CHAPTER 11 LEASE MAINTENANCE CHALLENGES
| Jurisdiction | United States |
(Dec 2010)
LEASE MAINTENANCE CHALLENGES
Ryan J. Morgan 1
Attorneys, Steptoe & Johnson PLLC
Charleston, West Virginia
SHARON O. FLANERY is a member of Steptoe & Johnson and is located in their Charleston, West Virginia office where she leads the firm's Energy group. She concentrates her practice in energy and mineral law with a client base that includes major oil and gas, coal, coalbed methane, pipeline and hydro companies. Her experience includes drafting, negotiating and interpretation experience with mergers and acquisitions, leases, joint venture agreements, contract mining agreements, joint operating agreements, sales and marketing agreements, and gathering, transportation processing agreements as well as due diligence experience in acquisitions and divestitures. Ms. Flanery is the recipient of the Best Lawyers Oil & Gas Lawyer of the Year award for 2011 for the Charleston, West Virginia metro area and has been recognized by "The Best Lawyers in America" in the fields of energy, mining, natural resources and oil and gas law. She is also recognized by "Chambers USA" as a band one, leading lawyer in the Natural Resources field. Ms. Flanery received a Juris Doctor degree from Duquesne University in 1991, where she was a member of the Law Review and she received a Bachelor of Science degree in petroleum engineering from West Virginia University in 1978, graduating cum laude. Prior to joining Steptoe & Johnson, Ms. Flanery served as Vice President of Exploration for Columbia Natural Resources Inc., where she was responsible for the Geoscience, Reservoir Engineering, Gas Supply, Marketing and Land Departments. Previously she was Assistant General Counsel at Columbia Gas Transmission Corp. and NiSource Corporate Services Company and was a member of the Law Department of CONSOL Inc. in Pittsburgh. Before obtaining her law degree she worked as a reservoir engineer in Appalachia and also at Aramco in Saudi Arabia in the early 1980s. Ms. Flanery is a member of the West Virginia, Pennsylvania and District of Columbia bars and holds a United States Patent and Trademark License. Ms. Flanery serves on the Board of Directors for the Black Diamond Girl Scout Council and is a Trustee for the Energy and Mineral Law Foundation. Ms. Flanery is also a member of the Advisory Accreditation Committee for the Department of Petroleum Engineering at West Virginia University. She has authored a number of papers. In the past, Ms. Flanery served on the Board of the West Virginia Chamber of Commerce and was President of the Alumni Association for WVU Minerals and Energy Resources Department. She is a past named Outstanding Alumni of the Year for the WVU Minerals and Energy Resources Department and she was selected as a guest lecturer by the Dean of the WVU College of Engineering and Minerals for the Distinguished Lecture Series.
RYAN J. MORGAN is a member of Steptoe and Johnson in Charleston, West Virginia. He concentrates his practice in the areas of energy, coal, oil, and gas with extensive experience in transactional, regulatory and title matters. From 1999-2007, he was the Assistant Prosecuting Attorney in Tyler County, and from 1998-2008, he was a solo practitioner. Ryan is a member of the Board of Directors, Sistersville General Hospital Foundation; Chair, Sistersville Heritage Foundation; West Virginia Governor's School Advisory Committee; Independent Oil & Gas Association; Energy & Mineral Law Foundation; NALTA; UTEC; Corporate Board, HOBY State Leadership Program; and the Lions Club. He has spoken and written numerous papers, and his professional memberships and awards include: "Generation Next," The State Journal 2010; Real Estate, Zoning & Land Use Committee, West Virginia State Bar; Mountain Honorary; West Virginia Law Review; Order of the Coif; and St. George Tucker Brooke, Fellow.
