IN THE SUPREME COURT OF THE STATE OF KANSAS
No. 91,733
THE TREES OIL COMPANY,
Appellant,
v.
STATE CORPORATION COMMISSION, CHESAPEAKE OPERATING, INC.,
OXY-USA, INC., and ANADARKO PETROLEUM CORPORATION,
Appellees.
SYLLABUS BY THE COURT
1. In this oil and gas appeal taken under K.S.A. 77-601 et seq., the district court decision affirming the Kansas Corporation Commission's order, pursuant to the Kansas Unitization Act, K.S.A. 55-1301 et seq., granting unitization and unit operation of the South Eubank Waterflood Unit is affirmed.
2. Under the facts of this case, the court makes the following findings and rulings: (1) Numerous standards of review and legal maxims of statutory construction are stated and applied; (2) the K.S.A. 55-1302 definition of "pool" is construed to include commingled Chester and Morrow formations which constitute a single and separate natural reservoir characterized by a single pressure system so that production of petroleum from one part of the pool affects the reservoir pressure throughout its extent; (3) there was substantial competent evidence to sustain all the Commission's findings and orders which were made in compliance with K.S.A. 2003 Supp. 55-1304 and K.S.A. 2003 Supp. 55-1305; (4) inclusion of the tracts of an unwilling minority participant in the unit was necessary to protect correlative rights and was supported by substantial competent evidence; (5) denying the unwilling minority participant's request to present supplemental technical geological evidence at an interim hearing held to consider only the fairness of the Unit Operation Agreement was not unreasonable, arbitrary, or capricious.
Appeal from Haskell district court, TOM R. SMITH, judge. Opinion filed February 18, 2005. Affirmed.
C. Michael Lennen, of Morris, Laing, Evans, Brock & Kennedy, Chtd., of Wichita, argued the cause and was on the brief for appellant.
John G. McCannon, Jr., assistant general counsel, argued the cause, and Susan B. Cunningham, general counsel, was with him on the brief for appellee Kansas Corporation Commission.
Jeff Kennedy, of Martin, Pringle, Oliver, Wallace & Bauer, L.L.P., of Wichita, argued the cause, and Stanford J. Smith, of the same firm, was with him on the brief for appellee OXY-USA, Inc.
Spencer L. Depew, of Depew Gillen Rathbun & McInteer, LC, of Wichita, argued the cause and was on the brief for appellee Anadarko Petroleum Corporation.
The opinion of the court was delivered
Per Curiam: This is an administrative appeal pursuant to K.S.A. 77-601 et seq. from the decision of the district court of Haskell County, Kansas, affirming the order of the State Corporation Commission of Kansas (KCC or Commission) granting the application of Chesapeake Operating Inc. (Chesapeake) to allow the compulsory unitization and unit operation of the South Eubank Waterflood Unit (Unit) pursuant to the Kansas Unitization Act, K.S.A. 55-1301 et seq., over the continuing objection of The Trees Oil Company (Trees).
The first issue was one of first impression involving the statutory definition of an oil and gas "pool" as defined in K.S.A. 55-1302, when considered by the KCC and district court. This issue becomes one of last impression as the result of 2004 amendments to K.S.A. 55-1302 which now clearly grant the rights Trees contests, as will be fully discussed in our opinion. See L. 2004, ch. 115, sec. 1.
Trees' second, third, and fourth issues involve the application of administrative law to the KCC orders and relate to the involuntary inclusion of Trees' property within the Unit, whether there was substantial competent evidence to uphold the KCC findings and rulings, and if the KCC acted arbitrarily and capriciously in refusing to allow Trees to present additional geological evidence at a second hearing the Commission ordered to consider only the fairness of the terms of the Unit Operating Agreement.
In order to fully understand the issues on appeal, it is necessary that we set forth in considerable detail the procedural history of this appeal, the evidence presented, the findings and orders of the KCC, and the rulings of the district court.
Procedural History and Factual Background
Several oil and gas operators, Chesapeake, OXY-USA, Inc. (OXY), and Anadarko Petroleum Corporation (Anadarko), own 16 oil and gas wells that produce oil out of a 3.7 miles long and 500- to 1,500-foot wide incised Chester and Morrow formation channel and desired to inject water into the Chester formation to produce substantial additional oil production beyond that possible with conventional pumping methods.
