Maintaining HBP Oil Leases During the Pandemic (Pt. 1)
The West Texas Index’s (“WTI”) historically low prices for crude oil due to the Coronavirus and its impact on the economy have raised questions for Texas operators and lessees of oil wells held by production. This paper, which is the first of two parts, discusses many of the questions that our clients, both independent operators and mineral owners, have presented to us in light of the pandemic. Part 2 of this paper discusses common lease provisions and operator obligations under the Texas Natural Resources Code that operators should be particularly mindful of in light of the pandemic and the resulting downturn in the energy market. Part 2 also discusses some potential solutions to the questions presented and issues raised in both part 1 and part 2 of this paper. The following is a link to part 2 of this blog: https://www.steedbarkerlaw.com/blog/maintaining-hbp-oil-leases-during-the-pandemic-pt-2
A. Common questions pertaining to operations of oil wells on leases held by production.
1. Do oil and gas leases permit the operator to cease production given that the operator may not be able to market and sell oil?
In short, the operator may not completely cease producing oil on a lease without terminating the lease unless permitted to do so pursuant to a savings clause in the lease or some other agreement with the mineral owners. Most leases contain the following savings clauses that are relevant to this discussion: (a) the shut-in royalty clause, (b) the force majeure clause, and (c) the cessation of production clause.
Shut-in royalty clauses typically state that if a lessee drills a well during the Primary Term that is capable of production in paying quantities and that well is shut-in for lack of market maintenance, the lease will not expire and will be held in force so long as the lessee makes some nominal payment to lessor. Lessees should carefully review these clauses to identify which circumstances would permit the lessee to pay shut-in royalties and how long the royalties would hold the lease. Unfortunately for operators of oil leases, most shut-in royalty provisions only apply to wells that are classified as gas wells. As such, the shut-in royalty provision in any given lease would probably not support cessation of production from an oil well unless the lease expressly states that the provision applies to oil wells. If the lease does permit shut-in of an oil well, then lessee should strictly abide by the royalty provisions delineated in the shut-in provision.
The force majeure clause is designed to prevent termination of a lease due to lack of production in paying quantities when the cessation is beyond lessee’s control. The scope and application of force majeure clauses are strictly construed as defined in the lease, and courts interpret these clauses based on the “plain, ordinary, and generally accepted meaning of the language.” See, e.g., Sun Operating Ltd. Partnership v. Holt, 984 S.W.2d 277, 288 (Tex. App. – Amarillo 1998, writ denied). Force majeure clauses do not typically provide exceptions for petulance or disease. It is unclear if the Coronavirus would trigger a more generalized force majeure provision. Until such time as this issue has been litigated and adjudicated, the prudent lessee should not rely on force majeure provisions for cessation of production.
Many force majeure clauses do contain provisions permitting cessation if the operator is prohibited from operating by any law, order or rule. In Texas, Governor Abbott recently issued an executive order implementing essential services and activities protocols. “Essential Services” are those delineated in Version 2.0 of the U.S. Department of Homeland Security’s Guidance on the Essential Critical Infrastructure Workforce, which states that “workers supporting the energy sector, regardless of the energy source” are considered essential. Given that operators and oil and gas purchasers are part of the essential work force, lessees should not rely on the stay-in-place order as a justification for ceasing production.
The cessation of production clause codifies the temporary cessation of production doctrine by providing express terms for resuming production of a well. Although most leases contain cessation of production clauses that give the operator a period of time to resume production [usually sixty (60) to ninety (90) days], the cessation must result from the well breaking down, usually from mechanical failure. Consequently, the economic downturn would not trigger the protection afforded the operator under the cessation of production clause.
In sum, lessees and operators are afforded little protection under the savings clauses of most leases unless the lease contains a shut-in provision or a force majeure clause that is expressly applicable to oil wells and the circumstances at hand.
2. Are lessees in danger of losing leases for a failure to produce in paying or commercial quantities?
The short answer to this question depends on the lease and the facts at issue, but lessees are not likely at risk of losing leases in the short term for a lack of production in paying quantities so long as production does not completely cease. Some of the modern customized leases we examine contain definitions for production in “paying” or “commercial” quantities. These definitions typically provide a formula (most commonly, profit over and above operating and marketing expenses) for a given period of time (e.g. three [3] months). Lessees should strictly construe these definitions when evaluating the level of income on production necessary to maintain a lease. In the example above, the lessee would be obligated to produce an average income over and above the cost of operating and marketing for a period of three (3) months. Prudent lessees should review their custom leases to ensure that they do not contain problematic definitions for “paying” or “commercial” quantities.
The majority of leases we review do not, however, contain express definitions for production in paying or commercial quantities. Texas common law has adopted a two-step approach to determine whether the lessee has maintained production in paying quantities sufficient to maintain a lease. See Clifton v. Koontz, 325 S.W.2d 684 (Tex. 1959). Under Koontz, the fact finder must first determine if the well turned a profit over operating and marketing expenses over a reasonable period of time. Id. If the well pays a profit over that time period, then the well is producing in paying quantities even if that income could never repay the initial capital costs or make the entire enterprise profitable. Id. at 690-91. The second step in assessing whether a well failed to return a profit over a reasonable time period requires the fact finder to determine if a reasonably prudent operator would continue to operate the well under the specific circumstances. Id. at 691. This an objective standard applied to the specific facts at issue, but the courts give the discretion to lessee in determining whether or not the well is profitable in light of considering several factors, including the depletion of the reservoir, the relative profitability of other wells in the area, and marketing and operating expenses. Id.
