Energy Litigation Update: Measure of Damages for Breach of a Contract to Drill Exploratory Oil or Gas Well: U.S. and English Law.

by Quinn Emanuel Urquhart & Sullivan, LLP

With recent increasing frontier exploration activity, greater attention has fallen on the value of work obligations received for the grant or assignment of exploration and development rights. In many parts of the world, it is common for rights to be granted in return for, inter alia, an undertaking to drill exploration wells. Companies that obtain these rights often farm them out in return for an undertaking to carry their costs of performing such drilling. What if the promisor decides that the exploration prospect has become too risky or not worth the investment? Can it walk away from the obligation, knowing that the promisee cannot prove any loss because, on a balance of probabilities, the work would not have led to a commercial discovery? This article reviews this issue under English and U.S. law.

English Law. No direct authority exists on this issue under English law. The general rule at common law is that contractual damages exist to position the plaintiff as he would have been had the contract been performed (to protect the plaintiff’s “expectation interest”). Given that damages awards are based on the reasonable balance of probabilities (namely, greater than a 50% chance that the loss in question was suffered), aiming to protect the promisee’s expectation interest when the usual likelihood of discovering a commercially viable reservoir will be less than 50% makes little sense in this context. Three alternative approaches to this issue are potentially available under English law, though none is particularly satisfactory.

The first approach would be to award “reliance interest,” covering the promisee’s wasted expenditure incurred in reliance on the contract being observed (restoring him to his pre-contractual position). Persuasive support for this approach is discussed in the Canadian Supreme Court’s decision in Sunshine Exploration Ltd. et al v Dolly Varden Mines Ltd. (N.P.L.) [1970] S.C.R.2. There, the Supreme Court awarded the license holder damages equaling the cost of performing the exploratory work that should have been carried out, reasoning that the contractor, by entering the agreement, had acknowledged that its own suggested works program was worth the cost of performing the contract and the license holder had given valuable consideration for that performance.

The second approach would be to award damages based on loss of chance or opportunity. Loss of chance damages are generally dependent on a hypothetical future event occurring (and the chance in question must be more than speculative). But in the scenario in question, irrespective of whether or not drilling occurs, there is either oil underground or there is not. Therefore, loss of chance considerations should not apply. Indeed, English courts have employed this rationale in medical negligence cases concerning failures to diagnose or treat conditions in sufficient time, where courts have confirmed that they will not award a patient damages for loss of a chance where his pre-existing injury or condition is such that the damage has already been done even if future treatment would have had a chance of success. In these cases, the actual existing state of affairs at the time of the negligence is determinative of the hypothetical question of what the plaintiff’s position would have been but for the breach of duty. See, e.g., Hotson v East Berkshire Area Health Authority [1987] A.C. 750 HL; see also Gregg v Scott [2005] UKHL 2.

The third approach would be to award so-called “Wrotham Park” or “negotiating” damages, named after the decision in Wrotham Park Estate Co v Parkside Homes [1974] 1 WLR 798, where damages are measured by reference to the benefit gained by the wrongdoer from the breach of contract. In that case, the defendant developed houses on land in breach of a restrictive covenant but both parties accepted that there had not been any reduction in land value as a result of the development. The Court awarded damages to reflect “such a sum of money as might reasonably have been a quid pro quo for relaxing the covenant.” Recently, Giedo van der Garde BV and another v Force India Formula One Team Ltd. [2010] EWHC 2373 (QB) has confirmed that such damages awards are available for breach of contract claims generally. In the drilling context, this would likely arise towards the end of the license period, when the license holder will have lost the ability to enforce the contractual obligation to drill (considering the long lead times to arrange drilling equipment). The loss would be quantified as the value that would have been agreed between the promisor and the promisee in a hypothetical negotiation to release the contractor from drilling obligations.

U.S. Law. U.S. law is more developed on the issue and courts have followed one of two approaches: the “cost of drilling” approach, and the “value of performance” approach.

Under the “cost of drilling” approach, damages for breach of contract to drill a well are calculated by the “cost of sinking the well contracted for, or of completing one partially sunk if the defendant has partially performed.” Fisher v. Tomlinson Oil Co., 215 Kan. 616, 619 (Kan. 1974). For example, in Fite v. Miller, 196 La. 876, 886 (1940), the defendant failed to drill a well that he agreed to drill in exchange for a half interest in an oil, gas, and mineral lease. Despite defendant’s evidence the well would have been a dry hole, the Louisiana Supreme Court awarded damages by measuring the cost of drilling because the plaintiff lost the right to have the well drilled and was entitled to the value of such drilling. Id.; see also Apache Bohai Corp. LDC v. Texaco China B.V., No. H-01-2019, 2005 WL 6112664 (S.D. Tex. Feb. 28, 2005).

Texas and California courts have rejected the “cost of drilling” approach to damages in this context in favor of the “value of performance.” See, e.g., Fisher v. Hampton, 44 Cal. App. 3d 741 (1975); Riddle, 136 Tex. at 134. Under this approach, courts measure damages based on anticipated and non-speculative benefits under a contract so that the non-breaching party is “in the same position as that in which [it] would have been put by performance.” Riddle, 136 Tex. at 134. Under this rule, a plaintiff may recover the value of royalty or the loss of profits on the retained lease. See Guardian Trust Co. v. Brothers, 59 S.W.2d 343, 345 (Tex. Civ. App. 1933); Hardwick v. Jackson, 315 S.W.2d 440, 441 (Tex. Civ. App. 1958). In contrast to the Canadian decision in the Dolly Varden case supra, a plaintiff may also claim damages arising out of lost profits on retained leases, provided that profits from an increased market value of the lease were contemplated by the parties when the contract was made, and the plaintiff would have sold all or part of its interest. See Whiteside v. Trentman, 141 Tex. 46 (1943); Sanchez-O’Brien Oil & Gas Corp. v. Austin Resources Corp., No. 14-96-96-00240, 1998 WL 322686 (Tex. Ct. App. June 18, 1998).

Practical Tip. Damages laws in England and the U.S. are tested by the particular circumstances of a contract to carry out exploration activity because of the inherently speculative nature of the work. In drafting an agreement under which one party agrees to carry out such work, there will always be doubt regarding the monetary consequences of a breach. While liquidated damages clauses (as distinguished from license clauses which allow for relinquishment) are rare in such contracts, they are the best route to avoiding an inevitably protracted legal debate on this issue.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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