Every Lessee for Himself! – In Cromwell v. Onshore, the El Paso Court of Appeals Doubles Down on Its Support of the “Anadarko Washout”

Note: The following legal update was featured in NADOA’s 2023 Q3 Magazine.

In 2019, the Texas Eighth District Court of Appeals reached its decision in Cimarex Energy Co. v. Anadarko Petro. Corp.,[1] raising eyebrows across the oil and gas industry. The Cimarex decision sent “non-op” lessees scrambling to double-check their lease language and straining to recall whether they ever signed that operating agreement.

Cimarex warned lessees that production on their lease may not extend it past its primary term if the lessee did not “directly cause” the production. In other words, if your lease does not provide otherwise and you are not party to an operating agreement, your lease may not be extended by the on-lease activities of your designated operator. Once the primary term of the lease expires, the leased interest would instead revert back to the lessor as an unleased cotenant. Of further concern is the possibility that another lessee may have taken a top lease that is now in effect.

In the wake of Cimarex, many practitioners expected the Supreme Court to weigh in on the decision and provide further clarity.[2] However, on August 28, 2020, the Supreme Court of Texas denied a petition for review, and on March 5, 2021, it denied a motion for rehearing on petition for review, tacitly endorsing the Cimarex decision. Now, in Cromwell v. Onshore,[3] the El Paso Court of Appeals has upheld and arguably expanded Cimarex. Cromwell potentially opens the floodgate for what will be referred to in this article as an “Anadarko Washout.” Conversely, the Texas Legislature has recently rebuked the washout of certain oil and gas interests. Effective September 1, 2023, Tex. Prop. Code § 31.001, et seq. creates a cause of action for the bad faith washout of overriding royalty interests.[4] However, no such protection currently exists for the washout of a working interest, whether or not in “bad faith.”

Note that in both Cimarex and Cromwell, the habendum clauses of the leases in issue were similar and generic. Each lease provided that it would be held for a fixed primary term and “so long thereafter as oil and gas is produced from said land or from land with which said land is pooled.” As demonstrated below, this “passive” habendum language creates a very much active obligation on lessees.

I.  Cimarex Energy Co. v. Anadarko Petro. Corp. (2019)

Cimarex Energy Co. (“Cimarex”) and Anadarko Petroleum Corp. (“Anadarko”) were cotenants who held separate oil and gas leases on the same property.[5] Anadarko drilled two producing wells on the property, which each paid out during Cimrex’s primary term.[6] Cimarex sued Anadarko for failure to account for its share of production, which resulted in a settlement agreement.[7] Importantly, no operating agreement existed between the parties either prior to or post-settlement. Once Cimarex’s lease expired, Anadarko stopped paying Cimarex under the settlement agreement and took a “top” lease on Cimarex’s mineral interest.[8]

As part of its argument that it now had the effective lease, Anadarko asserted that Cimarex’s “bottom” lease required Cimarex to actually drill or operate a well. Cimarex, it argued, was unable to passively rely on Anadarko’s development activities in the absence of an operating agreement. Cimarex argued that it did not have to directly cause production on the property to perpetuate the lease, and it could rely on Anadarko’s production to extend the lease into its secondary term. After all, it claimed, production was occurring on the lease. Cimarex also contended that the prior settlement agreement served as an operating agreement proxy.[9]

The court held that despite the “passive” voice of the habendum clause, Cimarex was required to “take some action to cause production,” and it could not rely on a cotenant’s production to keep its lease alive.[10] The court was not persuaded by evidence that Cimarex had made repeated unsuccessful attempts to enter into an operating agreement with Anadarko. The court noted that an operating agreement would fulfill the lessee’s requirement to cause production, but without such an agreement Cimarex and Anadarko were merely cotenants who owed no duties to each other and were entitled to act independently.[11] Cimarex knowingly took the risk that other tenants on the land might refuse to agree to a joint operating agreement, forcing it to commence production on its own.[12] The Cimarex court also rejected various additional arguments related to the settlement agreement and the parties’ course of conduct in finding for an implicit agreement to operate. This included correspondence referencing an “Operating Agreement” and referring to Cimarex as a “Working Interest Owner.” It was unclear whether Cimarex was the new reality or an oddity relegated to its facts.

II.  Cromwell v. Onshore (2023)

David Cromwell (“Cromwell”) was the owner of a small working interest under two oil and gas leases in Loving County. Each lease contained a habendum clause similar to that set forth above (i.e., “. . . and so long thereafter as oil and gas is produced from said land”). Anadarko E&P Onshore LLC (“Anadarko”) owned a much larger working interest in the same land.[13] Cromwell submitted his leases to Anadarko and asked multiple times for an operating agreement, but Anadarko never responded.[14]

After several successful wells were drilled, Cromwell was presented with – and paid – various joint interest billings (“JIBs”). In some months, Cromwell paid Anadarko and in other months his operational costs were netted out and he received a revenue check.[15] Cromwell also received authorizations for expenditures (“AFEs”) that referred to him as a “Working Interest Owner” and contained elections to participate in various expenditures.[16] Anadarko later claimed that these and other activities were conducted in error.

