Fee Lease 101 Series

The Habendum Clause – ‘Til Production Ceases Do Us Part

Fee Lease 101 Series, Lease Provisions, , , ,

The habendum clause is a fundamental provision of oil and gas leases. This clause (also called the term clause) sets forth the time period that the rights granted to the lessee under the lease are extended—i.e. how long the lease will be active.1

Basics

An habendum clause in an oil and gas lease typically contains two separate terms, the primary term and the secondary term. The primary term is a fixed period of time during which the lessee has the option, but not the obligation, to pay delay rentals and/or explore for and produce oil and gas. No actual production is necessary to keep the lease active during the primary term. Ten years used to be a common primary term; however, shorter primary terms (e.g. 1 to 5 years) are often seen in areas with proven fields or anticipated drilling.2 As with other lease terms, its length can be negotiated by the lessor and lessee; the relative bargaining power between the parties and the amount of bonus a lessee is willing to pay are important in determining term length.3

At the expiration of the primary term, the lease terminates as a matter of law unless production4 is achieved during the primary term. The time period under the secondary term is indefinite—so long as lease substances are produced, the lease remains in effect. While many leases expire at the end of the primary term without production, if production is achieved, it is not uncommon for oil and gas leases to be held by production for many years.

In having both a primary and secondary term, the interests of both lessors and lessees are represented. The fixed primary term protects lessors from having their mineral interests endlessly tied up without production and encourages development on the land. If production is not achieved by the lessee within the primary term, the lease terminates (unless otherwise extended, such as by other lease terms) and the lessor is free to re-lease his or her mineral interests. Conversely, if production is achieved, the lessee’s risk in expending substantial sums to develop the land is rewarded by extending the lease so long as production continues.5

Formulation

Although there are numerous variations of habendum clauses, a typical habendum clause will read substantially as follows:

[T]his lease shall remain in force for a term of ___ years from this date, and as long thereafter as oil or gas or either of them is produced from said lands.6

Additionally, the phrase “produced in paying quantities” or “produced in commercial quantities” is commonly included in the clause, along with phrases allowing for production to come from lands pooled or unitized with the leased lands.7

Meaning of “Produced”

As noted above, the typical habendum clause requires that oil or gas be “produced” from the leased land to extend the lease beyond its primary term. In most states, “produced” means exactly that—oil or gas must actually be produced from the leased land. A minority of states, including Oklahoma and West Virginia, hold that discovery of oil or gas is sufficient—no production is actually necessary—to extend the lease beyond its primary term, although the well must be completed and capable of production, and the lessee must make diligent efforts to market.8 Another minority of states, including Montana and Wyoming, appear to differentiate between oil and gas, with the discovery of gas being sufficient to extend the lease beyond the primary term, while actual production for oil is necessary to extend.9 The distinction arises because oil can be produced and stored economically while gas generally cannot be stored economically above the ground.10

Some habendum clauses include language that the lease will be extended “so long as oil or gas is capable of being produced in paying quantities.” In such instances, actual production is not necessary to extend the lease beyond its primary term, but may require a well that can be turned “on” to produce in paying quantities without the addition of extra equipment or repair.11

Once the lease is extended into the secondary term, if production ceases the lease automatically terminates (unless otherwise extended by a different provision in the lease).12 However, courts have held that it is not required that production be entirely continuous throughout the extended term to hold the lease. Courts recognize that production may temporarily cease due to repairs, breakdowns, and reworking operations.13 Where the lease is silent, and cessation in production is litigated, the burden of proof rests on the lessee to show that the cessation was for a reasonable reason and for a reasonable amount of time. Courts vary in what constitutes a reasonable amount of time.14 For example, one court held that a four-year cessation in production was “temporary,” while another court held that a six-month cessation was “permanent.” To provide more certainty in the face of inconsistent court rulings, modern oil and gas leases often include a “cessation of production” clause that specifies when production must be continued after cessation for the lease to not terminate.15

Meaning of “Produced in Paying Quantities”

