CHAPTER 4 DURATION OF THE LEASE AS DEFINED BY THE HABENDUM CLAUSE
| Jurisdiction | United States |
Drafting and Negotiating the Modern Oil and Gas Lease
(May 2018)
DURATION OF THE LEASE AS DEFINED BY THE HABENDUM CLAUSE
Washburn University School of Law
Topeka, KS
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DAVID E. PIERCE is a professor at Washburn University School of Law where he teaches courses in oil and gas law, energy regulation, environmental regulation, property, contracts, and legal drafting. He holds the Norman R. Pozez Chair in Business and Transactional Law. He is a past president of the Foundation.
I. Introduction
II. Analyzing Duration Issues
III. The Unspoken Issue
IV. When Did Speculation in the Oil Industry Become a Bad Thing?
V. What Really Motivates the Prudent Operator?
A. "Prudent" Operators Must Become "Scab" Operators
B. Why Should It Matter?
VI. The Meaning of "Produced," "Production," and Similar Language
A. The Required Act
B. The Required Amount
VII. Examining the Guts of Paying Quantities Analysis
A. The Three Basic Analyses
1. Kansas
2. Texas
3. Pennsylvania
B. Step One: Mathematical Cost Accounting
1. Revenue
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2. Expenses
a. Capital Expenses vs. Operating Expenses
(1) Direct and Indirect
(2) Frequent and Infrequent
b. Actual Paid Expenses
c. Imputed (Made Up) Expenses
d. Depreciation
e. Overhead
3. Accounting Period to Compare Revenue and Expenses
a. Self-Fulfilling Prophecy?
b. Information for the Prudent Operator?
C. Step Two: Justification for Maintaining a Losing Lease
1. Actions of a Prudent Operator
2. Actions of a Good Faith Operator
VIII. Critique and Recommendations
A. Drafting to Account for Reality
1. Substitute Minimum Royalty for Production
2. Patching-Up the Paying Quantities Analysis
B. Collapsing the Two-Step Analysis: The "Ritchie Analysis"
C. Making the Speculative Prudent
1. The Mathematical Context
a. Accounting Period
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b. Designated Expenses
c. Revenue Formula
2. Objectifying the Actions of Prudent Operators
a. Hope vs. Reason
b. Evidence to Establish Reason
IX. Conclusion
"One of the most notable acts of commercial suicide occurred when lessees embraced a fee simple determinable model for defining the duration of their lease rights." 1
I. Introduction
When it comes to the oil and gas lease, the industry has not been too creative. Most of its creations have proven to be woefully inadequate and often create more problems than they solve. For example, how did that drilling and delay rental clause work out? Driven by a form mentality proven problems are perpetuated and magnified. Oil and gas jurisprudence suffers from the same sort of rote. Or is it rot? We tend to focus on issues using whatever lens was created when the issue was first considered, often over a hundred years ago. There is a lust for certainty that has caused the industry to settle for things that are certain, but too often certainly bad.
This article focuses on the oil and gas lease habendum clause, particularly the paying quantities requirement. "Habendum clause" is a technical term used at common law to describe the part of a deed that states the duration of the interest granted. It typically began with the phrase "To have and to hold" and ended with a statement the property was being conveyed to the grantor "his heirs and assigns forever."2 The "heirs and assigns forever" established the duration of the grant: a fee simple absolute
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of unlimited duration. Today there is no need for a separate habendum clause because the duration will typically be reflected in the grant. For example, when "O conveys §303 to A" it will convey a fee simple absolute of unlimited duration.4 If the parties want to limit the duration of the grant, it will typically be stated as part of the grant, such as: "O conveys §30 to A for life."
Habendum clauses are uniformly found in oil and gas leases, usually as paragraph #2 of the document. The clause states the duration of the granted rights in terms similar to the following:
Subject to the other provisions herein contained this Lease shall be for a term of ___ years from this date (called "primary term") and as long thereafter as oil and gas or other hydrocarbons are being produced from said land or land with which said land is pooled hereunder. 5
The "Subject to the other provisions herein" language is intended to account for the drilling and delay rental clause and various savings clauses that are contained in other paragraphs of the lease. Although the limiting scope of the delay rental clause is well known, this language could create problems if a savings clause appears to be more limiting in some respect than the express terms of the habendum clause. It can be read to both expand and limit the effect of the habendum clause. As to savings clauses it is doubtful the "subject to" language is ever intended to limit the scope of the habendum
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clause as opposed to supplementing and expanding its scope. Nevertheless, the unlimited subject-to language is an unnecessary invitation to litigation.
