shut-in, because of the interpretation of the third and fourth proviso in the leases. The other two leases she refused to opine on as not all interested parties were before the Court. Justice Romaine concluded that the 7-25 Well was shut-in “for causes beyond the Lessees’ reasonable control, in that it was uneconomical to produce during the shut-in period given the low price of gas and the relatively high costs of production and processing, effectively the lack of an economic market.” In the event that the leases had terminated, Justice Romaine noted that the appropriate award of damages would be based on the royalty method. (para 568)
THE COURT OF APPEAL DECISION
Each of the justices of the Court of Appeal (Rowbotham J.A., McDonald J.A., and O’Ferrall J.A.) provided their own Reasons for Judgment, suggesting that the issues were controversial and capable of various interpretations. There were surprisingly few issues on which the Court of Appeal was unanimous. The key findings of interest to the oil and gas industry are summarized below.
1. Interpretation of Oil and Gas Leases
In Sattva Capital Corp v Creston Moly Corp, 2014 SCC 53 (found here), the Supreme Court of Canada held that contractual interpretation involves issues of mixed fact and law as it is an exercise in which principles of contractual interpretation are applied to the words of the written contract, considered in light of the factual matrix. This characterization would normally lead to deference being given to first instance decision-makers, unless an extricable question of law is identified.
Notwithstanding Sattva, and the significant number of cases that have followed it and applied a deferential standard, the majority in Stewart Estate applied the standard of correctness to the interpretation of the oil and gas leases. McDonald J.A. did so by pointing to pre-Sattva oil and gas lease interpretation cases, and by finding that the oil and gas leases were standard form contracts of adhesion. He felt that attempting to inject circumstances surrounding the formation of the contract into the analysis is a legal fiction. (para 273) O’Ferrall J.A. stated that “there is no such thing as a standard oil and gas lease”, but nonetheless felt that oil and gas leases were sufficiently similar to adopt McDonald J.A.’s approach. O’Ferrall J.A. found that strict construction is the rule for interpreting petroleum and natural gas leases and that the interpretation calls for a “correctness” standard.(para 339) He further observed that the literal interpretation of a lease is most appropriate where the original lessors and lessees are no longer available and involves “interpreting the words of the lease as they might have been objectively understood by an informed person reading them when they were executed, not how they would be read today.”(para 342) Finally, both of the majority Justices appeared concerned that the precedential value of the interpretation warranted a correctness standard.
2. Termination of the Oil and Gas Leases
The majority (O’Ferrall J.A. and McDonald J.A.) concluded that the five leases terminated following the shut-in of the 7-25 Well in 1995. O’Ferrall J.A. concluded there was sufficient factual evidence, without reference to expert evidence on which the trial judge relied, to decide the issue of whether the lessees by their conduct caused the leases to terminate in accordance with their terms. All the financial measures and economic indicators for the 7-25 Well analyzed by the experts at the trial were only relevant to the economics of the 7-25 Well and had nothing to do with the fourth proviso respecting suspensions or interruptions of production as a result of a lack of a market or other causes beyond the reasonable control of the lessees, because the capital costs associated with the well and risk associated with producing the hydrocarbons were irrelevant to the lessors under the leases and borne solely by the lessees.(para 406-407)
Justice O’ Ferrall found that the evidence of the operator’s engineers, when the 7-25 Well was shut-in, supported that it was the declining production and well economics that resulted in the shut-in of the 7-25 Well, not the lack of a market or other causes beyond the reasonable control of the lessees. O’Ferrall J.A. made these important statements on this issue:
“It is important to distinguish between interrupting or suspending production from a well capable of production and ceasing production from a formation which is no longer commercially productive. It is important to make this distinction because the fourth proviso in the lease provides some relief only for production operations which are “interrupted or suspended”. In 1995, production from the Crossfield Member was not being interrupted or suspended. Production was being brought to an end and the producing formation abandoned…” (para 372)
“A lack of or an intermittent market was not the cause of the cessation of production from the 7-25 Well. Continued production was simply uneconomic and there was no foreseeable prospect of that situation changing. From that point forward, the lessors were simply holding onto a lease which had terminated in accordance with its terms.”(para 373)
“…In this case, there was no well capable of producing the leased substances for five and a half years. The leases expired in accordance with their terms when the only formation then capable of being produced was abandoned and the decision was taken not to recomplete the well in the only other formation which, as it turned out, was capable of production (even though it was thought not to be capable of economic production at the time of abandonment). Once a lessee concludes that a well is not capable of economic production, such lessee must within 90 days commence drilling, working or production operations to either stimulate the existing formation or complete the well in another formation. The fourth proviso is simply inapplicable to the circumstances where there is no well capable of producing the leased substances in commercial quantities.” (para 395) (emphasis added)
