Week 3 - Oil and Gas

Wronski v. Sun Oil is another case showing

 that the rule of capture is not absolute.

The prior case, People’s Gas v. Tyner, showed one limitation on the rule of capture through ultrahazardous activity and strict liability. Wronski v. Sun Oil presents a different limitation based on

state conservation regulation.

Why the Date Matters

Wronski was decided in 1979.

The timing matters because oil and gas cases often reflect what was happening economically in the industry at the time.

 

The 1970s contained two major energy shocks.

1973:

• The United States experienced a global oil embargo associated with conflict in the Middle East.

• This sharply disrupted oil supplies.

1979:

• Another major disruption involving the Middle East caused another large increase in oil prices.

 

At the time, the United States was importing roughly 60% of its oil by some measures.

This created long gasoline lines around the country.

 

The situation was compared to what can happen in Houston after a hurricane, when gasoline suddenly becomes difficult to obtain and long lines form at stations.

 

Today, the United States generally produces much more of its own energy, so the same nationwide shortage problem does not occur in the same way.

 

However, transportation still matters.

 

Because the United States is geographically large, there are situations where it can be more economical to import oil or natural gas into a place such as Boston than to transport domestically produced energy all the way across the country.

 

That issue becomes relevant later in the Mid-America discussion.

 

The larger point for Wronski is that between 1973 and 1979, oil prices rose dramatically.

So 1979 represented both:

• crisis, because energy was scarce and expensive; and

• opportunity, because producers could make much more money from each barrel they produced.

 

That economic environment helps explain why an operator might knowingly produce more oil than legally permitted.

 (X)

(X)

Parties

The plaintiffs were landowners on one tract.

Sun Oil was operating on the neighboring tract as a lessee.

 

So there were two neighboring tracts:

Plaintiffs’ tract

and

Sun Oil’s leased tract.

 

The plaintiffs were landowners on the tract neighboring Sun Oil’s leased tract.

• They may have owned only the mineral estate, rather than both the surface and mineral estates.

• If so, the two estates had previously been severed: the plaintiffs owned the minerals, while someone else owned the surface estate.

• That separate surface owner was not a party to the lawsuit.

 

Sun Oil, meanwhile, was not the owner of the neighboring minerals. It was the lessee. That means a mineral owner, the lessor, had granted Sun Oil the right to develop and produce from that tract. The lessor also was not a party to the case.

 

So, although several property interests existed in the background, the actual dispute was between the plaintiffs on one tract and Sun Oil, the lessee operating on the neighboring tract. (X)

(x)

The Overproduction

Sun Oil overproduced oil from three wells.

• The total amount of overproduction was: 150,000 barrels.

 

This was not a minor technical violation.

• It was a very large quantity of oil.

• There was also documentation showing what happened.

• A midstream company had records connected to the production.

 

That meant there was a paper trail that could be obtained through discovery or subpoena.

 

Sun Oil produced approximately 150,000 barrels more than it was legally permitted to produce.

 

Of that overproduction, approximately 50,000 barrels were determined to be attributable to the plaintiffs’ tract. (x)

(X)

Rule of Capture Still Exists

• The rule of capture remains part of the background law.

 

• Normally, a landowner or lessee can produce oil and gas through a lawful well even though some of the hydrocarbons migrate from beneath neighboring land.

 

• That is the basic rule of capture.

 

• But Wronski shows that the rule of capture is subject to legal restrictions.

 

A producer cannot use the rule of capture to ignore

a valid state conservation regulation.

The fair-share principle means that each owner over a common oil and gas reservoir must have a

fair opportunity to recover that owner’s share of the oil and gas in the reservoir.

The problem is that the rule of capture encourages competition. Because oil and gas can migrate through the reservoir, each owner has an incentive to produce quickly before neighboring owners capture the resource first.

 

That competition can lead to excessive production and can interfere with other owners’ ability to recover their own fair share.

 

Conservation regulations help prevent that result by

 limiting how much an operator may produce.

An allowable is one example: even if a well is physically capable of producing more, the operator may produce only

the amount permitted by the state.

So the fair-share principle does not eliminate the rule of capture.

 

• Instead, conservation laws restrain the rule of capture so that

one operator cannot overproduce in a way that deprives the other owners over the common reservoir of a fair opportunity to recover their share.

In Wronski, Sun Oil exceeded the state-imposed allowables.

 

• The rule of capture therefore did not protect Sun Oil because its

production violated conservation regulations designed, in part, to protect the correlative or fair-share rights of the other owners.

Allowables

 

The state conservation agency imposed allowables on the wells.

 

An allowable is the

maximum quantity of oil or gas that a particular well may legally produce during a designated period.

 

The allowable might apply:

• per day;

• per week;

• per month; or

• over some other regulatory interval.

 

Example:

A well might physically be capable of producing 1,000 barrels per day.

If the allowable is only 600 barrels per day, the operator must stop at 600.

The operator cannot argue:

“But the well can produce more.”

 

Physical capability is different from legal permission.

 

Once the allowable is reached, production must stop for that regulatory period.

An allowable therefore directly restricts the producer’s ability to

take advantage of the rule of capture.

Allowables as a Limitation on the Rule of Capture

• The rule of capture might otherwise encourage a producer to take as much oil as possible through its wells.

 

• But a lawful regulatory allowable limits that right.

 

So even if hydrocarbons migrate into Sun Oil’s well from beneath the neighboring tract, Sun Oil may only produce the amount permitted by the applicable conservation regulation.

 

The key relationship is:

Rule of capture permits lawful capture of migrating hydrocarbons.

But:

Conservation regulation can limit how much may lawfully be captured.

