CHAPTER 4 DIVIDING, SURRENDERING, AND ASSIGNING THE LEASE: HOW PUGH CLAUSES AND OTHER PROVISIONS CAN ALTER THE INTEREST COVERED BY A LEASE
| Jurisdiction | United States |
DIVIDING, SURRENDERING, AND ASSIGNING THE LEASE: HOW PUGH CLAUSES AND OTHER PROVISIONS CAN ALTER THE INTEREST COVERED BY A LEASE 1
Jessica K. Fredrickson
Davis Graham & Stubbs LLP
Denver, CO
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SAM NIEBRUGGE is a partner at Davis Graham & Stubbs LLP in Denver, Colorado. His practice focuses primarily on transactional matters for the oil and gas and mining industries. In addition to his work with oil and gas and mining producers at DGS, he worked in-house for a large independent oil and gas producer. He is experienced in drafting and negotiating purchase and sale, development, exploration, joint operating, farmout, and master services agreements, as well as various other agreements in the oil and gas and mining industries. He has experience in both asset and equity transactions. He also has extensive experience preparing all forms of title opinions covering fee, state, and federal lands. He is a trustee, member of the Financial Advisory Committee and Special Institutes Committee, and the co-chair of the Oil and Gas Section for the 2018 Annual Institute for the Rocky Mountain Mineral Law Foundation (RMMLF). He is also the former chair of the RMMLF Young Professionals Committee. He has authored several papers and spoken extensively to in-house counsel and at continuing legal education events on all matters associated with the oil and gas industry.
JESSICA FREDRICKSON is an associate in the Natural Resources Department of Davis Graham & Stubbs LLP. Her practice focuses primarily on preparing title opinions covering private, state, and federal lands. She also has experience in drafting various agreements associated with upstream oil and gas matters, including purchase and sale agreements, exchange agreements, oil and gas leases, and surface use agreements. Ms. Fredrickson attended Kansas State University, where she majored in Political Science and minored in English. She is also a recent graduate of the University of Oklahoma College of Law.
[1] Introduction
Among the most important factors in any oil and gas company's ability to develop and maintain a core area of operations is the ability to assign, subdivide, and maintain oil and gas leases. In some cases, a company may acquire oil and gas leases executed several decades ago that may not necessarily reflect or be suited for the realities of modern oil and gas development. In other cases, a company may seek to obtain a new lease and encounter a lessor with a sophisticated knowledge of oil and gas leasing and significant leverage in requesting the insertion of provisions beneficial to the lessor. Decades of jurisprudence interpreting oil and gas leases add another layer of complexity in this process, particularly given the incredible variety of oil and gas leases, with the difference of a single word in some cases entirely changing the effect of a particular provision.
Retained acreage and Pugh clauses are two of the more common types of provisions inserted into an oil and gas lease with the goal of protecting the lessor's interest, both from the perspective of encouraging the lessee to efficiently develop the leased premises and in preventing dilution of the lessor's interest. The primary focus of this article is upon these clauses, including commonly litigated issues and cautionary advice for practitioners who may be charged with drafting them in the future. Specifically, these issues relate to the events that may (or may not) trigger the operation of the retained acreage or Pugh clause, certain pitfalls that have caused confusion as to the scope of the portion of the lease subject to termination, possible disputes as to the horizontal application of such clauses, and the interplay between the express lease terms and the applicability of state statutes. In addition to retained acreage and Pugh clauses, this article discusses certain practical considerations in the inclusion and drafting of entireties clauses in modern oil and gas leases, as well as the realities and complications of assigning, and in some cases, electing to surrender, an oil and gas lease.
Unless otherwise noted in this article, we have focused on clauses in fee oil and gas leases. Much of what we have written in this article could be applicable to oil and gas leases issued by each state or the Bureau of Land Management on behalf of the federal government, but the laws, regulations, policies, and procedures applicable to those state agencies or the Bureau of Land Management may demand results that are contrary to our conclusions in this article. We encourage any person dealing with these state or federal leases to closely consult with the agencies and experts in the field to determine what effect, if any, the topics in this article have on such leases.