A question that frequently arises when construing an habendum clause is how much production is necessary—i.e. is any amount of production sufficient to hold the lease, or must the production reach a certain level? As noted above, modern oil and gas leases commonly include the qualification that production be in “paying” or “commercial” quantities. For leases that only state “production” is required, courts generally have construed the clause to include this qualification. Thus, regardless of whether the lease includes the qualification “in paying quantities,” the term “produced” typically means “produced in paying quantities.”16

The question then becomes what constitutes “produced in paying quantities.” The Kansas Court of Appeals stated the general rule:

[T]he phrase “in paying quantities” as used in an oil and gas lease habendum clause means production of quantities of oil or gas sufficient to yield a profit to the lessee over operating expenses, even though the drilling costs or equipping costs are never recovered, and even though the undertaking as a whole may thus result in a loss to the lessee.17

Put simply, a lease is considered “producing in paying quantities” if production revenue is greater than operating expenses.

In determining production revenue, any royalty paid to the lessor is excluded, although any payment to overriding royalty owners generally are included as revenue.18 For operating expenses, any direct costs to operate, such as labor costs, electricity for pumping units, taxes (but not income taxes) payable by the working interest owner(s), and day-to-day maintenance cost are included.19 There is some dispute among courts whether depreciation and overhead costs should be included as operating expenses.20 Initial expenditures, such as the costs of drilling, equipping, and completing are not included as operating expenses.21 Such analysis makes economic sense—after these initial expenditures, an operator will continue to operate so long as the production on a lease is marginally profitable in order to recover as much of these costs as possible.22

It is important to have a reasonable time period when evaluating production revenues against operating expenses. Leases may operate negatively in the short-term, but profitably in the long-term. One source notes that in almost every instance, a time period of at least a year was used by the courts to evaluate profitability, and frequently a time period of eighteen months to three years was used.23 In times of distressed market conditions, courts have used longer time periods or have assessed whether the lease would have been profitable under normal market conditions.24

Conclusion

An understanding of the habendum clause is crucial when negotiating a lease or when evaluating whether a lease has been held by production past its primary term. As you do so, keep in mind that other lease provisions not discussed in this article may also affect lease duration, such as shut-in royalty, pooling, unitization, Pugh, continuous operations, delay rental, and cessation of production clauses, among others. Additionally, be aware that the law varies from jurisdiction to jurisdiction, and may be different from the general principles discussed in this article.

1See PEC Minerals LP v. Chevron U.S.A., Inc., 439 F. App’x 413, 416 (5th Cir. 2011).
2John S. Lowe, Oil and Gas Law in a Nutshell (6th ed. 2014).
3Id.
4Or a lease provision that serves as a substitution for actual production such as continuous drilling operations or payment of shut-in royalty.
5Lowe, supra note 2.
63 Patrick H. Martin & Bruce M. Kramer, Williams & Meyers, Oil and Gas Law § 603.3 (2014).
7Id.
8See McVicker v. Horn, 322 P.2d 410 (Okla. 1958); Eastern Oil Co. v. Coulehan, 64 S.E. 836 ( W. Va. 1909).
9See Severson v. Barstow, 63 P.2d 1022 (Mont. 1936); Pryor Mt. Oil & Gas Co. v. Cross, 222 P. 570 (1924).
10See 2 Eugene Kuntz, A Treatise on the Law of Oil and Gas § 26.6 (rev. ed. 2014). See also Lowe, supra note 2.
11Martin & Kramer, supra note 6.
12See Anadarko Petroleum Corp. v. Thompson, 94 S.W.3d 550, 554 (Tex. 2002).
13Martin & Kramer, supra note 6, at § 604.4.
14Id.
15Id. See also Dave Hatch, Potential Pitfalls of Continuous Drilling Provisions in HBP Fee Leases (Apr. 10, 2014), available at: http://www.hollandhart.com/pitfalls-of-continuous-drilling-provisions-in-hbp-fee-leases/.
161 Earl A. Brown, Earl A. Brown, Jr., & Lawrence T. Gillaspia, The Law of Oil and Gas Leases § 5.03 (2d ed. 2014).
17Avien Corp. v. First National Oil, Inc., 79 P.3d 223, 230 (Kan. Ct. App. 2003); see also Maralex Res., Inc. v. Gilbreath, 76 P.3d 626, 630 (N.M. 2003) (“To satisfy the habendum clause production must be in ‘paying quantities,’ such that the income generated from oil and gas production exceeds the operating costs.”).
18Lowe, supra note 2.
19Id. See also Martin & Kramer, supra note 6, at § 604.6(b).
20Martin & Kramer, supra note 6, at § 604.6(b).
21Kuntz, supra note 10, at § 26.7.
22Martin & Kramer, supra note 6, at § 604.6(b).
23Lowe, supra note 2.
24Id. See also Kuntz, supra note 10, at § 26.7.