Trees owns and operates one oil and gas well on 80 acres within the southern boundary of the proposed water flood project and, after attending two planning meetings in mid-2000, informed the other operators it did not wish to voluntarily participate in the project.
Planning on the project continued and, on June 27, 2001, Chesapeake filed an application with the Commission that sought unitization and unit operations of the area above described. OXY and Anadarko were allowed to intervene.
Trees filed a protest and request for a continuance in mid-July 2001. The hearing, which had originally been set for August 2, 2001, was continued, first to September 6, 2001, and later to September 20, 2001.
The hearing took place on September 20, 2001, with the Commission taking testimony from five technical witnesses and admitting exhibits. Posthearing briefs were filed, the record was closed, and the Commission took the matter under advisement.
On March 12, 2002, the KCC issued an Interim Order Requiring Additional Evidence, in which it stated: "The Commission has before it ample record and is ready to rule on the conditions in K.S.A. 55-1302(a) and (b)," but reopened the record for the specific purpose of receiving additional testimony as to whether specific terms of the Unit Operating Agreement were fair and equitable to all parties.
On April 3, 2002, the Commission heard additional evidence concerning the fairness of the specific terms of the Unit Operating Agreement. The Commission refused to reopen the record to allow Trees to present additional geological testimony.
On April 18, 2002, the KCC issued a detailed 26-page order of findings and conclusions granting Chesapeake's application for unitization and unit operations of the South Eubank Waterflood Unit. Trees' petition for reconsideration was denied, and it then filed a petition for judicial review before the Haskell County District Court.
Briefs were filed, oral arguments were held, and, on December 12, 2003, Haskell County District Judge Tom R. Smith issued a comprehensive 18-page decision in which the rulings and orders of the Commission were affirmed. Trees appealed.
We have jurisdiction by transfer on our own motion pursuant to K.S.A. 20-3018(c).
Ten pages of the Commission order contained a summary of the evidence presented which we will condense somewhat to show the testimony of the proponents and opponents of the application.
Rodney J. Vaeth, a Chesapeake expert landman, presented copies of the Unit Agreement and the Unit Operating Agreement which he testified incorporated the statutory requirements of the Kansas Unitization Act and met the required statutory percentages of both royalty and working interest owners who had approved both agreements. He testified 93.39152 percent of the working interest owners had approved Phase I of the agreements and 94.47862 percent had approved Phase II of the agreements. He further testified 69.396548 percent of the royalty owners on a surface acre basis had approved the agreements, that 64.00343 percent of the royalty owners had approved Phase I and 67.35903 percent of the royalty owners had approved Phase II of the agreements.
Jimmy W. Gowens, a petroleum geologist, testified for Chesapeake and described the reservoir and unit areas as portions of the Morrow and Chester sand formations in an incised channel 3.7 miles long and between 500- to 1,500-foot wide and described how the boundaries were established by the technical committee by seismic data and other factors. He noted that, within the field, Chesapeake operated 12 wells, Anadarko 4 wells, and Trees operates 1 well. He described the Chester sand as continuous from the north boundary of the Unit to the south boundary.
Gowens had personally been involved in drilling all of the Chesapeake wells. He testified seven of the wells within the proposed unit area have commingled production from both the Chester and Morrow formations and, as the result of such dual completions, both of the formations are in pressure communication.
Gowens testified he had prepared the hydrocarbon pore volume (HPV) maps which were used in determining the participation formulas. On cross-examination, he said the HPV values are a very reliable measure of oil in place.
In rebuttal testimony, Gowens said he doubted the ability of Trees to use the Lou Ethel well (a well south of Trees' Josephine well which was included in the Unit) as an injection well for a mini waterflood. He questioned whether there was communication between the two wells because of the possibility of a separating fault.
Chesapeake then presented the testimony of Dan Scott, a petroleum engineer with 22 years of experience. He testified the unit area is underlaid by productive Chester sand which is in good pressure communication throughout the Unit making it an excellent waterflood candidate.
