By Russ Darbyshire, Mesilla Energy Acquisition LLC

August, 2018

-Installment 2 of 3-

With the price of natural gas being close to historically low, it hardly seems worthwhile to hit on the subject of gas imbalances at the closing of a PSA.  But, in this lawsuit tale, there are several lessons to be learned, to avoid getting into a lawsuit. After being in the business 38 years, I have seen too many lawsuits that could have been avoided had both the parties, the seller and the purchaser, performed correct due diligence prior to the closing of the sale. This is the second step to follow if you want to get into a lawsuit (and possibly commit professional suicide).

Step Two: Ignore the Discomfort of Gas.

In July, 2001, Wapiti Energy, L.L.C. (“Wapiti”) entered into a purchase and sale agreement (“PSA”) with Petro-Hunt, L.L.C. (“Petro”) for the sale of Petro’s interest in a producing oil and gas property located in the Conroe Field, Montgomery County, Texas.  In that PSA, Petro represented and warranted that none of Petro’s interests being sold were “overproduced” relative to the other interests in the property. Overproduction is a liability on a working interest and represents an “imbalance” where a party’s interest is not produced according to that party’s share of ownership in the well.* The PSA required Wapiti to assume all liabilities associated with Petro’s interest.  As is common with many PSA’s, a “Final Settlement” takes place after the closing date of the PSA, to reconcile monetary issues related to production revenues and imbalance valuations.

After the closing date of the PSA, ExxonMobil (“Exxon”), the Operator of the property in question, informed Petro that Petro’s interest was overproduced by an “undetermined” amount. Petro informed Wapiti of this fact on October, 2001, before the Final Settlement date. Both parties acknowledged that the overproduction was a breach of Petro’s warranty under the PSA and that it lessened the value of Petro’s interest being sold to Wapiti.  Because of the looming deadline of the Settlement Date and the knowledge that Exxon could not arrive at an overproduced amount before then, the parties agreed to an additional agreement (“Extended Settlement”) that allowed for one more adjustment that would address gas imbalances to be reconciled once the overproduction amount was known.  In the Extended Settlement, both parties agreed that $3.70/MMBTU was the price any overproduced amount would be valued at.

In November, 2002, Exxon delivered its report on the overproduction amount to the parties indicating the overproduced amount was 115,518 MMBTU’s.  A few months later, Wapiti contacted Petro to reconcile the imbalance with an adjustment and close the books on the sale.  Because there was some disagreement on the amount of overproduction that Exxon reported, Petro refused to pay Wapiti for the imbalance.

On October 14, 2005, Wapiti filed suit against Petro to recover payment for the overproduced gas.  In the months leading up to the lawsuit, Wapiti had acquired other interests in this field, including the interest of Exxon. In the Exxon transaction, the Exxon interest was underproduced, to which Wapiti paid an additional amount for.

In 2009, Wapiti sold all of its interest in the Conroe Field to Denbury Resources, Inc. Wapiti claimed that it received less in the way of consideration for this sale because of the overproduced interest.  Petro disputed that claim, saying Wapiti, because of its prior acquisitions, had a net underproduced interest during the time of the sale.

Through years of legal maneuvers by both parties the trial court eventually found Petro had beached the Settlement Extension and awarded Wapiti $424,811.80 in damages for the overproduced position as well as prejudgment interest, taxable costs of court, and post-judgment interest, with the final judgement being entered on August 26, 2010.  The judgement was upheld in 2012 through subsequent appeals by Petro.

*Note: Overproduction is where a party does not take gas attributable to its share of production and instead, that gas production is allocated to another working interest owner in the well, where it is sold. In that instance, the interest attributable to the party not taking the gas is “underproduced”.  The interest of the party that did take the gas is thus “overproduced”.  An overproduced interest represents a liability on that party’s interest, because that party must either pay the underproduced party back in gas, or in cash.  Usually, a Gas Balancing Agreement, attached as an exhibit to a Joint Operating Agreement, governs the taking of production and the method of balancing that production imbalance between the parties.  Many times, reconciling of the imbalances can occur at the depletion of the well, where upon a cash amount, attributable to the imbalance, is given to the underproduced party.

There are several lessons here:

  1. If you are a Seller, never represent and warranty something you are not completely sure about. The way to be certain about a representation one is considering making is to perform proper due diligence to confirm that representation before you make it.
  2. If you are a Buyer, never rely on a warranty or representation: in fact, good due diligence researches all representations and warranties, sometimes even before a PSA is executed.
  3. When reconciling with a post settlement after the closing of a PSA, its important to get everything reconciled, even in the case of imbalances that might not be known with any certainty. Imbalances are not rocket science and can be estimated using revenue stubs and production runs with pretty close certainty.  In the era of depressed gas prices, the cost of any error is low (compared to the cost of possible litigation to collect).
  4. The longer you wait to reconcile any amounts under a PSA (whether its defect amounts, gas imbalances or other issues), the higher the chance one party will breach a settlement agreement. I make this last statement based on experience.

All of these issues point to failures in the due diligence process.  Presumably there was a period to conduct due diligence before the closing of the sale (if not, then that would more adequately explain this mess).  In that due diligence period, Wapiti could have requested pay stub information from Petro and could have easily calculated an approximate amount of the imbalance burdening Petro’s interest.  Yes, I know there are issues with processing costs, settlements and net backs that need to be taken into account, but even still, you can estimate those.  The judgment awarded Wapiti was a little over $424K and that included attorneys’ fees, damages and interest.  If you were to calculate the actual dollar amount of the overproduced gas, based on the gas price agreed to in the Extended Settlement and the overproduced volume Exxon reported, that comes to $427K, which is greater than the judgment.  So it would appear that Petro had legitimate concerns about the amount of overproduction that Exxon reported, or that as Petro asserted, Wapiti’s acquisitions in this field diminished the amount of the overproduced interest, issues that apparently the court took into consideration in its monetary award. It is unknown if any attempt to agree to an overproduced amount was made by the parties before the final settlement date, but it would appear that someone came up with the idea of having a side agreement to have another settlement when the final overproduced amount was arrived at by Exxon.  On the surface, that would seem a practical approach, to have another settlement when the final amount is known. The reality is this: if parties don’t settle monetary issues within the confines of the PSA and either a deadline of a closing date or a settlement date, instead delaying the day of reckoning, the chances increase someone is going to breach the agreement.  Even if Wapiti had to take a “haircut” on the amount of overproduction, I would assert that given the time from 2001 to 2012, when the final judgment was rendered, if Wapiti and Petro had agreed on an overproduced volume based on estimates, Wapiti would have had that money in hand and could have earned interest on it in the 11 years it took to collect (plus not have expended attorney’s fees and litigation costs), coming out ahead of the game.

From Petro’s side, how hard would it have been to run some preliminary due diligence on their gas sales and discover even a hint that their interest was overproduced?  Just a hint would have kept them from warranting that there was no overproduction and put in place a way to value and deal with any imbalance in the PSA.  This is a lesson that applies to not just gas balancing, but land issues, too.

Representations and warranties are always a red flag for me when I perform due diligence.  In one transaction I ran a due diligence team on, a mineral transaction, the Seller made representations as to what minerals were leased and unleased.  That opened the door for us: because how many chains of title are riddled with unreleased oil and gas leases, whose status is unclear?  Needless to say, such a claim created nothing but multitudes of clouds of title.  In fact, there were many interests that were claimed to be unleased, that were indeed under an in-force oil and gas lease and vice versa. 

I like takeaways.  The takeaway on this tale: run your diligence seriously, as a Seller and as a Buyer.


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