OIL AND GAS OUTLINE – PROFESSOR REED
FALL 2000
I. INTRODUCTION
A. Horton’s Rule:
1. In Oil and Gas law courts are extremely
reluctant to parole evidence into an oil and gas instrument. “I said what I meant and I meant what I
said.”
B. History:
1. Col.
Drake hit first oil well in 1859 at 69 feet.
C. Oil
Formation and extraction:
1. Where oil is found: Oil is rarely found in open containers
underground. It is found in sedimentary
rock.
2. How oil is formed: Exoskeletons of micro organisms settle and
guts decay. Pressure combined with
temperature converting the guts into oil.
Skeleton (bone) turns to rock.
3.
Recovery methods:
a. Primary recovery: just pump oil out. Get 25% of oil in field.
b. Secondary Recovery: pump salt water in to push oil out. Get
50% of the oil in the field.
c.
Tertiary: pump in detergents to push oil
out and wash formation out. Get 75% of the oil. No other used because costs more to get than
can sell the oil for. Examples: pump in
steam to make oil thinner, set reservoir on fire with injection wells to inject
oxygen and fire heats oil, making it thinner, inject carbon dioxide which
expands and pushes oil out.
D. Oil and Gas ownership:
1. Crown
Rule - minerals belonged to the Crown.
a.
i. minerals
ii. marital property
iii. common law procedure
2. Common law - no one owns wild animals.
3. Donkey Rule:
get to determine who uses property.
Can’t do whatever you want with it.
II. RULE OF CAPTURE:
A. In the beginning of oil and gas law, you had
the standard heaven to hell rule that you own everything from the center of the
earth to the heavens. This was not an
effective rule for the oil and gas industry, so the rule of capture was
developed - at the time, it was believed that oil and gas migrated.
B. Rule
of Capture (only applies underground):
1. Del
Monte Mining v. Last Chance Mining:
The owner of a tract of land overlying an oil and gas reservoir has the
right to capture all the oil and gas he brings to the surface through wells
located on his own property, even though the oil may be drained from his
neighbors tract.
a. The only remedy at common law for an adjacent
landowner to protect their land from drainage was to drill their own well (rule
of convenience).
b. Kelly
v.
C. Consequences
of the rule:
1. Encourages prolific drilling and rapid
production (operating wide open).
2. physical and economic waste such as
overdrilling and over-production.
D. Reinjected
hydrocarbons:
1. Champlin
Exploration v. Western Bridge: hydrocarbons
which have been severed from the ground and are reinjected are not subject the rule of capture. Severed hydrocarbons are personal property
and not real property - like they were prior to extraction- and are subject to
the law of abandonment.
a.
To abandon, must:
i. intend to abandon
ii.
and intent corroborated by some kid of physical act (Ex.: toss it out).
Absence of owner taking steps to recover it does not indicate abandoned.
b. Must show damage to your real estate to get
trespassory damages for reinjected
minerals that escape onto your land. Get
nominal damages unless you can show actual damage to your land.
2. Texas
American Energy v. Citizen Fidelity Bank & Trust: Gas extracted and piped from
a.
b. MAJORITY RULE: reinjected gas does not become subject to the
rule of capture.
E. RULE
OF CAPTURE AND TRESPASS:
1. Geo
Viking v. Tex-Lee Operating Co.: Can’t
get damages for loss of oil that would have been trespass had you actually
removed it. Fracturing across property
lines is a surface trespass and you can’t get damages for oil not retrieved due
to failure of the fracturing process.
Trespasser can’t claim under the rule of capture.
F. LIMITATIONS
ON THE RULE OF CAPTURE:
1. Conservation Statutes: to prevent physical and
economic waste and protect correlative rights.
a. What
conservation statutes do:
i. Well Spacing Rules: prevent overdriling by limiting the number of well that can be drilled in a given
area (based on acreage). Exceptions to
the well spacing are often necessary.
