Eog Resources Canada an Alberta General Partnership Represented by Its Managing Partner, Eog Resources Canada Inc. Plaintiff - v. -, 2013 ABQB 105

Court of Queen ’ s Bench of Alberta Citation: Eog Resources Canada v. Unconventional Gas Resources Canada Operating, Inc., 2013 ABQB 105 Date: 20130221 Docket: 1201 00577 Registry: Calgary Between: Eog Resources Canada an Alberta General Partnership Represented by Its Managing Partner, Eog Resources Canada Inc. Plaintiff - and - Unconventional Gas Resources Canada Operating, Inc. Defendant _______________________________________________________ Memorandum of Decision of J.B.

Hanebury, Master in Chambers _______________________________________________________ [ 1 ] This matter is before the Court by way of cross-applications to determine whether a Farmee lost its right under a Farmin Agreement to continue the work necessary to earn an interest in lands. The facts are not in dispute and the matter is one of contractual

interpretation. [ 2 ] The primary issue between the parties is whether the alleged failure of the Farmee to work continuously to complete the earning well terminated its right to earn an interest in lands immediately, or if termination could only occur after the issuance of a default notice permitting the Farmee to remedy the default. If such a notice was required, the Farmor did not argue that it had been given.

FACTS [ 3 ] The plaintiff, EOG Resources Canada (EOG), and the defendant, Unconventional Gas Resources Canada Operating Inc. (UGR), entered a Farmin and Option Agreement (Farmin Agreement) dated October 26, 2010. Under the Farmin Agreement UGR agreed to farmout 75% of its working interest in certain lands, which 75% interest would be earned by EOG if it undertook and completed certain work on the earning well at its sole cost and expense. Subclause 4(

a) of the Farmin Agreement reads: On or before March 31, 2011, the Farmee [EOG] will apply to license and, at its sole cost, risk and expense, conditional upon obtaining all necessary surface access approvals, regulatory approvals and rig availability, commence the drilling of the horizontal Earning Well [the “Earning Well”] and shall continuously conduct operations to drill, case and complete the well to Contract Depth as specified.

The parties referred to the commencement of drilling as “spudding” the well. [ 4 ] Subclause 17.1 of the Farmin Agreement provides that time is of the essence. [ 5 ] The well was spudded in January, 2011, which satisfied the obligation to commence the drilling by March 31, 2011, as required by subclause 4 (

a) of the Farmin Agreement. [ 6 ] The rig for the well was released in March, 2011, and completion operations on the well were conducted between March 9, 2011 and March 20, 2011, but not finished as EOG was required to leave the land during a sensitive period for caribou. [ 7 ] Meanwhile, on February 22, 2011, another company provided a notice to UGR asking it to participate in the drilling of a well on lands near the earning well [the option well]. UGR asked EOG if it would do so on UGR’s behalf.

EOG agreed as the information could be useful for its work on the earning well. [ 8 ] As a result, on May 12, 2011 UGR and EOG signed an amending agreement, amending the Farmin Agreement. It states: 1. Clause 4. EARNING WELL (

A) On or before March 31, 2011 is changed to August 31, 2011. 2. Clause 6. OPTIONS WELL(

S) The election and participation by EOG on behalf of UGR...[in this well will provide data useful to the Earning Well]. Therefore if the provision of such data to EOG is delayed, UGR shall immediately grant EOG an extension under Clause 4 for a period of time no less than the number of days during which such data remains undelivered; provided that in no event shall such extension extend past September 30, 2011. Clause 1 of the amending agreement changes the date for the commencement of drilling, which had already occurred, to August 31.

Clause 2 is arguably unclear and either the commencement of drilling or all work is delayed to, at the latest, September 30. [ 9 ] The receipt of the anticipated data was delayed; in fact it was never delivered as, despite two requests to participate, the option well was not drilled. Upon receipt of the second request to participate EOG declined to participate on UGR’s behalf.

