Canada: Omers Energy Inc. v. Alberta - (Energy Resources Conservation Board)

Omers Energy Inc. v. Alberta (Energy Resources Conservation Board): Alberta Court of Appeal interprets "capable of producing" to mean "presently capable of producing in meaningful quantities".

In Omers Energy Inc. v. Alberta (Energy Resources Conservation Board),1 the Alberta Court of Appeal confirmed the ERCB's interpretation of the Suspended Wells Clause in the standard form CAPL 91 oil and gas lease. In doing so, the Court held that for a lessee to rely on the Suspended Wells Clause to extend the lease beyond the primary term, the shut-in well must be: (1) "capable" of production in its existing state and configuration; and (2) that such "production" be meaningful in the sense that the continued operation of the well offers a reasonable expectation of a return to profitability within the short term. The Court's analysis and decision may impact thousands of oil and gas leases in Alberta and has significant implications for industry.

THE BACKGROUND

Omers sought to rely on the Suspended Wells Clause to extend the lease beyond the end of the primary term where a well was shut-in after encountering excess water during production. Despite attempts at re-working, the well never produced for more than a few minutes at a time. The lessor took the position that the lease had expired and granted a top lease. The top lessor, Montane Resources Ltd., took steps to challenge Omers' lease. Omers took the position that "capable of producing" meant that the well only had to be physically capable of achieving any production flow whatsoever, even in miniscule amounts. Montane applied to the ERCB to challenge the validity of Omers' well licence.

The ERCB ruled that, to rely on the Suspended Wells clause, the shut-in well had to be capable of production in a meaningful quantity. In 2009, the Alberta Court of Appeal granted leave to appeal in part on the basis that the case had significance to the oil and gas industry.

KEY ASPECTS OF THE DECISION

1. ERCB's Role in Interpretation of Oil and Gas Leases Confirmed. The Court of Appeal has again confirmed the growing practice of the ERCB to interpret oil and gas leases as part of its mandate. However, the Court of Appeal will continue to review the contractual language of the leases for correctness because the interpretation is a legal question beyond the specialized expertise of the ERCB.

2. Increasing Reliance on "Sensible Commercial Results." The Court of Appeal confirmed that each oil and gas lease must be interpreted on its own, including consideration of the text and the surrounding circumstances known to the parties, and the purpose and object of the transaction. Importantly, the Court's decision was driven by a desire to adopt an interpretation that lead to a "sensible commercial result." The Court of Appeal attempted to balance the lessee's interest in periodically shutting in a well because a well will not be profitable at every moment of production, and the lessor's expectations in the expedient development of the well in order to realize a commercial profit.

3. Entitlement to Shut-In for "Any Reason" Left Open. The Court of Appeal did not need to decide whether wells can be shut in for any reason, or would require "prudent reasons" and expressly left this issue open. The tone of the decision suggests that the Court may sometime in the future interpret the leases to include a requirement that a well shut-in must be "prudent."

4. "Capable of Producing" Not the Same as "Paying Quantities," but Pretty Close. Although the Court held that "capable of producing" does not mean the same thing as capable of producing "in paying quantities," the Court engaged in a detailed analysis of that language based on American authorities. It concluded that "capable of producing" meant more than producing a "mere puff" of gas, but something less than requiring that a well maintain commercial profitability at all times. The Court concluded that the overriding objective of oil and gas leases is for each side to earn a profit.

5. Putting Meaning into "Meaningful." The Court adopted the ERCB's new test of "meaningful" quantities, which the Court acknowledged was not significantly different from "paying" quantities. As the facts in Omers were relatively straightforward and the production from the well in issue was not meaningful "by any application of the word," the Court left the development of the test for future cases. The Court suggested that an appropriate test might be: "Would a reasonably prudent operator, for the purpose of making a profit and not merely for speculation, continue to operate a well in the manner that it does?" or "Is there a reasonable expectation of profitable returns from the well?" The Court further noted that if a well required an "operation," it was not capable of producing in meaningful quantities, which appears to be a very restrictive view that may have unintended consequences. The "meaningful production" test puts a significant burden on lessees to re-work wells that encounter difficulties in production within a relatively short time frame, or risk the expiration of the lease.

THE IMPLICATIONS

The potential reliance of the oil and gas industry on the standard form lease's use of only the word "capable" in the 91 CAPL Suspended Wells Clause does not appear to have factored in the decision. It is not clear whether evidence of industry practice was provided to the ERCB or the Court.

The test of "capable of producing in meaningful quantities" has important implications:

1. It establishes a contextual, rather than a "bright-line" test, potentially resulting in commercial uncertainty and leaving room for disagreement within the oil and gas industry over the proper interpretation of the word "meaningful."

2. Lessees will need to assess shut-in wells to determine whether they are capable of "meaningful" production, potentially requiring expensive and detailed technical, financial and legal analysis.

3. Lessors and top-lessees will have incentive to investigate shut-in wells to independently determine whether they have an argument that a well is not capable of "meaningful" production. The industry may see an increase in top-leasing and lease challenging activities targeting shut-in wells.

4. All of this will likely result in an increase in expensive litigation over expiry of leases. The issue may be litigated before the Court of Queen's Bench (through actions to prove caveats) or in front of the ERCB (by way of well licence challenge), and possibly before the Court of Appeal (on appeal or leave to appeal). This litigation may include associated and sometimes complex claims for trespass and accounting, or a second round of litigation on those issues may follow once a lease is determined or held to have expired. In those cases, the reasonableness of the lessee's position may be significantly scrutinized by the court.

5. Future decisions to shut wells in must be made with an eye to meeting the "meaningful production" test if challenged. Further, industry participants would be well advised to consider the Court of Appeal's warning that the entitlement to shut wells in may be limited to circumstances where there are "prudent" reasons for doing so. This would be a potentially significant change to industry practice. In Omers, "none of the parties ... challenged the right to shut-in a well for any reason whatsoever."

6. The potential application of the interpretation of "capable of producing" into other situations is uncertain. For example, would the interpretation in Omers inform a future interpretation of section 15(3) of the Oil and Gas Conservation Act, which provides that no person can apply for a well licence from a pool from which another well is "capable of obtaining production" in the same drilling spacing unit?

Canadian oil and gas industry participants with interests in CAPL 91 oil and gas leases, and other leases with similar wording, may wish to assess this decision with a view to mitigating potential risks and to identifying potential opportunities based on the new "meaningful production" test.

Footnotes

1. Omers Energy Inc. v. Alberta (Energy Resources Conservation Board), 2011 ABCA 251 (September 7, 2011).

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