Opinion ID: 882219
Heading Depth: 1
Heading Rank: 1

Heading: Reef Oil Corporation and Frank Hiestand.

Text: As stated above, the Sundheims based this lawsuit on three separate allegations. In summary, their amended complaint alleged that the defendants breached the implied covenants of protection, to reasonably develop the leasehold and to prudently operate the existing well. As a result, Sundheims allege the defendants are liable for damages. The District Court granted summary judgment in favor of defendants Reef Oil and Frank Hiestand on each of these counts. We will discuss each issue separately.
Each of the Sundheims' allegations are based upon covenants which have been implied by common law, into oil and gas leases. The purpose of the implied covenants is to fully effectuate the intentions of the parties to a lease. Obviously, the primary intention is to produce oil and gas for a profit and to obtain royalties for the lessor. U.V. Industries Inc. v. Danielson (1979), 184 Mont. 203, 602 P.2d 571. To insure this result is obtained the courts have implied, through the express terms of oil and gas leases, certain duties which must be performed by the lessee. These duties include the covenant to protect from drainage and the covenant to reasonably develop the leasehold, both of which are at issue in the case now before us. The Sundheims maintain that Reef Oil Corporation and Frank Hiestand breached the covenant to protect their leasehold from drainage. In their brief, the Sundheims estimate that as much as 145,000 barrels of oil were drained from their leasehold by adjacent oil wells. They further argue that Reef Oil and Hiestand, in accordance with their duty to protect, should have drilled offset wells in order to capture the oil before it was drained. Because these defendants failed to drill such wells, they breached the covenant to protect, and are therefore liable for damages for the value of the oil drained from Sundheims' leasehold. The District Court did not reach the merits of the Sundheims' argument because it found that they were barred from asserting their claim due to the fact that they failed to give written notice of the drainage or demand that an offset well be drilled. In reaching its conclusion, the court relied upon U.V. Industries Inc. v. Danielson (1979), 184 Mont. 203, 602 P.2d 571, where we stated: The offset drilling rule generally requires the lessor ... to serve written notice or demand upon the lessee or its assigns to drill an offset well as a precondition to the latter's duty to drill. Supra, 602 P.2d at 584. Based upon this language, the District Court interpreted U.V. Industries very narrowly to hold that the Sundheims could not bring an action for breach of the implied covenant to protect. All parties to this action agree that no written notice or demand was served. In U.V. Industries the plaintiffs brought a lawsuit alleging that the defendants failed to protect their leasehold from drainage and were liable for damages. The case involved four defendants. Two of the defendants owned an interest in a well, which was located on adjoining property. Apparently, this well caused the drainage to the plaintiff's leasehold. Faced with these facts, we held that written notice or demand was not required to be given the two defendants who held interests in the adjoining well. We based this conclusion upon the fact that these two defendants, through their ownership of the draining well, obviously knew of the necessity to protect the plaintiff's leasehold. Thus, application of the notice requirement was unnecessary. Two other defendants who held no such interest, were not deemed to have any knowledge of the drainage. Therefore, it was held that they must be given notice of their obligation to protect before any duty on their part would arise. The District Court interpreted U.V. Industries to hold that written notice or demand is always a prerequisite to a lawsuit for breach of the covenant to protect, unless the defendant owns the adjoining well which is draining the plaintiff's property. The Sundheims, on the other hand, maintain that under U.V. Industries, written notice or demand is only required when the defendant does not have knowledge of the drainage. According to Sundheims, a notice requirement in a situation when a defendant already has knowledge would be wholly unnecessary. Because there is evidence which tends to establish that Reef Oil and Hiestand knew of the draining of their leasehold, the Sundheims further argue that the District