Maintaining HBP Oil Leases During the Pandemic (Pt. 2)
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 second of two parts, 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. This paper 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 1 of this paper: https://www.steedbarkerlaw.com/blog/maintaing-hbp-oil-leases-during-the-pandemic
A. Lease provisions and Natural Resources Codes to watch for during the downturn.
1. Royalty payment schedules.
Some of our clients have expressed a desire to slow or cycle oil production and to store the oil until such time as the oil may be marketed. This may be an acceptable approach if circumstances permit, but lessees and operators should insure that doing so does not violate lease provisions or the Texas Natural Resources Code pertaining to payment schedules on royalty. Lessees should also be mindful that cessation of production may terminate the lease. Moreover, some sophisticated leases contain provisions that make timely payment of royalty a condition to the effectiveness of the lease. Lessees should be especially careful about making timely payments under these provisions so as to avoid losing a lease as a result of a late or missed royalty payments.
With respect to codified obligations, the Texas Natural Resources Code § 91.402 states, “The proceeds derived from the sale of oil or gas production from an oil or gas well located in this state must be paid…on or before 120 days after the end of the month of first sale of production form the well.” After that period, the lease controls the payment schedules. If the lease does not contain a payment schedule, barring a reasonable title dispute or other exceptions contained in the Code, the subsequent proceeds for oil must be paid no later than sixty (60) days after the end of the calendar month in which subsequent oil production is sold. Note that the Code’s given deadline is based on the sale of production. This gives the operator some leeway in holding production until such time as it may be sold. Again, a prudent lessee would review its lease to ensure it does not contain more stringent requirements on payment of royalties.
2. Minimum royalty provisions.
Many customized leases contain minimum royalty provisions that are typically quantified on an acreage basis over a given period of time. Some of these provisions call for minimum royalties to be paid annually, semiannually, or even monthly. The effects of the Coronavirus on the market do not warrant a breach of minimum royalty provisions. As such, prudent operators and lessees should review their leases for minimum royalty provisions and make necessary and timely payments of same. If lessors agree in writing, lessees may be able to amend the lease to temporarily waive the minimum royalty provisions. This is further discussed in the last section of this paper.
3. Drilling schedules and programs.
Some leases contain drilling schedules or programs that contractually obligate the lessee to drill a certain number of wells over a given period of time. In extreme cases, these schedules may be a condition to maintaining all or some of the leased premises. Here again, the recent economic downturn would not relieve lessee from this sort of contractual obligation and/or condition. Consequently, prudent lessees should review leases for drilling schedules and programs in order to avoid breaching these contracts or failing to satisfy conditions associated with the programs or schedules. Here again, lessee may want to consider requesting a waiver of these provisions from lessor. The waiver should be clearly drafted and executed in writing by both lessor and lessee.
B. Potential solutions for maintaining economic leases during the downturn.
1. Cycling or otherwise slowing production.
Some operators may elect to cycle or slow production if it is operationally and contractually possible. This option may be permissible under the reasonably prudent operator standard given the dramatic drop in the WTI. Of course, lessees should also make sure that this strategy is permissible under the lease at issue, and as mentioned above, the lessee should continue to make timely royalty payments as provided under the Texas Natural Resources Code and/or lease.
As was discussed in part 1 of this Paper, Lessees have an implied covenant to market oil at a reasonable price and develop the leasehold, but the lessee has satisfied this covenant if lessee acted as a reasonably prudent operator. With West Texas crude recently trading at negative values, in most cases lessors would probably not prevail in a claim for breach of an implied covenant based on lessee’s temporary reduction in production. In this case, lessor would have the burden of proving that producing at previous levels would be more profitable to lessee. If lessee cannot market the oil at all or generate any income from its production, lessor would have trouble convincing the fact finder that it was unreasonable to slow production during the downturn.
That said, this general assumption is subject to the facts at hand. For example, if lessor can show that lessee did have a market for oil that would have permitted lessee to generate some income that would have been greater after considering all the variables of slowing production (e.g. operational costs of slowing or cycling production vs. operational costs of continuing production as it was), then lessor may have a claim for breach of an implied covenant. This also calls for the operator to make reasonable forecasts on future pricing of oil in determining whether or not it is reasonable to slow production or delay sales of oil. Here, a prudent lessee would thoroughly consider all the economic variables and seek legal counsel before choosing to cycle or slow production.
2. Shutting-in oil wells.
Most oil leases do not contain savings clauses permitting lessee to shut in oil wells—for further discussion on this issue, please see part 1 of this paper. Lessees will, therefore, probably need to modify their existing leases with lessors if lessees wish to shut in oil wells. There are several ways of modifying a lease to accommodate this option, but amending the lease via a form letter agreement is probably the most time efficient means to modify a substantial number of leases. In a perfect world, the letter agreement would contain all of the following:
(a) Deferral of any obligation to produce or restore production or commence additional operations on the lease or lands pooled therewith. The deferral should contain a time frame that acknowledges the termination of the amendment upon conclusion of the stated deferral period.
(b) A waiver of the implied covenant to market and develop the leasehold under the lease and the lands pooled therewith. This addresses lessee’s implied covenant to market the oil as a reasonably prudent operator.
(c) A waiver of any obligation to pay shut-in royalties, minimum royalties, and compensatory royalties during the deferral period.
(d) A waiver of any conditions pertaining to the timely payment of royalty during the deferral period.
(e) A waiver of the obligation to maintain production in paying and/or commercial quantities during the deferral period.
(f) A waiver of any drilling schedules or programs.
(g) An option to extend the deferral period if lessor and lessee mutually agree to extend the period in writing.
(h) A statement that the letter agreement and amendment contained therein does not waive any rights of lessee under the terms of the lease, including, but not limited to, the force majeure clause.
(i) Signature lines for both lessor and lessee.
(j) A statement that failure of one or more co-lessors to execute the agreement shall not in any way affect the validity of the lease or the amendment in the letter agreement as to those lessors that did execute the letter agreement.
If lessors agree to execute the agreement containing all of the above, lessee will be relieved from liability for shutting in the well, with respect to both contractual obligations and implied covenants. Lessee will also reduce its risk of losing the lease for failure to produce in paying quantities. Many lessors may not agree to any or all of the above terms, and many may request consideration before executing the agreement. In fact, we have advised our mineral owner clients to avoid executing these agreements unless they can acquire some consideration, whether it be monthly rental payments or more preferable lease terms in an amended lease. Lessee should consider such responses on a case by case basis, but if lessor does not waive both contractual obligations and the implied covenants pertaining to shutting in a well, then lessee should not shut in the well. Here, the lessee can consider reducing production or slowing the marketing of the oil as previously discussed, but again, lessee must be mindful of the lease at issue, the implied covenants contained therein, and the Texas Natural Resources Code.
C. Conclusion.
Lessees may consider slowing production or shutting in wells to address the economic downturn caused by the Coronavirus. Slowing production may be subject to lease provisions, implied covenants in the lease, and/or the Texas Natural Resources Code. As such, lessees are advised to review the facts and leases and seek legal counsel before exploring this option. Unless expressly permitted under the lease, shutting in oil wells will require a lease amendment. The amendment may be executed via form letter agreement, and the letter agreement should contain waivers addressing lease obligations, implied covenants, and the lessee’s obligation to produce in paying quantities.
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.