Chapter 7 The Search to Establish When Permian Basin Oil and Gas Leases Are Held by Production

• Jurisdiction: United States

Chapter 7 The Search to Establish When Permian Basin Oil and Gas Leases Are Held by Production

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Corey F. WehmeyerSantoyo Wehmeyer P.C.San Antonio, TX

COREY F. WEHMEYER represents energy industry participants in trials, arbitrations and disputes. Clients include operators, working interest owners, drilling contractors, oil field service companies, pipeline companies, refiners, and mining companies. He has handled matters in Texas, Oklahoma, Louisiana, and North Dakota. He also represents clients in general real property and commercial litigation matters. As lead attorney, Corey has tried oil and gas jury trials to multi-million dollar verdict and judgment for clients, and has also secured take nothing defense verdicts. Corey is also an appellate attorney and has successfully represented energy clients in oral argument and briefing before the Supreme Court of Texas, and many intermediate courts of appeal. Corey is the Managing Shareholder of Santoyo Wehmeyer P.C. He is also Board Certified by the Texas Board of Legal Specialization in both of Civil Trial Law and Oil, Gas and Mineral Law.

I. Introduction

The Permian Basin in western Texas and eastern New Mexico has long been one of the world's most prolific unconventional oil and gas producing regions. And, due to technological advancements in drilling and completion techniques allowing operators to economically extract hydrocarbons from its low permeability reservoirs, the Permian Basin is currently producing at unprecedented levels.¹ Unsurprisingly, organic oil and gas leases on productive lands have been increasingly difficult to come by in the most desirable regions of the Permian Basin. As competition for sought-after oil and gas leases in this region continues, there has been no shortage of actual and threatened lease termination litigation in Texas, making it more important than ever for operators to be proactive in protecting and maintaining their valuable leasehold interests. The goal of this article is to identify key concepts and points for operators to evaluate when faced with challenges to the ongoing validity of their oil and gas leases.

This Article starts with a brief discussion of the beginning of the typical oil and gas lease and the nature of interests created thereunder in Part II. Part III examines when and how oil and gas leases terminate, both during and beyond the primary term, with an emphasis on the two-prong production in paying quantities test set forth in Clifton v. Koontz and lease termination in the event of a total cessation of production. Part III also discusses the application and effect of certain lease savings clause provisions that operators can utilize to perpetuate their leases in the absence of production or production in paying quantities. Finally, Part IV addresses various defenses potentially available to operators faced with lease termination disputes.

II. Beginning of an Oil and Gas Lease

In states like Texas that follow the ownership-in-place theory, courts generally view the lessee's interest under an oil and gas lease as a fee simple determinable estate in the oil and gas in place.² Meanwhile, the lessor retains a possibility of reverter.³ Oil and gas leases almost always contain a habendum clause, which is used to create the property interests owned by the parties to the lease.⁴ The habendum or term clause of an oil and gas lease sets the lease's duration.⁵ The primary term is a fixed term of years, generally ranging from one to five years, during which the lessee has the right, without the obligation, to explore for oil and gas on the leased premises.⁶ The secondary term is an extended period of time

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the lease is maintained if the lessee explores and develops the leased premises.⁷ As typically drafted, an oil and gas lease terminates at the end of its primary term unless the lessee is engaged in operations on, or is producing oil and gas from, the leased premises:

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.⁸

The "thereafter" or "production" language in the habendum clause operates as a special limitation upon the lessee's estate.⁹ Production, therefore, is a condition precedent to the extension of the lease beyond the primary term.¹⁰ Consequently, once production ceases in the secondary term (absent an express or implied savings provision), the leasehold estate terminates and the lessor is once again the owner of the fee simple absolute.¹¹ Texas courts have long held that the meaning of "production" in the habendum clause is synonymous with "production in paying quantities," a concept discussed extensively in Section III.B.1.¹² As outlined below in Section III.B.2 and Section III.C, several exceptions to this general rule exist to rescue a lease from termination, which would otherwise occur upon a cessation of production or failure to produce in paying quantities.