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[2] Common Drafting and Interpretation Issues in Pugh and Retained Acreage Clauses
In a typical oil and gas lease, the "habendum clause" provides the lessee the right to explore for and develop oil, gas, and associated hydrocarbons for a stated number of years (the "primary term") and so long thereafter as oil, gas, or associated hydrocarbons are produced in paying quantities from the leased lands or lands properly pooled, communitized, or unitized therewith (the "secondary term").2 Termination of the lease at the expiration of the primary term is subject to the operation of "savings" provisions in the lease, such as provisions related to the payment of shut-in royalties, temporary cessations of production, and drilling operations conducted by the lessee at the conclusion of the primary term.3 Subject to the lessee's right to pool or unitize under the terms of the lease, the express consent of the lessor to pool or unitize, or the operation of compulsory pooling or unitization statutes, the lessee may also extend the lease into its secondary term by virtue of production from lands pooled, communitized, or unitized with the leased lands.4
As a general principle, oil and gas leases are indivisible, meaning that production from or operations upon a portion of the leased lands (or lands properly pooled, communitized, or unitized therewith) may constitute production or operations sufficient to maintain the lease as to all leased lands.5 Lessors and
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lessees may modify this principle by including a retained acreage clause or a Pugh clause6 in the lease. Although frequently confused, these are two distinct types of clauses.7
The retained acreage clause8 modifies the habendum clause by providing that at the expiration of the primary term or the cessation of continuous drilling operations, the lease will automatically terminate as to all lands except those upon which a productive well is located or that have been included within a drilling, spacing, or proration unit.9 The Pugh clause,10 sometimes referred to in Texas as the "Freestone
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rider," modifies the effect of pooling by providing that production from or operations upon a pooled unit will serve to extend the lease only as to the lands included within the pooled unit.11
While these clauses in some instances present unique drafting issues, in many cases, they present common drafting and interpretation issues, and accordingly, much of the remainder of this Section applies generally to both retained acreage and Pugh clauses. Given the possibility of partial lease termination, practitioners should use great care in drafting these clauses, particularly with respect to the events that trigger their operation and the scope of the lands to be retained by the lessee, both in a vertical and a horizontal context.12 In addition, notwithstanding the express terms of the lease, it should also be remembered that a few states have enacted statutory Pugh clauses that may cause a partial termination of the lease, as discussed in greater detail in Section [2][D].
[A] Events Triggering Operation of the Retained Acreage or Pugh Clause
[i] Triggering the Retained Acreage Clause
The retained acreage clause has gained increasing popularity in recent years and, in many cases, is intertwined with the continuous operations provisions of the oil and gas lease.13 Of critical importance-and the source of much litigation-is the question of when the retained acreage clause is triggered. In most cases, the retained acreage clause provides that the lease will terminate at the later of the expiration of the primary term or the cessation of continuous operations.14 Texas, however, has seen a recent spate of
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litigation regarding whether the retained acreage clause requires termination of the leased lands not only as to lands not included in proration units upon the later of these two events, but also requires termination on a rolling basis as to the remaining lands as wells cease to produce.15
The Texas Court of Appeals for the El Paso district has considered this particular issue in great detail in recent years, twice refusing to uphold a rolling termination of the leased lands unless the lease is expressly clear that the parties intended such a result.16 First, in Chesapeake Exploration, L.L.C. v. Energen Resources Corp., the court interpreted the effect of a retained acreage clause stating that the lease would terminate as to all acreage except for that included within a proration unit with a well capable of producing oil or gas in commercial quantities.17 Chesapeake Exploration, L.L.C. ("Chesapeake") argued that this required termination not only upon the expiration of continuous drilling operations, but also on a rolling basis thereafter as wells ceased to produce.18 Chesapeake based this assertion largely upon the use of the term "proration unit" in the retained acreage clause.19 Specifically, Chesapeake submitted that because the proration unit itself exists only so long as the well produces, upon plugging and abandonment of the relevant well, the proration unit no longer existed.20 The use...
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