Is Flaring Just Bad For Business, Or Is It A Violation Of The Landowner’s Contract?

By Bret Wells, George Butler Research Professor of Law, UH Law Center

I have previously argued that the downturn in oil and gas development is the perfect time for the Texas Railroad Commission to change its regulations on flaring associated gas.

The current rules – known as Rule 32 – allow drillers to burn off natural gas produced along with more profitable crude oil if there isn’t an immediately available pipeline or other marketing facility to take it. That’s been generously interpreted, despite the fact that the gas could be captured and sold.

And while energy companies working in the Eagle Ford and other shale fields may find it more expedient to flare off that excess gas, landowners and other royalty owners may not be so quick to agree.

The landowner does not typically have a working interest in the oil, gas and other minerals that lie beneath their property; instead, mineral rights are typically transferred to an oil and gas operator through a lease. In return, the landowner typically reserves the right to be paid a royalty. Royalty clauses differ, but a typical clause would call for the landowner to be paid a royalty based on the amount of oil and gas that is produced and saved from the well, traditionally 1/8th of the gross production. At the peak of the last boom, that percentage rose to a higher fraction of the gross value of production.

If an operator flares commercially profitable associated gas, however, under the “expressed” terms of many leases, the landowner and other royalty owners would not be due any payment.

But there’s another factor at play, too. Texas courts have ruled that oil and gas leases create implied obligations among the parties, an effort to enforce the intent of the parties who executed the lease.  Under implied covenant law, the Texas courts require the operator to act in a reasonably prudent manner. Under this standard, the producer is required to consider not only its own financial interest but also that of the royalty owner. The producer is also required to act in a manner that prudently administers the mineral estate. If the operator fails to do any of that, it can be sued over the lost royalty that the landowner would have received had the mineral estate been operated in accordance with this reasonably prudent operator standard.

So, the legally relevant question is whether flaring commercially profitable natural gas in order to accelerate the production of crude oil violates this implied covenant standard.

Certainly the operator, which has a significant financial investment, may want to accelerate the timing of cash flow in order to recover its cost from its investment. But again, the reasonably prudent operator standard requires the operator to consider the financial interest of the royalty owner as well. The royalty owner has no cost investment and would likely want the operator to pursue a strategy that maximizes the amount of gross royalties paid on the associated gas over time. Flaring commercially profitable natural gas diminishes gross royalties. So, although a factual issue, a jury could well conclude that the reasonably prudent operator would have employed a strategy to minimize the flaring of commercially profitable natural gas.

If so, then an operator would be subject to a claim for damages for failing to live up to this standard, and the measure of damages would be the gross royalty that should have been paid on the imprudently flared gas.  Determining a damage award would be provable because the operator is required to meter and file a monthly, public report to the Railroad Commission on the amount of natural gas that it flares.

Successful damage claims for lost royalties on flared natural gas would send a clear message to the industry that it must immediately adopt sound conservation practices in the Eagle Ford shale, including not flaring commercially valuable natural gas. In the end, sound public policy is promoted when private litigation and the Railroad Commission’s own rules work together to motivate operators to conserve finite natural resources.

Providence, coupled with the ingenuity of the oil and gas industry, has blessed the state of Texas with another chance at a prolonged development of its natural resources in ways that were unimaginable less than 20 years ago.  Now is the time to ensure the Eagle Ford shale is developed in accordance with sound conservation practices — flaring commercially valuable natural gas is not one of them. The benefits of private litigation and regulatory changes that discourage flaring are two-fold: helping to create positive public policy for the state of Texas and assuring that reasonable expectations agreed to in oil and gas leases are met.

Bret Wells is the George Butler Research Professor of Law at the University of Houston Law Center.  He is also an Energy Fellow with UH Energy.   For the author’s further scholarly writings on this topic, please see Bret Wells, Please Give Us One More Oil Boom – I Promise Not to Screw It Up This Time: The Broken Promise of Casinghead Gas Flaring in the Eagle Ford Shale, 9 Tex. J. Oil, Gas & Energy Law 319 (2014).

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