Texas Statewide spacing rule is 40 acres (Rule 37), but field rules can
differ.
ii. Production limitations (prorating): limits the amount of oil and gas a well can
produce.
iii. Compulsory Pooling: allows a drained landowner to force neighbors
to share their well’s production.
iv.
Density controls: how may acres
to support one well.
2.
Correlative Rights:
a. Waste or wasteful production techniques will
bring liability, as will negligent damage to the ability of the producing
formation to produce for others.
b. Provides that each owner of a minerals in
common source of supply has the right to a fair chance to produce oil and gas
from the reservoir. Even if statute does
not mention correlative rights and waste, they must be implied.
i.
c. Denver
Producing & Refining Co. V. State:
Allowed gas-oil ratio of 2000 cubic feet per barrel of oil. Plaintiff seeks an increase in the ration to
5000. Average for the field is
1895. As oil moves out of the ground,
gas bubbles out of ground too. Prior to
the 1950’s technology not competent to recover and pipe natural gas.
i. preventing waste is more important than
correlative rights if have to choose.
d. Examples of Correlative rights:
i. Right to be protected from negligent
operation: Eliff: wells blew out,
cratered, and ignited. This was
considered waste. Party injuring
reservoir can not claim benefit of the rule of capture.
ii. Exxon
v. Railroad Commission: BTA drilled
to Ellenberger formation, but found nothing.
They plugged back to the Montoya, but it was near depletion. They want to plug back to the Devonian
formation. If they had originally
drilled with the intent of tapping the Devonian formation, spacing requirements
would not allow it. Exxon had a well
pulling from the Devonian formation, but it was not capable of extracting all
of the oil.
a. Test:
whether the existing well was drilled and completed in original formation legitimately and in good
faith, not as a subterfuge to bolster a later Rule 37 exception. Exception granted to prevent waste.
b. MER - Maximum Efficient Rate at which a well
can produce without impairing efficiency of the reservoir. Maintain reservoir
pressure as long as possible. Start here
to prevent tarring out effects.
3. Fair Share Rule:
a.
Wrongski v. Sun Oil Co.: Sun
Oil drilled several wells on nearby property within the field. Oil and gas conservation statute said one
well per 200 acres and limited production to 75 barrels of oil per day.
i. Fair share - each owner entitled to his
equitable and ratable share of recoverable oil and gas in a common pool in
proration of recoverable reserves underlying his and bears to recoverable
reserves in the entire pool. Also known
as correlative rights.
a. State in exercising its conservation power
may not do so in a way denying property owner a fair chance to produce his just
and equitable share of the oil and gas under his land. Limits conservation power.
b. Pickens
v. Railroad Commission: owners of
wells with thicker acreage (must drive further down to get to oil) wanted
production apportioned on acres/ feet because could get more credit. Thin owners (because oil pushing toward
thicker owner die to water rushing in) wants apportionment base on percent
acreage.
i. straight surface acreage allocation is the
most common unless utilization for enhance recover is involved in which case
formulas may be very complicated.
ii.
Substantial evidence that thin owner would not be able to
produce unless give credit for acreage.
Upheld a 50-50
apportionment.
4. One Well as a Matter of Right: if own land
and can’t place a well on it due to the spacing rules, if property in separate
ownership before 1916, then you are entitled to one well. If not separately owned until after 1916, but
carved out without any concern for minerals, then probably has right to one
well also.
a. Grounds for overruling an agency decision
(spacing rules):
i. claim order violates a statute
ii. claim order not supported by substantial
evidence in the record
II. LEASES
A. Property
Interests:
1. Fee interest - ownership of both the surface
and the mineral rights in a fee simple absolute.
a. A conveyance of land or all minerals conveys
every stick the grantor owns, except what you specifically reserve.
2. Surface interest: what remains in the bundle of rights with the
landowner after the mineral interest has been severed. It is all the rights that are not included as
part of the mineral interest.
a. landowner has a possibility of reverter, a royalty, and no responsibility for drilling or
maintenance fees.
