Opinion ID: 1829970
Heading Depth: 3
Heading Rank: 2

Heading: Payout

Text: The trial court awarded the State $12,075,343 as compensation for improper royalty rates, payout. The payout heading covers two distinct issues. First, the State claims that Exxon misinterpreted the payout terms of the leases and that it underpaid royalties. Second, the State claims that Exxon improperly withheld payment under payout for capital expenses that should not be included in drilling expenses. The payout clause is included only in the leases executed by Exxon in 1984 or later. It allows Exxon to recover its investment in actually drilling wells on the leased areas by allowing payment at lower royalty rates until the recovery of its investment, as discussed above and as defined in the leases at paragraph 29(1), is complete.
This rate issue arises because a single reservoir may be covered by more than one leased tract. Because it is not necessary, cost-effective, or environmentally advisable to drill a well on each leased tract to efficiently recover the gas and oil from the single reservoir, lessees are permitted to join several tracts over a particular reservoir as a unit. Production from that reservoir is then allocated on a percentage basis to the various constituent tracts under a plan formalized in a unit agreement negotiated with the AOGB and signed by DCNR. This allocation ensures that the owner of the mineral rights of each leased tract will be allocated his fair share of the proceeds, based on his proportional ownership of the mineral rights covered by the unit, as defined in the unit agreement. In those leases executed in or after 1984 that include provisions for payout, two rates were inserted in the blanks in paragraph 5(a) and paragraph 5(b) of the standard form lease  one payable until payout and the other higher rate payable thereafter. Exxon paid the lower royalty rate on all tracts in the unit, whether or not an individual tract contains a well, until the cost of each well on the unit is recovered. Exxon argues that the wording of paragraphs 5, 17, and 29(1) of the leases permit this interpretation. Paragraph 29(1) defines payout as: (1) As used in paragraph 5, the word `payout' shall mean `the point in time when the LESSEE has recovered from production, after deduction of state royalty, severance and production taxes, the direct expenses incurred in actually drilling wells on the leased area beginning, for each well, with the spud [14] date and ending on the date each well is ready to be put into production.' The cost of pipelines and treatment facilities are expressly excluded as recoverable expense items. Paragraph 17 reads: 17. In the event the acreage covered by this lease or any parts thereof is pooled or unitized by governmental order with other land, lease or leases in the immediate vicinity thereof (whether State land, Federal land or privately owned land), ... the entire acreage constituting such unit shall be treated for all purposes as if ... included in this lease except that in lieu of the royalties elsewhere herein specified, LESSOR shall receive on production from each of such units the proportion of royalties herein stipulated that the amount of LESSOR's ownership in the mineral interest in the acreage placed in the particular unit involved bears to the entirety of the mineral interest in such unit. Exxon relies on the words the entire acreage constituting such unit shall be treated for all purposes as if ... included in this lease to argue that the method it employs to calculate royalties, i.e., paying at the lower payout rate on all tracts in a unit until the allowable costs of the wells on the unit are recovered, is the correct method for calculating royalties because the terms of the leases apply to the entire unit and not just to the particular acreage on which the well was drilled. The State argues that paragraph 29(1) specifically limits its terms to tracts on which a well is actually drilled, and that Exxon is exploiting payout by paying royalties at a reduced rate on production from tracts on which no wells have been drilled. The meaning of the payout clause in the leases is clear: it permits the recovery of expenses for wells drilled on the leased areas. It is the interplay between the payout clause and the unitization clause that produces two different, but reasonable, interpretations. When a contract is subject to two reasonable but differing interpretations, it is ambiguous. Paragraph 27 of the leases dictates that such ambiguities will be construed in favor of the State. We agree with the trial court when it held: Well costs shall be used to determine payout only when a well is physically located on a leased area for which there is a payout provision in the lease. No well costs shall be allocated to other tracts/leases for determining payout. Accordingly, we hold that the trial court did not err in denying Exxon's motion for a JML on this claim, and we affirm the trial court's judgment.
The State claims that Exxon improperly seeks recovery under payout in conflict with paragraph 29(1), which expressly excludes from recovery the cost of pipelines and treatment facilities. Exxon argues that this Court set out guidelines as to what types of operations constitute drilling under Alabama law in Sheffield v. Exxon Corp., 424 So.2d 1297 (Ala.1982). According to Exxon, the Court in Sheffield, adopting Texas law, broadly defined such operations to include all physical and mechanical aspects of securing oil and/or gas production in paying quantities, including connection of pipelines to the well or the extension of pipeline to some point where the product might be marketed. 424 So.2d at 1302. Exxon has not included its costs for the gathering system and the OTF as payout expenses, but it has included its costs for corrosion-resistant flowlines, which carry the acidic wet wellstream from off-platform well templates to the production platforms and the offshore platforms themselves. Exxon attempts to justify including the costs of these facilities as necessary to put the wells into production and as being within the definition of drilling in Sheffield. The State argues that the drilling operations at issue in Sheffield were different from those at issue here, that this Court did not adopt Texas's definition of drilling, and that this Court in Sheffield stressed that each case must be considered on its own facts. Sheffield deals with the issue of how and when drilling or reworking activity on leased land or on pooled acreage will serve to extend a lease that has otherwise expired. The Court in Sheffield was required to interpret a clause in a lease that provided for the expiration of the lease when certain time periods had passed without the lessee's pursuing drilling or reworking on the leased land. This Court set out guidelines defining drilling and reworking under Alabama law in that context. It stated: [W]e intend to express guidelines as to what types of operations constitute drilling or reworking under Alabama law, but with the caveat that each case must be determined on its own particular facts. Sheffield, 424 So.2d at 1302. The guidelines set forth in Sheffield are clearly stated, as is this Court's caveat that each case must be taken on its own facts. Consequently, a lease agreement may dictate what operations, if any, are necessary to defeat a cessation of production clause. 424 So.2d at 1302. We now state that a lease agreement may dictate what operations, if any, are to be considered drilling, as does the payout clause of paragraph 29(1) of the leases at issue here. The leases at issue here clearly provide for recovery of direct expenses incurred in actually drilling wells and exclude pipelines and treatment facilities from recovery under the payout provision. This claim should have been decided as a matter of law based on the leases. Accordingly, the portion of the judgment of the trial court denying the recovery of expenses for pipelines under the payout clause on this issue is affirmed.