That is why Sun Oil was not protected simply by

invoking the rule of capture.

Why Overproduction Might Still Happen

When oil prices become extremely high, the financial incentive to exceed production limits also becomes larger.

 

• The decision-makers within a company may also have relatively short time horizons.

 

For example, corporate officers may only remain in particular positions for a few years.

 

That can create incentives to maximize present production or financial performance even if the company later faces legal consequences.

 

Compared to driving past a police station at 150 miles per hour.

• It seems obviously risky, but there can still be an economic motive behind it. (X)

(X)

Remedy

One possible property claim is

trespass

Another is

conversion. Trespass was not the relevant problem here.

Why There Was No Trespass

Sun Oil had legal permission to be on the land where it was operating.

It had an oil and gas lease.

• Therefore, Sun Oil did not wrongfully enter the tract simply by drilling and producing there.

• The wrongdoing was not its physical presence.

• The wrongdoing was the unlawful overproduction. (x)

(x)

Does the Lessee Need Permission From Every Mineral Cotenant?

No.

 

• A lessee does not necessarily need a lease covering 100% of the mineral estate before entering and developing the property.

 

• Permission from one cotenant can be sufficient to authorize entry.

 

This follows from basic cotenancy principles.

 

• Each cotenant has rights in the commonly owned property.

 

• One cotenant can therefore authorize another person to enter.

Example:

Two people share an apartment. One roommate invites a friend inside. The second roommate may dislike the friend or may not have personally invited that person. But the friend ordinarily is not a trespasser because one cotenant gave permission to enter. The same idea applies in the mineral context.

 

If one mineral cotenant authorizes a lessee to enter and develop the property, the lessee is not necessarily a trespasser merely because the other cotenants did not separately consent.

 

• This does not mean the operator may ignore the economic rights of the nonconsenting cotenants.

 

• It means only that the operator’s physical presence is not automatically trespass.

 (X)

(X)

Because the central problem involved wrongfully taking oil rather than wrongfully entering the land, ____ became the important remedy.

conversion

• Conversion concerns wrongful dominion or control over property belonging to another.

 

In the oil and gas context, the measure of damages can depend heavily on whether the taking was:

• innocent or unintentional; or

• intentional or in bad faith.

 

There are two measures commonly described here:

• mild rule;

• harsh rule.

Mild Rule

The mild rule generally applies to an

innocent, unintentional, or good-faith taking.

• Under this measure, the wrongdoer must pay the value of the oil or gas taken, but may deduct the costs that would have been necessary to produce it.

 

• The idea is that the plaintiff should recover the value it lost, but should not receive a windfall by avoiding expenses it would itself have incurred to bring the hydrocarbons to the surface.

Example:

Value of oil produced = $1,000,000

 

Reasonable production costs = $300,000

 

Recovery under mild rule = approximately $700,000

 

The $300,000 production cost is deducted.

 

• The wrongdoer is treated somewhat like a contractor who is allowed credit for the expense of producing the resource. (X)

(X)

Why the Mild Rule Is “Mild”

The defendant does not get to keep the converted property. It still has to compensate the rightful owner.

 

• But the damages are reduced by the cost of production.

 

That makes the measure less punitive.

 

The amount of allowable production costs can itself be a factual issue.

 

A court may have to determine what expenses were actually necessary to bring the oil or gas to the surface.

(X)

The harsh rule applies when the taking is

intentional or in bad faith.

 

Under the harsh rule:

production costs are not deducted.

 

Example:

Value of oil taken = $1,000,000

Production costs = $300,000

Recovery under harsh rule = $1,000,000

 

The wrongdoer receives no credit for the $300,000 spent producing the oil.

 

Why the Harsh Rule Is More Severe

The rule prevents an intentional wrongdoer from benefiting from the money it spent committing the wrongful act.

 

That makes the measure resemble punitive damages even though the claim itself is a conversion claim.

 

• The wrongdoer loses the ability to reduce liability through production-cost deductions. (x)

(X)

Application in Wronski

The trial court initially applied the mild rule, allowing Sun Oil to deduct its production costs from the damages owed.

 

But Sun Oil’s overproduction was intentional. Because the taking was intentional rather than innocent or accidental, the appellate court concluded that the harsh rule should apply.

 

Under the harsh rule, Sun Oil could not deduct its production costs.

 

So:

 

Trial court → mild rule → reversed/incorrect measure

Appellate court → harsh rule → appropriate because the overproduction was intentional (x)

(x)

Why the Rule of Capture Did Not Protect Sun Oil

 

Sun Oil could not rely on the rule of capture because the

production restrictions were a lawful exercise of state police power.

 

• The rule of capture does not override valid conservation laws.

Police power is a legal term referring to the state’s authority to regulate private conduct for public purposes.

 

• It is not limited to literal police activity.

 

Police power can support regulation designed to protect:

• health;

• safety;

• environment.

 

Oil and gas conservation regulation falls within this type of state authority.

 

States may therefore regulate matters such as:

• how much oil or gas may be produced;

• how wells may be operated;

• how reservoirs are developed.

 (x)

(X)

Conservation Laws

Conservation laws can lawfully restrain rights that would otherwise exist under the rule of capture.

 

In Texas, the Railroad Commission performs major oil and gas conservation functions.

 

So the structure is:

State police power

→ authorizes conservation laws and regulations

→ conservation laws restrict production

→ those restrictions operate as exceptions or limitations on the rule of capture.

 

Where an applicable conservation rule exists, the producer must obey it.

 

Where no conservation restriction applies, the rule of capture remains the background rule.