UGR was unhappy with EOG’s refusal and in an internal memo UGR’s president said that it was “time to pull the plug” on EOG. [ 10 ] This Farmin Agreement incorporates, by reference, a Farmout and Royalty Procedure (Farmout Procedure) of the Canadian Association of Landmen (C.A.P.L.) and the 1990 C.A.P.L. Operating Procedure (Operating Procedure). The former provides in subclause 13.1 C for a 30 day notice of default in certain circumstances.

[ 11 ] What followed was correspondence between the parties that can best be described as confusing [1] . UGR sent EOG what purported to be a default notice, and then ultimately took the position that EOG’s right to earn an interest had terminated without any notice being required. [ 12 ] The correspondence started on September 1, 2011, when UGR sent a letter to EOG asserting that EOG was in default of the Farmin Agreement as it had not: fulfilled its obligations under Clause 4 EARNING WELL of the Agreement and under Clause 6 OPTIONS WELL(

S) of the Amending Letter Agreement.

Specifically, EOG has “not completed the well to Contract Depth as specified” within the time frame specified, being “August 31, 2011" as amended in the Amending Letter Agreement. [ 13 ] The default notice provided that if EOG did not remedy this alleged default within 30 days UGR would, by notice, terminate EOG’s interest in the farm-out lands. [ 14 ] However, neither the Farmin Agreement nor the amending agreement required the well to be completed by August 31, or in fact by any specific date and on Sept. 23, 2011 EOG replied, asserting that the default notice was invalid. [ 15 ] On October 5, 2011 UGR responded that the default notice was a valid notice and said that as the default had not been remedied within the 30 days, EOG’s interest in the farmout lands and the well had been terminated. [ 16 ] Subsequent correspondence did not solve the parties’ disagreement. [ 17 ] Finally, on December 21, 2011, UGR’s counsel sent a letter to EOG stating that UGR had no obligation to issue a default notice, a position it has maintained in the pleadings filed in this action.

He stated that EOG was in breach of Clause 4 of the Farmin Agreement as it failed to continuously conduct operations to drill, case and complete the well. As a result, he said, EOG cannot earn a working interest under clause 5.

The letter says that Clause 13.01 C of the Farmout Procedure, which requires a 30 day notice prior to termination, is inapplicable. [ 18 ] EOG then looked to its legal remedies and issued a Statement of Claim in January, 2012 seeking a declaration that its right to earn under the Farmin Agreement in respect of the earning well remained valid and subsisting. [ 19 ] UGR filed a defence and counterclaim alleging that at all times subsequent to September 30, 2011 [2] , EOG was in breach of its obligations under subclause 4(

a) of the Farmin Agreement as it had failed after that date to continuously conduct operations to complete the earning well. [ 20 ] UGR made no plea in the alternative that if a notice were required under subclause 13.1 C, the notice was both justified and properly given. [ 21 ] The parties seek a determination from this Court as to whether EOG has any right to continue to earn an interest in the lands. If so, the parties indicated that they expected that EOG would be returning to the lands to complete the well. ISSUES [ 22 ] The positions of the parties raise two primary issues.

First, did EOG fail to continuously conduct operations after September 30, 2011? If so, was EOG’s right to, or interest in, the lands terminated immediately or was a notice of the default required under

subclause 13.1 C of the Farmout Procedure? For the reasons which follow I conclude that even if EOG failed to continuously conductoperations after September 30, 2011, EOG’s right to earn an interest in the well only came to an end if it was given a 30 day defaultnotice under subclause 13.1 C and then failed to cure the default. UGR does not claim to have given a default notice under subclause 13.1C. ANALYSIS [23] The parties both take the position that this matter can be determined by the Court on a

summary basis as there are no relevantfacts in issue and it involves the determination of the terms of a contract: Dow Chemical Canada Inc. v. Shell Chemicals Canada Ltd.,2010 ABCA 126 at para. 27; Zebroski v. Jehovah’s Witnesses, (AB KB), 1986 CarswellAlta 567, 71 A.R. 259,upheld as to the availability of

summary judgment, 1988 ABCA 256 , [1988] 87 A.R. 229, para. 5. Default [24] The first question to be determined is whether EOG failed to meet its contractual obligation under the Farmin Agreement tocontinuously conduct operations to drill, case and complete the well. [25] UGR says that EOG’s failure to continuously conduct operations to complete the well started with the expiration of theextension on September 30 and has continued the fourteen months until this application. It says that EOG should have ignored UGR’stermination letter of October 5, 2011, and gone back onto the lands.