Scott testified the project was economic and would result in incremental secondary recovery of at least 690,000 barrels of oil, a figure he believed to be conservative. He said the increased recovery would not be achievable through primary operations and would therefore prevent waste. The project, based on an oil price of $20 per barrel, was expected to achieve a gross profit of $6.2 million.
Scott then testified in detail regarding the determination of the unit participation percentages and formula. The parameters used included remaining primary reserves, current production, Chester well bores, Chester HPV, and Chester ultimate recovery. He opined the use of these parameters and resulting unit formula was fair and equitable and that 94 percent of the working interest owners had approved the two-phase participation formula.
The two-phase formula was described as Phase I with 50 percent remaining primary reserves and 50 percent current production and Phase II being 5 percent Chester well bores, 47.5 percent Chester HPV, and 47.5 percent Chester estimated ultimate recovery. Scott said he had been working on the waterflood since the summer of 1999 and had devoted over 1,000 hours to the study of the project.
Scott also testified in rebuttal to Trees' witnesses. He opined that the Trees' Josephine well was in pressure communication with the other Chester wells in the proposed unit. He said the reservoir pressure at that time was approximately 400 psi but that, through injection under pressure, they intended to bring reservoir pressure back to 1,500 psi. He testified the Trees' Josephine well, if allowed to remain a producer, would become much more productive as the result of the proposed waterflood with much of the production coming from the unit area as the result of migration of oil across the lease line in violation of correlative rights.
Scott strongly disagreed with Trees' witness Hupp that efficient operation of the Leather's Land 2-10 well (located directly north of the Josephine well) could prevent migration of oil. He noted that the initial production rate of the Leather's Land 2-10 well was only 87 barrels of oil a day and that injection rates would be as high as 1,100 barrels per day causing oil to bypass the Leather's Land 2-10 well and be pushed to the Josephine well in violation of correlative rights. Scott disagreed with Hupp, who had suggested the narrowness of the channel would prevent migration, pointing out a well bore is only 7 or 8 inches wide and the reservoir at the Leather's Land 2-10 well is over 1,000 feet wide, approximately the length of over 3 football fields. Scott estimated the amount of oil that could be lost by migrating of oil off the Unit onto the Trees' well could be as much as 18,000 barrels if Trees were omitted from the Unit.
Scott testified the natural state of the formations had been altered by commingling the Morrow and Chester formations in seven of the well bores, and the two zones are in pressure communication which means, from a pressure standpoint, they are one and the same. He further said it was intended to leave both sets of perforations open in the commingled wells that would become injection wells which could lead to additional recovery and production from the Morrow formation.
Scott opined the value of the Josephine lease without waterflooding would be approximately $130,000 but by implementation of the project the value could increase to $390,000 and that the increase in present net worth at a 10 percent discount rate was approximately $250,000.
Finally, Scott testified the wells in the proposed unit are in imminent danger of being abandoned due to economics and low levels of primary production.
Trees presented the testimony of Thomas G. Pronold, a geologist, and Kenton Hupp, a petroleum engineer.
Pronold testified the Chester formation in this area has different pressure compartments which could minimize the effectiveness of the proposed waterflood. He did not present any pressure studies to support this statement. Pronold acknowledged he could not determine whether interest owners were receiving credit for Morrow pay that was not actually producing. He did not present any seismic data on behalf of Trees, although it was available, in support of the possibility that the Morrow formation might be productive in the area of the Josephine well and acknowledged he would not recommend Trees to drill a well there for Morrow production.
Pronold acknowledged that seven of the wells in the area had been commingled between the Chester and Morrow formations as had been permitted by Commission orders.
Hupp testified that the technical committee undervalued the remaining reserves under the Josephine 1-15 well because it did not honor late term amounts of Trees' production. He did acknowledge that September 2000 through February 2001 production amounts would have been below the decline curve and that he did not account for those points in developing his exhibit.
Hupp said that geologic mapping was prepared without input from Trees but did acknowledge that he knew Trees had representatives at two technical committee meetings and a geophysicist present at the meeting on July 10, 2000. Hupp admitted that he believed the project was valid from an engineering standpoint and that the Chester formation is floodable.