 

The rule of capture therefore “lurks” in the background and applies unless another legal rule restrains it. (x)

(X)

Correlative Rights

Conservation regulation also protects correlative rights.

 

• Correlative rights concern the relationship among different owners whose lands overlie the same common reservoir.

• Each owner should have an opportunity to recover a fair share of the oil and gas in that reservoir.

 

Without regulation, the rule of capture can encourage every owner to race against neighboring owners.

 

That creates a danger that one operator will produce so aggressively that neighboring owners lose a meaningful opportunity to recover their share.

 

Conservation rules can prevent that result by limiting individual production. (x)

(x)

Relationship Between Correlative Rights and Wronski

 

• The Michigan conservation regulations protected the rights of neighboring owners by preventing one operator from taking more than its legally permitted amount.

 

• Sun Oil’s excessive production interfered with the plaintiffs’ ability to recover oil attributable to their tract.

 

• The regulatory restriction therefore served not only a general conservation purpose but also the specific goal of protecting neighboring owners’ correlative rights.

 

• Wronski illustrates how the judiciary can enforce those rights when a producer violates the conservation regime. (x)

(X)

Conservation Laws as a Limitation on the Rule of Capture

The rule of capture is the background rule governing production, but it is not absolute.

 

States can restrict production through conservation laws enacted pursuant to their police power.

Police power is the state’s authority to regulate activities in order to protect matters such as:

• health

• safety

• Environment

 

In the oil and gas context, conservation laws adopted under this authority can restrict how oil and gas are produced.

 

In Texas, the Railroad Commission performs this type of oil and gas regulatory function.

Thus, conservation laws operate as a limitation on the rule of capture.

 

• Where a conservation regulation applies, an operator must comply with that regulation even though the rule of capture would otherwise encourage production.

 

• Where no conservation regulation restrains production, the rule of capture remains the background rule. In other words, the rule of capture is always present unless some other legal rule limits it.

 (X)

(X)

Correlative Rights

Conservation laws also protect correlative rights.

 

Correlative rights are the rights of each owner over a common reservoir to have a fair opportunity to recover that owner’s fair share of the oil and gas in the reservoir.

 

• This is closely connected to the fair-share principle.

 

If several landowners own tracts over the same reservoir, each owner should have an opportunity to recover a fair share of the common resource.

 

The doctrine has two sides:

• each owner must have an opportunity to recover a fair share of the oil and gas; and

• no owner may waste the oil and gas or negligently damage the common reservoir.

 

So correlative rights are not simply a right to produce as much as possible. They protect each owner’s opportunity to recover while also limiting conduct that harms the shared reservoir or the rights of neighboring owners. (X)

(X)

Why Conservation Regulation Is Necessary

 

The rule of capture naturally creates a race to produce.

It may therefore be possible to recover more oil and gas from only a few properly managed wells than from having every individual landowner drill a separate well.

 

The basic idea is:

• Slower, controlled production can preserve reservoir pressure and increase ultimate recovery.

• This is one reason conservation laws restrict both the number of wells and the amount each well may produce. (X)

(X)

Allowables and Reservoir Pressure

 

An allowable limits how much oil or gas a particular well may produce during a specified period.

• Allowables help prevent the race to produce encouraged by the rule of capture.

 

Without production limits, each owner may think:

“If I do not produce it now, my neighbor will.”

 

That can lead everyone to overproduce.

 

Allowables restrain that competition.

 

Even if a well is physically capable of producing much more oil or gas, the operator may only produce up to the amount permitted by the allowable.

 

This protects reservoir pressure and can increase the total amount of hydrocarbons ultimately recovered.

 

The basic conservation idea is:

• If everyone produces as fast as possible, there may be a large amount of production at first but less production later.

If production is controlled, more of the resource may ultimately be recovered. (X)

(X)

Another major purpose of oil and gas conservation law is

preventing waste

• Waste can occur in several different ways.

Examples include:

• explosions

• blowouts

• unnecessary losses of oil or gas

• venting natural gas

• flaring natural gas

• improper drilling or completion practices

 

More modern regulation may also establish best practices concerning drilling and completing wells, particularly where groundwater is involved.

Venting and Flaring

Natural gas may be produced along with oil.

 

Suppose:

• oil prices are high;

• an operator is primarily interested in producing oil;

• natural gas is also coming out of the well;

• there is no nearby market or infrastructure for selling the gas.

 

The operator might vent or flare the natural gas.

Venting means releasing the natural gas.

Flaring means burning the natural gas.

But that gas has potential value.

 

It could potentially:

• be marketed;

• be sold; and

• generate royalty payments for the landowner.

 

So simply disposing of commercially useful gas can constitute waste.

 

• This is another area where conservation regulation can restrict what an operator would otherwise be tempted to do under the rule of capture. (X)

(X)

Number and Placement of Wells

 

Conservation laws can also regulate how many wells may be drilled and where those wells may be located.

 

• Suppose many landowners are located over the same reservoir. A conservation agency might determine that only four wells are necessary to efficiently develop the reservoir. That does not mean only the four owners whose tracts contain those wells receive the oil and gas revenues while everyone else receives nothing.

 

That would fail to protect the correlative rights of the other owners.

 

Instead, several tracts can be combined so that the owners share production from the limited number of wells.

 

For example, several groups of landowners may be combined together, and the owners within each group receive a proportionate share of the production.

 

The share is typically based on acreage.

 

• So even if the physical well is not located on every owner’s individual tract, each owner can still receive a proportionate share of the production.