3. Mineral interest: held by the owner of the minerals. Could be owned by the surface owner of could
be sold separately.
a. The rights held by the mineral interest:
i. right to enter and drill
ii. right to lease (executive right)
iii. right to receive the bonus (cash
consideration for the lease)
iv.
right to receive delay rentals
v. right to receive royalties (in best interest
to convey only this)
b. A conveyance of 1/16 of the minerals in and
under this land = 1/16 of the
minerals which is 1/16 of the 1/8
c. A conveyance of 5/8 of minerals in and under
the land reserving 4/8 = reserved
3/8. should have said reserved 1/2.
d. profit a pendre state - no ownership of
minerals until it is reduced to your
possession. Right to go on and get oil
is only right until oil is
removed.
e. To convey a mineral interest,
it must say “in and under the following
lands.”
f. Ownership in place - ownership
exists while oil is in the ground.
g. Be careful to exclude from a conveyance any
right that you want reserved or a conveyance of that right will be implied by
your failure to reserve - Anderson v.
Mayberry.
4. Leasehold interest: generally what is granted in an oil and gas
lease. The right to mineral interest
granted by an oil and gas lease. Also
called the working interest.
a. the usual oil & gas lease conveys a fee
simple determinable from
the lessor to the lessee. A mineral deed
actually conveys a fee simple to the grantee.
b.
a fee simple determinable may last forever, but is subject to automatic
termination upon the occurrence of certain conditions imposed by the lease.
c. Hunt
Oil v. Kerbaugh: unless language
says otherwise, lease gives oil and gas owner he right to make reasonably
necessary use of the surface to produce, drill for, develop, and explore oil
and gas. No duty to clean up when you
are done except in
i. Most leases today contain a clause
prohibiting operation within X feet of buildings, but applies only to buildings
on property at time of the lease unless says includes buildings hereinafter
constructed or get lessee to release the area around
the building. Is also common practice to
just go to the landowner and purchase a release of damages.
ii. Accommodation right - mineral owner’s right
to the surface is primary. But where
surface owner’s use of surface will be
effected and other options exist on the property,
must use method of least interference.
To modify the reasonable necessary provision, must have all three of the following:
a.
pre-existing use - lessor doing this before lease was taken.
b.
lessee wants to interfere
c.
lessee has reasonable alternative on the lease
iii. If lessee acting sloppily, maybe action at
common law under Environmental Torts:
nuisance, molecular trespass.
5. Royalty
Interests
a. a nonpossessory , cost free right to a share
of the gross production or a share of the proceeds from the sale thereof. It is a real property interest in
b. Royalty does not have the right of surface
use, the right to lease, and does not share in the benefits of the lease -
bonus, delay rental, or royalties - unless have a leasehold royalty.
c. Types:
i. Landowners Royalty: the fractional share of production payable to
the lessor in the royalty clause in the lease. Usually 1/8, but can be
higher. Also called a leasehold royalty.
ii. Overriding Royalty: carved out of the lessee’s interest. Where a lease is assigned and an overriding
royalty is reserved. Ends when lease
terminates.
iii. Nonparticipating Royalty: carved out of the mineral interest that
entitles its holder to a stated share of production without regard to the terms
of any lease, though it is frequently measured by a leasehold royalty. Granted by the lessor. All you own is a royalty interest.
iv. Term Royalty: royalty interest carved out of the mineral
interest for a specific term, which may be fixed for X # of years) or defeasible (for X # of years and so long
thereafter as there is production for the premises).
v. Perpetual Royalty: a royalty that may be extended forever; it is not limited in time.
vi. Mineral Royalty: similar to a defeasible term royalty in a
common law state; it is subject to prescription for nonuse and will terminate
in 10 years if production does not occur.
d. A lease royalty is created by the lease
clause and expires with the lease. The
landowner gets the royalty stick back when the lease expires.
e. A conveyance of 1/2 of the royalty in and
under this land = 1/16 of gross production.
