drafting issues

Saving the Best for Last – What Is All That Stuff at the End of My Lease?

Fee Lease 101 Series, Lease Provisions, Oil and Gas Agreements, , , , , , ,

On this blog, we have posted our complete Fee Lease 101 Series covering many of the standard fee oil and gas lease provisions from the granting clause to the pooling clause. However, there is typically a group of clauses towards the end of the lease form that appear to be the left-over clauses. These clauses include the assignment clause, proportionate reduction clause, warranty clause, surrender or release clause, and preferential right to purchase or option clause. They can have important ramifications on the relationship of the lessor and lessee and status of the lease and, accordingly, are discussed below.

I.      Assignment Clause

The assignment clause governs how the lessor and lessee may assign their respective interests. It may contain a restraint on the lessee’s power to assign the lease in whole or in part without the lessor’s consent. It may also contain a restraint on the minimum acres or minimum interest that may be assigned, such as “no less than forty acres” or “no less than the lessee’s entire undivided interest.” This restraint on assigning/alienation by the lessee is generally allowed; however, it will be strictly construed.

To avoid a claim that the clause is an unreasonable restraint on alienation, contemporary leases typically authorize assignments by either the lessor or lessee, in whole or in part, but will often include conditions to the assignment. For instance, it may state that lessee will not recognize a change in the lessor’s ownership until it receives an original or authenticated copy of the assignment. It may allow a partial assignment by the lessor, but will require that the assignment cannot increase the lessee’s obligations under the lease, such as drilling offsetting wells, protection of drainage, requiring separate measuring, or installation of separate tanks.

Although often the intent of the assignor, it is important that the assignment clause provides that the lessor relieves the lessee of any further obligations concerning the interest assigned.1 The assignor does not want to assign the interest and thereafter be stuck with the royalty payments if the assignee fails to pay the lessor. If a partial assignment of the lessee’s interest is allowed, a provision should be included that deals with the apportionment of rentals and royalties.

The following example assignment clause addresses all of the above requirements:

Ownership Changes. The interest of either Lessor or Lessee hereunder may be assigned, devised or otherwise transferred in whole or in part, by area and/or by depth or zone, and the rights and obligations of the parties hereunder shall extend to their respective heirs, devisees, executors, administrators, successor and assigns. No change in Lessor’s ownership shall have the effect of reducing the rights or enlarging the obligations of Lessee hereunder, and no change in ownership shall be binding on Lessee until 60 days after Lessee has been furnished the original or duly authenticated copies of the documents establishing such change of ownership to the satisfaction of Lessee or until Lessor has satisfied the notification requirements contained in Lessee’s usual form of division order. In the event of death of any person entitled to rentals or shut-in royalties hereunder, Lessee may pay or tender such rentals or shut-in royalties to such persons or to their credit in the depository, either jointly, or separately in proportion to the interest which each owns. If Lessee transfers its interest hereunder in whole or in part Lessee shall be relieved of all obligations thereafter arising with respect to the transferred interest, and failure of the transferee to satisfy such obligations with respect to the transferred interest shall not affect the rights of Lessee with respect to any interest not so transferred. If Lessee transfers a full or undivided interest in all or any portion of the area covered by this lease, the obligation to pay or tender rentals and shut-in royalties hereunder shall be divided between Lessee and the transferee in proportion to the net acreage interest in this lease then held by each.2

II.       Proportionate Reduction3

The proportionate reduction clause is also referred to as the lesser interest clause. It provides for reduction of rentals and royalties owed to the lessor in the event the lessor owns less than the full mineral estate. A typical proportionate reduction clause will provide:

In case said Lessor owns a lesser interest in the above described land than the entire and undivided fee simple estate therein, then the rentals and royalties herein provided shall be paid to Lessor only in the proportion that his interest bears to the whole and undivided fee.

However, the above example does not differentiate between the proportionate reduction of rentals and proportionate reduction of royalties. It focuses on the entire leased lands. What is the result if the lease covers a 640-acre section, the lessor owns 100% of the mineral estate in the W/2 of the section, 50% of the mineral estate in the E/2 of the section, and the well is located on the E/2? The lessor’s proportionate interest is 75% [(100% x 320/640) + (50% x 320/640)]. The lessor would not only receive 75% of the rental, but also 75% of the royalty even though the well is located on the lands in which the lessor only owns a 50% mineral interest.

The following example makes a distinction between rentals and royalties:

If Lessor owns less than the full mineral estate in all or any part of the leased premises, payment of rentals, royalties, and shut-in royalties hereunder shall be reduced as follows: (a) rentals shall be reduced to the proportion that Lessor’s interest in the entire leased premises bears to the full mineral estate in the leased premises, calculated on a net acreage basis; and (b) royalties and shut-in royalties for any well on any part of the leased premises or lands pooled therewith shall be reduced to the proportion that Lessor’s interest in such part of the leased premises bears to the full mineral estate in such part of the leased premises.

