Canada: Estoppel By Representation – Operator Has Duty To Communicate Clearly And Deal Fairly

Copyright 2008, Blake, Cassels & Graydon LLP

Originally published in Blakes Bulletin on Energy – Oil & Gas, November 2008

The main question in Solara Exploration Ltd. v. Richmount Petroleum Ltd. is whether Richmount Petroleum Ltd. (Richmount) is estopped from denying that a test well was complete and, therefore, that Dyno Energy Ltd. (Dyno) earned an interest in the lands at 2-40-26W4M (the Farmout Lands).

Background

Richmount and Dyno, now Solara Exploration Ltd., entered into a Farmout Agreement on September 1, 2005 (the Agreement), whereby Richmount, the farmor, farmed out 25% of its interest to Dyno, the farmee. Twin Peaks Holdings Corp. (Twin Peaks) and R.M.U. Resources Ltd. (RMU) also had working interests in the Farmout Lands, but were not parties to the Agreement. Richmount was the operator. Under the Agreement, Dyno would contribute funds, and Richmount was obligated to "drill, test, complete, cap or abandon the test well" to enable Dyno to earn.

Richmount would send out authorizations for expenditures (AFEs) to the non-operators (Dyno, Twin Peaks and RMU) to pay for the costs of drilling and development of the test well. Pursuant to the Agreement, prior to earning, which only occurred after "completion, capping or abandonment" of the test well, Dyno was obligated to pay all amounts or lose their interest in the well and any future wells on the Farmout Lands. Richmount initially sent two AFE to the non-operators. AFE #801605 was characterized as relating to "Development Drilling", and AFE #110501, which was characterized as "Completion", each of which were promptly paid by Dyno, as well as the other parties.

On November 18, 2005, after completion of the above operations, the test well was flow-tested to establish an initial productive rate for gas. On November 19, 2005, the testers indicated that the test well flowed for seven hours at a final gas rate of 1.8267 10³m³/day which was expected to stabilize at 1.521 10³m³/day after six months. This flow rate was considered uneconomical, so Richmount determined that fracture stimulation was required in order to stimulate gas production. To pay for the fracture, Richmount sent out AFE #512003 which was described as a "Workover" on the first page and "Completion" on the second page, and costs were described as "Completion/Workover/Re-entry". Dyno decided the fracing was not going to be economical so they verbally informed Richmount it was not going to participate "in the workover". Following this discussion, Dyno sent a letter to Richmount on January 13, 2006 which advised that they had elected not to participate in the activities and indicated that they would be going penalty. It is well known in the oil and gas industry that a farmee can elect to not participate and go "penalty" only after they have earned their interest. It was clear Dyno was of the belief that the test well had been completed and that it had already earned.

Richmount did not respond to the letter until June 2006 when they informed Dyno that it had failed to earn an interest. Richmount asserted that Dyno's failure to comply with its obligations under the Agreement to pay its proportionate share of the costs resulted in repudiation of the Agreement.

In June 2006, the test well was tied in, equipped and placed on production, and a second well was drilled by Richmount on the Farmout Lands in the fall of 2006 which has been on production since January 9, 2007.

Result

1990 CAPL Operating Procedure: "Completion" means the installation in, on, or with respect to a well of all such production casing, tubing and wellhead equipment and all such other equipment and material necessary for the permanent preparation of the well for the taking of petroleum substances therefore up to and including the outlet valve on the wellhead and includes, as necessary, the perforating, stimulating, treating, fracing and swabbing of the well and the conduct of such production tests with respect to such well as are reasonably required to establish the initial producibility of the well.

The judge at the Court of Queen's Bench of Alberta considered the definition of "Completion" in the 1990 CAPL Operating Procedure and interpreted it to have three aspects: the first addressing the equipment and material necessary for the permanent preparation of the well for the taking of petroleum substances; the second being that "completion" includes, as necessary, the perforating, stimulation, fracing and swabbing of the well; and the third being directed towards the production tests that are reasonably required to establish the initial productivity of the well. Dyno argued the need to "establish the initial producibility of the well" is the key aspect of that definition, and that that element had been met. The judge was of the view that the definition required "installation of all equipment and material necessary for the permanent preparation of the well for the taking of petroleum products", and that the onus of proving these elements were satisfied rested on Dyno. After consideration of all the evidence, the judge was not satisfied that Dyno had proven the above on a balance of probabilities.

The judge also determined that no breach of contract on the part of Richmount had been established that would lead to a declaration that Dyno had earned an interest. It was, however, determined that Richmount had an obligation, as operator under the Agreement, to disclose information which would impact on Dyno's ability to earn its interest. Despite earlier case law, when a party has a duty to disclose information, choosing to remain silent can amount to a representation. By failing to respond to the January 13, 2006 letter, the judge was of the view that Richmount represented the condition of completion had been met, which it could not now deny, and therefore was subject to estoppel by representation. Steven Waddams in The Law of Contracts (5th ed. at para.193) states: "The basic concept of estoppel is that a person is precluded from retracting a statement upon which another has relied". The judge found the AFEs sent by Richmount sent mixed messages, and through the letter, Richmount knew Dyno believed it had earned; Richmount's silence created reliance on that state of belief. The judge accepted that had Dyno known it needed to pay its share of the fracing to earn, that it would have contributed the requested funds.

As estoppel can be used as a sword when dealing with estoppel by representation, the judge found that Richmount had an obligation to respond to Dyno's assertion that it earned and was therefore now estopped from denying that Dyno earned 25% of Richmount's interest in the Farmout Lands. The judge declared that Dyno earned their interest in both wells on the Farmout Lands, that Richmount was required to provide a full accounting in relation to all costs and production for the test well, and that Dyno was required to pay at the penalty rate.

Conclusion

Operators are, by the nature of their position, privy to information that non-operators are not. When an operator/farmor is aware of information that affects a non-operator/farmee's ability to earn, remaining silent will not be deemed adequate to meet the operator's duties. It is the farmor's responsibility to ensure the farmee has sufficient and correct information to make informed decisions, if the farmor fails in this duty, and the farmee relies on such misinformation which results in loss to the farmee, then the farmor may be estopped from benefiting from the lack of information or from misinformation.

This case emphasizes the obligation that operators have to non-operators to communicate clearly and deal fairly, especially when the information is critical to a party's earning. While it is not a common situation for the farmor to also be the operator, it is easy to see that the duty to communicate clearly and provide adequate information could be applied to any situation involving operators. Operators must keep these duties in mind when corresponding with non-operators.

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