The entire royalty is 8/8, so 1/2 = 1/16. This royalty will fluctuate depending on the
marked, but never lower than 1/16.
f. A conveyance of 1/16 royalty is now accepted
as meaning 1/16 of the 8/8 royalty or 1/2 of it. This locks then in to 1/16 and it does not
fluctuate.
g. A conveyance of “1/160th part of all oil, gas, petroleum, sulfur,
and all other minerals that are produced and saved from the following lands” =
a conveyance of a royalty interest - Barker
v. Levy. You only have the right to
go in and get it.
6.
Requirements of a Conveyance:
a. name of grantor
b. words of grant - hereby grant,
sell and convey are magic words
c. name of grantee
d. description of the land
e. signature of the grantor
f. acknowledgment - if eligible to be recorded,
it must contain this - verification that
this is a true conveyance to provide notice to
subsequent purchasers
g. delivery - to party or their
agent.
7. You can’t convey what you don’t have. Even if you execute a deed, it is void. An attempt by grantor to convey more than he
has passes only what the grantor has.
IV. THE OIL & GAS LEASE
A. Purpose:
1. Lessee seeks the right to develop the leased
land for an agreed term without any obligation to drill. If production is obtained, the lessee wants
the right to maintain the lease for as long as is profitable.
2. Lessor wants the lessee to find and produce
oil because will allow him to collect his royalty.
B. The
basic clauses:
1. The
Granting Clause:
a. defines what right are give by the lessor,
describes the property, sometimes covers specific substances, often contains a
“mother hubbard clause” which provides that the grant will cover other lands owned or claimed by the
lessor in the area, even if they
are not specifically described.
i. In Tex., protects the lessee against
inaccuracies in a legal description caused by incorrect surveys, careless
location of fences, or other such mistakes, but does not act to convey large
tracts of land the parties have not chose to grant in the lease.
C. Habendum Clause: “The lease shall be for __ years from this
date (called the primary term) and as long thereafter as oil and gas, or other
minerals are produced.”
1. Primary Term: Sets the maximum period lessee can keep the
lease without drilling. Fixed period
during which the lessee will have no obligation to conduct drilling operations
and secure production on the property. - unless the lease was being drained and
that would be covered in a covenant.
a. If lessee chooses not to drill during the
primary term, he will still have to pay delay rentals to keep the lease in
effect.
2. Secondary Term: created by the language “as long thereafter
as oil, gas, or other minerals are produced.”
MAJORITY RULE: With only a
habbendum clause, you can’t wait until the last day of the lease to drill. Must drill and have production before the
primary terms ends (TX, LA, NM, MI, OH, IL).
a. Requirement of Production:
i. Actual production is required by most states
to extend a lease into the secondary term.
ii. MINORITY view: lease will not terminate if oil and gas is
discovered prior to the end of the primary term (OK,
b. How much production:
i. Unless lease says “whether or not paying
quantities”, must produce in paying quantities.
Two part test:
a.
have the operations been profitable?
1.
revenues from sale of product are greater than operating costs.
a. operating costs v. capital costs
i. predictability - expected or periodic
indicates operating
ii. Is it something new - if so, capital
iii. Size and cost - the higher, more likely to be
capital
iv.
Nearness in time to drilling operations tends
to show a capital expenditure.
v. Does it
extend the life of the well? If so, tends
to look like a capital cost. Pshigoda v. Texaco: costs of reworking the well are capital and not
deducted from profit.
b. Stanolind Oil and Gas v. Banhill: Paying quantities
requires that production occur prior to the
end of the primary term. If no market
for sour gas
at the time it is extracted, no gas is being sold,
therefore, no production and the lease expires.
b. Would a
REASONABLE PRUDENT OPERATOR continue
to operate the lease? (applies even if appears
to be operating at a loss.)
i.
ii. factors:
depletion of reservoir and price for which lessee is able to sell his
product, relative profitableness of other wells in the area, operation and
marketing costs of the lease, net profit, lease provisions, reasonable period
of time under the circumstances, and whether or not lessee holding lease for
speculative purposes.
iii. If all you have is de minimus production, but
want to keep the lease, need to get landowner to agree to amendment.
c.