III.       Warranty Clause4

The warranty clause provides a warranty of title by the lessor with respect to the interest described in the granting clause. Additionally, the warranty clause provides the basis for applying the doctrine of after-acquired title in the event the lessor acquires an interest in the leased premises after giving the lease. The following are two examples of warranty clauses:

    • Lessor hereby warrants and agrees to defend the title to the land herein described and agrees that the Lessee, at its option may pay and discharge in whole or in part any taxes, mortgages, or other liens existing, levied, or assessed on or against the above described lands, and in the event it exercises such option, it shall be subrogated to the rights of any holder or holders thereof and may reimburse itself by applying the discharge of any such mortgage, tax, or other liens, to any royalty or rental accruing hereunder.
    • Lessor hereby warrants and agrees to defend title conveyed to Lessee hereunder, and agrees that the Lessee at Lessee’s option may pay and discharge any taxes, mortgages or liens existing, levied or assessed on or against the leased premises. If Lessee exercises such option, Lessee shall be subrogated to the rights of the party to whom payment is made, and, in addition to its other rights, may reimburse itself out of any royalties or shut-in royalties otherwise payable to Lessor hereunder. In the event Lessee is made aware of any claim inconsistent with Lessor’s title, Lessee may suspend the payment of royalties and shut-in royalties hereunder, without interest, until Lessee has been furnished satisfactory evidence that such claim has been resolved.5

The second warranty clause above allows the lessee to suspend payments to the lessor without interest in the event of a title dispute. However, a lessee should never suspend rental payments even if there is a title dispute. Failure to pay rentals could be fatal if the suspension is later determined to be unjustified.

As set forth in the above examples, the warranty clause often will contain a subrogation provision pertaining to a superior lien existing prior to the execution of the lease. To protect the lessee from the lease being extinguished if the superior lien is foreclosed, the clause authorizes the lessee to satisfy any liens and be subrogated to the rights of the lienor. The clause may vary in the types of claims or obligations the lessee is authorized to satisfy, including mortgages, deeds of trusts, taxes, assessment, charges, and encumbrances. Additionally, the clause may address whether the lessee may satisfy the claim or obligation prior to maturity thereof; and whether the lessee is authorized to withhold payments to the lessor for rentals, royalties, or other sums in satisfaction of the claim to reimbursement.

The warranty clause must be read in relationship to the granting clause and proportionate reduction clause. If the lessor owns less than 100% of the mineral interest, a granting clause that only describes the lands, but not the interest, is technically a breach of the warranty clause, but the proportionate reduction clause acts to proportionately reduce the lessor’s interest and the rental and royalties owed. If the granting clause describes the lessor’s percentage mineral interest in the lands, there is no breach of warranty, but there may be confusion as to the applicability of the proportionate reduction clause – is the lessor entitled to 100% of the rentals and royalties, i.e. not further proportionately reduced.

Cases have held that the warranty in the lease does not warrant the title of the lessor, it actually warrants title to the lessee. The warranty clause can be used to make a claim for a breach of warranty if the mineral interest covered by the lease is subject to an interest carved out of the mineral estate. For example, if prior to execution of the lease, the lessor’s mineral interest is subject to a non-participating royalty interest, it could be argued that the warranty clause, in some cases, results in the lessor’s royalty interest being reduced by the amount of the non-participating royalty interest.6

Many lessors will strike out or delete the warranty clause. As discussed above, legitimate reasons exist for using this clause. If the lessor insists on deleting the warranty clause, the lessee should at least propose one of the options for protection: make it a special warranty (“by, through and under”); limit the damages for a breach of warranty to money paid for the bonus, rentals, and royalties; or have the lessor execute an indemnifying division order in the event of production attributable to the leased premises.7 However, even if stricken, some courts have held that a warranty of marketable title is implied by law by use of the words “grant” or “convey” in the granting clause.

IV.       Surrender or Release Clause8

The surrender or release clause was originally included in the “or” form lease to relieve the lessee of the obligations to either drill or pay rentals by allowing the lease to be surrendered back to the lessor. In contrast, the “unless” form lease permits a lessee to extinguish its obligations by merely failing to perform the obligation, i.e. lease will terminate unless rental is paid. However, a surrender clause is also useful in an “unless” form lease when the lessee desires to surrender only a portion of the lease. Following are two examples of a surrender clause:

      • Lessee may, at any time and from time to time, deliver to Lessor or file of record a written release of this lease as to a full or undivided interest in all or any portion of the area covered by this lease or any depths or zones thereunder, and shall thereupon be relieved of all obligations thereunder arising with respect to the interest so released. If Lessee releases less than all of the interest or area covered hereby, Lessee’s obligation to pay or tender rentals and shut-in royalties shall be proportionately reduced in accordance with the net acreage interest retained hereunder.
      • Lessee may at any time surrender or cancel this Lease in whole or in part by delivering or mailing such release to the Lessor, or by placing the release of record in the County where said land is situated. If this Lease is surrendered or cancelled as to only a portion of the acreage covered hereby, then all payments and liabilities thereafter accruing under the terms of this Lease as to the portion cancelled, shall cease and terminate, and any rentals thereafter paid may be apportioned on an acreage basis, but as to the portion of the acreage not released the terms and provisions of this Lease shall continue and remain in full force and effect for all purposes.

Of course, there are many variants of the surrender clause. As set forth in the above examples, a surrender clause may require that written notice be provided to the lessor and/or recording of the release. In some cases, the clause requires the notice be given at some particular date or after certain events have occurred (such as “after production is achieved”) or the surrender is not effective until some particular date after giving notice (such as “the surrender shall become effective 30 days after delivery of the release to Lessee”). The clause may also require a payment as a condition to the surrender.