 

This allows the state to:

• limit unnecessary wells;

• preserve reservoir pressure;

• prevent waste; and

• protect the correlative rights of all owners. (X)

(X)

Main Goals of an Oil and Gas Conservation Agency

The two traditional goals of an oil and gas conservation agency are:

1. prevent waste; and

2. protect correlative rights.

 

Examples include:

• Texas — Railroad Commission

• Oklahoma — Corporation Commission

• North Dakota — Industrial Commission

his is the basic answer to the question:

 

What does an oil and gas conservation agency do?

• It prevents waste and protects correlative rights.

 

A third goal has increasingly developed:

 

• protection of the environment.

 

Historically, however, environmental regulation was often handled by a separate environmental or natural-resources agency rather than by the oil and gas conservation agency itself.

 

That division can create coordination problems because the oil and gas regulator and the environmental regulator may be dealing with different parts of the same activity. (x)

(X)

Why Property Instruments Are Recorded

 

A separate property-law point:

 

• The basic reason property instruments are recorded is to put the public on notice.

 

• Recording gives third parties notice that a particular property interest exists.

 

• That principle becomes important later when determining priority among competing property interests. (X)

(X)

Oil and gas conservation agencies may regulate development through several different mechanisms.(x)

(X)

Permits

An operator may be required to obtain a permit before drilling.

 

This is particularly important when high oil prices attract new operators into the industry.

 

Oil and gas development is dangerous and technically complex.

 

Permitting helps prevent inexperienced operators from simply beginning drilling operations without regulatory oversight. (x)

(X)

Bonding

An operator may also be required to post a bond. Bonding requires the operator to put up financial security. This provides protection if the operator later fails to comply with its obligations. (X)

(X)

Restrictions on Drilling

The state can restrict:

• whether a well may be drilled;

• where it may be drilled; and

• how many wells may be drilled.

This prevents unnecessary drilling and helps protect the reservoir.

 (X)

(X)

Prorationing

 

• Prorationing controls how much oil or gas may be produced.

• Allowables are connected to this concept because they restrict production from particular wells.

• Prorationing therefore regulates the quantity of production rather than simply the physical location of wells. (X)

(X)

Compulsory or Forced Pooling

 

• Compulsory pooling allows the state to combine multiple tracts or mineral interests so that a smaller number of wells can efficiently develop the reservoir while all of the owners share in the production.

• Typically, an oil company petitions the state for the pooling arrangement. The state can then combine the affected interests and provide that the owners share the proceeds. (X)

(x)

Pooling Example

Suppose state spacing rules require:

• 40 acres for one oil well

 

But four neighboring owners each own only:

10 acres.

 

Individually, none of the owners has enough acreage to satisfy the 40-acre requirement.

The four 10-acre tracts can be pooled:

 

10 acres + 10 acres + 10 acres + 10 acres = 40 acres.

 

One well can then be drilled on the pooled 40-acre tract.

 

• The owners share production from that well according to their respective interests, typically based on acreage.

 

• Pooling therefore allows the reservoir to be developed efficiently without requiring a separate well on every small tract. (x)

(X)

Compulsory Pooling and Texas

Compulsory or forced pooling is available in most producing states.

 

• Texas is much more limited in its use of compulsory pooling.

• Historically, Texas has shown greater resistance to forcing individual landowners to share production with surrounding owners.

 

That reflects the strong property-rights idea that:

“This is my tract, and I can do what I want on my tract.”

 

Other jurisdictions, such as Oklahoma, have historically been more receptive to communal development arrangements. (x)

(X)

Pooling vs. Unitization

Pooling and unitization are related concepts, but they are not technically the same thing.

 

At this point, the basic distinction does not need to be fully developed.

 

Pooling can be understood through the acreage example:

 

Several smaller tracts are combined to satisfy the acreage requirement for one well.

 

Example:

Four 10-acre tracts

→ combined into one 40-acre unit

→ one well

→ production shared among the owners.

 

Pooling and unitization will be distinguished more carefully later. (X)

(X)

Correlative Rights – Full Definition

The doctrine of correlative rights requires that each landowner over a common reservoir be given a fair opportunity to recover that owner’s fair share of the oil and gas in the reservoir.

 

The owner does not necessarily have a right to physically drill a well anywhere or produce without restriction.

 

Instead, the owner must have a meaningful opportunity to participate in recovery of the common resource.

 

That opportunity may be protected through:

• production limits;

• well-spacing rules;

• pooling;

• other conservation regulations; or

• a legal claim when another owner wrongfully interferes with that right.

 

The flip side is that an owner cannot exercise its own production rights in a manner that wastes the resource or negligently damages the common reservoir. (X)

(X)

So the doctrine can be summarized as:

• Each owner gets a fair opportunity to recover a fair share, but each owner must also respect the shared nature of the reservoir.

Correlative Rights – Common Law vs. Conservation Regulation

A question arises about how correlative rights relate to conservation laws.

 

• Correlative rights can be understood as a common-law principle giving each owner over a common reservoir a fair opportunity to recover that owner’s share of the oil and gas.

 

• But without regulation, that common-law principle may have limited practical force because the rule of capture still strongly favors whoever produces first.

 

In other words:

• correlative rights recognize that each owner should have a fair opportunity to recover from the common reservoir;

• but the rule of capture encourages each owner to produce as much as possible before neighboring owners do;

• without regulatory limits, the rule of capture can overwhelm the practical protection offered by correlative rights.

 

Conservation laws give correlative rights more enforceable force by turning the principle into specific legal restrictions. (X)

(x)

For example, a state agency can impose:

• allowables;

• spacing requirements;

• production limits;

• pooling requirements.

 

If an operator violates one of those regulations, the neighboring owner does not have to rely only on an abstract common-law fairness argument.