Hupp expressed concern that Trees would not get credit for Morrow reserves but did acknowledge that he was not aware of any other operation in the Unit that was to receive credit for Morrow production that was not actually being produced. He acknowledged Trees would be getting a share of Morrow production from the Unit even though there would be no Morrow production from the Trees' tract itself.
Hupp criticized the use of HPV or oil in place as a parameter in the participation formula as being unreliable and speculative, although he acknowledged he had previously advocated use of oil in place before the Commission and that the Commission had used HPV on unit orders before.
Chesapeake and Trees presented additional testimony on April 3, 2001, in response to the Commission's interim orders limited to the fairness of the terms of the Unit Operating Agreement.
Professor David E. Pierce of the Washburn University School of Law, who teaches in the oil and gas law area, qualified as an expert witness and testified on behalf of Chesapeake. He was familiar with the agreements and said they were patterned after the model forms of the American Petroleum Institute. They are standardized provisions generally used in the oil and gas industry and satisfied the statutory requirements of the Kansas Unitization Act, K.S.A. 55-1301 et seq.
Professor Pierce opined the agreements were fair in that all owners were treated the same. Decisions were required to be made in good faith and provided adequate protection for the interests of an unwilling participant. Pierce specifically testified the "recovery of costs" provision of the Unit Operating Agreement was authorized by statute and was fair in that if a nonoperating working interest owner elected not to assume additional risk, it compensated the operator for the additional risk it assumed when it financed the operation.
Gayle Gentry Bishop testified on behalf of Trees. She is its president, principal shareholder, and has had operating responsibility for the past 17 years. Bishop said she felt the agreement was unfair to Trees because, as an unwilling participant, it was being forced to take risks it did not wish to take. It had no practical way to protect itself from majority decisions that Trees believed to be adverse to its interests. She objected to lost cash flow and being required to contribute to unit expenses.
Bishop said Trees had not known it could be forced to participate in the project and had not perceived a need to be involved in Unit planning.
There were three provisions of the agreement which Bishop believed to be unfair. Article 4.3 was objected to because it allowed decisions by a majority vote and, consequently, the other participants would effectively control unit operations. She further objected to Chesapeake and OXY determining the values of personal property delivered to the Unit and expressed concern about the future use of a tank battery that was also used for Trees' Lou Ethel No. 15 well.
Chesapeake presented Scott on rebuttal. He testified the cash flow impact on Trees was proportionate to all participants. As to the equipment valuation objection, he testified that all equipment owned by Trees in connection with the Josephine well, except for the casing, would be pulled and returned to Trees so no valuation would be needed. As to the tank battery in question, it would not be disturbed by unit operation and would remain fully available for use in connection with Trees' Lou Ethel well which was not a part of the Unit.
Rulings and Orders of the Kansas Corporation Commission
The Commission order first recited the evidence presented as has been summarized above. It was then noted that Trees raised a threshold legal issue that the proposed unitization could not go forward because it violated the statutory requirements for unit operation of a "pool," defined in K.S.A. 55-1302 as
"an underground accumulation of oil and gas in a single and separate natural reservoir characterized by a single pressure system so that production from one part of the pool affects the reservoir pressure throughout its extent."
Trees' argument was said to center on the wording "single and separate natural reservoir" as precluding unitization of two reservoirs connected by well bores completed so that the formations become commingled.
The Commission declined to apply what it characterized as a narrow and restricted reading of the statute because it deemed that doing so would result in substantial waste including loss of 690,000 barrels of oil production and economic loss of approximately $6.2 million of gross profits after expenses.
It was noted this was a matter of first impression in Kansas, although two Oklahoma cases had determined a pool such as exists here would be acceptable under the Oklahoma statute. The word "natural" is not used in the Oklahoma statute, so the Commission determined it must address that feature of the Kansas statute to determine if it should result in denial of the Chesapeake application.
The Commission pointed out that the Kansas Unitization statute is founded on the public policy of prevention of waste, conservation of oil and gas, and protection of correlative rights. Parkin v. Kansas Corporation Commission, 234 Kan. 994, 1006, 677 P.2d 991 (1994). There is no indication the legislature intended to prevent oil bearing reservoirs from unit operation because of commingled production of what was originally separate reservoirs. The fact deemed the most significant was that waste could be prevented by allowing unit operation of the Chester formation.