As to partial surrenders, as provided in the examples above, if the lessee releases part of the lease, the lessee is relieved of all obligations concerning the released part, and rentals and shut-in royalties are proportionately reduced according to the amount of acreage released. However, some clauses specifically provide that certain obligations, including payment of rentals or royalties, will not be affected by a partial surrender. If a partial surrender is authorized, the size of the surrendered or retained lands may be addressed in the clause, i.e. “not less than ten (10) acres;” “contiguous;” or “any legal subdivisions thereof.” Including the phrases “at any time or times” or “may at any time, or from to time to time” clearly evidence that successive partial surrenders by the lessee are allowed. The lessee should include a provision that the partially surrendered lands shall remain subject to the easements and right-of-way provided in the lease for the lessee’s operations. Additionally, restrictions on the lessor’s or its subsequent lessee’s use of the surrendered land should be included stating that the lessor shall not interfere with the original lessee’s operations and requiring adequate set-backs from the exterior boundary of the lands retained or any well drilled by the original lessee.

V.       Preferential Rights to Purchase and Options10

To protect the lessee, particularly with the advent of the short primary terms contained in contemporary leases, preferential rights to purchase and options to extend the primary term or renew the lease have been added to the lease. The following is a preferential right to purchase a new lease clause:

If during the term of this lease (but not more than 20 years after the date hereof) Lessor receives a bona fide offer from any party to purchase a new lease covering all or any part of the lands or substances covered hereby, and if Lessor is willing to accept such offer, then Lessor shall promptly notify Lessee in writing of the name and address of the offeror, and of all pertinent terms and conditions of the offer, including any lease bonus offered. Lessee shall have a period of 30 days after receipt of such notice to exercise a preferential right to purchase a new lease from Lessor in accordance with the terms and conditions of the offer, by giving Lessor written notice of such exercise. Promptly thereafter, Lessee shall furnish to Lessor the new lease for execution, along with a time draft for the lease bonus conditioned upon execution and delivery of the lease by Lessor and approval of the title by Lessee, all in accordance with the terms of said draft. Whether or not Lessee exercises its preferential right hereunder, then as long as this lease remains in effect any new lease from Lessor shall be subordinate to this lease and shall not be construed as replacing or adding to Lessee’s obligations hereunder.11

The twenty year limitation is to avoid a violation of the rule against perpetuities in some states. This provision provides that the new lease is subordinate to the old lease to avoid any question about the status of the new lease while the old lease is still in effect.

An option to extend the primary term may provide for the lease to be extended for a specified period of time upon payment of a specified consideration. For instance, the following is an option to extend the primary term:

Lessee is hereby given the option to extend the primary term of this lease for an additional Two (2) year(s) from the expiration of the original primary term hereof. This option may be exercised by Lessee at any time during the original primary term by paying the sum of One Hundred and 00/100 Dollars ($100.00) per net mineral acre to Lessor or the credit of Lessor mailed to Lessor at the above address. This payment shall be based upon the number of net mineral acres then covered by this lease and not at such time being maintained by the other provisions hereof. If, at the time this payment is made, various parties are entitled to specific amounts according to Lessee’s records, this payment may be divided between said parties and paid in the same proportion. Should this option be exercised as herein provided, it shall be considered for all purposes as though this lease originally provided for a primary term of Five (5) years.

A lease may also contain an option to renew the lease. Courts have differed on whether there is a distinction between “renew” or “extend.” In an Ohio decision, the court held that the clause “Lessor grants Lessee an option to extend or renew under similar terms a like lease” provided the lessee with two options: (1) to extend the lease on the same terms as the existing lease; or (2) to renegotiate for a renewal “like lease” on similar terms. The court reasoned that the terms “renew” and “extend” are distinct terms.12

In our Fee Lease 101 Series, we have covered most of the standard fee oil and gas lease clauses. As discussed above, these “left-over” provisions can affect the lessor’s and lessee’s, and their successor and assigns, rights, interests, and obligations and the status of the lease. A caveat for this article, and all our Fee Lease 101 Series articles, in interpreting any lease provision, care must be used in examining the specific language of the provision and the case law of the jurisdiction must be understood and applied. In order to avoid unintended consequences, the same caveat applies to drafting any lease provision.

1 See Pennaco Energy v. KD Co. LLC, 2015 WY 152, ¶ 19 (2015) (Finding, “Among the covenants [obligations] the original lessee-assignor retains after assignment of its interest are those requirement payments of rentals and/or royalties and restoration of the surface to its original condition once production activities have ceased.”).
2 Thomas W. Lynch, The “Perfect” Oil and Gas Lease (An Oxymoron), 40 Rocky Mtn. Min. L. Inst. 3-1, § 3.10 (1994).
3 See, generally, id. § 3.09.
4 See, generally, 4-6 Williams & Meyers, Oil and Gas Law § 685.1.
5 See, generally, Lynch at fn. 3, § 3.15.
6 Id.
7 Milam Randolph Pharo & Gregory R. Danielson, The Perfect Oil and Gas Lease: Why Bother!, 50 Rocky Mtn. Min. L. Inst. 19-29 (2004).
8 See, generally, 4-6 Williams & Meyers, Oil and Gas Law § 680.
9 The use of the terms “surrender” or “release” are used interchangeably to describe this clause. For purposes of this article, we will use the term “surrender”.
10 See, generally, 4-6 Williams & Meyers, Oil and Gas Law § 697.6.
11 See, generally, Lynch at fn. 3, § 3.17.
12 Kenney v. Chesapeake Appalachia, 2015 Ohio 1278 (Ohio Ct. App. 2015); Eastman v. Chesapeake Appalachia, 754 F.3d 356 (6th Cir. 2014).