 

The owner can sue based directly on the regulatory violation.

 

That can be easier and more practical than trying to construct a claim entirely from older common-law doctrines.

 

A regulatory claim may also provide remedies such as attorney’s fees that might not be available under older common-law theories. (X)

(x)

So the relationship is:

• Correlative rights provide the underlying principle.

• Conservation regulations give that principle concrete legal force.

Champlin Exploration

 

Background

Champlin Exploration arose in Oklahoma in 1979.

 

The dispute involved petroleum that escaped from refinery tanks in large quantities.

The tanks leaked so much petroleum that the product moved across a property boundary onto another tract. This was not a small spill. The amount of escaped petroleum was large enough to be commercially valuable and to support substantial litigation.

 

The defendants were collecting the escaped petroleum and selling it.

So the situation was essentially:

 

refinery tanks leak petroleum

→ petroleum migrates onto neighboring property

→ other parties collect it

→ those parties sell it for money.

 

The defendants included:

• Champlin Petroleum;

• Western Bridge Company; and

• Peckham.

 

Peckham was not simply an unrelated individual. He was an officer associated with one of the corporate defendants.

 

That creates the possibility of other legal disputes beyond the narrow oil-and-gas question.

 

For example, if a corporate officer personally takes valuable petroleum that arguably belongs to the corporation, fiduciary-duty issues may arise. (X)

(X)

Multiple Possible Lawsuits

The reported oil-and-gas case represents only one piece of a much larger possible dispute.

 

Other potential litigation could include:

• claims between the corporate defendants;

• fiduciary-duty claims involving Peckham;

• proceedings before the Oklahoma Corporation Commission;

• environmental enforcement by the EPA;

• claims arising from unsafe refinery conditions;

• personal injury or property-damage claims if the petroleum caused a fire or explosion.

 

The central oil-and-gas issue, however, is much narrower.

 (X)

(X)

Main Question

Once oil or gas has already been produced and brought through the wellhead, does the rule of capture apply again if the hydrocarbons later escape? Answer:

No, not merely because they escape.

Before production, rights in the oil and gas underground are part of the mineral estate and are treated as real property. Once the oil or gas is produced and brought to the surface, it becomes personal property.

 

I essence once it has been produced and reduced to possession, it becomes:

 

• personal property.

 

That distinction is critical in Champlin.

 

• The petroleum had already been produced. It therefore had already become personal property before it leaked from the tanks.

 

The fact that it escaped from the tanks did not automatically return it to the rule of capture. (X)

(X)

No Abandonment

The petroleum also had not been abandoned. Abandonment requires more than simply losing physical possession of property.

 

• The original owner had not intentionally given up ownership of the petroleum.

 

• So even though the petroleum escaped and moved onto another tract, it still belonged to its original owner.

 

The defendants could not simply say:

 

“It ended up on our property, so now it belongs to us (X)

(X)

Connection to the Wild-Animal Analogy

This relates back to the old Property-law analogy between oil and gas and wild animals. An uncaptured wild animal generally belongs to no one until someone captures it. But once an animal has been captured and reduced to possession, ownership exists.

 

The key question is what happens if possession is later lost.

 

• Champlin rejects the idea that produced petroleum automatically becomes free for anyone to take simply because it escapes after production.

The oil had already been captured and converted into personal property.

 

Because it was not abandoned, ownership remained with the original owner.(X)

(X)

Rule from Champlin

Once oil or gas has been produced and reduced to possession, it becomes personal property.

 

If that produced petroleum later escapes, it does not automatically become subject to the rule of capture again.

If the original owner has not abandoned it, title remains with that owner.

 

So:

Unproduced oil and gas in reservoir

→ rule of capture may apply.

Produced oil and gas

→ personal property.

Produced oil and gas that later escapes but is not abandoned

→ still belongs to the original owner. (x)

(X)

Texas American Oil Corp. v. Citizens Fidelity

 

Background

 

The case arose in Kentucky and was decided in 1987.

 

Why Store Natural Gas Underground?

Natural gas demand is seasonal.

 

Demand is especially high in colder areas during the winter because natural gas is widely used for heating.

Natural gas is also used for:

• manufacturing;

• fertilizer production;

• other industrial purposes.

Demand for heating is lower during the summer.

That creates a practical problem.

 

Natural gas may be available during the summer when demand and prices are lower, but much

more gas will be needed during the winter. (X)

(X)

Underground storage solves this problem.

The basic process is:

1. Transport natural gas north through interstate pipelines during the summer.

2. Inject the gas into a suitable underground formation.

3. Leave the gas stored underground.

4. Withdraw it when winter arrives and demand increases.

 

This allows natural gas produced during lower-demand periods to be saved for periods when it is more valuable. (x)

(X)

Suitable Storage Formation

The underground formation must have:

• porosity; and

• permeability.

Porosity means the rock contains open spaces in which gas can be stored.

Permeability means the gas can move through the interconnected spaces in the rock.

 

The formation used for storage should also contain:

no native natural gas.

 

If native natural gas were already present in the formation, injecting additional gas could interfere with the mineral owner’s right to produce the naturally occurring gas.

 

So the company wants a formation that:

• can physically hold injected natural gas;

• allows the gas to move within the formation;

• does not already contain native natural gas belonging to a mineral owner.

 

The absence of native gas is key because otherwise the storage operation could interfere with another owner’s mineral rights. (X)

(X)

Permission to Store Natural Gas

 

A company cannot simply find a useful underground formation and begin injecting gas into it.

 

• The company must obtain permission.