The Commission's order then looked to the rule of statutory construction set forth in Todd v. Kelly, 251 Kan. 512, 516, 837 P.2d 381 (1992), that
"'courts are not permitted to consider only a certain isolated part or parts of the act, but are required to consider and construe together all parts in pari materia. When the interpretation of some one section of an act according to the exact and literal impact of its words would contravene the manifest purpose of the legislature, the entire act should be construed according to its spirit and reason, disregarding so far as may be necessary the strict letter of the law.' [Citation omitted.]"
The order pointed out the legislature had previously amended the act to make unitization easier to accomplish by lowering the 75 percent sign up requirement in the original act to 63 percent. The clear intent of the statute would not be advanced by giving "natural" the significance Trees urged. It was noted the word "natural" may have been used for unrelated reasons and there was no reason within the statutory scheme for such a narrow interpretation.
The Commission noted this specific question, while not the subject of any Kansas cases, had been addressed by Professor Ernest E. Smith in an article on the Kansas Unitization Act, Smith, The Kansas Unitization Statute: Part II, 17 Kan. L. Rev. 133, 137 (1968), which the Commission quoted as follows in its order:
"'[The Kansas statute] requires "a single and separate natural reservoir characterized by a single pressure system so that production from one part of the pool affects the reservoir pressure throughout its extent." If "natural" is read as defining "reservoir" and not "single pressure system"–as, indeed seems the most obvious construction–then a series of vertically separated reservoirs which have been brought into pressure communication through multiple-completion drilling and production techniques would qualify as a "pool" under the statute and could be developed as a single unit under the act. Such a construction would be entirely consistent with the definition, in that production from one such reservoir would affect the pressure throughout all the reservoirs. It would also be consistent with the purposes of the act insofar as these include the avoidance of economic waste and uneconomical methods of production.'"
The Commission stated it agreed with this reasoning. It also noted the Chester and Morrow formations had previously been authorized to be commingled by a Commission order and there was not expected to be any significant recovery from the Morrow formation, with the primary production coming from the secondary recovery of the Chester formation.
The Commission noted it would not be prudent to separate the formations at this time as it would be costly, without benefit, and any possible Morrow production would be lost. The Commission's order concluded that the interpretation called for by Trees is not required and it "will not interpret the statute to require foregoing over $6 million in additional production because the reservoir to be unitized for secondary recovery is incidentally connected to a reservoir, such as the Morrow formation, with no secondary recovery potential of its own."
The Commission order then looked at the additional issues Trees raised as to the fairness of the allocations and the Unit Operating Agreement itself as it impacts a minority working interest owner. The Commission said that it had taken a closer look at the agreement but was satisfied that the proposed unit is fair and equitable to all participants.
As to the allocation formula, it was found to use well recognized measures and was reasonable. The cut-off point was reasonable, and the fact Trees gave fracture treatment to its Josephine well to temporarily increase production in April 2001, after the January to May 2000 period used, did not improperly affect the allocations of interests. The allocation of the Morrow production to Phase I of the allocation was found to be reasonable because of the existence of some Morrow production.
While a short-term revenue loss to Trees would result from conversion of the Josephine well from a producing well to an input well, there was substantial credible evidence that the value of Trees' lease with unit operation is higher than without. All participants lose short-term cash flow but will recover its allocated share of unit production.
The Commission order then moved to the three Trees' claims of unfairness in the Unit Operating Agreement addressed by the April 3, 2000, hearing and found: (1) There was nothing inherently unfair about majority rule where the majority was obligated to use good faith and equally treated all participants, (2) valuations of personal property must be treated fairly and, based on the Scott testimony, there would be no valuation questions, and (3) the Trees' tank battery remained usable in conjunction with another well.
