Tidelands Royalty B Corp. v. Gulf Oil Corp.

• Citation: 804 F.2d 1344
• Decision Date: 02 December 1986
• Docket Number: No. 85-1506,85-1506
• Parties: TIDELANDS ROYALTY "B" CORP., Plaintiff-Appellee, v. GULF OIL CORPORATION, Defendant-Appellant.
• Court: United States Courts of Appeals. United States Court of Appeals (5th Circuit)

Page 1344

804 F.2d 1344

TIDELANDS ROYALTY "B" CORP., Plaintiff-Appellee, v. GULF OIL CORPORATION, Defendant-Appellant.

No. 85-1506.

United States Court of Appeals Fifth Circuit.

Dec. 2, 1986.

Rehearing Denied Jan. 14, 1987.

Gene W. Lafitte, New Orleans, La., C. Steven Matlock, D.L. Case, Dallas, Tex., Deborah Bahn Price, New Orleans, La., for defendant-appellant.

Leo Hoffman, Kenneth S. Beat, Dallas, Tex., John M. McCollam, Robert B. Wiygul, New Orleans, La., for plaintiff-appellee.

Appeal from the United States District Court for the Northern District of Texas.

Before WISDOM, DAVIS, and JONES, Circuit Judges.

WISDOM, Circuit Judge:

This appeal presents a question of first impression involving oil and gas law. The question is whether, under Louisiana law, the grant of an overriding mineral royalty by a mineral lessee imposes an implied obligation on the lessee to protect the royalty owner from drainage caused by the lessee's operations on adjacent lands. ¹ We answer neither affirmatively nor negatively. Instead, we answer the question with another question: is the diminution of the royalty owners' payments the result of a breach of the lessee's implied obligation to act in good faith with respect to the interest of the royalty owner? Because the district court did not address this second question, we remand the case for further proceedings.

I. The Facts and Proceedings Below

This case arises from an agreement in 1951 between Gulf Oil Corporation ("Gulf") and the predecessors of Tidelands Royalty "B" Corporation ("Tidelands"). The object of the agreement was the sale to Gulf of confidential geophysical data covering 2,700,000 acres of offshore lands off the Louisiana coast. The consideration for this data was $2,000,000 and the promise to grant overriding royalties in any leases obtained over certain tracts designated in the agreement. ² Gulf was successful in obtaining leases from the federal government for Blocks 332 and 333 in the West Cameron Area off the coast of Louisiana. Block 333 is not within the area subject to the agreement, but 4,062 acres of Block 332 are covered by the agreement. Fulfilling its obligation under the agreement, Gulf assigned an overriding royalty interest to Tidelands covering the 4,062 acres and incorporating the terms of the 1951 agreement.

Gulf began operations on its leases. After drilling a dry well in Block 332, a successful gas well was completed in Block 333. From a drilling platform later erected on Block 333, five more wells were directionally drilled. Gulf completed two wells in Block 332 and three wells in Block 333. At least two of the wells in Block 333 are draining gas from reservoirs that underlie both blocks.

Tidelands brought this suit contending that Gulf breached an implied covenant to protect Tidelands from drainage caused by Gulf's operations in Block 333. Gulf admitted the fact of drainage, but argued that the 1951 agreement precludes the implication of an obligation to protect against drainage. On Tidelands' motion for partial summary judgment, the trial court held that "there is an implied covenant under the 1951 Agreement which requires Gulf to protect Tidelands' interests from drainage by Gulf's own operations." ³ Gulf appeals from this holding.

II. The Nature of the Relationship Between Gulf and Tidelands

The agreement between Gulf and Tidelands does not expressly create an obligation to protect against drainage. Implied obligations, however, are common in mineral leases. For example, there is no doubt that a lessee has an implied obligation to protect his lessor from drainage. ⁴ This obligation derives from the basic obligation of the lessee to act as "a reasonably prudent operator". ⁵ The existence of drainage does not necessarily indicate a breach of any implied obligation. Rather, a breach is shown only upon proof that the lessee neglected to take the same economically feasible steps that a reasonably prudent operator would have taken to protect against the drainage. ⁶

The district court of course noted that the agreement between Gulf and Tidelands is not a mineral lease. ⁷ The court concluded, however, that the implied obligations attending a mineral lease also attend overriding royalty interests. ⁸ This finding serves as the premise for the district court's holding. We do not accept it as dispositive of this case, because it does not take into consideration the different relationships from which overriding royalties are created.

