This paper discusses a recent decision of the Court of Queen's Bench of Alberta (Calgary) subjecting to scrutiny a commonly used term ?"to earn an interest"? in the oil and gas industry. In reviewing that phrase, the court sought to rely on the meaning of the term "completion," as defined under the 1990 Canadian Association of Petroleum Landmen Operating Procedure. Ultimately, the court did not decide the case on the basis of whether the defendant had "completed," but rather on the equitable doctrine of estoppel. In doing so, the court concluded that the plaintiff in this case had indeed earned an interest under the agreement.
Under what circumstances may a farmee in a Farmout and Participation Agreement be regarded as having earned an interest? This was the kernel question with which Madam Justice S. L. Martin had to contend in the recent case of Solara Exploration Ltd. v. Richmount Petroleum Ltd. (2008), ABQB 596.
Richmount Petroleum Ltd. ("Richmount"), Twin Peaks Holdings Corp, ("Twin Peaks") and R.M.U. Resources ("R.M.U.") jointly owned a 100% working interest in certain lands (the "Farmout Lands") pursuant to a Crown Petroleum and Natural Gas Lease. Subsequently, Richmount, Twin Peaks, R.M.U. and the corporate predecessor of Solara, Solara Exploration Ltd. ("Solara") entered into a Farmout and Participation Agreement dated September 1, 2005 (the "Farmout Agreement").
Under the terms of the Farmout Agreement, Richmount (as Farmor) granted Solara (as Farmee) the right to earn a portion of its interest in the Farmout Lands "upon completing, capping or abandoning the test well". Richmount was appointed to act as initial operator. The Farmout Agreement incorporated by reference the 1990 Canadian Association of Petroleum Landmen Operating Procedure (the "1990 CAPL"), which is commonly used in the Canadian oil and gas industry to define the rights and obligations between working interest holders who hold interests jointly with one another.
As contemplated under the Farmout Agreement, Richmount, as operator, forwarded several Authorizations for Expenditure ("AFE") to Solara for, firstly, the drilling, and secondly, the perforation and pressure testing of the test well. Solara approved and paid its share of those AFE's. However, Solara refused to pay for a third AFE sent to it by Richmount for a "Completion/Workover… to run 73mm tubing and fracture an interval in the Mannville Group to maximize gas [production]". It took that position because, in its view, the test well had already been "completed" by the drilling, perforation and testing of the well and as such, the work program envisaged under that third AFE was a post-completion measure that it was not prepared to fund. Solara grounded its decision on the test results indicating that the test well was uneconomic. Rather than pay for the third AFE, Solara elected to "go penalty", as would be permissible under the 1990 CAPL assuming Solara had earned its interest. Solara conveyed its decision to Richmount in a letter dated January 13, 2006.
As to Richmount, it decided to proceed with the work program envisaged under the third AFE regardless of the decision by Solara not to participate. Richmount did not respond to Solara's letter of January 13, 2006, for five months ? until June 5, 2006. In Richmount 's letter of June 5, 2006, it articulated for the first time its position that Solara, in failing to pay for its share of the third AFE (or participating in the operations contemplated thereunder), had not earned under the Farmout Agreement. As things turned out, Richmount's fracture operation was hugely successful leading to the production of petroleum substances in commercial quantities in the Farmout Lands.
Did the AFE that Solara refused to pay for amount to a pre or post completion operation? This question was important because the Farmout Agreement equated completion with the right to earn an interest. The term "completion" was defined with reference to the 1990 CAPL, in part, as follows:
"[T]he installation in, on, or with respect to a well of all such production casing, tubing and wellhead equipment and material necessary for the permanent preparation of the well for the taking of petroleum substances therefrom up to... the perforating, stimulating, treating, frac'ing and swabbing of the well and the conduct of such production tests with respect to such well as are reasonably required to establish the initial producibility of the well." (emphasis added).
The court was reluctant to reach a conclusion on the matter of "completion" pointing to the novelty of the question and the lack of conclusive factual or expert evidence before it. Ultimately, however, relying on the equitable doctrine of estoppel, it found that Solara had indeed "earned". According to the court, upon receiving Solara's letter of January 13, 2006, Richmount knew that Solara was under the impression that it had earned and did not do anything about it. It could not now turn around to deny that state of affairs. Furthermore, the court did not regard the absence of an "earning letter", widely used in the industry, as dispositive. "Representations", express or implied, were what mattered in this case.
Four comments may be made regarding this decision. First, as the case makes apparent, the definition of "completion" in the 1990 CAPL is inelegantly drafted1. This definition lends itself to two possible interpretations as observed by the court: on one hand, it appears to envisage measures taken in connection with "the permanent preparation of the well for the taking of petroleum products," and on the other, it seems merely to be concerned with measures intended "to establish the initial producibility of the well". Some clarity over that term would be helpful.
Second, the court appears, as between the two possible interpretations of Article 101 (h) of the 1990 CAPL, to favour the following interpretation of "completion"? "the permanent preparation of the well for the taking of petroleum substances". In doing so, however, the court does not go to great lengths to develop its reasons as to why it appeared to favour that reading of Article 101 (h) of the 1990 CAPL.
Interestingly, under the current 2007 CAPL, "completion" is now defined as follows:
"[M]eans the installation in or on a well, up to and including the outlet valve of the wellhead, of all production casing, tubing, equipment and material necessary (other than a pump or other artificial lift equipment) for the ongoing recovery of Petroleum Substances. Completion includes the perforation, stimulation, treating, acidizing, fracing and swabbing of that well and the production tests reasonably required to establish its initial producibility." (emphasis added).
It will be observed that the phrase, "for the permanent preparation of the well," is dropped, while that of "production tests reasonably required to establish its initial [the well] producibility" is retained. This amendment appears to run counter to the position favoured by the court, and seems closer to the argument advanced by Solara that the initial producibility of the well was the appropriate test in determining whether a well was "complete".
Third, as the result in this case shows, a party failing to challenge the position stated to it by another party on the question of earning might find that it is estopped from doing so afterwards. Representations should be promptly challenged in appropriate circumstances to prevent others from invoking this doctrine. In practice, an earning letter usually comes from the farmor, and of course, would have been dispositive in Solara's favour. In a title review, the reviewer looks out for the earning letter but there should be no controversy that earning can occur in its absence.
Finally, the case points up the risks to a farmee of leaving the power to control the operations by which earning is defined in the hands of the farmor. If, as in the more typical case, the farmee controls the drilling, equipping and completing of the test well, the farmee will maintain control - or at least a much greater degree of control regarding whether earning has occurred.