III. Termination of an Oil and Gas Lease

A. Termination During the Primary Term

An oil and gas lease may terminate prior to the end of the primary term if the lease requires that the lessee commence drilling operations within a certain time after the effective date of the lease.¹³ The typical form leases used in Texas throughout the twentieth century contained operations and delay rental clauses which required the lessee to commence operations within a certain period, or, alternatively, pay the lessor annual delay rentals for the right to maintain the lease throughout the primary term.¹⁴

1. Payment of Delay Rentals

Though most oil and gas lease do not expressly obligate the lessee to drill, there are several instances in which the lessee may have an implied duty to do so.¹⁵ Historically, one such duty has been called

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the implied covenant to drill an initial test well.¹⁶ Because a central goal of the lessee is to have the option, without the obligation, to drill, the implied covenant to drill an initial test well was problematic for lessees.¹⁷ To avoid the implied covenant, some oil and gas leases contain a delay rental clause that expressly provides that the lessee may maintain the lease throughout the primary term, without drilling, by paying periodic delay rentals.¹⁸ The delay rental clause allows the lessee to extend the lease from period to period during the primary term without drilling by paying delay rentals that are usually nominal—often $1.00 per net mineral acre.¹⁹ In general, there are two different types of delay rental clauses: (1) the "unless" clause and (2) the "or" clause.

The "unless" delay rental clause, which was once the most widely used type of delay rental clause in Texas, creates a special limitation whereby the lease will automatically terminate unless a well is commenced or delay rentals are paid.²⁰ The lessee typically has three options under an "unless" delay rental clause: it can maintain the lease by commencing drilling operations, it can maintain the lease by paying delay rentals, or it can let the lease expire by doing neither.²¹

An alternative to the "unless" delay rental clause is the "or" delay rental clause.²² Unlike the "unless" clause, an "or" clause does not result in automatic termination upon a failure to commence drilling operations and failure to pay rentals properly.²³ Instead, the "or" clause simply imposes an affirmative duty upon the lessee to either commence drilling or pay rentals or surrender the lease before the anniversary date.²⁴ If the lessee does not drill, the lessor is entitled to recover the delay rentals if they have not been paid.²⁵

Beginning in the 1980s and commensurate with shorter primary terms, use of the delay rental clause declined in favor of paid up leases, which, if properly drafted, expressly allow the lessee to maintain the lease for the full primary term without being obligated to drill a test well.²⁶ A well-drafted paid up lease will recite that no rentals are due (or have been pre-paid as part of the lease bonus) and will disclaim the implied covenant to drill an initial test well.²⁷

2. Commencement of Drilling

Most leases provide that a lessee may maintain its rights throughout the primary term by commencing a well.²⁸ Consider the following language contained within an "unless" delay rental clause:

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If operations for drilling are not commenced on said land, or on acreage pooled therewith as above provided for, on or before one year from the date hereof, the Lease shall terminate as to both parties, unless on or before such anniversary date Lessee shall pay . . . the sum of ($___), herein called rentals, which shall cover the privilege of deferring commencement of drilling operations for a period of twelve months.

The majority rule is that the phrases "operations," "operations for drilling," "engaged in drilling operations," and the like, when used in this context, do not require actual drilling.²⁹ Rather, preparatory activities such as building access roads to the drill site, moving tools and equipment onto the drill site, providing a water supply, and similar activities are generally sufficient so long as they are performed with the bona fide intention to proceed with diligence to the completion of the well.³⁰ Though determining whether the lessee commenced drilling activities during the primary term may be a question of fact, at least one Texas court has ruled on this issue as a matter of law where the lessee selected the location of an oil well, hauled equipment to the drilling site, and provided a water supply for drilling purposes.³¹

B. Termination at the End of the Primary Term or During the Secondary Term

A lease will typically terminate at the end of the primary term if the lessee is not producing oil or gas or has not utilized one of the savings provisions in the lease that excuses or serves as a...