Oil and Gas Lessee is Good Faith Trespasser During the Pendency of An Appeal for Breach of Contract

January 23, 2012 | Erika Eckley

 

In a continuation of a dispute regarding an oil and gas lease, the court reviewed several issues following a final appellate court decision cancelling an oil and gas lease as to two of three lessors. Following the final adjudication of the case cancelling the lease, the two lessors brought suit against the operator/lessee for trespass, conversion, and an accounting of income from gas and oil sales because the lessee continued production on their properties during the appeal of the decision to cancel the lease. 

The original lease agreement, at issue in the first case, covered two tracts of land. One of the plaintiffs owned all of the mineral interests in his tract; the mineral interests were split between two of the plaintiffs on the second tract of land. The lessee had a 7/8 working interest in the lease and the three plaintiffs had a 1/8 royalty interest based on their respective interests in the land. 

In November 2002, a fire damaged most of the production facilities on the two tracts of land. Production had ceased, so in late 2003, the plaintiffs sought to be released from the lease because the terms had been broken when production stopped. All parties agreed to a ratification of the lease expressed through an addendum that required that all wells be put back into production within 120 days, to plug all wells not use for production within six months, and that failure to comply with the previous terms would result in termination of the lease.

When the lessee failed to comply with the terms of the addendum, two of the lessors brought the first court action to terminate the lease. The third lessor who owned 1/2 interest in the mineral rights on the second tract of land was a not a party to the suit. The trial court cancelled the lease. On appeal, the court affirmed. But, the lessee could continue to operate on the split tract of land to fulfill the lessee’s obligation to the lessor not involved in the litigation. However, despite the ruling terminating the lease, the lessee continued to operate the wells on both tracts of land.

The lessor/plaintiffs from the first suit brought the current suit for trespass and conversion and sought an accounting of all oil sold under the lease since the termination of the lease effective August 2004. The third lessor also sought to terminate his lease and also sought an accounting. The two actions were consolidated. The trial court cancelled the lease between the third lessor and the lessee and declined to award some operating expenses to the lessee for his alleged costs of production after the lease was terminated. The lessee appealed.

On appeal, the court upheld the trial court’s termination of the lease with the third lessor due to the lessee’s substantial breach of the addendum. The primary question for the court, however, was a determination as to whether the lessee was a good faith trespasser during the time he continued to operate the wells on both tracts of land during the appeals process, which would entitle him to recover his operating expenses. If it was determined that the lessee was trespassing in bad faith, he would be precluded from recovering any costs of operation. 

Typically, when an oil and gas lease is in effect, the leaseholder negotiates the royalty payment and bears all of the operating expenses himself. When a lease is cancelled, however, and the leaseholder continues production, he may be entitled to recoup his expenses for the cost of operation benefitting the owner of the mineral rights. Both direct and indirect expenses for the drilling, production, and marketing can be recovered, but the operator must prove the reasonable and necessary expenses. 

There was no dispute that the operator had a right to continue to remain on the tract of land with the split mineral interests because there was still a valid lease between the operator and one of the lessors. The question raised on appeal was whether the operator was a good faith trespasser for remaining on the tract of land upon which the lease was cancelled. 

A good faith trespasser has an honest and reasonable belief that he has a right to be on the land. In the case of mineral rights, the good faith trespasser is entitled to offset the expenses of extracting the oil and gas from the proceeds of the sale of the oil and gas. The mineral rights owner is entitled only to the net profit as damages. A bad faith trespasser, however, knows he does not have a right to be where he is and is a converter of the oil and gas extracted. Bad faith trespassers are held strictly liable for their actions and are not entitled to offset the costs of their production. The mineral rights owner is entitled to all profits from the extraction.

In reviewing the particular facts, the appellate court determined that the lessee had a good faith belief that he had a continuing duty under the entirety clause of the lease to the third lessor with whom he still had a valid lease.  The operator also continued to make royalty payments to the two other leaseholders during the pendency of the appeal in the first lawsuit, which demonstrated “an honest intention to abstain from taking unconscientious advantage of another.”  The court also determined that a good faith trespasser retains his status if a subsequent lawsuit is filed until a final judgment is entered. 

The court reasoned that allowing the good faith trespasser to retain his status until the final adjudication of a dispute was a good policy. The court found that the harm to landowner was minimal because he would still recover the net profits from the production if he is successful. The burden to the producer, however, would be great. The producer lessee has significant capital invested in the equipment necessary for production and he should be able to protect the investment from harm or deterioration to prevent permanent damage. Also, the wells would have to remain dormant during the period of the appeal and significant resources could be necessary to restore the equipment to working order if the lessee was successful on appeal. For these reasons, the court held that good faith trespassers should be entitled to retain possession during the appeal of an order cancelling an oil and gas lease absent a showing of significant damage to the lessor.

Upon review of the particular expenses, the court agreed that several of the claimed expenses by the lessee/operator were incurred before the cancellation of the lease and were, therefore, not recoverable. The court also upheld the trial court’s ruling that expenses for a contract pumper and lease supervision could only be recouped for the period in which the wells were actually in production and that after June 2008, any costs incurred were solely for the benefit of the operator and not recoverable. The court also held that legal fees were not legitimate, recoverable operating expenses. The remaining expenses were recoverable as proven because the operator was a good faith trespasser. Dexter v. Brake, No. 104,457, 2012 WL 167338 (Kan. App. Jan. 20, 2012).