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Article: February 2020: Energy Litigation Update

Business Litigation Reports

The Kids Are (Not) Alright: Parent-Child Well Interference

Oil and gas industrialists often refer to the initial well drilled in a sector as the “parent well”;  whereas, the subsequent wells drilled in the sector will be known as the “child wells.”  In recent years, producers have found that tight well-spacing can (and often does) reduce output from the parent wells and the later-drilled child wells.  While changing practices as a result of this revelation may protect future reserves, many companies may have already impaired enormous amounts of producing reserves by pursuing drilling programs that use tight well-spacing, likely giving rise to increasing litigation over an important legal question:  Who should bear the cost of the losses caused by these failed drilling strategies?

            E&P companies typically construct yield forecasts for a sector by drilling a parent well and extrapolating the future performance of the sector from yield models based on the parent well’s production.  In large part, however, those production models rely on historic data from conventional plays—i.e., large  subterranean pools of oil and gas, recoverable by vertical drilling activity.  However, E&P companies are discovering that historic conventional data provides unreliable guidance for analyzing reserves available in unconventional plays—i.e., small pockets of oil and gas trapped in shale rock, recoverable by horizontal drilling activity and hydraulic fracturing.  Notably, tight well-spacing affects production from unconventional plays significantly more than production from conventional plays. 

            Over the past several years, tight well-spacing has been the modus operandi of many producers in the most active oil and gas plays.  See Matthew Insley, Down Spacing:  The Next Chapter in the U.S. Oil Boom, Daily Reckoning (Sept. 23, 2013).  By concentrating their drilling activity, producers theorized that they would be able to maximize the volume of minerals that they can extract from the reservoirs in a short period of time.  The unintended consequence of tightening the well-spacing, commonly referred to as downspacing, came in the form of reduced well performance for both parent and child wells.  See Trent Jacobs, Three Trends Shaping Global Production: US Well Spacing, Argentine Shale, and Middle East Conventionals, J. Petroleum Tech. (Nov. 20, 2018).  When drilled too close to the parent well, child wells often cannibalize the parent well’s projected production.  Participants in the oil and gas markets refer to this phenomenon as well interference.  See Connor McLean, Changes in Permian Spacing to Strand DUCs?, BTU Analytics (Oct. 3, 2019).

            Already, E&P companies have started to abandon the model of drilling many tightly spaced wells that once prevailed in the SCOOP and STACK of Oklahoma and the Permian Basin of Texas.  Concho Resources, Devon Energy, Continental Resources, Centennial Resource Development, and other E&P companies active in those areas have acknowledged that tighter well-spacing has caused declines in production.  See Sven Del Pozzo, Analyst Commentary: Concho…, Connect Upstream Insight (Oct. 31, 2019); Trent Jacobs, Shale Executives Address Investor Concerns Over Production, Frac Hits, Up-Spacing, J. Petroleum Tech. (Feb. 27, 2019).  Some of these producers insist that the effects are localized; nevertheless, well interference has already caused significant losses in today’s major oil and gas plays.  See Del Pozzo, Analyst Commentary.

            Where there are losses, litigation will surely follow.  Well interference threatens to spark disputes in the oil patch, including litigation between E&P companies and their stakeholders—securities holders and royalty interest holders.

Disputes with Securities Holders

            In some circumstances, suspected well interference has already led to litigation.  Market reports indicated that Alta Mesa Resources experienced setbacks from well interference.  See Jacobs, Shale Executives Address Investor Concerns.  Shortly after these reports surfaced, a plaintiff-side securities litigation firm announced its investigation of the producer.  See Securities Class Action Has Been Filed Against Alta Mesa Resources, Inc., Globe Newswire (Jan. 31, 2019).  Weeks later, a second plaintiff-side firm filed suit against Alta Mesa Resources in the District Court for the Southern District of Texas, alleging that the company overstated the value of assets acquired during a business combination with Alta Mesa Holdings, LP.  See Camelot Event Driven Fund v. Alta Mesa Resources, Inc., No. 19-cv-00957 (S.D. Tex. Mar. 14, 2019).  The securities litigation was stayed when Alta Mesa and many of its affiliates filed voluntary petitions for bankruptcy relief on September 11, 2019.  See In re Alta Mesa Resources, Inc., No. 19-35133 (Bankr. S.D. Tex. Sept. 11, 2019).

            With well interference causing producers to write down assets across the Permian Basin, the SCOOP, and the STACK, we can expect further securities litigation.  We will likely see E&P companies defend their use of downspacing as a reasonable application of the best geophysical science of the early fracking boom; whereas, plaintiff-side advocates will likely develop theories accusing executives of sacrificing long-term production for short-term gains—eviscerating asset values in the process.

Disputes with Royalty Interest Holders

            Substantially all E&P companies hold their mineral interests subject to royalty obligations:  upon producing minerals, the E&P company must tender all royalty payments before taking any sale proceeds.  A royalty interest generally amounts to one-eighth (1/8) of the sale proceeds of the produced minerals. 

            Under the laws of most states, an operator of an oil or gas lease owes an implied duty to royalty owners to operate with reasonable care while producing minerals.  See, e.g., Amoco Prod. Co. v. Alexander, 622 S.W.2d 563, 567 & n.1 (Tex. 1981) (discussing the covenant to operate with reasonable care); Union Texas Petroleum v. Corp. Comm’n of the State of Oklahoma, 651 P.2d 652, 668 (Okla. 1981) (discussing economic waste in the context of well-spacing).  Some states regulate well-spacing by imposing minimum spacing requirements.  See Order No. 213539, Okla. Corp. Comm’n (Apr. 16, 1982) (establishing 640-acre drilling and spacing units for the production of gas from the Mississippian, Woodford, Hunton, Viola, and Arbuckle formations in Garvin County, Oklahoma).  Other states, including Texas, do not.

            As the consequences of well interference ripple through the oilfield, royalty interest holders may attempt to hold E&P companies accountable for the failed experiment of downspacing.  Perhaps royalty holders will allege that producers breached their duty of reasonable care by pursuing untested production methods like downspacing; perhaps the producers’ efforts to extract as much volume as quickly as possible will survive allegations of economic waste.  Although regulatory rulings may be probative of reasonable care, no case on point holds that compliance with those rulings is dispositive.  Only one thing can be certain:  any litigation on this point will test the contours of several areas of law, including oil and gas law, business torts, and regulatory law.

Conclusion

            When an unforced error erodes asset values, litigation generally follows.  Well interference and its effect on the values of oil and gas assets will likely follow this rule, rather than falling within an exception.  Whether engaged on the defense side or the plaintiff side, Quinn Emanuel’s oil and gas trial attorneys understand the legal and economic issues involved with downspacing and well interference.  Get us on your side.

Note:  Quinn Emanuel Urquhart & Sullivan, LLP represented Kingfisher Midstream, LLP and affiliates against Alta Mesa Holdings, LP and affiliates in an adversary proceeding within the Alta Mesa bankruptcy cases.  Quinn Emanuel guided Kingfisher to win summary judgment against Alta Mesa Holding on the precedent-setting issue of whether certain disputed gathering agreements created real covenants under Oklahoma law.  No confidential information has been included in this article.