Court erred in granting summary judgment based upon lack of notice. We agree with the Sundheims' interpretation of U.V. Industries. There is no sound reason to require a lessor to give a lessee notice of drainage in an action for damages, if the lessee already has such knowledge. Under the implied covenant to protect, a lessee is charged with the duty to act as a reasonable operator and to protect the leaseholder's interest. This duty requires the lessee to manage the leasehold in such a manner as to bring profit to both himself and the lessor. Obviously, if the lessee failed to drill an offset well, while knowing the leasehold was being drained, he would fail to meet this duty. In such a circumstance, he should not be excused for the sole reason that the lessee failed to comply with a requirement that is unnecessary. Our conclusion on this issue is consistent with the overall holding of U.V. Industries. Both the defendants and the District Court based their conclusion upon a single statement which occurred in a lengthy and complicated opinion. However, the statement relied upon must be read and understood within the context of the entire opinion. In U.V. Industries, we stated that generally a lessor must serve written notice or demand upon a lessee to drill an offset well as a precondition to the latter's duty to drill. U.V. Industries, 602 P.2d at 584. However, as rationale for this general rule we quoted a passage from an earlier case which stated: . . . A usual implied covenant is one against drainage, which is not here involved. The necessity of drilling offset wells is not brought about by the acts of the lessee, but by those of third parties, unless the lessee owns adjoining acreage. Hence, before a breach of an implied covenant could be claimed as substantial, the necessity of protecting the leased premises must be brought home to the lessee in some manner by reasonable notice or demand on the part of the lessor. (Emphasis supplied.) Berthelote v. Loy Oil Co. (1933), 95 Mont. 434, 446, 28 P.2d 187, 190. As this passage clearly indicates, it is only reasonable notice which is required as a precondition to the duty to drill an offset well. The passage does not indicate that written notice is required. Moreover, a close reading of U.V. Industries reveals that the written notice requirement was mentioned only once. Throughout the rest of the opinion, this Court spoke in terms of reasonable notice, or notice. Clearly, the reasonable notice requirement is satisfied when the lessee has knowledge of drainage. Section 1-1-217, MCA, defines notice as follows: 1-1-217. Noticeactual and constructive. (1) Notice is: (a) actual whenever it consists of express information of a fact; (b) constructive whenever it is imputed by law. (2) Every person who has actual notice of circumstances sufficient to put a prudent man upon inquiry as to a particular fact has constructive notice of the fact itself in all cases in which, by prosecuting such inquiry, he might have learned such facts. As this statute indicates, a person is deemed to have constructive notice when he is in possession of all of the relevant facts and circumstances. Certainly, constructive notice rises to the level of reasonable notice as required by Berthelote v. Loy Oil Co. (1933), 28 P.2d 187, 95 Mont. 434. Therefore, we now clarify our earlier holding in U.V. Industries and hold that before a lessee's duty to drill an offset well arises, he must have reasonable notice of the necessity to protect the leasehold. Such notice can either be express, from the lessor, or constructive, gained from the surrounding circumstances. Further support of this holding is found in the general rule that oil and gas leases are to be construed liberally in favor of the lessor and against the lessee. See Clawson v. Berklund (1980), 188 Mont. 48, 610 P.2d 1168; Thomas v. Standard Development Co. (1924), 70 Mont. 156, 224 P. 870. This rule is only applicable to those cases in which a lessor is seeking relief in the form of damages, however. If he is seeking other forms of relief, such as forfeiture of the lease, he must give written notice in order to give the lessee a chance to cure the breach. See Summers, Oil and Gas Volume 2 § 412 (1990). The burden of proof is upon the lessor to establish the fact that the lessee knew of the drainage. Therefore, upon remand, the Sundheims must prove that both Reef Oil Corporation and Frank Hiestand knew or should have known that the Sundheim leasehold was being drained by the adjacent wells.