The specific facts likely mandated the decision in this case as there appears to have been a clear intention to abandon this well and no intention to produce it again from any formation. The well was shut-in because it was no longer capable of production, not because of the lack of a market or intermittent market, or matters outside the lessee’s reasonable control. However, the strong statements above could be interpreted to mean that any decision by a lessee to suspend a well based on a lessee’s own well-specific economic analysis that a well is no longer commercially productive or profitable, will always trigger termination absent other steps being taken. In this way, the majority decision applied to other situations has the potential to ignore the fact that in some instances, it is in fact a lack of a market or intermittent market, or matters outside the lessee’s reasonable control, which drive down the well revenues and which may render a well no longer commercially productive. The applicability of O’Ferrall J.A.’s statements to other situations will have to be carefully considered in future cases. For example, if the lessee’s internal analysis is that a temporary shut-in is required due to low commodity prices, or other reasons outside the lessee’s control, it is not clear that Justice O’Ferrall’s comments would be equally applicable or that the subjective evidence of the lessee would carry as much weight as it did in this case. It seems that the approach of the trial judge based on objective, expert evidence may very well still be relevant in the future.(para 343) Further, Justice O’Ferrall also cautioned against using oil and gas lease cases decided after the date of execution of the leases unless the decisions “were interpreting identically worded leases executed in or about the same time”.(para 342) This caution may very well apply to Stewart Estate in the future.
3. Confirmation of Subsurface Trespass and Conversion
While arguments have often been made that there cannot be trespass or conversion to mines and minerals, due to the lack of possession by the plaintiff, the Court of Appeal decided that this debate should be “put to bed”. The Court concluded that there can be subsurface trespass to mines and minerals and the Court will compensate for trespass and wrongful conversion. (para 171, 416)
4. The Appropriate Remedy
The appropriate measure of damages is highly dependent upon the circumstances and the trespasser’s conduct. Justice Rowbotham summarized the remedy options as follows:
“By way of introduction, case law and academic commentary demonstrate that remedies for trespass in the context of removal of a resource range along a continuum based on courts’ perceptions of what is just and equitable in the face of the trespasser’s conduct. If a trespasser’s conduct warrants punishment, it may be required to disgorge the entirety of the benefit gained from the trespass with little or no allowance for costs incurred in earning that benefit or improvements made to the property. This is the so called “harsh” rule. The harsh rule is designed to deter wilful trespass. At the other end of the spectrum, when the trespass is not tainted by fraud or bad faith, is the “mild” rule which requires the trespasser to disgorge the revenues less certain expenses, but with no allowance for profit to the trespasser. There has been a further refinement to the mild rule. When neither party knew of the trespass and the property owner would have been unable to realize the benefit the trespasser obtained from the trespass, courts have permitted the trespasser to retain the benefit of the trespass and ordered the trespasser to pay the property owner a reasonable fee for the use of the property. This is known as the “royalty method”. The lessee pays the property owner contractually agreed royalties and any bonus associated with negotiating a new lease.” (para 196);
Interestingly, between the trial decision and Court of Appeal decision, each of these remedy options was held by at least one judge to be justified by the facts of this case, which illustrates the uncertainty surrounding the appropriate remedy in any particular case. Specifically:
- The royalty method measure of damages was favoured by Justice Romaine at trial. The Court of Appeal considered this measure of damages inappropriate where the lessees knew or ought to have known that their leases had terminated in accordance with their terms. (para 421-422, 441-444) The royalty method measure of damages should not be used where there is potential to encourage lessees to wrongfully continue production after leases terminate, thereby promoting questionable litigation over lease validity;
- Disgorgement of net benefits of production received by the lessees, being, revenues less production, gathering and processing costs (mild rule), was favoured by the majority of the Court of Appeal; and
- Disgorgement of gross sales revenues, being all benefits of production (harsh rule) was the measure of damages favoured by Justice McDonald. He had some particularly strong comments about the conduct of the lessees and felt that “by no stretch of the imagination could it be said the lessees were acting in good faith…”.(para 312-317)
The majority decisions of Justice Rowbotham and Justice O’Ferrall cast some doubt about the future of the harsh rule of damages in cases of trespass following lease termination. Justice Rowbotham was of the view that the harsh rule “should no longer be available to remedy a trespass of this nature”(para 219) while Justice O’Ferrall preferred the “just and equitable” approach and held that the paramount consideration in assessing damages is what will promote “peace in the patch”.(para 439) It is unfortunate there was not a more detailed analysis of the applicability of the duty of honest contractual performance in contracts to oil and gas leases as set out in Bhasin v Hrynew, 2014 SCC 71 (see our previous bulletin on Bhasin v Hrynew found here).