 

• Without permission, using another person’s property for underground storage could constitute trespass.

 

• The company therefore needs some legal instrument authorizing the storage activity.

 

That instrument might take the form of:

• a lease;

• an agreement;

• a grant.

 

The instrument gives the natural gas company the right to enter the property and use the underground pore space for storage.

 (X)

(X)

The property owner may receive compensation for allowing the storage company to use the property.

 

One possibility is:

an upfront cash payment.

 

Another possibility is:

a royalty-type payment tied to the amount of natural gas stored or withdrawn. (x)

(X)

For example, the agreement might require the storage company to pay the property owner a certain amount for every MCF of natural gas:

• injected into storage; or

• withdrawn from storage.

MCF is a unit used to measure natural gas.

 

A continuing royalty arrangement may benefit both sides.

 

For the property owner:

• the owner receives continuing payments as the storage facility is used.

 

For the company:

• it avoids having to make a large payment upfront and instead pays as it uses the storage space.

 

So the parties might structure compensation around actual storage activity rather than a single initial payment. (x)

(X)

Is the Gas-Storage Right Contractual or a Real-Property Right?

Once a company obtains permission to use underground pore space for natural-gas storage, an important question is how that storage right should be legally characterized.

 

It could potentially be structured as:

• a contractual right; or

• a real-property right.

 

The wording of the instrument can affect that characterization.

 

If the parties want the storage right to resemble a real-property interest, the document can be drafted more like a deed by including:

• words of grant;

• a legal property description; and

• other language associated with a conveyance of property.

 

If the parties want it to look more like a contract, the document can instead be drafted as an agreement without deed-like words of grant.

 

The distinction matters because a contractual right and a real-property right can receive very different treatment if one of the parties later enters bankruptcy. (x)

(X)

Why the Contract vs. Real-Property Distinction Matters in Bankruptcy

 

An executory contract generally involves continuing obligations that remain to be performed in the future.

 

• For example, a gas-storage agreement might require continuing royalty payments as natural gas is injected into or withdrawn from the formation.

• If the storage arrangement is merely an executory contract, bankruptcy may allow the debtor to reject the contract.

 

By contrast, if the instrument created an actual real-property interest, the property right is not simply eliminated in the same way an executory contract may be rejected.

 

So characterization matters because:

 

Contractual storage right

→ potentially vulnerable in bankruptcy.

 

Real-property storage right

→ stronger continuing property interest.

 

That distinction becomes especially important to a bank lending money to a company engaged in natural-gas storage.

 (X)

(X)

Bank Z – What Security Should the Bank Obtain?

Suppose Bank Z lends money to Gas X to finance its natural-gas storage operations.

 

The bank wants collateral securing repayment of the loan.

The appropriate form of security depends on what type of property is being used as collateral. (X)

(X)

Real Property

 

If Gas X owns a real-property interest, Bank Z can generally secure its loan through:

• a mortgage; or

• a deed of trust.

 

In Kentucky, the discussion uses a mortgage.

If Gas X defaults on the credit agreement, Bank Z may foreclose on the mortgaged real property.

 (X)

(X)

Personal Property

Once natural gas has been produced and brought to the surface, the gas is personal property.

 

• Personal property is not secured through an ordinary real-estate mortgage.

• Instead, Bank Z can obtain a security interest under the UCC and perfect that interest through a:

UCC financing statement.

• If Gas X defaults, Bank Z can enforce its security interest against the personal property.

 

So the basic distinction is:

 

Real property

→ mortgage / deed of trust.

 

Personal property

→ UCC security interest + financing statement.(x)

(X)

The Hard Question: What Happens When Produced Gas Is Put Back Underground?

 

Natural gas that has already been produced is personal property.

But a natural-gas storage company then takes that produced gas and injects it back underground.

 

That creates the central problem:

• Does the gas remain the company’s personal property after it is reinjected underground, or does putting it back underground cause the producer to lose ownership?

 

This issue matters directly to Bank Z.

If the gas remains personal property:

 

• a UCC security interest may protect the bank.

 

But if reinjecting the gas changes the legal character of the gas or creates real-property rights connected with storage:

 

• a UCC filing alone may not be enough.

 

That is why Bank Z may need both a UCC security interest and a mortgage covering relevant real-property interests. (X)

(x)

Hammonds – 1934

 

The older rule came from Hammonds in 1934.

 

Under Hammonds, a producer that reinjected natural gas underground:

lost title to the gas.

 

The reasoning relied on the traditional analogy between oil and gas and wild animals.

Once the gas was returned underground, it was treated as having returned to its natural or wild state.

 

The slide describes this through:

• animus revertendi.

 

The basic idea was that once the gas was released back underground, it again became capable of being captured by someone else. (x)

(X)

The analogy is:

A person captures a wild animal.

If the animal is later released back into the wild, the person may lose the ownership that arose from possession.

 

Likewise, under Hammonds:

 

natural gas is produced

→ producer acquires possession and title

→ gas is reinjected underground

→ gas returns to its “wild” state

→ producer loses title.

 

The class analogy:

“You have let the fish go.”

Someone else could potentially capture it later. (X)

(X)

Practical Problem with Hammonds

The Hammonds rule created a serious problem for underground gas storage.

 

A company would have little reason to take valuable natural gas that it owns and inject it underground if doing so automatically caused the company to lose title.

 

That would make commercial gas storage extremely difficult.

 

It would also hurt landowners whose underground formations contained no valuable native oil or gas but could still have economic value as storage formations.

 

Those landowners could potentially make money by granting storage rights.

 

If gas companies refused to inject gas because they would lose ownership, those landowners would lose that opportunity as well.