As their second issue, the Sundheims argue that the District Court erred in granting summary judgment on their claim that Reef Oil and Frank Hiestand breached the implied covenant to reasonably develop the leasehold. The District Court held that this covenant was not breached because the Sundheims accepted delay rental payments. As further justification for its ruling, the court held that the covenant to reasonably develop does not arise until after production has been obtained on the leasehold. Because we uphold the lower court based upon the prior reasoning, we will not review the latter. In short, the Sundheims maintain that their acceptance of delay rental payments does not excuse the defendants from fulfilling their duty to reasonably develop their leasehold. They argue that because oil was discovered and pumped in paying quantities from the Sundheim No. 1 well, Reef Oil and Frank Hiestand had a continuing duty to further develop the leasehold. According to Sundheims, the payment of delay rentals has no bearing on this duty. We need not dwell upon the legal intricacies of the Sundheims' argument. The issue can be resolved through resort to the clear wording of the leases. Paragraph 2 of these leases states: It is agreed that this lease shall remain in force for a term of three years from date and as long thereafter as oil or gas of whatsoever nature or kind or either of them is produced from said land or premises pooled therewith or drilling operations are continued as hereinafter provided. If prior to discovery of oil or gas on said land or on acreage pooled therewith, lessee should drill a dry hole or holes thereon, or if after discovery of oil or gas production thereafter should cease for any cause, this lease shall not terminate if lessee commences additional drilling or reworking operations within sixty (60) days thereafter or (if it be within the primary term) commences or resumes the payment or tender of rental on or before the rental-paying date next ensuing after expiration of three (3) months from the date of completion of a dry hole or cessation of production. (Emphasis added.) Paragraph 4 of the leases states: If operations for the drilling of a well for oil or gas are not commenced or if there is no oil or gas being produced on said land or on acreage pooled therewith as hereinafter provided on or before one year from the date hereof, this lease shall terminate as to both parties unless the lessee on or before that date shall pay or tender to the lessor ... the sum of $320.00 which shall operate as a rental and cover the privilege of deferring the commencement of operations for drilling of a well for twelve months from said date. In like manner and upon like payments or tenders the commencement of operations for drilling of a well may be further deferred for like periods of the same number of months successively. According to these two sections of the Sundheim leases, Reef Oil had a duty to explore for or produce oil and gas from the Sundheim leasehold. If it failed to adequately carry out this duty, the terms allowed the Sundheims to terminate the lease. However, Reef Oil could, instead of engaging in drilling or production operations, make delay rental payments of $320.00 per year. Upon payment of this sum, Reef Oil was excused from the drilling and operating requirements contained in the lease. It is undisputed that the delay rental payments were made by Reef Oil and were accepted by the Sundheims. Therefore, by the terms of the contract, Reef Oil was not impliedly required to engage in further development of the Sundheim leasehold. The rental clauses contained in the lease were presumably bargained for and are supported by consideration. We will not look beyond these express provisions in order to impose a duty upon Reef Oil which is in contravention of their terms. In short, the rental clause contained in the Sundheim leases relieves Reef Oil of all drilling obligations save that of offset drilling. Williams & Meyers, Oil and Gas Law § 835.1 (1990). See also Hemingway, Law of Oil and Gas § 8.10 2d Ed. (1983). The duty to drill an offset well is imposed through the covenant to protect, not through the covenant to reasonably develop. Therefore, there was no breach of the development covenant and summary judgment on this issue was properly granted.
The Sundheims maintain that Reef Oil and Frank Hiestand, in addition to breaching implied covenants to the lease, also violated the prudent operator standard. This standard is best understood through analogy to the reasonable man standard of tort law. Simply stated, the prudent operator is a reasonable man engaged in oil and gas operations. He is a hypothetical oil operator who does what he ought to do not what he ought not to do with respect to operations on the leasehold. Williams and Meyers, Oil and Gas Law § 806.3 (1990). Sundheims argue that Reef Oil and Frank Hiestand breached this obligation because they did not develop the leasehold. Instead, they took the lease for speculative purposes, and while they were searching for an individual to commence drilling operations substantial drainage occurred. The District Court granted summary judgment in favor of the defendants on this count. It held that the prudent operator standard was not in itself an independent cause of action and the prudent operator standard is applied in conjunction with and serves to define the other implied covenants. We agree with the District Court. We have previously held that the Sundheims have presented a valid cause of action for breach of the implied covenant to protect. The duty to act as a prudent operator underlies this contractual obligation. In order to prevail on this issue, the Sundheims must prove at trial that, under the circumstances of their case, Reef Oil and Frank Hiestand did not act as reasonably prudent operators to prevent drainage. Proof of this issue necessarily entails a showing that actual drainage occurred and that an offset well would have produced oil in paying quantities. Williams and Meyers, Oil and Gas Law § 822 (1990). Proof of the second element of the above test would necessarily establish that the defendants failed to act as reasonably prudent operators and, assuming drainage can be established, that they breached the covenant to protect. This rule of law is supported by the rationale that a reasonably prudent operator would drill an offset well if he could gain a profit and if it was necessary to protect the value of the lease. On the other hand, no breach of this standard, could be established if it cannot be shown that such a well could be drilled at a profit to the lessee. Accordingly, in such circumstances there would be no breach of the covenant to protect. It is clear from the facts of this case, that the Sundheims allegations of breach of the covenant to protect and breach of the prudent man standard are one in the same. Proof of one necessarily entails proof of the other. Therefore, the District Court correctly granted summary judgment dismissing the allegation alleging breach of the prudent operator standard.