TABLE OF CONTENTS
I. Introduction
II. Legal Standards for Defining Key Contractual Provisions
A. Paying Quantities
B. Continuous Drilling and/or Continuous Operation
C. Temporary Cessation of Operations
III. Establishing Production
IV. Breaches of Implied Covenants
A. Covenant of Reasonable Development
B. Covenant of Further Exploration
C. Covenant to Protect Against Drainage
D. Covenant to Market Production
E. Covenant to Conduct Prudent Operations
F. Remedies for Breach of Implied Covenants
V. Defenses to Claims of Termination of a Lease
A. Estoppel/Waiver
1. Production Prevented by Lessor's Conduct
2. Suspended Operations During Lease Challenges
3. Lease Benefits Accepted by Lessor
B. Statute of Limitations/Adverse Possession
1. Statutory Period
2. What Does the Adverse Possessor Acquire?
3. Hostile Use
C. Leasehold Savings Clause
D. Shut-In Clause
E. Force Majeure Clause
F. Pooling Clause
VI. Other Challenges
A. Cotenants and Development
1. Majority Rule
2. Minority Rule
B. Unknown or Missing Owners
C. Free Gas Clauses
D. Shut-In Provisions
E. Royalties
F. Judicial Ascertainment
G. Apportionment
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I. Introduction
One of the most serious questions that oil and gas producers and anyone purchasing a lease must confront is whether the lease remains valid. Whether the lease is decades old or was signed recently, if the lease has expired by its terms, it is worthless to the lessee or anyone else who may be assigned the interest. Although there are risks involved in determining whether an oil or gas lease remains valid, there are steps that lessees can take when drafting leases to help maintain their interest in the future. Similarly, those seeking to purchase a lease can limit their risk if they know what provisions and what conduct to look for when performing due diligence.
This paper is intended to serve as a practical tool for those who either hold leases or are considering whether to purchase leases. Part I of this paper defines the legal standards which govern contractual provisions that will determine whether a lease will remain in effect. Part II addresses sources for finding information about a well's past production to assist in determining whether a lease has been held by production. Part III addresses implied covenants and the ramifications for a lessee when such a covenant is breached. Part IV examines defenses that a lessee may use to save a lease from termination. Finally, Part V looks at problems that may result from older lease language and highlights areas where lessees and purchasers should exercise caution.
II. Legal Standards for Defining Key Contractual Provisions
A. Paying Quantities
The habendum clause in most oil and gas leases contains language indicating that the lease is effective for an initial term and for so long as production of oil or gas "in paying quantities" (sometimes expressed as "in commercial quantities" or other similar terms) continues. Yet, rarely is the term "paying quantities" defined in the lease. This term is of special
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significance because, in the absence of production in paying quantities, the lease will automatically terminate at the expiration of the primary term. In many jurisdictions, the lease will also terminate automatically upon cessation of production after the expiration of the primary term unless the lease is extended by the operation of some special provision.
If not expressly defined by the parties, the phrase "paying quantities" has generally been held to mean profitable production after operating expenses have been deducted. The costs of drilling and preparing a well for production are not typically taken into account in determining whether the lease is producing or is capable of production in paying quantities. Generally speaking, if the well is producing at some level, the burden of proof is on the lessor to prove that production is not profitable and that a prudent operator would not continue to operate the lease under the circumstances.2
In West Virginia, the phrase "in paying quantities" is construed with reference to the good faith judgment of the operator. Under West Virginia law, a lessor cannot declare a lease forfeited merely because he thinks the quantity of gas produced is insufficient to constitute a paying well, as long as the lessee claims it is such a well and is willing to pay the rent stipulated therefor. Rather, it is for the lessee to say, when acting in good faith, whether the gas is producing in paying quantities.3 A profit over operating costs, even a small one, constitutes paying quantities when the operator is exercising its judgment in good faith. By contrast, the West Virginia Supreme Court has ruled that free oil or gas for domestic use is not enough, standing alone, to constitute production in "paying quantities."4
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Pennsylvania courts have held that "paying quantities" means production in such quantities as would yield to the lessee a reasonable profit after deducting the entire cost for drilling, equipping and operating the wells.5
In New York, the lessee has the initial right to determine whether production is in "paying quantities."6 New York follows the majority rule and evaluates paying quantities as follows:
So long as the lessee produced oil or gas, or both in what he believes, in good faith, to be in paying quantities so as to give him some compensation and pay royalties to the owners of the freehold, so long as he may stay in possession. After it is producing, he is the one that has the initial right to determine whether it is in 'paying quantities,' or in good faith if he determines that the production is not in 'paying quantities' he may abandon or surrender his lease. If, on the other hand, there is no production and it is reasonable from the facts to determine that production has finally ceased, then the lessor may recover possession of his lands free of the lease. Temporary cessation of production does not terminate the lease.7
In Ohio...
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