EOG responds that it risked charges of trespass if it had done so. [26] The parties filed no case law on the question of whether the alleged failure occurred for the four days between September 30and October 5, or the 14 months until this application. Furthermore, they provided no information to help the Court to understand thecontext of the term “continuously” as used in subclause 4(a). [27] Without this law and information the Court risks making a decision that is not sensitive to the commercial realities of theindustry and is, simply, a bad precedent.

Therefore, for the purposes of deciding the next question I will assume, without deciding, that afailure to continuously conduct operations to complete the well occurred. Was a Notice of Default Required? [28] UGR first says that this Court need look no further than clauses 4 and 5 of the Farmin Agreement.

Clause 4 sets out the workprogram to be undertaken, and Clause 5 says that “[p]rovided Farmee has performed all of its obligations and requirements pursuant toClause 4 of this Agreement ...then the Farmee shall have earned 75% of the Farmor’s working interest in the Farmout Lands...” In otherwords, if the farmee spuds the well and then continuously works on it to completion, it has a right to a certain working interest in thelands. This, says UGR, is the end of the matter.

Relying on the text and case law cited below, it says that if those requirements are notmet, the interest is not earned. [29] The purpose of farmout agreements is to share the risks and rewards of a speculative venture and allocate risk between theparties. The farmor allocates part of the risk of a “play” to the farmee, who then earns an interest in it by meeting its obligations underthe agreement: Solara Exploration Ltd. v.

Richmount Petroleum Ltd., 2008 ABQB 596, paragraphs 1, 71. [30] The usual work program contemplated in a farmout agreement is a program where the farmee must drill to completion one ormore wells and provide information to the farmor before the interest is earned. This work program is usually put in terms of an obligation, although it can be phrased as an option: Canadian Oil and Gas (2nd ed.), Bennett Jones Verchere & N. Bankes, eds.,(Toronto: Butterworths, 2012) para. 7.91.

The authors note that where the work program is an option the courts will usually insist uponstrict compliance with its terms and the default clause will often not be available.

[31] This commentary from Canadian Oil and Gas is not helpful to UGR’s argument, as in this case the wording on its face speaks not of an option but of an obligation, which would indicate that the default clause is relevant[3]. [32] The case of Royal Bank v. Joffre Resources Ltd., (AB KB), [1985] 38 Alta. L.R. (2d) 216 is also cited byUGR in support of its

interpretation of clauses 4 and 5. In that case the farmee failed to make a $100,000.00 payment required under thefarmout agreement. The Court held at para. 29 that the farmee was in default and could not demand a transfer of its interest in thefarmout lands until the default was remedied. As the Court found that the default could be remedied, this case is not helpful to UGR’sargument. [33] UGR also relies on Freyberg v. Fletcher Challenge Oil and Gas Inc., 2005 ABCA 46.

In that case the lessee of a natural gaslease argued that the lease had not been terminated as clause 18 of the lease required a 90 day notice of default. The Court found thatprior case law had already held that the failure of a lessee to produce when it was economical and profitable to do so results in thetermination of the lease. As the lease had been terminated pursuant to such a failure by the lessee, there was no scope for clause 18,which provided for a relief from forfeiture. [34] UGR argues that the Freyberg approach should apply in this instance.

