State v. Alaskan Crude Corp.

          Appeal from the Superior Court No. 3 AN- 10-04671 CI, of the State of Alaska, Third Judicial District, Anchorage, Charles W. Ray, Jr., Judge.

          John C. Hutchins, Assistant Attorney General, and Jahna Lindemuth, Attorney General, Juneau, for Appellant and Cross-Appellee.

          James W. White, pro se, Houston, Texas, Appellee and Cross-Appellant.

          James B. Gottstein, Law Offices of James B. Gottstein, Anchorage, for Appellee and Cross-Appellant James W. White (limited appearance for oral argument).

          No appearance by Appellee and Cross-Appellant Alaskan Crude Corporation.

          Before: Stowers, Chief Justice, Winfree, Maassen, Bolger, and Carney, Justices.

          OPINION

          MAASSEN, JUSTICE.

         I. INTRODUCTION

         An oil and gas lessee conducted drilling activity on the last day of the lease term; the lease provided that such activity would extend the term. Two days later, however, the Department of Natural Resources (DNR) sent the lessee a notice that his lease had expired. The lessee suspended drilling activities and asked DNR to reconsider its decision and reinstate the lease.

         DNR reinstated the lease several weeks later. The lessee, however, contended that the reinstatement letter added new and unacceptable conditions to the lease, and he pursued administrative appeals. Six months later DNR terminated the lease on grounds that the lessee had failed to diligently pursue drilling following the lease's reinstatement.

         The superior court reversed DNR's termination decision, ruling that DNR had materially breached the lease by reinstating it with new conditions. Both DNR and the lessee appealed to this court. DNR asks us to affirm the termination of the lease, and the lessee asks us to remand to the agency for a determination of his damages.

         We conclude that although DNR breached the lease in its notice of expiration, it cured the breach through reinstatement. And DNR's subsequent decision to terminate the lease is supported by substantial evidence that the lessee failed to diligently pursue drilling activities following reinstatement. Finally, we conclude that neither DNR nor the superior court erred in failing to address the lessee's damages claim. We reverse the superior court's decision reinstating the lease and affirm DNR's termination decision.

         II. FACTS AND PROCEEDINGS

         A. Facts

         On January 1, 2002, DNR and an individual lessee entered into a competitive oil and gas lease identified as ADL 389922, covering a 4, 800-acre parcel near Cook Inlet. The lessee later assigned the lease to James W. White.^[1] The lease had a primary term of seven years, but it also identified circumstances in which the term could be extended.

         On the leased land was a plugged and abandoned well. It was White's intent to reenter and test this well, but reentry was prohibited by spacing regulations of the Alaska Oil and Gas Conservation Commission (AOGCC) because of the well's proximity to a property line. The AOGCC granted White an exception from the regulations, and in March 2005 it granted White a permit to reenter and test the well.

         White began drilling in June 2007, but he soon suspended operations following the announcement that a fertilizer plant, his only prospective buyer, was about to close. On December 31, 2008, the last day of the seven-year lease term, a DNR inspector observed signs of activity at the drill site: the presence of a drill rig, the assembly of a blowout preventer, and completion of the initial reentry of the well plug.

         B. Agency Actions And Proceedings

         On January 2, 2009, DNR mailed White a notice of expiration, informing him "that in accordance with the lease agreement, ADL 3 89922 expired on December 31, 2008," and "[t]he case file has been closed in this office." White suspended operations and moved his equipment from the drill site. But on January 15 he wrote the Director of the Division of Oil and Gas, asking him to clarify whether the expiration notice had been sent in error. White called the Director's attention to paragraph 4(c)(1) of the lease, which allowed extension of the lease if drilling had "commenced as of the date on which the lease otherwise would expire";^[2] White asserted that he was drilling on the last day of the lease term, as witnessed by the DNR representative at the site. He claimed that the expiration notice was "a direct breach of [the] lease contract" and damaged his interests as lessee. He asked DNR to "please correct [the notice] and advise me by email before 2:00PM Friday, January 16th that the lease is still in effect." DNR did not immediately respond to White's letter.

         On January 20 White appealed the expiration notice to the DNR Commissioner, seeking "reinstatement of the lease term" or an acknowledgment that the lease had not expired. White sent another letter to the Commissioner on January 26. Urging the Commissioner to make a decision, he asserted that DNR had "received ample documentation of prior well boring activities, along with video, eye witness testimony and photos of... setting the blowout preventer on December 31, 2008."

         On January 27 the Commissioner retracted the expiration notice and reinstated the lease. The Commissioner found that White's documented activity on the last day of the lease term was "drilling" as defined in paragraph 34(4) of the lease and extended the lease under paragraph 4(c)(1). But the Commissioner advised White that the well had to be completed "within 90 days of this decision" or the lease would be automatically terminated. The Commissioner added: "After 90 days from the date of this letter, April 27, 2009, we will review your progress to determine whether continued lease extension is warranted." The Commissioner summarized:

[T]he continued extension of the lease is contingent upon (1) continued drilling of the well; (2) completion of the well by April 27, 2009; (3) valid permits for all operations; and (4) sustained production within 90 days following the cessation of drilling. The failure to comply with any of these conditions will result in the automatic termination of this lease.

         On February 11 White sought reconsideration of the reinstatement letter. He asserted that the letter's conditions on reinstatement were in fact attempts to unilaterally modify the original lease, and he asked the Commissioner to "remove any and all extra conditions included in [his] decision." Taking particular issue with the requirement that he complete the well by April 27, White warned that he could not drill once winter was over and would not "risk further capital and resources if the lease will expire if [he does] not finish the drilling operations before the arbitrary deadline."