On balance, Stewart Estate does not provide much further certainty to lessors or lessees as to which measure of damages will apply, although it does suggest that conduct approaching bad faith or that which would warrant an award of punitive damages will be required for the harsh rule to be invoked. In the meantime, parties to leases will continue to enter uncertain territory once it is alleged, and then denied, that a lease has terminated. What is clear is that the conduct of both sides from that point forward, as well as the time period of the claim, will be scrutinized very carefully by the Courts when assessing the appropriate measure of damages.
5. The Starting Date for the Claim or Damages Calculation
Stewart Estate addresses and conflates two important aspects in determining the start date of the calculation of damages, or the start date of the claim: limitations and the concept of leave and licence.
With respect to limitations, the majority of the Court of Appeal awarded damages for the period commencing two years before the Statement of Claim was issued, (para 229, 312) and concluded that The Limitations Act was a defence to the claim for damages arising prior in time.(para 183) Justice Rowbotham did this by deferring to the trial judge’s findings that the lessors knew that production had ceased when they stopped receiving monthly royalty cheques and did not take reasonable steps to discover their injury. The plaintiffs were not entitled to rely on the date that they obtained legal advice regarding the status of the leases because lack of knowledge of the law is generally not enough to postpone limitations. However, because the tort of trespass is a continuing tort, it results in a new actionable wrong each day and, therefore, the plaintiffs were able to claim damages for two years prior to the filing of the Statement of Claim.
With respect to the concepts of leave and licence, or related matters of consent, waiver or estoppel, at issue was whether the lessor’s acceptance of royalty or shut-in payments precluded some or all of the lessor’s claims. The majority (Rowbotham J.A. and McDonald J.A.) applied an earlier Court of Appeal decision and held that once a claim is filed and pursued, absent any implied or express encouragement to continue production, the mere fact that royalty payments are taken and no formal demand is made to stop producing are not determinative and do not equate to leave and licence. However, in the period before certain lessors were added as plaintiffs, acceptance of royalty payments constituted leave and licence and a defence to the claim for that period of time.
6. GORR Owner Liability to Account for GORR Payments under Terminated Lease
The majority of the Court of Appeal (O’Ferrall J.A. and McDonald J.A.) noted that a GORR carved out of the lessee’s working interest and entitling the holder to receive a portion of the lessee’s production revenue, is limited in duration to the life of the lease from which it is carved. The GORR expires once the lease from which it is carved expires. In contrast, a GORR carved from the mineral owner’s title “is not so easily extinguished.” A GORR owner is not a working interest owner and is not jointly and severally liable for the value of natural gas wrongfully converted under an expired lease, but the GORR owner may have to account to the lessor for royalty payments received once the lease terminated.(para 465-467)
In this case, the GORR owner had received benefits of production after the termination of the leases. The majority held that this benefit was something that had to be accounted for back to the lessor, either by the lessee (which had deducted the GORR payments as a cost in calculating net income under the mild rule) or the GORR owner. The majority refrained from finding that the GORR owner was directly liable to the lessors and directed the parties to implement the Court of Appeal’s direction, with any disputes to be determined by the Court of Queen’s Bench.
7. Top-Lessee claims
The Court of Appeal confirmed the trial judge’s conclusion that the top-lessees have no claim to damages in their own right. This was based on the specific wording of the top-leases which required a determination that the leases had terminated. It is quite possible a differently structured top-lease could create an interest in land sufficient to give rise to a direct cause of action.
Further, the unanimous Court of Appeal also upheld the trial judge’s determination that the promotion and funding of litigation by a top-lessee in return for a significant portion of any damage award is not sufficient to be considered champerty and maintenance.