It argues that Clauses 4 and 5 of the Farmin Agreementresult in the termination of the lease when their requirements are not met by the lessee, with the result that there is no room for thedefault clauses to operate. [35] However Freyberg was a case involving a lease, not a Farmin Agreement and the Court relied on a body of case law that hadalready found that immediate termination occurred in similar fact situations. The contract in issue in this case is not a lease and the onecase cited by UGR, Joffre Resources (supra), was to the contrary and indicated that a default could be remedied.

The decision inFreyberg is distinguishable and not helpful to UGR’s argument. [36] UGR’s argument that EOG immediately lost its right to earn an interest in the lands upon failing to continuously work on thecompletion of the well is not supported by the law it cited. [37] Furthermore, the words found in clauses 4 and 5, on their face, do not support an

interpretation that EOG earned no interestwhatsoever in the lands. It spudded the well and was, at its sole expense, working towards its completion, all with the goal of satisfyingthe requirements necessary to vest its interest. It is not disputed that the interest of EOG cannot vest until the completion of itsobligations. However, that does not mean it has acquired no interest in the lands.

It has a contingent or conditional interest in the lands. [38] UGR then argues that if clauses 4 and 5 do not, on their own, result in the termination of any right of EOG to earn an interestin the lands, subclause 13.1 A of the default provisions found in the Farmout Procedure is applicable and achieves the same result. Itallows for an immediate termination, that is, a termination without a notice of default. [39] It is trite law that the

interpretation of contracts “involves a search for meaning within the constraints of the words and their context, [and] an ideal

interpretation is one which accords with both”: Geoff R. Hall, Canadian Contractual

Interpretation Law (2nd ed.),(Markham, Ont.: LexisNexis, 2012) at 9; and as referenced in Golden Capital Securities Ltd. v. Investment Industry RegulatoryOrganization of Canada, 2010 BCCA 359, para. 44. [40] Like the Farmout Procedure, the Operating Procedure is widely used in the oil and gas industry and when there is no judicialconsideration of a certain term found within it the Court has held that it should approach its

interpretation and application according tofirst principles. It should seek the intention of the parties and read the words chosen by the parties “in their natural and normal meaningwithin the contract as a whole”: Solara (supra), para. 74. While the Court should not refashion the agreement, where words bear twoconstructions it should adopt the

interpretation which is commercially sensible: Solara (supra), paragraphs 75 - 77. See as well KelesProduction Co. v. Husky Oil Operations Ltd., 1991 CarswellAlta 68, para. 68. [41] As this case law indicates, the Court should examine the default provisions as found within the contract, to seek the intentionof the parties from the words chosen by them as used in their natural and normal meaning. In my view subclause 13.1 A is on its faceinapplicable and it is subclause 13.1 C that governs this situation.

Furthermore, when those subclauses are viewed in the context ofclause 13.1, it reveals a purposeful scheme for dealing with the farmee’s acts of default as they occur at various stages of the project.

[ 42 ] Subclause 13.1 A is the provision relied upon by UGR to argue that EOG’ failure to continue completion work terminated any interest it had in the lands. It provides that if the Farmee fails to spud the test well or commence any other operation by the date set out in the head agreement or any mutually agreed extension, the farmee’s right to conduct operations terminates. In this case, the only operation that was to commence by a certain date in the Farmin Agreement was the spudding of the well.

Therefore, only a failure to spud the well by that or any amended date would leave EOG incapable of earning its right to an interest in the lands. [ 43 ] The hiatus granted in the Amending Agreement for the continuing work on completion does not come within 13.1 A as there was no date for its commencement set out in the Farmin Agreement. [ 44 ] Subclause 13.1 C provides that if the Farmee is in default of “any of its obligations...under the Head Agreement [Farmin Agreement], other than as provided in the preceding Subclauses” the Farmor may give the Farmee notice of the default with the Farmee to have 30 days to remedy the default, failing which the Farmor may, by notice, terminate all or any portion of the interest of the Farmee acquired in the Farmout Lands. [ 45 ] UGR argues that this subclause cannot apply as it speaks to an interest that has been acquired by the Farmee and the Farmee had no interest.