Top Leases: Assessing (and Avoiding) the Risks of Novation

Due Diligence, Fee Lease 101 Series, Lease Provisions, Oil and Gas Agreements, Title Issues/Curative, , , , , , , , ,

You only have three more months on the primary term of an oil and gas lease that was issued nearly five years ago with a 1/6th royalty.  A drilling permit should be issued any day now, and you anticipate commencing operations to drill a well in sufficient time to hold the lease.  You instruct your landman to obtain a top lease from the mineral owner just in case there is a hiccup and you can’t start operations in time to hold the existing lease. Your landman negotiates a new lease from the mineral owner covering the same lands but has to agree to a 3/16ths royalty in order to obtain the top lease.  But, the top lease fails to expressly state that it is a top lease to the existing lease and doesn’t contain any other language clarifying that the top lease will only be effective if and when the underlying existing lease expires.  Despite the precautionary top lease, the well permit is issued when expected and you are able to commence drilling a well in time to hold the prior existing lease.

After the well is drilled and completed, is there a risk that the mineral owner could successfully argue that the new top lease is a replacement of the existing lease and you are required to pay a 3/16ths royalty instead of a 1/6th royalty? In the oil and gas industry, you often hear landmen and attorneys frame the question as whether or not the top lease will be deemed a “novation” of the prior existing lease. But what is the standard to prove a novation? How likely is it that the mineral owner above could successfully argue that the top lease is a novation of the prior lease, even though the well was drilled in time to hold the prior existing lease? This article will provide a brief overview of the elements and burden of proof to establish a novation.

A recent 2015 case out of Pennsylvania provides an excellent overview and example of the novation analysis in the context of oil and gas leases. In Mason v. Range Resources-Appalachia LLC, 120 F. Supp. 3d 425, 433 (W.D. Pa. 2015), an oil and gas lease was issued in 1961 in Western Pennsylvania and was arguably held by gas storage operations on the property (and by the payment of rentals). Years later, during the Marcellus shale boom, a landman working for Range Resources obtained an oil and gas lease in 2007 from the same mineral owners and covering the same lands as the 1961 lease. Range Resources only later discovered that it already owned the existing 1961 lease. Testimony in the case indicated that the leasing environment at that time was “chaotic,” that Range Resources did not have a good process for evaluating lease validity, and that landmen were taking leases without conducting complete due diligence of possible existing leases. Range Resources did not drill a well within the term of the 2007 lease, and the mineral owners asserted that the 2007 lease was a novation of the 1961 lease (which had unique provisions allowing the lease to be held by rental payments for gas storage), and that the 2007 lease then expired.

The Pennsylvania court set forth four elements to show a novation, which elements are the same or similar in other jurisdictions that have undertaken a discussion of novation:

“(1) the displacement and extinction of a prior contract, (2) the substitution of a valid new contract for the prior contract, (3) sufficient legal consideration for the new contract, and (4) the consent of the parties.”1

The Pennsylvania court further stated that “whether a contract has the effect of a novation primarily depends upon the parties’ intent” and “the party claiming the existence of a novation bears the burden of demonstrating the parties had a meeting of the minds.” The court stated that evidence of the parties’ intent to enter in to a novation can be shown “by other writings, or by words, or by conduct, or by all three.” Courts in other states have similarly emphasized that a party claiming a novation has the burden of proof, and that the party asserting the claim of novation has the burden of proving all of the required elements for a novation.2 A novation is never presumed. Instead the presumption is that the new contract was taken conditionally or as additional security, absent evidence of intention to the contrary.3 In the Pennsylvania case, the court determined that the mineral owners continued to accept rentals under the 1961 lease even during the term of the 2007 lease, and there was no evidence that the parties expressly intended to replace the 1961 lease with the 2007 lease.

Returning to our example above, the case law suggests that a mineral owner attempting to argue that the top lease was a novation of the base lease would have a very challenging case. But there is still a risk of such a claim, even if the claim is ultimately for nuisance value only. How can an operator protect itself from novation claims? Obviously, the best approach is to always put language in any top lease that makes it clear that the lease will only go into effect if and when the base lease expires by its terms, and make that intent clear in any other written correspondence to a landowner (such as an initial offer letter).

But what if an operator accidentally obtains a standard lease with no top lease language when it already owns an existing lease? For drilling purposes, the mineral interest will be leased either way. But an operator should ideally take steps to address any ambiguity resulting from the top lease and clarify the intent of the parties. If the well is successfully completed in time to hold the existing lease, the best approach would be to have the mineral owner (and operator) sign and record a ratification document where the parties acknowledge that the base lease was held by the drilling of the well, and that the top lease will remain of record as a top lease only in the event the well ceases operations.

Another approach (with attendant risks) would be to send an informative letter to a landowner prior to drilling, informing them of the pending well, stating that the operator will deem the base lease as held by the drilling of the well. That would at least set up an estoppel argument, and the operator will know prior to drilling the well whether or not the landowner objects and claims a novation. Or, an operator may simply pay proceeds on the prior existing lease, see if the landowner accepts royalty payments under that lease, and simply run the risk of a future novation claim. There may also be facts that make an operator more confident that a novation argument will be unsuccessful that justifies a riskier wait-and-see approach.4

Each fact scenario will be different, and an oil and gas lessee must evaluate the facts and risks to determine what level of clarification and curative action it requires to address risks of novation claims when there are overlapping leases.

