CHAPTER 9 DEFINING THE LESSEE'S COVENANTS TO DRILL AND DEVELOP A LEASE
| Jurisdiction | United States |
(May 2018)
DEFINING THE LESSEE'S COVENANTS TO DRILL AND DEVELOP A LEASE
Louisiana State University Paul M. Hebert Law Center
Baton Rouge, LA
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KEITH B. HALL is the Director of the Mineral Law Institute and the Campanile Charities Professor of Energy Law at Louisiana State University Law School in Baton Rouge, Louisiana where he teaches Mineral Rights, Advanced Mineral Law, International Petroleum Transactions, and an Energy Law Seminar that focuses on environmental issues relating to the oil and gas industry. Before joining LSU Law School, he was member of Stone Pigman Walther Wittmann in New Orleans, where he practiced law for 16 years, focusing his practice on oil and gas law, environmental law, and toxic tort litigation. He is a member of the Board of Editors for the Oil & Gas Reporter, the Board of Trustees for the Rocky Mountain Mineral Law Foundation, the Advisory Council for the Institute for Energy Law, and the Board of Trustees for the Energy & Mineral Law Foundation. He previously served as Chair of the Louisiana State Bar Association's Environmental Law Section. Before attending law school, he earned a B.S. in Chemical Engineering from Louisiana State University and worked for eight years as a chemical engineer.
Implied covenants1 are obligations that are not expressly imposed by a contract, but which courts nevertheless find are binding on one or more parties to the contract.2 Courts routinely hold that oil and gas lessees are bound by several implied covenants. This paper reviews the various implied covenants that have been recognized as binding oil and gas lessees, and examines the justifications for recognizing those covenants. The paper then discusses various issues that sometimes arise in implied covenants disputes, including the remedies that are available, certain procedural issues, and whether a lessee must continue to perform his implied contractual duties while a lawsuit is pending in which a lessor argues that a lease is invalid or that the lease is no longer in effect. Finally, the paper addresses the application of implied covenants in situations involving new technology and discusses the application of implied covenants in shale plays.
I. A Primer on Implied Covenants
A. History of and Justifications for Implied Covenants
For more than 100 years, courts have held that a mineral lessee's duties include various implied covenants that are not expressly stated in a lease. The earliest case to recognize the existence of implied covenants may have been Stoddard v. Emery, an 1889 case in which the Pennsylvania Supreme Court stated in dicta that oil and gas lessees are bound by an implied covenant to reasonably develop the leased premises.3 Three years later, the Pennsylvania Supreme Court again stated that a lessee was bound by an implied covenant of reasonable development,4 and just a few years later, the same court held that lessees are bound by an implied covenant to protect the leased premises against drainage.5 Ohio soon followed suit in recognizing implied
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covenants,6 as did the United States Eighth Circuit in in Brewster v. Lanyon Zinc Co.,7 a decision which is still recognized by several commentators as one of the leading cases on implied covenants.8 Today, every state with any significant amount of oil and gas jurisprudence has recognized the existence of implied covenants.9
Implied covenants exist with respect to contracts generally, and are not unique to oil and gas leases. Indeed, in most states, the basic law of contracts provides that all parties are bound by an implied covenant of good faith and fair dealing.10 But that is a very general duty. With respect to oil and gas leases, courts hold that oil and gas lessees are bound by several implied covenants that include much more specific duties. Further, implied covenants seem to play a bigger role in the law of oil and gas leasing than in general contract law.
The reason that implied covenants play a bigger role in oil and gas leases than in some other contracts probably is due to a particular characteristic of oil and gas leases. Namely, because of the complexities and uncertainties involved in oil and gas exploration and development, leases seldom state how many wells the lessee will drill, when and where he will drill, or to what depth.11
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Similarly, leases usually do not specify what a lessee will do to protect the leased premises against drainage or to market any product that is found. All these things are left to the discretion of the lessee, even though these aspects of the lessee's performance are critical to the ultimate benefit that the lessor receives from the lease transaction (particularly given that a major part of the benefit allocated to the lessor is the right to a royalty which is based on production).12 One early commentator stated, "It is doubtful if any other character of legal instrument can be found in which one of the parties has so much potentially at stake with so little express contractual protection."13 It is this characteristic of oil and gas leases that provides a "practical" explanation of why courts hold that lessees are bound by implied covenants.