The Granting Clause: The Gift That Keeps on Granting

Fee Lease 101 Series, Lease Provisions, Title Issues/Curative,

The granting clause of a lease contains the required words of grant that create an interest in the lessee.1 This clause is typically found at the beginning of the lease and is often overlooked when drafting a lease, to the detriment of the lessee. The granting clause generally covers three main topics: (i) the leased substances; (ii) the associated easement rights; and (iii) the property description.

Leased substances

The granting clause should include a careful description of the substances covered by the lease. Typical granting clauses include language such as “oil, gas, and other minerals,”2 “oil and all gas of whatsoever nature or kind,”3 or some variation of these simplistic descriptions. Even though this language may, at first glance, seem uncontroversial, the failure to adequately list the substances covered by the lease has led to a multitude of lawsuits.

For example, the failure to adequately define the leased substances can lead to questions whether the lease covers coalbed methane, which depending on the state, may not be included in a general grant of gas. Another problem is encountered when interpreting what is included in the “other minerals” under a lease. The parties to a lease should not rely on a court to dictate what substances are covered by that lease.

As a practical matter, the goal in drafting the leased substances portion of the granting clause is to ensure that the lease covers all substances that are necessary to produce the oil and gas from the leasehold. Any special substances that may be encountered, such as coalbed methane, helium, carbon dioxide, hydrogen, or sulfur, should be individually listed in the lease. By including a list of known or expected substances, together with catch-all language to cover substances that may not yet be known or expected in the field, the lessee can avoid unfavorable interpretations by a court that could render the lease unprofitable or unusable.

Associated Easement Rights

The second part of the granting clause is the description of the easement granted to the lessee. Historically, the grant of an easement and the right to conduct surface operations has been broadly, if not vaguely, described in the lease. The lessee has, instead, relied on the implied right of access to the surface estate arising from the mineral estate’s dominance. Reliance on this implied right of access can be problematic when the surface owner engages in activities that prevent or inhibit oil and gas development or when the surface owner disagrees with and challenges the lessee’s use of the surface estate.

As for split estate lands, the lessee should be careful to ensure that the lease does not grant and that the lessee does not rely on a right of access that was not reserved or conveyed in the deed creating the split estate. Keep in mind that the lessor can only grant the rights that the lessor owns.

To avoid these issues, I recommend that this portion of the granting clause describe the specific activities that the lessee will be conducting on the leased premises, such as construction and location of the various production facilities, powerlines, roads, pipelines, and any other activity that may foreseeably be required to produce the oil and gas. By describing the specific activities, the surface owner is put on notice of the types of activities that the lessee is planning to conduct on the surface estate. If a lawsuit ensues, it will be very difficult if not impossible for the surface owner to argue that they were unaware that the surface would be used for these activities.

I note also that, even though the lessee, through careful drafting of the lease, may be able to secure surface access for gathering facilities and other surface disturbance activities not related to production of oil and gas from the leasehold, this grant of access could be terminated upon expiration of the lease term. For such activities, I recommend that the lessor obtain a separate surface use agreement specifically granting the right to conduct these activities to ensure that they survive termination of the lease.

