Interpreting offset well clauses in light of horizontal drilling: an analysis of two new cases

Two decisions addressing offset well obligations pertaining to leased lands in Saskatchewan were recently released: Canadian Natural Resources Limited v Lisafeld Royalties Ltd. and Whitecap Resources Inc. v Canadian Natural Resources Limited. These decisions are significant given their interpretation of offset well clauses in light of horizontal drilling operations that were not contemplated when the lease was entered into.

Canadian Natural Resources Limited v Lisafeld Royalties Ltd. (2019 SKQB 201) (Lisafeld)

Overview

On August 21, 2019, the Saskatchewan Court of Queen's Bench ruled on a dispute regarding Canadian Natural Resources Limited's (CNRL) obligations under a lease that was originally granted in 1949 (the 1949 Lease). It should be noted that given the age of this lease, it employed an earlier version of the offset well clause than in Whitecap Resources (discussed below). Unlike in Whitecap Resources, there was no "drill, drop or pay" obligation; instead, when the offset well obligations arose, the only options available were to drill or to risk termination of the lease for default.

This case dealt with an offset well (the Horizontal Well) that was spud on legal subdivision (LSD) 2 of the leased lands. It was then completed as a horizontal well under LSD's 3 and 4 in the Frobisher zone, which were not part of the leased lands. The Horizontal Well obtained production in 2012 but was shut down and ceased production in 2015.

There are two formations of relevance in this case - the Midale formation and the Frobisher formation. The Midale formation lies above the Frobisher formation. In 1956, a well was drilled under the 1949 Lease into the Midale and Frobisher formations (the 1956 Well). After testing, it was determined that no oil could be produced from this well and it was converted into a water injection well.

What happened?

In 2016, Lisafeld served a notice of default on CNRL stating that it was in breach of the 1949 Lease offset well obligations since it failed to drill a well into the Frobisher formation in response to the production from the offsetting Horizontal Well. Following this notice, CNRL commenced an action against Lisafeld. CNRL sought declaration that there was no breach or default under the 1949 Lease and that the 1949 Lease remained in full force and effect.

The Court's decision

While Justice Chicoine addressed a number of issues in his decision, a few are particularly noteworthy.

Did an offset well obligation arise pursuant to the lease between CNRL and Lisafeld?

In determining that this was a question of contractual interpretation, the Court stated that "the answer lies in the interpretation to be given to the words 'adjoining drilling unit', and more specifically, whether a horizontal well has a different 'drilling unit' than a vertical well."

CNRL argued that based on the position of the Horizontal Well, it was not a well drilled on any drilling unit laterally adjoining the Lisafeld lands. Justice Chicoine found that this was an unreasonable interpretation. He stated that the issue was whether commercial production was being obtained from an oil well drilled into one of the oil producing formations on the adjacent lands. Justice Chicoine further noted that the location of the vertical section of the horizontal well was not relevant and so long as production was being obtained from LSD's 3 and 4, the offset provision in the 1949 Lease applied.

Justice Chicoine then addressed CNRL's argument that a "drilling unit" is not the same for a horizontal well as it is for a vertical well. He found that for the purposes of the case at hand, "drilling unit", "drainage unit" and "spacing unit" were all synonymous. He concluded that the proximity of the production from the boundary of the leased lands is not what triggers the offset wells provision of the lease. In applying a common sense interpretation, Justice Chicoine found that the wording of "any well drilled on any drilling unit laterally adjoining the said lands" included horizontal wells. It did not matter that the parties would not have contemplated horizontal wells when entering into the 1949 Lease.

Did the drilling of a dry hole in 1956 satisfy the offset obligation in respect of the Frobisher formation in the adjacent spacing unit?

Perhaps the most interesting of Justice Chicoine's findings is the conclusion that the 1956 Well satisfied CNRL's offset well obligations under the 1949 Lease arising from the Horizontal Well. It is also notable that this conclusion was not necessarily needed given the below findings regarding the timing of Lisafeld's notice of default.

CNRL's position was that the 1956 Well, which had been drilled into the Midale and Frobisher formations on the spacing unit comprised of LSD's 1 and 2, fully satisfied its offset well obligations in regards to any wells drilled upon spacing units that were laterally adjacent. CNRL argued that the offset wells provision did not require them to drill a new well into the Frobisher formation every time a new well was drilled into a laterally adjacent spacing unit, as it had already been determined by the 1956 Well that the Frobisher formation was not viable for commercial production of any leased substances.

Lisafeld disputed CNRL's assertion and argued that due to the dramatic changes in drilling technology over the past 60 years, the 1956 Well drill stem test results should not be accepted and that CNRL was expressly required under the 1949 Lease to drill an offset well every time a triggering well was drilled adjacent to the leased lands.

Justice Chicoine sided with CNRL and found that the 1956 Well satisfied the offset well obligation to explore production in the Frobisher formation. Therefore, CNRL was not obligated to drill an offset well in response to the drilling of the Horizontal Well.

In coming to this conclusion, Justice Chicoine stated that while counteracting drainage is one of the purposes of offset well obligations, the clause in this case did not specify where the offset well had to be drilled. It only stated that the offset well had to be drilled "on the drilling unit of the said lands laterally adjoining the said drilling unit on which production is being so obtained." Justice Chicoine also noted that while a horizontal well drilled on adjacent land may trigger offset well obligations, this did not mean that CNRL had to drill a horizontal well to fulfil this obligation. The offset wells clause only required CNRL to drill the well "to the horizon in the formation from which production is being obtained from the adjoining drilling unit." A vertical well could satisfy this obligation.

