Strata Production Co. v. Mercury Exploration Co.

• Citation: 916 P.2d 822,121 N.M. 622,1996 NMSC 16
• Decision Date: 15 April 1996
• Docket Number: No. 22273,22273
• Parties: STRATA PRODUCTION COMPANY, a New Mexico corporation, Plaintiff-Appellee, v. MERCURY EXPLORATION COMPANY, a New Mexico corporation, Defendant-Appellant.
• Court: New Mexico Supreme Court

Page 822

916 P.2d 822

121 N.M. 622

STRATA PRODUCTION COMPANY, a New Mexico corporation, Plaintiff-Appellee, v. MERCURY EXPLORATION COMPANY, a New Mexico corporation,

Defendant-Appellant.

No. 22273.

Supreme Court of New Mexico.

April 15, 1996.

[121 N.M. 625] Atwood, Malone, Mann & Turner, P.A., Steven L. Bell, Richard J. Valle, Roswell, for Appellant.

Stratton & Cavin, P.A., Harold D. Stratton, Jr., Sealy H. Cavin, Jr., Albuquerque, Browning & Peifer, P.A., James O. Browning, Albuquerque, for Appellee.

OPINION

FROST, Chief Justice.

Defendant-Appellant Mercury Exploration Co. (Mercury) appeals from a judgment rendered in favor of Plaintiff-Appellee Strata Production Co. (Strata) for breach of contract and negligent misrepresentation. Mercury argues on appeal that: it modified its unilateral contract offer with Strata before Strata's acceptance by performance; the trial court incorrectly interpreted the contract terms; the trial court failed to reduce Strata's damage award by the proportionate interests owned by subsequent investors; and the trial court used the incorrect measure of damages for calculating Strata's lost profits for breach of the contract. We affirm.

I. FACTS

Both Strata and Mercury are engaged in the business of petroleum exploration and production. In 1991 Strata began putting together a drilling prospect in Lea County, New Mexico, which it called the Red Tank Prospect. As part of the Red Tank Prospect, Strata obtained farmout agreements from Exxon Co., Mobil Producing Texas and New Mexico Inc., and Mercury for drilling rights on three tracts of roughly adjacent land. These tracts are named the Cercion tract, the Paisano tract, and the Lechuza tract, respectively. The Mercury farmout agreement for the Lechuza tract is the contract at issue here.

A farmout agreement is an assignment of a lease and drilling rights by a lease-owner not interested in drilling to another operator interested in drilling. 8 Howard R. Williams & Charles J. Meyers, Oil & Gas Law 389 (1995). The primary characteristic of a farmout agreement is that the assignee is obligated to drill one or more wells on the assigned acreage as a prerequisite to the completion of the assignment. 8 id.

Strata and Mercury entered into their farmout agreement effective August 28, 1991. Glenn Darden, a vice president of Mercury, drafted the farmout agreement. In the farmout agreement, Mercury represented that it owned or controlled all of the lease covering the Lechuza tract. The farmout agreement provided in relevant part that upon initiation of drilling a test well to a specified depth within 120 days of entering the agreement, Mercury would assign to Strata 100% of the working interest in the lease. Mercury also stated in the farmout agreement that it would assign to Strata a net revenue interest of 76.5% of the total revenue interest in the leased land.¹ Under the terms of the lease Mercury subdivided the Lechuza tract into four 40-acre parcels arranged in a checker-board pattern, and Strata could earn Mercury's lease rights for each parcel by successively drilling test wells on the respective parcels. Finally, a clause in the agreement noted that the agreement was on an option basis with no penalty for failure by Strata to drill the test wells other than termination of the agreement. Strata paid no consideration to Mercury for this farmout agreement.

On October 1, 1991, Strata entered into a participation agreement with twenty-four investors. Under this participation agreement, Strata sold to the investors a proportionate share of its working interest in the leases in exchange for proportionate contributions to pay for the capital outlays necessary to begin drilling. Strata ultimately retained only 1.5% of its original working interest acquired from Mercury. The investor with the largest interest was Meridian Oil Production, Inc. (Meridian), which acquired a 50% interest from Strata.

On October 29, 1991, as part of its Red Tank Prospect development, Strata began drilling a well on the Cercion tract pursuant to its farmout agreement with Exxon. This Cercion well was a "wildcat," meaning that it was an exploratory well in an unproven territory and in fact was the first well to produce within the general area of the Red Tank Prospect tract. See 8 Williams & Meyers, supra, at 1218 (defining wildcat well). As a wildcat, the Cercion well was an extremely risky undertaking, costing approximately $600,000 to drill and complete. On November 5, Strata requested an extension of the 120-day drilling deadline, which would otherwise expire on December 11.