Temporary Cessation Doctrine - once actual production and
marketing in paying quantities have been established, a temporary cessation of
production, due to a sudden stoppage of the well or some mechanical breakdown
of the equipment, or the like, will not terminate the lease if the lessee
exercises diligent efforts to restore production and there is a reasonable
expectation of success within a
reasonable period of time. Usually about 60 days - Pack v. Sante Fe Minerals.
Lease to continue after primary term as long as production does not
cease for 60 days without resuming. BUT
must actually have production before can have cessation. A well that has never produced can not cessate -
1. Court considers three factors: duration of cessation - longer the time more
likely to be permanent; cause of the cessation - if not within lessee’s control
most likely temporary; lessee’s efforts to restore production - if slow to act,
cessation most likely permanent.
a. Arkansas Supreme Court held that a cessation of production for more than 4 years as
the result of a fire at the well was temporary.
Saulsberry v. Siegel. This is most likely the outer limit of a
temporary cessation.
b.
2. Savings Clause - To avoid litigation
over what “temporary” means and how long
is a reasonable time to restore production.
It specifies that a cessation of production will not cause the lease to
terminate as long as the lessee commences corrective work within a stated
period of time, like 60 to 90 days.
3. when you have two or more defensive clauses
with different time periods, to be safe,
should operate under the shorter time period, or to be even safer make the time
periods all the same.
d. Shut-in Royalty Clause - permits the
lessee to maintain a lease upon which
wells are shut-in (capable of producing but are not) by payment of a shut-in
royalty. “While there is a gas well or
wells on the land covered by this Lease or acreage pooled therewith, whether it
be before or after the primary term hereof, and such well or wells are shut-in,
and there is no other production, drilling operations, or other operations
being conducted capable of keeping the Lease in force under any of its
provisions, lessee shall pay as royalty to lessor (and if it be within the
primary term hereof such payment shall be in lieu of delay rentals) the sum of
a $1 per year per net mineral acre, such payment to be made to the depository
band hereinafter named on or before the anniversary date of this Lease next
ensuing after the expiration of 90 days from the date such well or wells are
shut-in, and thereafter on the anniversary date of the Lease during the period such
wells are shut-in, and upon such payment it shall be considered that this Lease
is maintained in full force and effect.”
1.
well must be capable of producing if paying quantities
a. A shut-in well is when the control valves of
a producing well are turned to the stop production.
2. most often occurs where a well is completed
but is just waiting for a market
a. If the clause’s language does not limit its
use - by referring to lack of market or pipeline connections, for example - the
clause should be held applicable whatever the cause of the shut-in so long as
the lessee acts for a good faith business purpose.
3. need this to prevent the lease from
terminating at the end of the primary term, even when the well is capable of
producing (TX, NM).
4. provides for constructive production,
typically in the form of shut-in royalty payments.
5. failure to make the shut-in royalty payments
will result in the termination of the lease
6. If you have a 60 day clause and a 90 day
grace for shut-in, 60 day clause wins and you must pay within 60 days. That is why
you want operations habendum.
7. If you shut-in clause doe not specify the
time that the shut-in payment is due, payment is due before the well is
shut-in. Pay as near to shut-in as can. May have to consider double payments to be
safe.
8. If you pay the wrong person, you will lose
the lease. Acceptance of royalty
payments, however, does not estop the lessor from terminating the lease. (this
is different from delay rentals).
9. If have a strong shut-in royalty clause,
don’t really need a strong force majeure clause. Make sure you draft it so it applies to both
oil and gas wells.
3. Delay Rental Clause: “if operations for drilling not commenced
within one year from the date of this lease, the lease shall terminate unless
lessee pays delay rentals of $__ to the lessor.”
a. Failure to pay delay rentals
will cause the lease to terminate:
i. failure to pay on or before the due date (on
time)
a. acceptance of a payment late is conduct
inconsistant with expiration of the lease, so lease remains in effect.
b.
clause allowing for mailing of delay rentals - if not delivered on time, lease
still in effect.
ii. in at least the proper amount (right amount)
a. Express clause: If lessee shall on or before the due date,
make a bona fide effort to pay rentals, and such payment is ineffective, (there
is a notice component also) lessee shall be obligated to pay proper rental but lease shall not terminate.