 (X)

(X)

White and Lone Star – Later Rule

 

A later rule rejected the idea that reinjected natural gas automatically becomes completely wild again.

 

White and Lone Star treated the gas as:

 

• not wild, but controlled

 

The gas remains natural gas, but it remains under the control of the storage operator even though it has been injected underground.

 

The analogy is:

a tiger in a cage.

 

It is still a wild animal by nature, but it is controlled.

 

Likewise, injected natural gas remains natural gas, but the storage company continues to exercise control over it.

 

• Therefore, reinjection does not automatically mean that the producer abandons the gas or loses ownership.

 

This was a major change from Hammonds because it made commercial underground gas storage workable. (x)

(X)

Native Gas vs. Exotic Gas

 

The stored gas is also described as:

 

• not native, but exotic to the Oriskany Sandstone.

 

Native gas means natural gas that naturally existed in the underground formation.

 

Exotic gas means gas that was produced elsewhere and later injected into the formation for storage.

 

So:

Native gas

→ naturally occurring gas originally present in the formation.

 

Exotic gas

→ gas introduced into the formation from somewhere else.

 

The storage company wants a formation with no native natural gas.

Why?

 

• Because if native gas already existed there, injecting additional gas could interfere with the mineral owner’s right to produce that native gas.

 

The gas-storage company is therefore placing its own previously produced gas into a formation that is useful for storage but does not already contain native gas belonging to another mineral owner. (X)

(X)

Migration of Stored Gas

 

Injected natural gas will not necessarily remain directly beneath the injection well. Because the formation has porosity and permeability, some of the gas can move through the formation and migrate beneath neighboring tracts.

 

• That movement does not automatically create ordinary trespass liability.

 

This kind of migration may be treated as a judicially excused trespass.

 

The analogy is an airplane passing through the airspace above private property.

 

• A property owner has rights associated with the property, but not every intrusion into the surrounding space gives rise to actionable trespass. Similarly, stored natural gas may move beneath neighboring property without automatically creating ordinary trespass liability. (X)

(X)

Is a UCC Financing Statement Enough for Bank Z?

 

This returns to the slide question:

 

If Bank Z lends money to Gas X to finance gas storage, what securities should Bank Z obtain?

 

• A UCC financing statement may protect Bank Z’s interest in the natural gas as personal property.

 

• But a UCC filing may not be enough.

 

Gas X may also possess real-property rights associated with:

• the storage formation;

• the right to use the pore space;

• leases or grants covering the storage property.

 

A careful lender may therefore want both:

• a UCC security interest and financing statement covering personal property; and

• mortgages covering relevant real-property interests. (X)

(X)

So:

 

Personal-property interest

→ UCC security interest.

 

Real-property interest

→ mortgage.

 

Taking both can protect the bank if the borrower later enters bankruptcy and questions arise about how the storage rights or assets should be legally characterized. (X)

(X)

Recording the Mortgage

Obtaining a mortgage is not enough.

The mortgage must also be recorded.

 

The reason for recording is:

• to put third parties on notice.

 

Example:

 

• Gas X borrows money from Bank Z. Bank Z obtains a mortgage but does not record it.

• Gas X later borrows money from another lender. The second lender takes and properly records its own mortgage.

 

• If Gas X later enters bankruptcy, the parties may now have a priority dispute. The party that properly recorded its interest may have priority over the party that failed to record.

 

So protecting the lender requires both:

 

• obtaining the appropriate security interest

 

And

 

• properly perfecting or recording that interest. (X)

(X)

Bona Fide Purchaser and Notice

 

Another possible complication is a bona fide purchaser, or BFP.

 

• A BFP is generally a purchaser who acquires property without notice of another person’s competing interest.

 

If an earlier property interest was not properly recorded, a later purchaser without notice may potentially obtain priority over the earlier claimant.

 

The discussion also raises other potentially competing interests, including:

• previously recorded leases;

• mortgages covering the mineral estate;

• later lenders; and

• subsequent purchasers.

 

Texas is a notice state

 

The broader point is that gas-storage transactions can create complicated priority questions involving both property law and secured transactions. (X)

(X)

Who Has the Storage Rights?

 

The next slide question is:

 

Who has the storage rights?

 

Suppose the surface estate and mineral estate have been severed.

There is:

• a surface owner; and

• a mineral owner.

 

Gas X wants to use an underground formation for natural-gas storage.

 

The question becomes:

 

• From whom should Gas X seek permission?

 

The answer depends on who owns the: pore space (x)

(X)

Pore Space

 

Pore space is the open space within underground rock formations. The formation itself consists of rock, but the rock contains microscopic spaces or pores.

 

• Oil, natural gas, water, or injected substances such as CO₂ can occupy those pores.

 

Natural gas placed into underground storage sits within this pore space.

 

Therefore, determining who owns the pore space helps determine who has the right to authorize its use for storage.

 (X)

(X)

General Rule – Pore Space Belongs to the Surface Owner

 

In most states, the majority rule is:

• the surface owner owns the pore space.

 

New Mexico has codified this result by statute.

 

In Texas, case law treats the pore space as belonging to the surface owner.

 

Some jurisdictions may follow a different rule, so applicable state law must always be checked.

 

Thus, under the ordinary Texas rule:

 

Surface owner

→ owns the pore space.

Mineral owner

→ owns the mineral estate. (X)

(X)

Why Can the Surface Owner Own Something Underground?

The term surface estate can be misleading.

 

• It does not mean that the surface owner owns only the grass, soil, and everything physically above the ground.

 

The surface estate also includes portions of the underground rock matrix that support the surface.