After the primary term of Cromwell’s leases expired, Anadarko top leased Cromwell’s lessors and asserted that Cromwell had never executed an operating agreement. Cromwell sued alleging that a “constructive” operating agreement had been formed based on the activities above. The trial court held for Anadarko on summary judgement and Cromwell appealed.

On appeal, both Cromwell and Anadarko agreed that oil and gas were produced in paying quantities on Cromwell’s leases, and the court must decide whether that production may be attributed to Cromwell.[17] Cromwell attempted to distinguish Cimarex by arguing that he did exactly what Cimarex had not done: he participated in production by sharing in its costs, risks, and liabilities.[18] Cimarex’s chief defense had been that it could rely on Anadarko’s production to perpetuate its lease. Cromwell, on the other hand, argued that his actions amounted to constructive participation and implied an operating agreement.[19]

The court of appeals held that Cimarex squarely applied to the facts of Cromwell, and that Cromwell’s actions were insufficient to “cause production” under his leases. The court rejected the idea of “constructive participation,” finding instead that Cromwell’s payments were ordinary operating expenses owed by a nonparticipating cotenant. Further, correspondence from Anadarko referring to Cromwell as a working interest owner and other “course of conduct” activities did not rise to the level of a constructive agreement between the parties.[20] Cromwell’s bottom leases thus expired at the end of their primary terms, and Anadarko’s top leases took effect.

III.  Takeaway from Cimarex and Cromwell

Cimarex was a wake-up call for non-operators in Texas that is further emphasized by Cromwell. It seems that in the absence of a signed operating agreement, the standard “passive” habendum clause in a lease creates an obligation to actually cause the production. This does not, the El Paso Court maintains, run afoul of judicial safeguards preventing surprise forfeitures because a habendum clause is a special limitation and a special limitation is not a forfeiture.[21] Cromwell further expands Cimarex by rejecting arguments in favor of constructive participation, or an implied operating agreement based on the parties’ course of conduct. Thus, stealthy operators appear to have a powerful weapon in the form of the Anadarko Washout.

IV.  Avoiding an Anadarko Washout

Following Cimarex and Cromwell, non-operating lessees should ensure that they enter into a valid operating agreement (or pooling agreement) prior to the expiration of the primary term of their leases. It remains unclear whether different facts may lead to a “constructive” operating agreement, but such an argument appears to be tenuous at best.

For added protection and to avoid an intentional washout, lessees should ensure that their leases provide that any operations on the leased premises, (i) whether or not caused by the lessee or its successors or assigns, (ii) whether or not conducted in accordance with an executed operating agreement, and/or (iii) whether or not the lessee conducted, participated in, or consented to the drilling, reworking, completion, or other operations resulting in production, will maintain a lease past its primary term and will fulfill the lessee’s obligation to cause production on the lease. Otherwise, a well-capitalized party may attempt to wield Cimarex offensively by refusing to enter into an operating agreement.[22]

As of the date of this article, it remains to be seen whether Cromwell will file an appeal and the Supreme Court will weigh on the possibility of creating an “operating agreement by estoppel.” Otherwise, the Anadarko Washout may be here to stay.

*Revised on October 2, 2023

[1] 574 S.W.3d 73 (Tex. App.—El Paso 2019, pet. denied).

[2] See Durrett, Brandon, Turn Around, Don’t Drown: A New Generation of Oil and Gas Lease Washouts: in Texas and How to Avoid Them, 53 Tex. L. Rev. 473, 495 (2021).

[3] 2023 Tex. App. LEXIS 5848 (El Paso 2023). Note that this opinion, dated August 4, 2023, was later withdrawn and a substantively identical opinion was substituted on September 27, 2023, at 2023 Tex. App. LEXIS 7465. For purposes of this article, citations are to the original August 4 opinion.

[4] Under Tex. Prop. Code § 31.001, “bad faith” is defined as “the conscious taking of action for the purpose of washing out all or part of an overriding royalty interest.” “Washout” means the “[intentional] elimination or reduction of an overriding royalty interest in an oil and gas lease by the forfeiture or surrender of the oil and gas lease . . . and the subsequent reacquisition of a lease . . .”

[5] 574 S.W.3d 73, 80.

[6] Id. at 83.

[7] Id. at 83-84.

[8] Id. at 84.

[9] Id.

[10] Id. at 93.

[11] Id. at 95.

[12] Id.

[13] 2023 Tex. App. LEXIS 5848 at 3.

[14] Id.

[15] Id. at 4.

[16] Id. at 5.

[17] Id. at 11.

[18] Id. at 19.

[19] Id. at 26.

[20] Id. at 29.

[21] Id. at 31.

[22] Similar to Anadarko stonewalling Mr. Cromwell.