         On February 18 the Commissioner granted reconsideration and gave White the opportunity "to submit additional written material or request a hearing." The Commissioner advised White that during reconsideration the reinstated lease "remain[ed] in effect for [White] to pursue continued drilling operations." White declined a hearing but submitted another letter explaining his position in detail. On June 10 the Commissioner reaffirmed the January 27 reinstatement letter, explaining that the language White deemed a modification was simply a departmental interpretation of lease paragraph 4(c)(1) and governing law - AS38.05.18O(m) and 11 Alaska Administrative Code (AAC) 83.125. The Commissioner wrote that the April 27 deadline was his interpretation of the lease requirement that drilling be completed with reasonable diligence and that it had been calculated by trebling the 30-day estimate White gave in his own original plan of operations. Responding to White's argument that DNR "could not require that he bring the completed well into production within 90 days after drilling ends," the Commissioner stated that "the 90 day requirement is clearly set forth in AS 38.05.l8O(m) and [the] lease."^[3]

         Six weeks later, by letter from the Director of the Division of Oil and Gas dated July 23, 2009, DNR terminated White's lease for "two independent reasons": first, because "according to the AOGCC, Mr. White [did] not have a valid drill permit"; and second, because "White did not continue to diligently drill after the lease was re-instated on January 27, 2009." The Director explained that DNR had attempted to confirm White's drilling activities and permit status following the reinstatement. DNR had sent White letters, and White had responded but without answering DNR's specific questions. DNR eventually learned that the AOGCC had terminated White's drilling permit, an action White was appealing.

         White appealed the termination of his lease to the Commissioner, asking that it again be reinstated. After some procedural delay not relevant here, White was granted an administrative hearing presided over by the Deputy Commissioner. White asked for "reinstatement of ADL 389922 lease terms, or alternatively an acknowledgment from DNR that the lease term did not expire as stated in a letter dated January 2nd, 2009, and also an order dated July 23rd, 2009." The Deputy Commissioner's decision affirmed termination of the lease.

         White appealed to the superior court. The court ordered a remand for a new administrative hearing on the ground that DNR violated White's due process rights when one of its attorneys, having initially advised DNR on White's administrative appeal, then advised the Deputy Commissioner in her role as hearing officer. To provide guidance on remand the superior court also addressed the terms of the January 2009 reinstatement letter and the AOGCC permit. The superior court directed DNR that it could not terminate White's lease based on the permit's validity before the AOGCC had finally decided that issue. As for the reinstatement letter, the court interpreted its four conditions as not imposing "new conditions or unilateral amendments .... Instead, DNR appears to be reminding White of his obligations under the lease." The court directed the agency on remand to review White's efforts after reinstatement "to determine if he continued drilling with reasonable diligence" based on the totality of the circumstances, stressing that failure to meet the April 27 deadline alone was insufficient to show a lack of reasonable diligence.

         On remand, following a second administrative hearing before a different hearing officer, the Commissioner again upheld DNR's termination of the lease. The Commissioner explained that White "did not demonstrate that [he] continued to drill with reasonable diligence or... failed to drill for reasons demonstrating reasonable diligence within the totality of the circumstances."

         White again appealed to the superior court, where the case was heard by a different superior court judge.^[4] After briefing and argument, the court ruled that DNR's January 2009 notice of expiration was a material breach: "An unjustified, outright cancellation of a contract cannot be other than a 'material breach.'" The court further determined, contrary to the court's analysis in the first appeal, that the breach was not cured by DNR's reinstatement of the lease 25 days later; the court reasoned that the reinstatement letter's requirement for "sustained production within 90 days following cessation of drilling" fundamentally conflicted with paragraph 4(d) of the lease, which allows a lessee at least six months after notice to bring "a well capable of producing oil or gas in paying quantities" into production.^[5] The court interpreted the lease as requiring "reasonableness and diligence, not deadlines," especially deadlines resulting in automatic termination if not met. The court held that DNR's material breach relieved White of his own lease obligations, and it therefore ordered that the lease be reinstated for a reasonable time for White "to resume, and then diligently continue, drilling in accordance with the Lease." The court declined to address White's damage claims, noting that "[w]hether other remedies are in order was not addressed by the parties."

         Both parties appealed to this court.^[6]

         III. STANDARDS OF REVIEW

         We "independently review the merits of an administrative determination."^[7]

We have "recognized four principal standards of review for administrative decisions: (1) the substantial evidence standard applies to questions of fact; (2) the reasonable basis standard applies to questions of law involving agency expertise; (3) the substitution of judgment standard applies to questions of law where no expertise is involved; and (4) the reasonable and not arbitrary standard applies to review of administrative regulations."[8]

         "Questions of contract interpretation generally raise questions of law that we review de novo."^[9] "Under this standard, we exercise our independent judgment, substituting it 'for that of the agency even if the agency's [interpretation] ha[s] a reasonable basis in law.' "^[10] We will "adopt the rule of law that is most persuasive in light of precedent, reason and policy."^[11]

         However, notwithstanding the usual substitution of judgment standard for questions of contract interpretation, we have applied the reasonable basis standard of review to agency interpretations of specialized contract terms derived from statutes or regulations.^[12]

         IV. DISCUSSION

         DNR appeals the superior court's decision that it must reinstate White's lease, arguing that neither the January 2009 notice of expiration nor the subsequent reinstatement letter was a material breach of the lease. White's appeal argues that the superior court erred by failing to remand the issue of his damages to the agency for a determination of what he is owed.

         A. The Commissioner Did Not Err In His 2013 Decision Affirming Termination of the Lease.

         We agree with the superior court that DNR's January expiration notice materially breached the lease, but we conclude that the breach was cured by the reinstatement letter. Thereafter, White continued to have the contractual duty to engage in drilling operations with reasonable diligence; the ...