The district court relied on the Louisiana case of Wier v. Grubb ⁹ and two Texas cases, Bolton v. Coats ¹⁰ and Phillips Petroleum Co. v. Taylor ¹¹ in concluding that the implied obligations in mineral leases apply to overriding royalties. ¹² In each of these cases, the overriding royalty was created in the context of a sublease agreement; the original lessee assigned his interest to another and retained an overriding royalty. ¹³ Under Louisiana law, the assignment of a lease with the retention of an overriding royalty creates a sublease, regardless of how the parties style their agreement. ¹⁴ Therefore, the cases cited by the district court support only the proposition that a sublessor is entitled to the protection of the same implied obligations that protect the original lessor. ¹⁵ Because Tidelands is not Gulf's sublessor, these cases are not dispositive in defining Gulf's implied obligations to Tidelands. ¹⁶

As in this case, royalty interests may be created outside of the lessor-lessee relationship. A landowner may convey a royalty interest in his land before leasing or may convey a portion of his reserved royalty in an existing lease. ¹⁷ The creation of a royalty interest by these means establishes an executive-nonexecutive relationship. The landowner holds an executive interest--the exclusive right to grant leases on the subject tract. ¹⁸ The royalty owner holds a nonexecutive interest--an interest that does not include the right to grant leases. ¹⁹ The distinguishing characteristic of a nonexecutive royalty interest is its "passive" nature. ²⁰ The royalty owner has no right to explore, develop, or lease the subject tract. ²¹ Moreover, the landowner has no obligation to develop or lease the premises for the benefit of the royalty owner. ²² Although the nonexecutive royalty owner may be dependent solely on the executive's will to realize the potential value of his royalty, the realization that the landowner also has an interest in leasing and development justifies the gamble of purchasing the royalty. ²³

We find that the rules governing the executive-nonexecutive relationship apply to the relationship between Gulf and Tidelands. Tidelands has only a passive interest in the tracts subject to its overriding royalty. It has no right to produce or explore for minerals in the tracts, nor is it obligated to share the costs of production. The agreement specifically negates any duty of Gulf to acquire leases on the tracts or develop any leases that may be acquired. ²⁴ In these respects, the relationship between Gulf and Tidelands is consistent with the description of an executive-nonexecutive relationship.

In contrast, the relationship of the parties here is inconsistent with a lessor-lessee relationship. A lessee undertakes an affirmative, implied obligation to develop the leased premises. ²⁵ The parties specifically agreed that Gulf did not have this duty. Moreover, the lessor surrenders his exclusive right to explore for and produce minerals in exchange for the lessee's obligation to develop and protect from drainage. ²⁶ Unlike a lessor or sublessor, Tidelands had no interest in the tracts when it sold the geophysical data in exchange for cash and possible overriding royalties. Finally, the lessor does not dispose of his interest, he only leases it. Thus, the lessee must reasonably develop the property or lose his lease; otherwise, the lessee could permanently deprive the lessor of his reversionary interest in the minerals underlying the leased land. ²⁷ Tidelands, on the other hand, has no reversionary mineral interest in the tracts being drained. Its only "interest" in the tracts was its compilation of geophysical data concerning those tracts, which it disposed of in exchange for $2,000,000 and possible overriding royalties. ²⁸ Accordingly, Gulf's obligation to Tidelands to protect against drainage should not be determined under the "reasonably prudent operator" standard imposed on a mineral lessee. Instead, Gulf's obligations should be determined under the standard of care owed to a nonexecutive royalty owner by his grantor.

III. The Nature of the Duty Owed to the Nonexecutive Royalty Owner

Before 1975, Louisiana courts declined to recognize any implied duties arising from the executive-nonexecutive relationship. In Uzee v. Bollinger, ²⁹ the Louisiana First Circuit upheld the right of the executive to execute a lease with terms that favored the executive at the expense of the nonexecutive royalty owner. ³⁰ The Uzee court held that the executive did not act as a fiduciary, ³¹ nor was he under a duty "to deal fairly and in good faith". ³² In a similar situation, the Louisiana Supreme Court approved the holding of Uzee in Gardner v. Boagni. ³³ These decisions followed earlier ones that had recognized the executive's right to refrain from leasing so that the royalty interest burdening his right would expire by prescription. ³⁴ Louisiana jurisprudence contrasted with that of most states, which recognize an implied duty in the executive-nonexecutive relationship ranging from that of "good faith and fair dealing" to that of a fiduciary. ³⁵

The duties of the executive were addressed by the legislature in 1975 with the enactment of the Mineral Code. Article 109 of the Mineral Code provides:

The owner of the executive interest is not obligated to grant a mineral lease, but in doing so, he must act in good faith and in the same manner as a reasonably prudent landowner or mineral servitude owner whose...