Requires that this clause be placed in the lease and a good faith effort on the
part of the lessee to pay the correct amount or the correct person.
b.
Errors made by bank are not chargeable to the lessee.
c. Schwartzemberger
v. Hunt: paying less than the
correct amount will allow the lease to expire.
iii. to the proper parties (right people)
a. if in doubt, pay each heir the highest amount
that could be entitled to.
iv. in the manner provided (right away)
b. Delay rentals can not be made after the
expiration of the primary term. Only
production in paying quantities will hold the lease after the primary term.
c. This is a condition of title and not a
covenant because it provides options.
The unless for provides lessee with three options: drill, pay, or
lose the lease
d. Humble
Oil v.
e. Clauses that requires lessor to notify the
lessee that the delay rental has not been paid and give him 30 days to remit
payment is repugnant to the delay rental clause and will not be upheld.
f. Drilling Operations:
1. Most leases provide that the lease will be
maintained if the lessee commences drilling operations. Actual drilling is not required. It generally is sufficient if there are some
physical operations on the surface of the land, directly related to drilling,
which are conducted in good faith, provided those operations are diligently
pursued until a well is completed.
ii. road
building and operation to prepare to drill
2. Getting a rig you know is not capable of
drilling an oil well
will not commence drilling. It must be
capable of drilling.
3.
4. Dry Hole clauses - Used to clarify
the payment of delay rentals after the lessee has drilled a dry hole. Always affirms the lessee’s right to maintain the lease for the remainder of
the primary term by paying delay
rentals. A well is not dry if you
actually find something -
5. Operations clause - Used to protect
the lessee against expiration of the primary term while drilling operations are
in progress. Makes drilling operations
the equivalent of production for
the purposes of the habendum clause.
a. Need to be careful in the wording in such
clauses. Some clauses have been written that only permits completion of the operations begun before the
end of the primary term. A better clause would be one that
will permit the lessee to commence
a well before the end of the primary term, abandon
it after the primary term and continue to hold the lease by starting another well within 60 days.
b. If you have an operations habendum, you
don’t really need a 60
day clause.
c. Should you define operations?
i. Without a definition, term is construed
liberally in favor of the
lessee.
ii. If you define it, you are limited to what
you defined. If you go to far, you may have adhesion problems.
6. Force Majeure clause - lists acts of
God and other catastrophes beyond the reasonable control of the lessee that
will excuse the lessee from performing certain acts, which if not performed
would have terminated the lease.
a. Only excuses obligations and habendum is not
an obligation. Force majeure should say
that your primary term is extended during force majeure situations.
b. If you don’t have one, you can’t plead it - Perlman v. Pioneer Limited Partnership. Equity won’t help either because it only
protects against forfeiture and forfeiture would not occur. Lease would just expire.
V. THE LEASE ROYALTY CLAUSE
A. Cost
Free
1. The royalty interest is free of the costs of
development, exploration, and production.
2. Is not
profit-sharing or cost-bearing.
B. Deductions
from Royalty
1. Majority Rule: a royalty may be subject to other costs, like
those subsequent to production such as cleaning, transportation, and pipeline
costs. Oil royalties may also be reduced
for processing costs like pulling out the salt water. Market value at the mouth of the well.
2. Minority (OK. KA, CO): market value does not include transportation
and treatment costs to make it marketable.
C. Failure to pay royalty will NOT
automatically terminate the lease. This
is a covenant, and liability for its breach will be restricted to damages.
1. Government leases may contain a clause
causing automatic termination if royalty is not paid.
D.
Division Orders
1. an agreement by those entitled to share in
production proceeds as to how the funds should be distributed. They are used to protect the lessee from
being caught in the middle of disputes over who should be paid.