1 Another novation case in the oil and gas context, Warrior Drilling & Eng’g Co. v. King, 446 So. 2d 31, 33-34 (Ala. 1984), framed the elements as: “[T]o establish a novation there must be: (1) a previous valid obligation, (2) an agreement of the parties thereto to a new contract or obligation, (3) an agreement that is an extinguishment of the old contract or obligation, and (4) the new contract or obligation must be a valid one between the parties thereto.”
2 In re United Display & Box, Inc., 198 B.R. 829, 831 (Bankr. M.D. Fla. 1996). See also Fusco v. City of Union City, 618 A.2d 914 (App. Div. 1993); Alexander v. Angel, 236 P.2d 561 (1951); Scott v. Bank of Coushatta, 512 So. 2d 356 (La. 1987); Credit Bureaus Adjustment Dep’t, Inc. v. Cox Bros., 295 P.2d 1107 (1956).
3 For example, a Utah court conducting a novation analysis stated: “The burden of proof as to a novation by the transaction in question rests upon the party who asserts it; … an intention to effect a novation will not be presumed; … in the absence of evidence indicating a contrary intention, it will be presumed, prima facie, that the new obligation was accepted merely as additional or collateral security, or conditionally, subject to the payment thereof; and the intention to effect a novation must be clearly shown.” First Am. Commerce v. Washington Mut., 743 P.2d 1193 (Utah 1987); see also Tri-State Oil Tool Indus., Inc. v. EMC Energies, Inc., 561 P.2d 714, 716 (Wyo. 1977).
4 For example, if the existing lease covers multiple parcels in several drilling units, and the new lease only covers one parcel, that may make an argument for a novation more difficult. Also, if there are unrecorded documents that evidence clear intent that the second lease was intended only as a top lease, that fact may make an operator more confident that a novation claim would be unsuccessful.

Utah Oil & Gas Update

Oil and Gas Regulations, Royalty Issues, Title Issues/Curative, , , , , , , , , , , , , ,

UTAH COURT OF APPEALS APPLIES THE OPEN MINES DOCTRINE, REJECTS PETITION TO CONSTRUE WILL IN FAVOR OF LIFE TENANTS

In re Estate of Womack, 2016 UT App 83, 2016 WL 1729528, involved a decedent whose formally probated Will devised a 160-acre parcel to his three children, in equal shares. See id. ¶ 2. In his Will, the decedent specified that “the oil, gas and mineral rights under the said property . . . are devised to each of my children, share and share alike, for life,” remainder to the decedent’s grandchildren. Id. In 1990, the district court entered an estate closing order that named the decedent’s three children as the owners of the 160-acre parcel outright. Id. ¶ 3. In 1992, the district court amended the estate closing order “to conform to the Will” and provide for the grandchildren’s remainder in the minerals, which had been incorrectly omitted in the prior order. Id. ¶ 4. In 2008, an oil and gas company leased the minerals underlying the 160-acre parcel, but a question arose as to who was entitled to the proceeds of production. Id. ¶ 5.

In an effort to clarify who was entitled to the proceeds of production, one of the life tenants petitioned the district court to reopen the decedent’s estate and construe the Will in favor of the life tenants. According to the life tenant, the prior order’s lack of specificity resulted in an ambiguity that should be resolved in favor of the life tenants, based on an affidavit from the drafting attorney regarding the decedent’s intent. Id. ¶¶ 5 and 6. Two of the remaindermen challenged the petition, asserting that the requested relief would require the court to re-construe a provision of the Will that had already been construed, and that the court would be required to vacate or modify its prior order. This, the remaindermen contended, was barred by a six-month statute of limitations. Id. ¶ 14 (citing Utah Code Ann. § 75-3-412). The district court agreed with the remaindermen and denied the life tenant’s petition to construe the Will.

The life tenant appealed, claiming that the district court had misinterpreted the nature of the petition, and that the petition only sought clarification of the prior estate closing order, which was not subject to the six-month limitations period. The Court of Appeals affirmed the district court’s decision. The Court cited the open mines doctrine and concluded that the remaindermen were entitled to the proceeds of production because the Will did not specify otherwise. The Court found that the prior estate closing order had already construed the Will as creating life estates in mineral rights, and “[l]ife estates in mineral rights, by default, do not encompass a right to any proceeds from new mineral extraction.” Id. ¶ 17 (citing Hynson v. Jeffries, 697 So.2d 792, 797 (Miss. Ct. App. 1997). In the Court’s view, the Will was not ambiguous, and clarification was not necessary. Id. The Court found that the prior estate closing order “implicitly granted extraction proceeds to the [remaindermen] (albeit by default).” Id. ¶ 19. Because the petition sought to prove the decedent’s intent for the life tenants to receive income from the minerals, “rather than letting such proceeds default to the holders of the remainder” under common law, the Court found that the six-month time limit for vacations and modifications of prior orders applied, and the petition was time-barred. Id.

UTAH LEGISLATURE CONFIRMS THAT FEDERAL, STATE, AND TRIBAL INTERESTS MUST BE EXCLUDED WHEN CALCULATING SEVERANCE TAX ON OIL AND GAS

In the May 2015 edition of the Rocky Mountain Mineral Law Foundation Mineral Law Newsletter, we reported on the Utah Supreme Court’s decision in Anadarko Petroleum Corporation v. Utah State Tax Comm’n, 2015 UT 25, 345 P.3d 648 (Utah 2015). In Anadarko, the Court held that an oil and gas operator may exclude federal, state, and tribal interests when calculating its severance tax rate.