 

This is connected to traditional property concepts such as lateral support.

 

Example:

A owns Blackacre. The neighboring landowner excavates a large quarry directly beside Blackacre. If that excavation removes the support beneath or beside Blackacre and causes the land to collapse, A may have a claim based on the right of lateral support.

 

• The same basic property concept helps explain why underground rock and pore space can belong to the surface estate.

 

So:

“Surface estate” is the legal name of an estate.

It does not mean that every part of that estate must literally sit at ground level. (X)

(X)

Carbon Sequestration

Pore-space ownership has become especially important in CO₂ sequestration projects.

 

• CO₂ sequestration involves injecting carbon dioxide underground for storage.

 

The same ownership question arises:

Who has the right to authorize the use of the underground pore space?

 

• Under the majority rule described above, the surface owner ordinarily owns the pore space.

 

• A CO₂ sequestration company would therefore generally negotiate with and compensate the surface owner for the right to use that pore space.

 

The surface owner does not own the CO₂ merely because the CO₂ sits inside the pore space.

Instead:

Surface owner

→ owns the pore space.

 

Sequestration company

→ injects and stores the CO₂ there pursuant to an agreement.

 

The mineral owner does not automatically receive compensation simply because the storage occurs underground. (X)

(X)

From Whom Should Gas X Seek Permission?

 

Ordinarily, Gas X needs permission from the owner of the storage or pore-space right.

 

Under the Texas default rule, that generally means:

the surface owner.

 

However, that is not the first step in the analysis.

 

• Before applying the default rule, Gas X must check the instrument that originally separated the surface estate from the mineral estate.

 

That is the:

severing instrument

Severing Instrument

 

A severing instrument is the conveyance that separates the mineral estate from the surface estate.

 

Suppose A owns all of Blackacre, including both the surface and minerals.

 

• If A sells the entire property to B:

• A conveys everything to B.

 

That is simply a conveyance. A leaves the ownership picture completely.

 

But suppose A instead:

• sells the minerals to B and keeps the surface; or

• sells the surface to B and reserves the minerals.

Now the transaction does two things:

• conveys a property interest; and

• separates the mineral estate from the surface estate.

 

That document is a:

severancing instrument. (X)

(X)

Why the Severancing Instrument Comes First

The severancing instrument may expressly state who owns a particular right.

For example, it could expressly allocate the pore-space right to:

• the surface estate; or

• the mineral estate.

If the severancing instrument expressly addresses the pore space:

 

the instrument controls.

 

Only if the instrument is silent do you turn to the applicable:

• statute; or

• case law. (x)

(X)

So the correct order of analysis is:

1. Check the severancing instrument.

2. Determine whether it expressly allocates the pore-space or storage right.

3. If the instrument is silent, apply the jurisdiction’s statutory or common-law default rule.

 

Therefore, you should not automatically begin with:

“Texas says pore space belongs to the surface owner.”

 

You first ask:

What does the severancing instrument say?

If it is silent, then in Texas the default rule is that the pore space belongs to the surface owner. (X)

(X)

Slide Questions – Complete Answers

 

Who has storage rights?

The person who owns the pore-space/storage right. First check the severancing instrument. If it is silent, apply the jurisdiction’s default rule. In Texas, pore space generally belongs to the surface owner.

 

From whom should Gas X seek permission?

Gas X should obtain permission from the owner of the pore-space/storage right, generally the surface owner under the Texas default rule unless the severancing instrument provides otherwise.

 

If Bank Z lends money to Gas X to finance gas storage, what securities should Bank Z obtain?

 

Bank Z should consider:

• a UCC security interest and financing statement covering personal property, including the produced natural gas; and

• a mortgage covering relevant real-property interests.

 

This protects the bank against uncertainty over whether particular assets or storage rights are characterized as personal property or real property. (X)

(X)

Clarification Questions - End of Class

 

Why does the surface owner own the pore space if the pore space is underground?

 

Surface Estate and Ownership of Pore Space

 

• The term surface estate does not mean that the surface owner owns only the physical ground surface and everything above it.

 

• Under common law, the surface estate also includes the rock beneath the surface that supports the land.

 

So the better way to think about it is:

 

Surface estate = a legal estate, not merely the literal surface of the ground.

 

• This helps explain why underground pore space can belong to the surface owner even though the pore space is physically below ground.

 

Right of Lateral Support

The common-law right of lateral support helps illustrate this principle.

 

Suppose A owns Blackacre.

A neighboring landowner excavates a large quarry immediately next to Blackacre.

If the excavation removes the support for Blackacre and causes the land to collapse or slide, A may have a claim because the neighboring owner interfered with Blackacre’s right of lateral support.

 

This shows that ownership of the surface estate includes rights associated with the underground rock that physically supports the surface.

 

That same principle helps explain the rule that the:

rock matrix beneath the land belongs to the surface owner.

 

The rock matrix is the actual solid rock formation below ground.

 

The pores within that rock make up the pore space.

 

• Therefore, even though the pore space exists underground, it can still belong to the surface estate. (X)

(X)

Carbon Sequestration

 

The same pore-space issue is important for CO₂ sequestration.

• CO₂ sequestration involves injecting carbon dioxide into underground formations for long-term storage.

A question was raised:

 

If the surface owner owns the pore space, does that mean the surface owner also owns the CO₂ stored inside it?

 

No.

 

The distinction is:

The surface owner owns the pore space, not the injected CO₂ itself.

 

A company that wants to conduct CO₂ sequestration would typically negotiate an agreement with the surface owner for the right to use that pore space.

 

The company may then pay the surface owner for that storage right. (X)

(X)