This is a reiteration of the first argument made by UGR and, as earlier noted, in my view the Farmee does have an interest, a contingent or conditional interest. On its face this subclause appears to be applicable to an obligation to carry on the completion work, which is what URG says EOG failed to do. [ 46 ] Furthermore, the provisions of subclause 13.1 D, which deal with a fully earned interest, support the view that 13.1 C refers to interests that are being earned.

Subclause 13.1 D provides: No termination of the Farmee’s interests or rights under this Clause will apply to any portion of the Farmout Lands in which the Farmee had earned a Working Interest hereunder, unless that default is with respect to any condition subsequent applicable to those lands pursuant to Subclause 3.4A. [ 47 ] These three subclauses deal with the remedies available to the Farmor for breaches by a Farmee in three different sets of circumstances: a Farmee who fails to spud the well by a date certain (or commence another agreed-to operation by a date certain) will lose its rights; a Farmee who fails to honour other obligations once the well has been spudded is entitled to notice before losing its interest; and a Farmee who has earned a working interest is entitled to the protection of that interest unless its default is in relation to a condition subsequent. [ 48 ] From a commercial perspective this makes sense.

Prior to spudding the farmee has not made a significant investment in its acquisition of a working interest. With spudding and ongoing work its investment is significant and the termination of its interest without a notice of its default and an opportunity to remedy it appears commercially unreasonable. [ 49 ] These provisions set out a series of remedies depending on the status of the Farmee’s interest upon default.

These provisions, in their “natural and normal meaning”, do not support UGR’s argument that EOG’s alleged failure to resume completion activities immediately terminated any rights it had under the agreement pursuant to subclause 13.1 A. CONCLUSION [ 50 ] Assuming, as I have, that EOG failed to continue the operations necessary for completion after September 30, 2011, subclause 13.1 C is applicable. The Farmor was under an obligation to give notice to the Farmee of its default. The correspondence indicates that this never occurred.

Therefore, the interest of EOG in the lands has not been terminated. [ 51 ] If the parties cannot agree as to costs, they may be spoken to within 30 days of this decision.

Heard on the 05 th day of December, 2012. Dated at the City of Calgary, Alberta this 21 st day of February, 2013. J.B. Hanebury M.C.C.Q.B.A. Appearances: Stanley Carscallen, Q.C. and Natalie L. Climenhaga Carscallen LLP for the Applicant / Defendant Michael P. Theroux and Peter Verschoote Bennett Jones LLP for the Plaintiff / Respondent Appendix A Description of the Correspondence Between the Parties On September 1, 2011, UGR sent a letter to EOG noting EOG in default of the Farmin Agreement, alleging that it had not: fulfilled its obligations under Clause 4 EARNING WELL of the Agreement and under Clause 6 OPTIONS WELL(

S) of the Amending Letter Agreement. Specifically, EOG has “ not completed the well to Contract Depth as specified ” The default notice provided that if EOG did not remedy this alleged default within 30 days UGR would, by notice to EOG, terminate EOG ’ s interest in the farm-out lands pursuant to the Farmin Agreement.

EOG responded on September 23, 2011, by way of a letter advising that the default notice was invalid. On September 23, 2011, EOG sent another letter to URG providing notice of a situation of force majeure due to ground conditions and stating that it could not access the well. On October 5, 2011, UGR sent a further letter to EOG advising that the default notice was a valid notice and stating that, as EOG had not remedied the default within the 30 days, EOG ’ s interest in the farmout lands and the well had been terminated.

On October 5, 2011, UGR sent a further letter to EOG advising that the default notice was a valid notice and stating that, as EOG had not remedied the default within the 30 days, EOG ’ s interest in the farmout lands and the well had been terminated. It also rejected the claim of force majeure and said: As indicated in our Default Notice of September 1, prior to that date EOG advised UGR that EOG would not be requesting that UGR elect to participate in the operations proposed in the SkyWest Energy Corp.