The Utah legislature recently codified the rule established by Anadarko. See S.B. 17, ch. 324, 2016 Utah Laws (amending Utah Code Ann. §§ 59-5-102 and 59-5-103.1). S.B. 17 confirms that the severance tax on oil and gas does not apply to federal, state, or tribal interests in oil and gas. As such, for purposes of determining the amount of severance tax, these exempt interests should be excluded when calculating the value of oil and gas and the tax rate. S.B. 17 applies to a taxable year beginning on or after January 1, 2015, as well as to severance taxes “for any taxable year, including a taxable year beginning before January 1, 2015, that is the subject of an appeal that was filed or pending on or after January 1, 2016.” Id.

(Re-printed from Andrew J. LeMieux, Utah Oil & Gas, Rocky Mountain Mineral Law Foundation Mineral Law Newsletter, May 2016)

Unitizing the Lessor’s Interest: No, It’s Not the Same as Pooling

Due Diligence, Federal Lands, Fee Lease 101 Series, Lease Provisions, , , , , , ,

The terms “pooling” and “unitization” are often used interchangeably, but they have different meanings. Pooling is “the bringing together of small tracts sufficient for the granting of a well permit under applicable spacing rules,” while unitization is “the joint operation of all or some portion of a producing reservoir.”[1] While pooling and unitization are both used to prevent waste and protect correlative rights,[2] unitization works on a much larger scale, allowing an operator to maximize the amount of resources extracted from an entire field or reservoir, without regard to lease or property boundaries. Generally, the lessee of a fee (private) oil and gas lease is free to commit its working interest to the unit agreement, but the lessee can only commit the lessor’s interest through voluntary ratification, compulsory unitization, or a unitization clause. This article will focus specifically on the third option: the unitization clause in fee leases.

Unitization clauses (if included at all) generally follow two patterns. First, the unitization clause may be interwoven into the pooling clause. Second, the unitization clause may appear separately, often immediately following the pooling clause (we believe this to be the preferred method). There are typically four parts to a “standard” unitization clause.

Part One – When can the lessee unitize the lessor’s interest?

Example: Lessee shall have the right to unitize, pool, or combine all or any part of the leased premises with other lands in the same general area by entering into a cooperative or unit plan of development approved by any governmental authority.

The unitization clause should expressly grant to the lessee the authority to unitize the leased premises under a cooperative or unit plan of development. Depending on the type of unit being formed (for example, a federal exploratory unit or a state voluntary unit), the language should be broad enough to cover the proposed plan of development. Because the lessee may not know its future unitization plans at the time it negotiates a lease, the lessee should ensure that the unitization clause is broad enough to cover all forms of unitization.[3]

Even with a unitization clause, the lessee has an implied duty of good faith and fair dealing when pooling or unitizing a fee oil and gas lease.[4] This means that the lessee should be careful when attempting to commit a lease that is about to expire or includes non-productive lands, or when the lessee’s economic interests are not aligned with those of the lessor. However, if the unit plan of development is approved by a governmental entity (such as the BLM or the state conservation commission), courts will generally defer to the government’s approval in determining whether the lessee acted in good faith.[5]

Unfortunately, when describing how the leased premises can be unitized with other lands, it is not uncommon to find combined pooling/unitization clauses where the lessee mistakenly used pooling language (such as “into a drilling or spacing unit in conformance with a state drilling or spacing order”) instead of replacing it with unitization language (such as “to one or more unit plans or agreements for the cooperative development or operation of one or more oil and/or gas reservoirs or portions thereof”).

Properly drafted unitization clauses should cover the development of a field or reservoir as opposed to just those lands within a single drilling or spacing unit.

Part Two – How will the terms of the lease be affected?

Example: When such a commitment is made, this lease shall be subject to the terms and conditions of the unit plan or agreement and this lease shall not terminate or expire during the life of such plan or agreement.

To effectively extend the lease under the unit plan of development, the lease terms should be amended to conform to those of the unit agreement. This can be done either by having the lessor ratify the unit agreement or by including express language to that effect (such as described above) in the unitization clause. This will ensure that the lease won’t expire while the operator of the unit is actively engaged in drilling operations under the unit agreement.

Conforming the lease to the unit agreement may not be the end of the analysis in terms of lease extension. Specifically, all or a portion of the leased premises could still expire if the lease contains a severance provision in the unitization clause or a separate Pugh clause. A severance provision in a unitization clause could result in lease expiration as to any non-unitized lands at the end of the primary term. For example:

Anything in this lease to the contrary notwithstanding, actual drilling on, or production from, any unit or units (formed by private agreement or by any State or Federal governmental authority, or otherwise) embracing both lands herein leased and other land, shall maintain this lease in force only as to that portion of Lessor’s land included in such unit or units, whether or not said drilling or production is on or from the leased premises.

Similarly, a Pugh clause could result in lease expiration as to any non-producing lands at the end of the primary term. For example:

Notwithstanding any provision to the contrary, this lease shall terminate at the end of the primary term or any extended term, as to all the leased land except those lands within a production or spacing unit prescribed by law or administrative authority on which is located a well producing or capable of producing oil and/or gas or lands on which Lessee is engaged in drilling or reworking operations.

The threat posed by either of these provisions requires careful review of the lease as a whole. Oftentimes, Pugh clauses are negotiated independently of the general lease terms and ultimately included on an addendum attached to the lease. As a result, they are not always consistent with the other terms of the lease. To avoid ambiguity, when negotiating a fee oil and gas lease, it is prudent to review any included Pugh clause (and all other lease terms) and consider how it will reconcile with the unitization clause. Ideally, the Pugh clause should only result in lease expiration as to those lands outside of an approved unit. However, at a minimum, the Pugh clause should be drafted (or amended) so as to not sever the lands within a unit production area (for example, a participating area in a federal exploratory unit).