Although implied covenants are universally recognized in U.S. oil and gas law, authorities have disagreed about the "theoretical" justification for such covenants. One theory is that a public policy favoring production of oil and gas is a justification for implied covenants.14 But two other theories are more common.15 One of the more common theories is that implied covenants fill gaps in contracts, giving particularized expression to the parties' own implicit intent. Thus, courts do not impose implied covenant obligations on lessee. Instead the court merely finds the common intent of the parties. Under this theory, implied covenants are implied-in-fact. The other common theory is that courts impose implied covenants on lessees as a means to promote fairness.16 Under this theory, implied covenants are implied-in-law.17
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In the vast majority of cases involving implied covenant disputes, the theoretical basis of implied covenants is merely an academic question. The parties' dispute will turn either on the scope and extent of the lessee's implied covenant duties, or on some procedural issue relating to implied covenants, or on some issue unrelated to implied covenants, not on whether the covenant at issue is implicit in the parties' contractual intent or imposed as a matter of law by courts. But in rare cases the theoretical basis of implied covenants will determine the resolution of a dispute. For example, in Smith v. Amoco Production Co.,18 the court had to determine whether a lessee's implied covenants were implied-in-law or implied-in-fact because, reasoned the court, a different statute of limitations would apply depending on whether the covenant was based on the implied intent of the parties or on a rule of fairness imposed by law.
B. The Standard of Conduct for Compliance with Implied Covenants
With respect to implied covenant duties, lessees are not held to a fiduciary standard,19 and they are not required to exercise perfect judgment,.20 On the other hand, a lessee's discretion is not unfettered. Courts universally hold that oil and gas lessees are required to act as reasonably prudent operators, taking into consideration both their own interests and those of their lessors.21 This modern description of the "reasonably prudent operator" standard is very similar to that stated in a 1905 case that arose in Kansas, Brewster v. Lanyon Zinc, Co.22 Brewster stated, "Whatever, in the circumstances, would be reasonably expected of operators of ordinary prudence, having regard to the interests of both lessor and lessee, is what is required."23
Depending on one's viewpoint, the reasonably prudent operator standard is either the standard of conduct that applies when determining whether the lessee has complied with each one of several implied covenants to which lessees are bound, or the reasonably prudent operator standard itself is the sole implied covenant, though there are several different types of situations that recur with sufficient frequency that it is useful to discuss the lessee's implied duty in each of
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those types of situations as being a separate implied covenant. The text below discusses the lessee's implied duties as being separate implied covenants.
C. The Most Commonly Recognized Implied Covenants
There is substantial similarity between the particular implied covenants recognized by different jurisdictions and various commentators. Some of the implied covenants most frequently recognized in jurisprudence or commentary are covenants to: (1) promptly drill an initial test well; (2) reasonably develop the premises; (3) conduct further exploration; (4) protect against drainage; (5) diligently market minerals; and (6) restore the surface.24 Nevertheless, there are some differences in the implied covenants which different jurisdictions recognize25
Further, different jurisdictions sometimes use different terminology to describe implied covenants that are the same in substance.26 For example, the Texas Supreme Court sometimes states that there are three implied covenants - covenants to (1) develop the premises, (2) protect the leasehold, and (3) manage and administer the lease.27 But a duty to protect against drainage is
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part of the general duty to protect the leasehold,28 a duty to market is part of the duty to manage and administer the lease,29 and a duty to explore may be included in the duty to develop.30
1. Covenant to drill a test well
Early in the history of the oil and gas industry, several courts held that a lessee has an implied duty to drill at least one test well on the leased premises relatively soon after the lease is executed.31 The...
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