This article does not address maintenance of the lease during the primary term. Although many leases still have drilling and delay rental clauses, the trend has been to replace them with the so-called "paid up" lease. Problems with the delay rental clause are often catastrophic because compliance with the strictures of the clause are typically a condition or special limitation on the life of the lease. Even though lessees hire an army of lease administrators, stuff happens. Delay rental payment problems will inevitably occur and when they do the impact is usually a loss of the lease.6
The "paid up" lease suggests either that the bonus has been paid to maintain the lease during the primary term or that delay rental is being paid in advance at the time the lease is taken. It is often unclear which is being done. Too often the provision is drafted to suggest that a separate payment has been made, distinct from the bonus payment, in the form of an advance delay rental. Rarely will lessees ever pay a separate amount of money designated as advance "paid-up" delay rental. Instead, a single bonus payment is made to obtain the lease.
A better technique to avoid the trappings of delay rental while negating the implied covenant to drill a test well is to simply state:
During the primary term of this lease lessee is under no obligation to explore, test, drill, or otherwise develop the leased land. This provision does not relieve the lessee from any express or implied obligation it may have to protect the leased land, as a prudent operator would, from significant drainage.
The paid up lease is a clunky way to state and accomplish this goal. Paid-up language invites the lessor who just entered a lease transaction to ask: "I got my bonus, where's my paid-up delay rental?" Merely stating there is no obligation to develop avoids creating expectation of the never-paid "paid-up" payment.
The focus of this article is on the following part of the habendum clause: "and as long thereafter as oil and gas or other hydrocarbons are being produced from said land . . . ." Before jumping into the guts of what "produced" means, consider what must be produced under the A.A.P.L. Form
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675 lease: "oil and gas or other hydrocarbons are being produced . . . ."7 The word "and" has given rise to litigation when the lessor argued both oil and gas must be produced to satisfy the habendum clause.8 The lessee's intent was no doubt to extend the lease whether it produces only oil or only gas. The reference to "other hydrocarbons" is consistent with the "other hydrocarbons" language contained in the granting clause of this lease form. It would appear to exclude carbon dioxide because "other hydrocarbons" suggests the terms "oil" and "gas" are referring to hydrocarbon substances as opposed to a non-hydrocarbon gas like carbon dioxide.9
Although this article focuses on "production" under the habendum clause, determining whether a lease has terminated requires consideration of all lease provisions that impact its duration. The following section focuses on the analytical process that should be followed when determining whether a lease is being maintained into and during the secondary term.
II. Analyzing Duration Issues
As the oil and gas lease approaches the end of its primary term, the lessee must focus on the habendum clause to ensure there is production that will extend the lease to and within its secondary term. Step one is to ascertain whether there is actual production in paying quantities taking place throughout the secondary term. If there is, the inquiry is at an end, the lease continues. If there is anything less than actual production in paying quantities, step two is to determine whether there is unique language, within the habendum clause, that excuses the actual production or paying quantities
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requirements.10 If so, the inquiry may again be at an end with the lease continuing. If steps one or two do not maintain the lease, step three inquires if there is a well capable of producing in paying quantities and located in a state, such as Oklahoma, that does not require actual production to maintain the lease.11 If so the underlying facts determine whether the lease is still in effect.
Assuming the lease is not maintained under the habendum clause, step four inquires whether the failure to produce in paying quantities is covered by the temporary cessation doctrine. This requires a factual analysis that evaluates the cessation circumstances.12 Step five inquires whether the failure to produce may be excused under one of the savings clauses contained in the lease. If so, step six requires analysis of the facts to determine if the terms of a savings clause have been satisfied. Step seven is to ensure there is no unique language that...
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