Part Three – How will the lessor’s royalty interest be calculated?

Example: Where there is production on any particular tract of land covered by such plan, it shall be regarded as having been produced from the particular tract of land to which it is allocated and not to any other tract of land and the Lessor’s royalty interest shall be based upon production only as so allocated.

Generally, a pooling clause will allow the leased premises to be combined with other lands to form a drilling unit, wherein proceeds from production anywhere on the drilling unit are allocated according to the percentage of the acreage of each tract divided by the total acreage of the drilling unit. However, because units are concerned with the development of a field or reservoir, the unitization clause should provide that proceeds from production should only be allocated to that tract included in a unit production area (such as a participating area in a federal exploratory unit). In other words, if the lessor’s interest is properly committed to a cooperative or unit plan of development, production anywhere on the unit will hold the lease, but the lessor will only receive proceeds from production if its tract is included in a unit production area containing a producing well (not the drilling or spacing unit that would exist if the well was drilled outside of the unit).

So what happens if the lessee’s working interest is committed to the unit agreement, but the lessor’s royalty interest is not? While the lessee will be allocated proceeds according to its proportionate share of the unit production area, the lessor will be allocated proceeds on a leasehold basis. This can result in a windfall either for the lessor or the lessee (compare the allocation of proceeds from the 1H and 2H wells in the diagram to the right, assuming 320 acre standup spacing units).

Part Four – How can the lessee commit the lessor’s interest?

Example: Lessor shall formally express Lessor’s consent to any cooperative or unit plan of development by executing the same upon request of Lessee.

The mechanism for the lessee to commit the lessor’s interest to a cooperative or unit plan of development varies depending on the unitization clause. Many unitization clauses allow the lessee to unilaterally commit the lessor’s interest by executing the unit agreement. In some cases, such unitization clauses require the lessee to record a memorandum of the unit agreement. Other unitization clauses, such as the example above, require the lessor to formally consent to the unit plan of development when requested by the lessee. This is typically done by executing a ratification of the unit agreement. In any event, the agency administering the unit (for example, the BLM for a federal exploratory unit) may need to confirm the commitment status of the fee lessor. As such, and to avoid a potential dispute down the road, the lessee may decide to obtain the lessor’s ratification of the unit agreement, even if the terms of the lease do not require it.

Unitization Clause Checklist:

  • ✓ Is there a unitization clause?
  • ✓ Does the unitization clause cover the proposed type of unit?
  • ✓ Does the unitization clause allow the leased premises to be combined with other lands for the development of a field or reservoir (as opposed to a single drilling unit)?
  • ✓ Does the unitization clause amend the lease terms to those of the unit agreement?
  • ✓ If there is a severance provision in the unitization clause, will it impact the proposed operations?
  • ✓ If the lease contains a Pugh clause, is it consistent with the unitization clause? Will it impact the proposed operations?
  • ✓ Does the unitization clause allocate proceeds from production within the unit production area (as opposed to a drilling or spacing unit)?
  • ✓ Will the proposed unitization plan be exercised in good faith?
  • ✓ If required, did the lessor execute a ratification of the unit agreement? Was it recorded?

[1] Williams & Meyers, The Law of Oil and Gas, § 8-U.
[2] In Utah, for example, correlative rights are defined as “the opportunity of each owner in a pool to produce his just and equitable share of the oil and gas in the pool without waste.” Utah Code Ann. § 40-6-2(2).
[3] See, e.g., Trans-Western Petroleum, Inc. v. U.S. Gypsum Co., 584 F.3d 988 (10th Cir. 2009).
[4] See, generally, Williams & Meyers, The Law of Pooling and Unitization § 8.06.
[5] See Amoco Prod. Co. v. Heimann, 904 F.2d 1405 (10th Cir. 1990).

Co-Authors
David Hatch and Andrew LeMieux

Practical Advice Regarding Pooling Clauses

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

Pooling is a fundamental concept within oil and gas law, but one that is often misunderstood. Pooling is most commonly defined as “the combining of two or more tracts of land into one unit for drilling purposes … accomplished voluntarily, or through compulsion.”1 In other words, it is how a lessee is able to extend a lease without physically drilling on the lease. For private (fee) oil and gas leases, the ability of the lessee to pool the lease is typically addressed in the lease provisions. These provisions are known as the pooling clause. This article provides some practical tips in dealing with the issues that arise from pooling clauses.

The first question that should be asked is if there is an existing spacing order in place for the lands and formation(s) involved. Many pooling clauses provide that the lease can only be pooled in conformity with a spacing order from the applicable state regulatory agency. If you encounter such a clause, you will need to check for a state spacing order, and if an order is not already in place, you will need to initiate the required steps to obtain an order. There may also be an order in place that does not match your proposed operation. If so, a new order would need to be obtained modifying the existing order. If spacing is governed by statewide spacing, you will want to double check the language in the pooling clause to confirm that statewide spacing is sufficient.

If the proposed well will be a horizontal well, there are special considerations that need to be addressed. Some lease provisions specifically address horizontal spacing. Many states have special statewide rules that are in place for horizontal wells. Particular attention should be paid to any total acreage limitation included in the pooling clause of the lease, for example, the lease cannot be included in a pooled unit for oil greater than 160 acres. If the lease has this limitation, an amendment to the lease may be the best option to eliminate this conflict.