8. Declarations Where Lessor Interest is in Dispute
The owner of the lessor interests in two of the five oil and gas leases was in dispute and potential owners were not party to the action. The Court of Appeal had earlier denied intervenor status in the Stewart Estate appeal to a potential lessor on the basis that the applicant had the same position as the other lessors before the Court (found here). While the trial judge and Justice Rowbotham did not believe that the Court should provide the relief requested without the other affected parties present, the majority of the Court of Appeal (O’Ferrall J.A. and McDonald J.A.) held that this dispute was not a reason to decline to rule on the validity of all five of the leases. We believe this potentially problematic approach was heavily influenced by the fact there was evidence before the Court of Appeal that the other potential lessor supported the position of the lessors on the appeal regarding the termination of the leases. This was likely a decision based on practical realities and should not be taken as an adoption of a practice of obtaining in rem relief without all affected parties before the Court.
This case has significant implications to the oil and gas industry, both from a legal and a practical perspective:
- The wording in historic oil and gas leases, especially where original lessees and lessors are unavailable, will be interpreted, “as they might have been objectively understood by an informed person reading them when they were executed, not how they would be read today.”And the Court of Appeal may very well be the effective decision-maker as it appears it will apply a correctness standard to its review.
- In interpreting the applicability of the shut-in provision in a lease, the Courts may first focus on the actual subjective analysis by the lessee to determine the reasons for the shut-in at the time, and will not focus on, or will give much less weight to, expert evidence analyzing the economic performance of the well after the fact. Lessees should be very careful in documenting the reasons for shut-in should they later wish to take the position that the shut-in was due to market circumstances or other circumstances out of the lessee’s control.
- Lessees should operate under the assumption that under standard oil and gas leases, once a lessee concludes that a well is not capable of economic production, the lessee has the specified number of days within which to stimulate the existing formation or complete the well in another formation. The fourth proviso may not apply to a well that is no longer capable of producing leased substances in commercial quantities.
- Lessees who intend to recomplete a well in a different zone where the well has been properly shut-in under the terms of the lease, but where the shut-in is beyond the specified number of days allowed under the terms of the lease, should immediately approach the lessor for a re-grant on the same terms. If there is a top lease already in place, the lessee should consider dealing with the top lease before any capital costs are spent on recompleting the well in a different zone.
- Lessees who know or ought to know that their lease has expired but who continue to produce hydrocarbons under the lease will likely be liable for subsurface trespass and conversion and will likely be required to disgorge the net revenue from production to the lessors (mild rule). However, in any particular case the Courts will apply what is “just and equitable” and, for egregious behaviour, the lessees may still be required to disgorge gross revenue from production to the lessors (harsh rule). Conduct justifying the harsh rule of damages remains unclear.
- Lessors and underground storage operators should take comfort in the Court of Appeal recognition of subsurface trespass to mines and minerals and the remedies for subsurface trespass and wrongful conversion.
- Limitations and the concepts of leave and licence, or estoppel or waiver, will continue to be issues in lease termination cases. Lessors are expected to take reasonable steps and exercise due diligence in discovering their injury, and the limitations clock may start running shortly after production ceases and long before lessors obtain a legal opinion that their lease has terminated. Further, acceptance of royalty payments or other encouragement to continue production may preclude a trespass claim until the lessor provides a clear notice to vacate the property or commences and serves an action.
- GORR owners beware. Where the GORR is carved out of a lessee’s working interest, the GORR expires once the lease from which it is carved expires. GORR owners should be cautious where payments are received after a well has been shut-in and then placed back on production. In such circumstances, the GORR owner may be best advised to hold the payments in trust pending a title opinion or a re-granted lease. Lessors will be entitled to an accounting for the amounts paid to the GORR owner following lease termination. The GORR owner may be accountable to the lessor, or possibly to the lessee who has to account to the lessor, for any GORR payments received after the lease terminates.
- The practice of top-leasing and litigation maintenance and funding by top-lessees does not constitute champerty or maintenance. While top-lessees do not have a direct claim against lessees for trespass where their interest is contingent upon a “determination” that existing leases have terminated, a differently structured top-lease may possibly give rise to a direct claim.
- While it may be possible to obtain in rem declarations as to the validity of leases even where not all parties who arguably have an interest in the leases are before the court, the prudent practice to avoid complex issues at trial is to have all affected persons as parties to the action.