The Leased Premises

Finally, the granting clause should include a description of the land covered by the lease. This should, of course, include a legal description of the property together with the acreage covered by the leasehold. For small or irregular tracts of land, the lease should include a Mother Hubbard clause4 to ensure that inadequately described property that is adjacent to and contiguous with the leasehold will be covered by the lease.

In the event that the lease is limited in depth, the property description should include language that identifies the specific interval covered by the lease, making sure that the depth description is tied to a measured depth in a specific well. A carefully crafted depth description will avoid confusion as to the actual depth covered by the lease.

Other Considerations

A common, but surprising, issue is that some granting clauses fail to include present words of grant. That is, the granting clause describes the activities that can be undertaken on the leasehold but does not expressly grant the rights to the underlying oil and gas.5

Another issue that you should be aware of is that, with horizontal drilling resulting in ever increasingly long laterals, the easement in the granting clause should include language granting the lessee a subsurface easement to accommodate horizontal development. Again, if this subsurface easement will be used for the benefit of lands located outside the leasehold, the subsurface easement should be created by a separate agreement between the parties, thereby preventing the easement from terminating with the underlying lease. Also, for a lease limited by depth, the granting language should include a subsurface easement for all depths that must be traversed in order to access the leased interval.

In summary, through careful drafting of the various components of the granting clause, the lessee can protect itself from unexpected complications and ensure that it is allowed to fully develop and produce the oil and gas resource.

1Patrick H. Martin & Bruce M. Kramer, Williams & Myers, Manual of Oil and Gas Terms 497 (12th ed. 2003).
2David E. Pierce, Incorporating a Century of Oil and Gas Jurisprudence Into the “Modern” Oil and Gas Lease, 33 Washburn L. J. 786 (1994).
3Martin & Kramer.
4A clause commonly included in contemporary leases to meet the problem of adequately describing strips of land owned by a lessor contiguous to the land specifically described by the lease and intended to be covered by the lease. Id. at 246. Also known as a cover-all clause or an all-inclusive clause.
5Pierce.

Potential Pitfalls of Continuous Drilling Provisions in HBP Fee Leases

Fee Lease 101 Series, Lease Provisions,

A common but often overlooked oil and gas lease provision is the “continuous drilling” or “continuous operations” provision. Generally, a continuous drilling provision allows a temporary cessation of production without automatically resulting in the termination of an oil and gas lease that has been extended by production. In order to qualify for the temporary cessation, certain operations (as defined in the lease or by case law) must be commenced on the leased premises or lands pooled or unitized therewith within a specified time period (typically from 30 to 120 days). Two examples are as follows:

If, at the expiration of the primary term of this lease, oil or gas is not being produced on the leased premises or on acreage pooled therewith but Lessee is then engaged in drilling or reworking operations thereon, then this lease shall continue in force so long as operations are being continually prosecuted on the leased premises or on acreage pooled therewith; and operations shall be considered to be continuously prosecuted if not more than ninety (90) days shall elapse between the completion or abandonment of one well and the beginning of operations for the drilling of a subsequent well.

If, at the expiration of the primary term, oil or gas is not being produced on said land, but lessee is then engaged in drilling or reworking operations thereon, the lease shall remain in force so long as operations are prosecuted with no cessation of more than 30 consecutive days.

Continuous drilling provisions are of particular importance when analyzing older, HBP leases. Specifically, a number of situations should be considered. Has your lease produced each and every month since the expiration of the primary term? Have you or your predecessor ceased production to rework the well or recomplete in a new formation? Have severe weather conditions caused a temporary cessation of production? Each of these situations could potentially lead to a finding that your lease has expired.