The court in Koontz also made clear that there is no set time period that the court looks to when applying the production in paying quantities doctrine. In Koontz, the lessor argued that the lease terminated when the well failed to operate at a profit for two (2) months. Id. at 690. The court rejected this argument, stating that “there can be no arbitrary period for determining the question of whether or not a lease has terminated.” Id. If anything is to be gleaned from case law on this subject, it is that the time periods for determining profitability are always fact specific. See, e.g., Sullivan v. James, 308 S.W.2d 891 (Tex. Civ. App. – San Antonio, 1958) [six (6) months]; and Pshigoda v. Texaco, Inc., 703 S.W.2d 416 (Tex. Civ. App. – Amarillo, 1986); BP Am. Prod. Co. v. Laddex, Ltd., 458 S.W.3d 683 (Tex. App. – Amarillo, 2015) [holding that fifteen (15) months did not constitute a reasonably sufficient amount of time to analyze production in paying quantities].
Given the volatile nature of the oil and gas business, particularly in light of the Coronavirus, courts are not likely to consider time periods of less than one (1) year when applying the production in paying quantities doctrine. See Caleb Fielder, Marginal Wells and the Doctrine of Production in Paying Quantities, 57 Landman Mag. 2, 3 (2011) [stating that courts rarely consider periods under one (1) year]. Moreover, it is probably reasonable for an operator to continue to operate under the expectation that the recent market downturn will correct itself after the quantity demanded for oil has returned in whole or in part following the recession of the Coronavirus.
The conclusion here is that in the short term, lessees are not likely to lose leases currently held by production for failure to produce in paying quantities unless the lease at issue contains a definition for a production in paying quantities that contains a very short time frame for analyzing profitability. Prudent lessees should review their custom leases for such definitions to ensure that they can produce in paying quantities for the defined period. If there is no definition of production in paying or commercial quantities in the lease, operators would probably be able to hold the lease if they can maintain production in paying quantities as averaged over a one (1) year period, depending on the circumstances and whether or not a prudent operator would continue to produce over that period.
3. What are the operator’s duties under the implied covenants in an oil and gas lease held by production?
There are several implied covenants in an oil and gas lease that can be broadly categorized into the following: (1) the implied covenant to develop the premises; (2) the implied covenant to protect the leasehold; and (3) the implied covenant to manage and administer the lease. Amoco Production Co. v. Alexander, 622 S.W.2d 563, 567 (Tex. 1981). The standard of care in testing the performance of implied covenants by lessees is that of a “reasonably prudent operator under the same or similar facts and circumstances.” Shell Oil Co. v. Stansbury, 410 S.W.2d 187, 188 (Tex. 1966). Every claim of improper operation or a breach of implied covenants by a lessor against a lessee should be tested against this duty. Note, this an objective standard that is applied to specific sets of facts.
When the lessor claims that lessee has breached this duty, the lessor has the burden of proving that the lessee has failed to act as a reasonably prudent operator. Thus, the reasonably prudent operator standard requires that the lessor prove that the desired action by the lessee would be profitable to the lessee because a reasonably prudent operator does not seek to operate at a loss.
For example, the lessee does not have an implied duty to drill wells unless the wells would be profitable. To impose this duty on a lessee, the lessor would have to prove that lessee can recover oil and/or gas having a value in excess of all reasonable costs of drilling, producing, and marketing oil and gas. Notably, drilling expenses are included in measuring profitability under implied covenants. Given the current status of the oil market, lessees are not likely breaching an implied duty to drill new wells, but prudent lessees should be aware of any contractual drilling schedules and programs that would obligate them to continue to drill new wells within a given time frame.
Some of our clients have asked whether shutting in a producing oil well, if permitted under the lease or some other contract, would be a breach of the duty or implied covenant under the reasonably prudent operator standard. Shutting in producing wells may damage existing reservoirs, so the question is whether slowing or stopping production during such an extreme economic downturn would be reasonably prudent in light of the possibility of causing long term damage to the reservoir and, therefore, production. This question can only be answered on a case by case basis. Some of the relevant variables would be the type of formation at issue, the cost of shutting in and reopening a well for production, the current and forecasted price of oil, and the long-term effects of shutting in a well. In order to prove that lessee breached its duty of care, the lessor would have to prove that refraining from shutting in the well or slowing production would have been more profitable to the lessee than the alternative. This is essentially a speculative math question that would be very difficult for a lessor to prove by clear and convincing evidence in an action against operator for breach of an implied duty to act as a reasonably prudent operator.
Thus, the primary concern with shutting in a producing well is acquiring contractual consent from the lessor so as to avoid losing or breaching the lease. Nonetheless, a prudent lessee or operator would also include an acknowledgement from lessor in such contract stating that shutting in the well is reasonably prudent given the circumstances. The contract should also include a waiver of liability for shutting in the well. This covers both the contractual concerns and removes liability for breach of an implied covenant.
B. Conclusion.
Lessees should not shut in wells or otherwise cease production unless the lease or some other agreement with the lessor expressly permits the lessee and/or operator to do so. Lessees are probably not at risk of losing HBP leases from short term failures to produce in paying quantities unless the lease at issue expressly calls for a very short period for analyzing profitability. Last, when deciding how to manage and operate leases during the economic downturn, Lessees should carefully consider their leases and the implied covenants contained in same.
DISCLAIMER: Please be advised that the express language in any given lease and the particular facts at issue always control, so the prudent operator and/or lessee should thoroughly review leases before assuming that the general principals discussed above. Moreover, this paper was not intended to be, and shall not be construed as, legal advice. Should you have specific questions about this issue or any other oil and gas issues, please email me at wmadden@steedbarkerlaw.com.