2. Division orders are signed by all those who
may claim a share of the proceeds, and they bar the co-owners from suing the
party to whom the division order is addressed if there are subsequent
disagreements over the way in which the proceeds were divided.
3. Lessee liability
a. as a general rule, a lessee or purchaser who
pays according to the amounts warranted
by the division order is protected even though one owner is later found to be
overpaid. However, the underpaid owner
may revoke the order, correct the error, and receive the proper amount in the
future, but may not recover past underpayment from the lessee.
b. Exceptions:
The Texas Supreme court has held a lessee liable for past deficiencies
in royalty payments where:
i. the lessee prepared the erroneous division
orders AND
ii. the lessee was unjustly enriched by his own
error.
4. After
1991, lessee can require lessor to sign a division order, but set a form lessee must
use. Can’t sneak provisions in ratifying
other leases or those
will be void.
E.
The Market Value Problem:
1. This
occurs where one is determining the market price at the well. In
a. transportation cost if
reasonable
b. processing costs if reasonable
c. costs of running the processing plant if
reasonable
2. How to
determine market value: generally done
by reference to the geographic area in which similar gas is
sold. So, look at comparable sales.
F. Royalty on take or pay clauses: A gas contract on take-or-pay clause
obligates a purchaser to pay for a percentage of the gas that the producer can
produce, whether or not the purchaser actually takes it. Payments by the purchaser to the lessee.
1. Typical lease states “buyer will take, or pay
if not taken, $__ mcf/day.” Buyer must pay for contract volume and
contract price.
a. Majority Rule: lessors cannot secure any share of take or
pay payments made to their lessees because royalty not due until gas actually
produced.
b. take or pay payments are based on gas not
produced; royalties are due only on gas that is PRODUCED. Therefore, lessors do not share in the take or pay payments. Diamond
Shamrock v. Hodel.
c. If a settlement of a take or pay clause were
to effect and change the royalty, the lessor may have a better claim, but if
the reasonably prudent operator were to make the settlement, probably no claim.
i. Minority
View: Frey v. Amoco Production: “look
not at the parties’ intent to provide expressly for take-or-pay payments, but
rather at the parties general intent in entering an oil and gas
lease...reflecting the mutuality of objectives and sharing of benefits inherent
in the lessee-lessor relationship.” (
G. Proceeds Clause - “on gas, 1/8 of
market value; provided, that if lessee sells the gas [at the well, on the
lease, or in the field] then the royalty shall be 1/8 of the amount the lessee receives from the sale.” The best clause would say whether before or
after processing. If gas is not sold,
then no royalty is required.
1.
Majority Rule (TX, LA) - absent something in the lease to the contrary,
royalty means 1/8 market value at well on day produced. This means royalty goes up with
the market price.
2. Minority - royalty paid only upon market
value provided in the contract if said value is prudent and in good faith.
VI. IMPLIED COVENANTS IN OIL AND GAS LEASES - violation of an implied covenant will not
automatically terminate the lease.
A.
The Covenants: (all held to the reasonable prudent operator standard)
1. To Develop
2. To Protect
3. To Manage
B. In
1. Implications to the “In fact” designation
a. Statute Of Limitations for breach of contract
applies - statute begins to run
when should have realized it, not when actually realized it.
b. the lessee remains liable even after
assignment of the lease
c. allows the parties to contract around them if
they want to . No punitive damages in
C. The
Standard of Performance:
1. THE REASONABLY PRUDENT OPERATOR: the lessor has the burden of proving that the lessee has failed, as to
a particular implied covenant,
to do what a reasonably prudent lessee would and should have done in similar circumstance. Usually means that the lessor needs to show
that the action would have been profitable to the lessee.
a. The drilling expenses are included in
measuring profitability under implied covenants.
D. The
Implied Covenant to Protect: also known as the covenant to protect
against drainage. Requires that lessee
act as a reasonably prudent operator to protect the leased premises against
drainage. This is an exception to the
general rule that the lessee has no obligation to drill during the primary
term. Payment of delay rental payments
is no bar to a claim under this covenant.
1.