The Commission order noted Trees' protest had not been helpful in improving the agreement and that "[Trees] only wants out." Trees' request to be omitted from the Unit would violate the public interest as well as correlative rights. Under the statute, waste or harm to correlative rights would occur without Trees being included in the Unit. Convincing evidence of this is that omission of the Trees' tracts and Josephine well would allow as much as 18,000 barrels of oil to migrate from the Unit onto the Trees tracts. The remaining well on that end of the Unit would not adequately prevent this migration. The Commission concluded this discussion by stating: "Prevention of harm to correlative rights is one of the principal goals of the Unitization statute and supports keeping the Trees tract in the Unit."
The Commission's order held that the Chester and Morrow formations had been commingled and now constituted one common source of supply, approved the described unit area for a waterflood operation, found without unit operations substantial waste would occur, found participation percentages were fair to Trees and other participants, approved the Unit Operating Agreement as fair and equitable, held exclusion of Trees from the Unit would violate correlative rights by allowing 18,000 barrels of oil to migrate from the Unit to Trees' tracts, and found all applicable statutory requirements had been satisfied.
It is from these findings and orders that Trees appealed pursuant to the Kansas Act for Judicial Review and Civil Enforcement of Agency Actions (KJRA), K.S.A. 77-601 et seq., to the District Court of Haskell County, Kansas.
District Court Decision
The District Court of Haskell, Kansas received briefs from all the parties, reviewed the testimony and exhibits, heard their oral arguments, and on December 12, 2003, affirmed the KCC in a well-reasoned 18-page written decision which set forth the issues as follows:
1. "The Trees Oil Company alleges the State Corporation Commission erred, because they ordered compulsory unitization and unit operation of two separate natural reservoirs and in so doing, they have misinterpreted or erroneously applied Kansas law and pursuant to K.S.A. 77-621(c)(4) this Court should reverse and set aside the order issued by the State Corporation Commission in this proceeding."
2. "The Trees Oil Company further claims the finding by the State Corporation Commission to include the tracts of land operated by the Trees Oil Company in the South Eubank Unit is not supported by substantial, competent evidence in the record and should be reversed and set aside by this Court pursuant to K.S.A. 77-621(c)(7)."
3. "A third claim raised by the Trees Oil Company in this proceeding is the exclusion of the Trees Oil Company's proffered testimony was unreasonable, arbitrary and capricious and should be reversed pursuant to K.S.A. 77-621(c)(8)."
4. "In their fourth claim of error, The Trees Oil Company claims the State Corporation Commission's finding that the deletion of those tracts of land operated by the Trees Oil Company from the proposed unit would cause correlative rights violations and is not supported by substantial, competent evidence in the record as a whole and should be reversed by this Court pursuant to K.S.A. 77-621(c)(7)."
5. "The fifth and last issue raised in this proceeding by the Trees Oil Company is their claim the unit participation factors or percentages assigned to them did not fairly and equitably assign relative value to the Tree Oil Company's tract. Therefore, the Order amounts to an unconstitutional taking of the Trees Oil Company's property and should be reversed and set aside by this Court pursuant to K.S.A. 77-621(c)(1)(7)(8)."
The district court noted the power of review by the courts does not give the court authority to substitute its judgment for that of the Commission, see Farmland Industries, Inc. v. Kansas Corporation Comm'n, 24 Kan. App. 2d 172, 176, 943 P.2d 470 (1997), rev. denied 263 Kan. 885 (1997), and the burden was on Trees to show the Commission's orders were invalid. See K.S.A. 77-621(a)(1).
The district court first considered Trees' second and fourth claims of error that the findings of fact of the KCC were not supported by substantial evidence. These claims relate to the inclusion of the Trees' tracts in the Unit and that deletion of the tracts from the Unit would violate correlative rights. These two contentions were stated to deal with the same issue in a slightly different manner.
The court found there was substantial evidence to uphold the KCC's findings. It was noted the Commission, as the trier of fact, has the right to determine the credibility of the witnesses and the weight such testimony is to be given. Correlative rights were stated to mean that each owner or producer in a common source of supply can only take a proportional share of the oil obtainable, Aylward Production Corp. v. Corporation Commission, 162 Kan. 428, 431, 176 P.2d 861 (1947), and that the protection of such rights is one of the KCC's obligations, Mobil Exploration & Producing U. S. Inc. v. Kansas Corporation Comm'n, 258 Kan. 796, Syl. ¶ 1, 90