For Justice Chichoine, the issue appeared to be where the 1956 Well was drilled not when it was drilled. His conclusion that a well that was drilled 60 years earlier in the adjoining drilling unit established that the Frobisher formation was unsuitable for commercial production appears to be the basis upon which he determined that the 1956 Well satisfied the offset obligation. This determination is troublesome on a number of fronts, including the advancements in drilling technology that have taken place since 1956. One hopes that this determination will be limited to the specific wording of the offset well provision in the 1949 Lease or held to be obiter since the Horizontal Well was not producing when Lisafeld issued the notice of default (as discussed below) and should have little precedential value.

Timing issues with Lisafeld's notice of default

Justice Chicoine made two points in regards to the timing of Lisafeld's notice of default. First, based on language from the 1949 Lease, he found that CNRL was required to commence drilling an offset well within six months of the date that the well on the adjoining land had been placed into production. Justice Chicoine then found that "Lisafeld did not give CNRL written notice requiring it to remedy such default which would have allowed CNRL to remedy the default within 90 days as provided for by Clause 18 of the 1949 Lease." Lisafeld instead waited to send formal notice until more than 19 months after the Horizontal Well had stopped producing.

Second, Justice Chicoine found that by the date that Lisafeld delivered formal notice of default to CNRL, there was no default to be remedied, as there was no possibility of any actual drainage in regards to the Horizontal Well. Justice Chicoine emphasized the fact that the Horizontal Well was no longer producing and therefore there was no current risk of drainage. Given the purpose of the offset well obligation, there was no point in requiring CNRL to drill an offset well.

Whitecap Resources Inc. v Canadian Natural Resources Limited (2019 ABQB 698) (Whitecap Resources)

Overview

On September 11, 2019, the Alberta Court of Queen’s Bench ruled on a dispute involving the drill, drop or pay offset well obligations that Whitecap Resources Inc. (Whitecap) owed to CNRL under three oil and gas leases.

What happened?

Whitecap entered into three different oil and gas leases with Devon Canada Corporation (Devon). These leases related to three parcels of land in Saskatchewan in the Viking geological formation. The applicable spacing unit for a vertical gas well in these locations is one LSD. All relevant wells span two LSDs, are horizontal wells, and with the exception of one Whitecap well, are classified as oil wells.

In April 2014, after acquiring the leases from Devon through an assignment agreement, CNRL undertook an offset well review of the leases. CNRL subsequently issued default notices to Whitecap alleging that Whitecap was in default of its offset well obligations. It took the position that Whitecap’s obligations under the leases had been triggered. CNRL argued that since Whitecap had not elected to drill, drop or pay, it was deemed under the leases to have elected the last option and that compensatory royalties were owing to CNRL.

The Court’s decision

In his decision, Justice Slawinsky undertook an in-depth analysis of a number of issues related to the specific leases and parcels of land. There are a few elements of his decision that are of particular interest.

The spacing units for the horizontal wells were one LSD

The offset well clause in the leases said specifically, "in the case of an offset well which is classified as a horizontal well… a reference to a Spacing Unit herein shall be deemed to refer to one (1) Legal Subdivision." The Court refused to find that difficulties related to downspacing approvals or the commercial viability of drilling a well could counter the plain meaning of this clause. Failing to drill on the basis drilling would be uneconomical is not a reason to avoid the obligation. It held that for one of the leases the adjacent wells drilled by a third party triggered Whitecap’s obligations on three different LSDs and compensatory royalties were payable for each LSD.

The type of substance drilled from the offset well does not affect defensive drilling obligations

The Court held that there was "no merit to CNRL’s position that a new adjacent well producing 'leased substances', which an independent regulator classifies as an oil well, will trigger an offset obligation on the leased lands simply because the existing well is producing 'leased substances' that contain a higher volume of gas than oil from the same formation." Essentially, unless the parties specifically contract for leased substances to be treated separately, it is the formation and not the product that matters for the purposes of the offset well obligations. It is also of note that Justice Slawinsky held the existing well, characterized as producing gas, adequately satisfied the offset well obligations even when a new well was drilled on adjacent lands.

One offset well only needs one defensive well to satisfy the offset well obligations

The question here was whether one offset well required multiple defensive wells or multiples of compensatory royalties depending on the number of spacing units laterally or diagonally adjacent to the offset well spacing unit. The Court found that only one defensive well on the leased spacing unit is necessary to satisfy the offset well obligations in response to a single offset well in the absence of evidence that more wells were reasonably required to protect against drainage. The Court held that this interpretation was commercially reasonable and consistent with the other lease clauses. Interestingly, this interpretation leaves open the possibility that if drainage is established, a lessee may need to drill multiple wells to protect the lands against drainage. Presumably this would also require a lessee that chose not to drill to pay compensatory royalties on more than one spacing unit laterally or diagonally adjacent to the offset well spacing unit.

The compensatory royalty should be calculated using the amount attributable to the adjacent LSD

The Court found that compensation should be based on the production of leased substances from the adjacent spacing unit only. Where horizontal wells span multiple spacing units, the royalty is calculated by proportioning the total production of the offset well equally by the number of LSDs that the producing section of the well borehole spans.

Conclusion

While these two offset well decisions provide some guidance regarding the interpretation of offset well obligations in relation to horizontal drilling operations, they also raise other questions. As a result, ensuring compliance with older versions of offset well provisions, particularly when dealing with horizontal wells, will continue to be challenging.