On November 10, 1991, Strata's title attorney, Sealy Cavin, Jr., noticed some discrepancies in a 1982 lease agreement concerning the Lechuza tract which indicated that additional, previously unknown parties might also have a working interest in the Lechuza tract. On November 26 Mercury granted Strata a 30-day extension on the 120-day drilling deadline. Cavin produced a formal drilling title opinion on December 9, 1991, which demonstrated that Mercury did not own 100% of the working interest in the Lechuza tract, nor was it able to transfer a 76.5% net revenue interest in the land which it had promised in the farmout agreement.

Strata promptly began negotiations with the newly discovered parties and was able to procure similar working-interest assignments from all but one party. Ironically, the one newly discovered party that would not transfer its 17.1875% working interest in the Lechuza tract was Meridian, which was already a 50% investor in Strata's drilling consortium as noted above. Meridian apparently was not aware that it had this 17.1875% interest when it entered into the participation agreement with Strata.

In addition, another party, Ann Hudson, was unwilling to transfer a full 76.5% net revenue interest from her share and instead retained a larger royalty for herself. This retention resulted in an additional shortfall of 2.033258% net revenue interest below the 76.5% net revenue interest Mercury promised to assign, entirely apart from the missing 17.1875% working interest that Mercury was unable to transfer.

Strata completed the Cercion well and put it into production as a commercial well in December 1991. The location and success of the first Cercion well indicated that the Lechuza tract would also generate commercially productive wells. Strata then requested an additional 30-day extension beyond the January 11, 1992, deadline for commencing drilling under the Mercury farmout agreement, which Mercury refused. Strata therefore commenced drilling on the first 40-acre parcel of the Lechuza tract on January 10, 1992, and completed the well in early February 1992. Strata subsequently drilled wells on two of the three remaining 40-acre parcels, thereby earning the lease assignments for those parcels under the Mercury farmout agreement. The first and second Lechuza wells were commercially productive, the third was not.

Strata sued Mercury for breach of contract and negligent misrepresentation for failing to deliver 17.1875% of the working interest and 2.033258% of the net revenue interest for the Lechuza tract wells. After a bench trial, the court found in favor of Strata and awarded damages of $616,555.22. Mercury appeals from the trial court's findings in favor of Strata and challenges the court's calculation of damages. Because we affirm the trial court's award of damages for breach of contract, we need not address Mercury's claims regarding the tort of negligent misrepresentation.

II. CONTRACT FORMATION

On appeal we will not disturb the trial court's factual findings unless the findings are not supported by substantial evidence. Hill v. Community of Damien of Molokai, 121 N.M. 353, 362, 911 P.2d 861, 870 (1996); Segal v. Goodman, 115 N.M. 349, 353, 851 P.2d 471, 475 (1993). We are not bound, however, by the trial court's legal conclusions and may independently draw our own conclusions of law on appeal. Hill, 121 N.M. at 363, 911 P.2d at 871; C.R. Anthony Co. v. Loretto Mall Partners, 112 N.M. 504, 510, 817 P.2d 238, 244 (1991).

A. Mercury's Offer

Mercury first argues that its farmout agreement with Strata was a unilateral contract, which it was free to revoke or modify before Strata's acceptance. Mercury contends that Strata's discovery of Mercury's inability to transfer all of the relevant interests worked an effective modification of its offer in the farmout agreement.

The farmout agreement provided for Strata's acceptance by performance, namely drilling a test well to a specified depth on the Lechuza tract. The agreement did not provide for a penalty if Strata failed to drill a test well, except that the agreement would lapse. Strata was not obligated to take any action under the agreement. Accordingly, the farmout agreement was a traditional unilateral contract, in which the offeror makes a promise in exchange, not for a reciprocal promise by the offeree, but for some performance. See 1 Joseph M. Perillo, Corbin on Contracts § 1.23 (rev. ed.1993) (describing unilateral contracts). In a unilateral contract, the offeree accepts the offer by undertaking the requested performance. Generally, the offeror is free to revoke or revise the offer before acceptance. See 1 id. § 2.18 (revocability of offers).

In this case the farmout agreement expressly provided that it was on an option basis, holding open the underlying unilateral contract offer for 120 days. Ordinarily, an option contract serves to make an offer irrevocable for the stated period of time. However, to be effective, the option contract generally must be supported by some consideration given in exchange for holding the underlying offer open. See 1A Arthur L. Corbin, Corbin on Contracts § 262 (1963) (discussing option contracts). Strata acknowledges that it did not pay Mercury for this option contract. Accordingly, Strata must demonstrate a substitute for consideration which would serve to make the option...