Thoroughbred Assocs., L.L.C. v. Kan. City Royalty Co.

• Decision Date: 26 June 2020
• Docket Number: No. 120,068,120,068
• Parties: THOROUGHBRED ASSOCIATES, L.L.C., et al., Appellants/Cross-appellees, v. KANSAS CITY ROYALTY COMPANY, L.L.C.; Robert E. Thomas Revocable Trust; and D.D.H., L.L.C., Appellees/Cross-appellants.
• Court: Kansas Court of Appeals

58 Kan.App.2d 306

469 P.3d 666

THOROUGHBRED ASSOCIATES, L.L.C., et al., Appellants/Cross-appellees,

v.KANSAS CITY ROYALTY COMPANY, L.L.C.; Robert E. Thomas Revocable Trust; and D.D.H., L.L.C., Appellees/Cross-appellants.

No. 120,068

Court of Appeals of Kansas.

Opinion filed June 26, 2020.

Jeff Kennedy and Marcia A. Wood, of Martin, Pringle, Oliver, Wallace & Bauer, L.L.P., of Wichita, for appellants/cross-appellees.

Matthew W. Brockman and David A. Elder, of Hartzog Conger Cason, of Oklahoma City, Oklahoma, and William J. Skepnek, of The Skepnek Law Firm, P.A., of Lawrence, for appellees/cross-appellants.

Before Leben, P.J., Powell and Schroeder, JJ.

Leben, J.:

This case is the latest installment in a 17-year fight over revenue from gas leases organized into a single operating unit in Comanche County, Kansas. The fight centers on a simple issue: is a lease owned by the unit's former operator, Thoroughbred Associates, L.L.C. (Thoroughbred), included in the unit? If so, Kansas City Royalty Company, L.L.C. (KC Royalty) and the other defendants are entitled to their share of profits from unit gas production.

In a prior appeal, the Kansas Supreme Court held that the plain language of the lease precluded its inclusion in the unit if only the lease terms were considered. Thoroughbred Assocs. v. Kansas City Royalty Co. , 297 Kan. 1193, 308 P.3d 1238 (2013). But the court remanded the case to see if KC Royalty could show that the lease was unitized (made part of the single operating unit) under several alternative theories.

The district court ruled in KC Royalty's favor after a trial, and Thoroughbred filed this appeal challenging various aspects of the district court's conclusion that the parties had included the lease in the unit by modification, waiver, or equitable estoppel. KC Royalty cross-appealed, challenging the district court's decision not to award it attorney fees under K.S.A. 55-1617. We affirm the district court's conclusion that the lease is in the unit, but reverse its decision about the extent of KC Royalty's interest in the unit. We also affirm the district court's denial of attorney fees.

FACTUAL AND PROCEDURAL BACKGROUND

Our decades-long unitization saga begins with Thoroughbred president Robert Patton, who in 1997 started acquiring oil-and-gas leases from mineral owners in the Warmwater Prospect near Coldwater, Kansas. Those efforts paid off in December of that year when Thoroughbred successfully drilled the Bird Well, a prolific gas well that produced from the Mississippian rock formation.

To protect the Bird Well from competition, Thoroughbred acquired leases on the nearby property. It executed three leases with the mineral-rights owners of a 120-acre tract (the Tract) next to the Bird Well. After signing those leases, a 1/3 mineral interest in the Tract (or 40 mineral acres) owned by Oxy USA Inc. remained unleased.

The Oxy Lease

In July 1998, Thoroughbred contacted Oxy about selling its 1/3 interest in the Tract. Oxy drafted a lease (the Lease) using its standard form for Kansas wells; the parties signed the Lease on July 21 and later recorded it in the Comanche County deeds office.

Three features of the Lease stand out. First, Oxy granted Thoroughbred the power to unitize the Lease. That meant Thoroughbred could consolidate the Lease with others it owned in the area to form a single, joint operation. See Williams & Meyers, Manual of Oil and Gas Terms, p. 1191 (17th ed. 2018). If unitization occurred, Thoroughbred would own a working interest in the unit while Oxy and the other lessors would own a royalty interest. A working interest is the lessee's share of production after deducting royalty paid to the lessor; a royalty interest is a lessor's share (usually 1/8) of any oil and gas produced. Mulsow v. Gerber Energy Corp. , 237 Kan. 58, 61, 697 P.2d 1269 (1985). But Thoroughbred could include the Lease in a unit only if certain conditions existed. Those conditions do not affect the issues in this appeal.

Second, the Lease had a one-year primary term; it would expire in a year unless Thoroughbred had started drilling. If it had, the Lease continued for as long as Thoroughbred produced oil or gas in paying quantities from the Tract. And if Thoroughbred put the Lease in a unit, production from anywhere in the unit (not just the Tract) would extend the Lease because unit production was treated as if it had occurred on the Tract. Under what's called a Pugh clause, however, production from unitized lands would maintain the Lease "only to depths from the surface down to the deepest producing interval." In other words, the Lease would expire below the deepest depth drilled for gas production anywhere in the unit during the primary term.