Independent Operations Notice dated August 10, 2011 which was a replacement notice for an earlier Independent Operations Notice dated February 22, 2011, which was the basis of the Amending Letter Agreement dated May 12, 2011, amending the terms of the Farmin Agreement. To the extent that any obligations of EOG to complete the Earning Well had been deferred by the provisions of the Amending Letter Agreement, such deferral ended immediately upon EOG ’ s election not to participate in the SkyWest ION.

On November 29, 2011, counsel for EOG sent a letter to UGR reiterating its position that EOG was not required to complete the well by August 31, 2011. It advised that EOG was ready to proceed with operations under the Farmin Agreement as the force majeure situation had been resolved but asked that UGR first provide written notice of the withdrawal of its termination notice of October 5, 2011. On November 29, 2011, counsel for UGR sent a letter to EOG acknowledging that the obligations under subclause 4(

a) of the Farmin Agreement may have arguably been extended to August 31, 2011 by virtue of the Amending Agreement of May 12, 2011, but further analysis of that issue was not necessary. It states that UGR had terminated EOG ’ s interest pursuant to subclause 13.1 A of the Farmout Procedure.

It provides: If the Farmee [EOG] fails to spud an Earning Well or commence any other operation by the date required in the Head Agreement [the Farmin Agreement] (or any mutually agreed extension) and force majeure does not prevent the performance of that obligation, the Farmee ’ s right to conduct operations hereunder terminates … By letter dated December 5, 2011, EOG sent a letter to UGR stating that it had recently undertaken operations necessary to complete the well, including submitting a new caribou protection plan and obtaining all necessary road use permits to undertake field operations and sending all necessary operations notifications.

This letter again requested that UGR withdraw the termination notice as EOG anticipated being able to undertake field operations in the near future. UGR responded with a letter dated December 9, 2011, and declined to withdraw the default notice. It said that the minor steps undertaken by EOG “ are simply far too late to preserve any right to earn that you had ” under the Farmin Agreement.

On December 19, 2011, EOG responded, noting that UGR ’ s purported default notice of September 1, 2011, did not assert a breach of EOGs obligation to continuously conduct operations and that notice of such an alleged default was required under

article 13.1 C of the Farmout Procedure. The letter also stated that if UGR asserted that EOG was in default it should send a notice as required under

article 13.1 C. Finally, on December 21, 2011, UGR ’ s counsel sent a letter to EOG stating that UGR had no obligation to issue a default notice, a position it has maintained in the pleadings filed in this action. He stated:

[EOG ’ s] letter is predicated on a fundamental misunderstanding of the Farmin Agreement. The letter fails to recognize that under the terms of the Farmin Agreement, EOG has only a conditional right to earn under Clause 5 of the Farmin Agreement. The condition is that EOG must have performed all of its obligations and requirements pursuant to Clause 4 of the Agreement and

Article 3.00 of the Farmout & Royalty Procedure. By failing to continuously conduct operations to drill, case and complete the well to contract depth following the rig release on March 3, 2011, EOG has put itself into the position of being in breach of Clause 4. It has thereby deprived itself of the ability to earn a working interest in the Farmout Lands under Clause 5.

The letter goes on to state that Clause 13.01 C of the Farmout & Royalty Procedure does not apply as the default that has arisen is the kind referred to in Subclause 13.01 A “ which serves to terminate EOG ’ s right to conduct operations. ” In other words, UGR was claiming that termination of any right of EOG to continue operations was automatic and did not require prior notice. [1] A description of all of the correspondence can be found in Appendix A. [2] I note that in its Reply argument filed in this application URG states that this is the latest date by which EOG ’ s default commenced and the earliest date was May 23, 2011, when the first SkyWest completion notice expired.

EOG points out, correctly, that a breach as of this earlier date is not found in the Statement of Defence. Therefore the Court has considered the question of default only as of September 30, 2011. [3] The use of the word “ option ” in the title of the head agreement, Farmin and Option Agreement, appears to refer to the drilling of “ Optional Wells. ” It is the earning well which is the subject of this dispute.