Production in Paying Quantities

Originally published by Teri Rodriguez.

Since this blog’s post on production in paying quantities on January 26, 2016, the Louisiana Second Circuit Court of Appeal rendered its latest decision on the subject in Middleton v. EP Energy E&P Co., L.P., 50,300-CA (La. App. 2d Cir. 2/3/16).  While not particularly groundbreaking, Middleton does provide further guidance to mineral lessees and litigators with respect to the relevant factors and time period considered in a paying quantities case.  Specifically, courts must consider all relevant factors, not just profit, when determining whether production is in paying quantities.

The Middleton plaintiffs filed suit in 2013 claiming that three mineral leases maintained by a unit well had terminated because the well failed to produce in paying quantities for a 41-month period from August 1991 to December 1994.  After discovery, the plaintiffs filed a motion for summary judgment asserting the leases had terminated because well expenses exceeded revenue by $56,477.55 for the 41-month period.  Defendants filed cross motions for summary judgment asserting that the well actually made a profit of $2,905.96 over the 41 months, an average of $70.87 per month.  The district court granted the plaintiffs’ motion finding that the 41-month period of production proposed by the plaintiffs was “consistent with the jurisprudence” and that, even adopting the defendants’ calculations, “operating a well at a loss or minimal profit for 41 months is not sufficient to induce a reasonably prudent operator to continue production.”

On appeal, the Second Circuit first addressed the defendants’ argument that the plaintiffs should be prohibited from alleging failure of production in paying quantities for a time period that occurred nearly 20 years before suit was filed.  The appellate court rejected this argument observing that the Louisiana Third Circuit in Lege v. Lea Exploration Co., Inc. 631 So. 2d 716 (La. App. 3d Cir. 1994) considered a production period that occurred seven to ten years before the date of trial.  The court also, unsurprisingly, rejected defendants’ argument that the court was required to consider production during the 17 years following the 41-month period.

Ultimately, the Second Circuit reversed the district court’s judgment on other grounds.  First, the court recognized that the plaintiffs’ calculation of expenses included extraordinary expenses for the installation of a compressor and workover operations and instructed that “such nonrecurring expenses are not considered as operating expenses for the purpose of determining production in paying quantities.”  When these expenses were deducted from the well costs, the well made an average monthly profit of $70.87 during the 41-month period.

The court then explained that, although the district court found the $70.87 monthly profit insufficient, the determination of paying quantities is a fact-intensive inquiry that requires the consideration of various factors in addition to profit.  The court further instructed that the fact finder must consider:

“all matters which would influence a reasonable and prudent operator. The factors that the court should consider include the depletion of the reservoir, the price at which the product can be sold, the relative profitability of other wells in the area, the operating costs of the lease and the net profit.”

Consequently, the court ruled that the district court exceeded its role at the summary judgment stage and held that a genuine issue of material fact existed on the paying quantities issue.

Again, although Middleton does not break new ground on the subject of paying quantities, there are some important takeaways.  Firstly, the decision reaffirms that extraordinary, nonrecurring expenses are not operating expenses.  Secondly, the court accepted the plaintiffs’ 41-month period as the relevant time period for determining whether production was in paying quantities.  Previous cases have considered far shorter time periods – from a minimum of eight to a maximum of eighteen months, so it is not surprising that the court accepted a longer period proposed, in this instance, by the landowner-plaintiffs because longer periods ordinarily favor the operator in paying quantities determinations.  Finally, and most importantly, Middleton holds that a fact finder may not base its determination of production in paying quantities on profit alone.  Instead, the court reiterated that the fact finder must consider “all of the factors which would influence a reasonably prudent operator to continue production, including the market price available, the relative profitability of other nearby wells, the operating costs, the net income and the reasonableness of the expectation of profit,” and, according to the earlier enumeration of factors in the opinion, “the depletion of the reservoir.”

Note:  The Middleton plaintiffs have filed an application for rehearing with the Second Circuit, and the court’s decision on February 3, 2016, is not yet final.

 

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