Third, the Lease granted Oxy a 3/16 royalty on production from the Tract. Oxy would receive that same royalty on unit production based on its proportionate interest in the unit.

The Rietzke Unit

In fall 1998, production in the Warmwater Prospect heated up. In August, Thoroughbred drilled the Rietzke Well about 1,000 feet south of the Bird Well. In September, Thoroughbred recorded a Declaration of Unitization in the county deed office stating its intent to form a 640-acre unit (the Rietzke Unit) comprised of the "gas rights" in several listed leases. Thoroughbred also recorded an Affidavit of Commencement of Operations, which said that the drilling of the Rietzke Well had extended those leases beyond their primary terms. Both documents listed the Lease and the Tract as in the Unit.

In October, Thoroughbred prepared a document for the Unit called the Title Opinion. Title opinions state the extent of each lessor's mineral interest in a unit. Oil-and-gas operators like Thoroughbred provide these documents to purchasers so they know who to pay and in what amounts. Williams & Meyers, Manual of Oil and Gas Terms, p. 1160. The Title Opinion listed Oxy's royalty interest as in the Unit, and it described the Declaration as having "unitized the [listed] leases."

Thoroughbred drilled five successful wells in the Unit, none of which were located on the Tract covered by the Lease. These wells produced oil and gas from different rock formations found at different depths beneath Earth's surface. From shallowest to deepest, these formations were the Lansing, Kansas City, Marmaton, Altamont, Mississippian, and Viola. Some wells produced from one formation, while others produced from several:

Well	Drill Date	Formations & Substances
Rietzke	August 1998	Mississippian (gas)Altamont (gas)Lansing-KC (gas)
Jamie	August 1999	Mississippian (gas)
Husker	January 2001	Viola (oil, gas)Mississippian (gas)
Blackshirt	September 2001	Viola (oil, gas)Altamont (gas)
Tunnelwalk	December 2001	Viola (oil, gas)Mississippian (gas)

Thoroughbred also drilled two dry holes in the Unit that didn't produce oil or gas in paying quantities: the Big Red Well, drilled in October 2001, and the Craig Bohl Well, drilled a month later.

The sale to KC Royalty

For several months after Thoroughbred formed the Unit, it sent Oxy drilling information, production reports, and royalty payments for the Rietzke Well. Oxy also signed a division order for that well. Thoroughbred had the lessors sign an order for each new well that stated their agreement to receive the share of production listed in the Title Opinion. Thoroughbred then provided the orders to buyers.

In June 1999, Oxy sold its interest in the Lease to KC Royalty and another entity whose interest Robert E. Thomas Revocable Trust and D.D.H., L.L.C. later acquired. For simplicity, we'll refer to these three entities collectively as KC Royalty.

In a letter notifying Thoroughbred of the sale, KC Royalty ratified any division orders Oxy had signed and asked Thoroughbred to start sending royalty payments to KC Royalty. Thoroughbred sent KC Royalty its first royalty check on June 30, 1999, for May production from the Rietzke Well. And in November, KC Royalty signed a division order from Thoroughbred for the Jamie Well that listed KC Royalty's royalty interest in the Unit. KC Royalty continued to receive royalty payments for two and a half years; Thoroughbred cut a final check to KC Royalty in December 2001.

The business relationship sours

Early on in their relationship, KC Royalty's managing partner, Robert Blair, sent Patton several letters about whether the Bird Well was draining the Rietzke Well. Drainage occurs when a deeper producing well reduces pressure in a reservoir, causing the oil or gas to migrate. Williams & Meyers, Manual of Oil and Gas Terms, p. 307. The Bird Well, located just outside the Unit and about 1,000 feet north of the Rietzke Well, was producing gas from the Mississippian. That formation is below the Altamont, where the Rietzke Well produced at the time. Believing that the Bird Well was draining the Mississippian, Blair asked Patton to drill an offset well in the Unit that would produce from that formation. Patton denied that drainage was occurring but was open to drilling an offset well. KC Royalty could have drilled its own offset well without Thoroughbred's permission if the Lease was not in the Unit.

Another dispute arose in October 2001, this time over whether KC Royalty would participate in the Big Red Well that Thoroughbred planned to drill on the Tract to test Viola production. In a letter about the issue, Blair disputed Patton's recent assertion in a phone call that the Lease was still effective in the Mississippian, which is above the Viola.

Patton said that if KC Royalty participated in the Big Red Well, it would have to pay for its proportionate share of drilling costs in the Viola but not for any costs above the Viola. They didn't reach an agreement, so Thoroughbred drilled the Big Red Well without KC Royalty's participation.

On November 6, 2001, Thoroughbred filed two intent-to-drill notices for Viola wells on the Tract. Thoroughbred never drilled the wells, but filing the notices prevented anyone else from drilling at the proposed sites for one year unless Thoroughbred consented....