Elements:
a. substantial damage
b. reasonable prudent operator would drill a
well to protect the premises against drainage. - the well would have been
profitable.
c. damages - measured by royalty the lessor
would have obtained had the offset well been drilled with interest to date
of trial. Need to
prove with reasonable certainty the quantity of production that the
offset well would have achieved.
d. lessor must give lessee notice of demand and
time to remedy.
e. applies to field wide drainage. There is a duty to protect against field wide migration subject to the RPO
standard.
2. Remedy:
a.
In
b. If
legal remedy insufficient,
E. The
Implied Covenant to Develop:
Once oil and gas are found on the premises, the courts have recognized
an obligation to continue to develop the premises reasonably. An economically motivated prudent operator
will fully develop resources under his control within a reasonable period of
time. Lessee must proceed diligently
-time is an important factor. If paying
delay rental payments, don’t have to worry about this.
1. Elements:
a. there is a probability that additional wells
drilled would return the costs of
drilling, completing, and operating, plus a reasonable profit.
i. Can refer to geological testimony as to
probable sites, technological information from nearby wells to establish
probability and productive capacity, and financial statistics of production
prices.
b. the lessee has acted imprudently in failing
to drill such wells
i. Successful development of nearby property,
passage of an extended period of time without development, and willingness of
other operators to drill may suggest a breach.
c. damages (equal to amount of royalty lost
because of the lessee’s failure to drill developmental wells) are subject to a
4 year statute of limitations. This can
be difficult to prove.
d. Lessee needs to be informed of his breach and
should be given opportunity to redeem himself, by commencing further
development within a reasonable time.
Notice and demand are only required when seeking termination of the
lease.
e. If lease contains a clause pertaining to
development or limiting the scope of this covenant - lessee not required to
drill more than X wells per X acres -
will be upheld by the court and this covenant will not apply unless court views
the number of well established in the lease to be a minimum number of wells.
2. Remedy:
a. Cancellation:
Common remedy in
b. Conditional Cancellation: lessee is ordered to commence additional
development within a stated period or suffer cancellation of the lease.
c.
Damages: may be awarded in addition to
cancellation or solo.
3. In large tracts, it may not be a good idea to
rely on this covenant, instead have a continuous
drilling clause in the lease - if you develop the land, you have an
obligation to drill another well in so many days after the first well is drilled. So you are required to continuous drill the
premises until you reach a certain density specified in the lease. Failure to drill to this density will
obligate the lessee to release the undeveloped tracts back to the lessor.
F. The
Implied Covenant to Manage: Includes
the duty to market, operate with care, apply for exemptions, variance, permits,
manage property in a safe condition (diligent and proper operation), etc. Could include a duty to Farm Out.
1.
Elements of covenant to market:
a. requires the lessee to market production from
the leased premises within a reasonable period to time (more time for gas) and at the best available price.
i.
ii. Lessee has a good faith duty to obtain the
highest price for the product. Amoco v.
iii. favored notion clause - clause
allowing lessor to get high revenues from purchaser for production as the
market goes up. Courts no longer like
this. To be sure getting same as everyone
else in the area.
iv. Notice to the lessee is essential where the
lessor asks the court to exercise equitable powers to cancel the lease. May also be required by the contract
principle of cooperation whenever the basis for the claim of breach of the implied
covenant is the lessee’s failure to market the product within a reasonable
period of time; presumably, the lessee can mitigate the lessor’s damages by
acting promptly after such notice.
v. Lessor cannot be held to have waived this
covenant unless he knowingly ratified the terms of a gas contract.
vi. The purpose of the shut-in royalty clause is
protect the lessee against loss of the lease for failure of production where
marketing isn’t possible or advisable, not to relieve the lessee of the duty to
market.
b. Must show the lessee acted imprudently
i. Amoco v. First Baptist: proved that other owners had contracted
to sell their gas on substantially better terms than those obtained by
Amoco. Amoco had obtained a substantial
improvement in the price that it received under the 1969 contract by trading
off the interests of the lessors.