Oil and gas wells generally do not have perfect production histories. Williams & Meyers states: “Since repairs, breakdowns, and reworking operations are incidental to the normal operation of a lease, the parties must have contemplated that the temporary cessation of production caused by such events would not result in automatic termination of the lease.”1 Based upon this implied understanding, if an oil and gas lease does not contain a continuous drilling provision, the lessee may extend the lease by exercising reasonable diligence in the continuance of its operations on the leased premises. In other words, courts have held that a temporary cessation of production is allowed where no specific deadline is provided.2 What is temporary? There is no hard and fast rule. An Arkansas court found a temporary cessation where a fire destroyed a producing well and production was not resumed for four years.3 However, whether a cessation of production is temporary is a question of fact that will depend on the individual circumstances.4 Although the individual facts may vary, courts typically weigh the following factors: failure of the lessor for a substantial period of time to claim forfeiture during which time the lessee was engaged in activities on the lease, absence of drainage, intent of lessee to hold the lease, and diligence of the lessee in seeking to find a market or to resume production.5 Due to the fact-intensive nature of the analysis, each circumstance must be carefully reviewed under the applicable case law in that state.

The continuous drilling provision was created in order to provide more certainty in the face of inconsistent court rulings. While providing the parties with a more reliable test, a continuous drilling provision could prove fatal to an HBP lease. According to Williams & Meyers: “Where there are express savings provisions in a lease that specify dates [i.e., 30-120 days] by which the lessee must take certain action or the lease will terminate, the temporary cessation of production doctrine will not apply so as to extend the lease beyond those specified time limits.”6 Unlike the analysis above, the specific time periods by which a lessee must recommence operations are hard and fast.7 Absent some other lease provision, mechanical issues with the well, lack of a market, or any other delay in production could cause a lease to be deemed expired in as few as 30 days without production. Therefore, careful attention should be made to the production (and operations) history on the leased premises to ensure any continuous drilling provision has been strictly observed.

Despite a constant push for greater efficiencies in acquisition due diligence and title opinions, a thorough HBP analysis should not be forgotten. Such analysis may require obtaining well records back to the date of first production, reviewing the complete well file, and investigating the cause of any delays in production.

For More Information Contact:
David B. Hatch
Phone: 801-799-5834
Email: dbhatch@hollandhart.com

1Williams & Meyers, “Oil and Gas Law” § 604.4.
2Id.
3Saulsberry v. Siegel, 252 S.W.2d 834 (Ark. 1952).
4See Watson v. Rochmill, 155 S.W.2d 783 (Tex. 1941).
5Williams & Meyers, § 604.4 at fn. 11; see, e.g., Somont Oil Co. v. A & G Drilling, Inc., 49 P.3d 598 (Mont. 2002) (finding the intent and diligence of the operator in restoring production is a factor in determining with a cessation of production is temporary).
6Williams & Meyers, § 604.4.
7See, e.g., Greer v. Salmon, 479 P.2d 294 (N.M. 1970) (finding that where the lessee didn’t strictly comply with the 90-day cessation clause the lease terminated).

Entireties Clauses in Oil and Gas Leases: Are Mineral Owners Outside Your Unit Entitled to Proceeds?

Fee Lease 101 Series, Lease Provisions, Royalty Issues, ,

Most oil and gas leases, with certain conditions, permit the lessee to develop the leasehold as a whole, so that drilling one well on one tract covered by the lease will satisfy drilling obligations for all tracts covered by the lease. The language typically reads as follows: “if the leased premises are now or hereafter owned in severalty or in separate tracts, the tracts, nevertheless, may be developed and operated as an entirety.” Known fittingly as the “entireties clause,” by treating the lease as a whole, even if certain tracts are later carved off and sold to others, the clause relieves the lessee of the obligation to drill offset wells to protect owners of the other non-producing tracts from internal drainage.

How are royalty payments treated? Early court decisions developed what is known as the non-apportionment rule, which holds that if the tracts covered by a lease were owned by different parties, and a producing well was drilled, for example, in Bob’s tract, then Jill, who owns a neighboring tract, is not entitled to any proceeds from production from the well on Bob’s tract. The basic principle is that each separate is owner is entitled to production from his or her own tract, free from the claims of the others. The non-apportionment rule was soon recognized as unfair, especially if the lessee was under no obligation to drill offset wells. The rule left landowners like Jill receiving no benefits from production on the leasehold. To avoid the unfair result, language was inserted into the entireties clause to allow for the apportionment of royalty payments. Typical language reads as follows: “royalties shall be paid to each separate owner in the proportion that the acreage owned by him bears to the entire leased area.” Thus a balance was introduced: lessees were allowed to develop the leased premises as a whole while all lessors benefited from production from anywhere within the whole.

Entireties clauses can take any variety of forms, but the form of concern here contains royalty apportionment language. For example:

If the leased premises are now or hereafter owned in severalty or in separate tracts, the premises, nevertheless, may be developed and operated as an entirety, and the royalties shall be paid to each separate owner in the proportion that the acreage owned by him bears to the entire leased area. There shall be no obligation on the part of the lessee to offset wells on separate tracts into which the land covered by this lease may hereafter be divided by sale, devise, or otherwise, or to furnish separate measuring or receiving tanks for the oil produced from such separate tracts.

Now suppose that Bob owned an undivided fractional mineral interest in two 640-acre sections of land, and that he leased his interest in both sections to XYZ Oil in 1985. The lease included the entireties clause above. In 1990, just before the lease expired, XYZ Oil drilled a prolific well (the Titan I well) in the north section, and the well continues to produce today. The lease did not have a Pugh clause, and thus the Titan I well held both the north section and the south section by continuous production. Meanwhile, in 1995, Bob conveyed all of his interest in the south section to his sister Jill by mineral deed. In accordance with the entireties clause, Bob and Jill updated ownership of the lease with XYZ Oil, and Jill thereafter enjoyed her apportioned royalty proceeds from the Titan I well.

To continue the story, in 2014, ABC Oil leased up the remaining undivided mineral owners in the south section, and drilled the Minerva I well on a 640-acre unit basis. XYZ Oil, as lessee of Bob’s and Jill’s lease, participates in the well. A title examination is ordered for the south section, and the examiner confirms not only that Bob’s and Jill’s lease is held by production from the Titan I well, but also that the entireties clause in the lease provides for the apportionment of royalties. At this point the examiner alerts ABC Oil that title to the north section covered by the lease will need to be examined in order to confirm the party or parties entitled to royalty proceeds from the Minerva I well. Perhaps Bob conveyed his interest in the north section to his children and grandchildren. By virtue of the entireties clause, such new owners will be entitled to their apportioned share of royalties, even though production is from a well located in the south section of the lease. Confirming such ownership will require a potentially burdensome title examination of land outside of the subject drilling unit. The title examination problem intensifies when a lease containing an entireties clause covers multiple tracts spread across multiple sections.

Entireties clauses with the type of royalty apportionment language discussed here are not ordinarily found in leases of recent vintage (their use having fallen out of favor), and appear most often in leases dating from the 1950s to 1970s. Importantly, such leases often contain no Pugh clause. Thus, particular care should be taken when reviewing the provisions of leases that have been held by production for multiple decades. Even when certain tracts of leases with royalty apportionment clauses have been released, some have argued that the lessors of released tracts remain entitled to proceeds from actively producing tracts. The entireties clause should also be carefully reviewed in the context of the other lease provisions, which may impact the application of the entireties clause. Further, any lease amendments should be carefully scrutinized because in some instances entireties clauses will have been deleted and replaced with a form of Pugh clause.

The entireties clause deserves the attention of operators, especially considering the many different forms in which the clause is drafted. The royalty apportionment-type clause treated here is just one variant with critical implications for the proper distribution of proceeds, but each lease needs to be examined in its own right with attention paid to the particular language used, in order to determine what issues might arise out of its application beyond royalty apportionment.

Sources:
1-7 Law of Pooling and Unitization § 7.04 (3d ed.).
4-6 Williams & Meyers, Oil and Gas Law § 678.
1-XII The Law of Oil and Gas Leases § 12.01 (2d ed.).
Gene L. McCoy, The Entirety Clause—Its Current Use and Interpretation, 12 Rocky Mt. Min. L. Inst. 10 (1967).
William S. Livingston, The Entirety Clause and the Drafting of Division Orders, 5 Rocky Mt. Min. L. Inst. 12 (1960).