The next question when reading a pooling clause is what role, if any, the lessor will have in the pooling process. The most common oil and gas lease terms allow the lessee to pool the lease without obtaining any additional consent from the lessor. In some cases, if the lessor desires to retain this right, they will strike out the pooling provision in the entirety, or add a specific lease provision requiring their consent. If the lease does not have a pooling clause, or if the pooling clause is stricken, the lease can only be pooled with the express consent of the lessor. This consent would be expressed by having the lessor execute a pooling agreement. The pooling agreement should be recorded to provide third parties with notice of the terms of the agreement. If obtaining consent is not an option, compulsory pooling by the governing state agency would be the alternative.

Some leases require that notice of the pooling be provided to the lessor in order for the pooling to be effective. If the pooling clause requires that notice be mailed to the lessor, an effort should be made to locate both the last address of record and a current address, utilizing online resources. If a more recent address is discovered, the notice should be mailed to both the address of record and the new address that was located. More commonly, the lease requires that for it to be properly pooled, a proper declaration of pooling needs to be executed and recorded by the lessee in the applicable county. Care should be taken in drafting the declaration of pooling. It should be signed by all parties owning a working interest in the lease. In order to be recorded, the signatures will need to be originals and it will need to be notarized. It should describe the specific lease(s) being pooled, including the recording information (Book/Page, Entry No.) for each lease. It should cite the authority to pool contained in the lease, for example: “Pursuant to Paragraph 10 of the lease.” It should define the pool, the total lands included and the formation(s) covered. If the lease covers more lands than what is being pooled, the declaration should describe all of the lands covered by the lease. This is particularly important in states that utilize a tract index recording system. If the pooling is in conformity with a state spacing order, it should be noted. If the party executing the declaration was not the original lessee, a statement as to the succession (Book/Page, Entry No. of the document transferring the interest in the lease) should be included. If the operator is drilling the well to earn an interest in the lease from another party, for example under a farmout agreement, it is recommended that the declaration be executed by both the record title owner and the party that is to earn the interest. Doing this would avoid any dispute as to the correct party to execute the declaration. Once executed, confirmation should be made that the declaration of pooling is properly recorded and, if it is a tract index state, that it is has been properly indexed against the lands.

Confirmation should be made that the effective date of the pooling is either the date of, or prior to the date, of first production. The effective date should also be prior to the termination date of the lease. Most lease provisions provide that the declaration of pooling must be prior to lease expiration. In the event the well was drilled prior to lease expiration, but the declaration of pooling was not timely recorded in order to avoid any issue, the lessor should execute a pooling declaration which includes a statement that the lease was properly pooled prior to the expiration date of the lease.

Finally, after reading the specific pooling provisions in the leases to be pooled, a broader examination of some additional issues raised by pooling the lease should be conducted. Confirmation should be made that all of the leases to be pooled are private leases. If the pool includes either federal, Indian, or state leases, additional steps will be needed to pool these leases. As to state leases, various state agencies have adopted different rules and procedures regarding private pooling agreements. As to federal and Indian leases, there are two ways to pool them: a federally approved unit or communitization agreement. The nuances of federal unitization and communitization will be further explored in a subsequent article in this series.

1 Patrick H. Martin and Bruce M. Kramer, Williams & Meyers, Oil and Gas Law § P Terms. (LexisNexis Matthew Bender 2016).

Pugh(eee)…Get Those Lands Outta Here: A Look at the Pugh Clause

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

For the unwary, Pugh clauses (pronounced “Pew”) can sometimes stink.  Although it is a fairly common provision in many fee oil and gas leases today, there is no industry standard Pugh clause.[1] As a result, the many variations of the Pugh clause can provide unpleasant surprises to both lessors and lessees who assume that all Pugh clauses operate similarly.  From an industry perspective, it is essential for landmen negotiating oil and gas leases to understand how a Pugh clause will operate an­­­­d potentially affect other provisions in the lease.  Additionally, with the sharp decrease in oil prices, many oil and gas companies have pushed drilling schedules into the indefinite future.  The delay in drilling necessitates a careful review of the underlying lease portfolios to determine when certain leases will expire. A thorough understanding of the effect of a  Pugh clause’s on a lease is vital to this review.

So What Is It?

As a general rule, production, or other operations, on “any part of the land, included in an oil and gas lease will perpetuate the lease beyond the primary term as to all of the land covered by the lease.”[2] Moreover, if lands are pooled or unitized, production or operations on any of the lands within the unit can extend all leases committed in whole, or in part, to the drilling or spacing unit.[3] This means that an oil and gas lease can be held past its primary term by production on only a small portion of the leased lands or on lands outside of the leased lands that are located in a drilling or spacing unit. Understandably, lessors can be less than thrilled to discover that all of their lands are locked-up by a lease when only a small portion of their lands are included within a drilling or spacing unit—preventing them from re-leasing their non-producing lands so that they can receive additional bonus payments, rentals, or production royalties from these lands. Without an “express provision in the lease, the lessor only has recourse to the implied covenant of reasonable development (or further exploration in a state that recognizes such a covenant)” to force additional development on the lessor’s lands or allow them to re-lease the lands altogether.[4]

A Pugh clause can prevent this scenario. Named after a Louisiana lawyer named Lawrence Pugh,[5]  the Pugh clause operates to sever the non-producing lands or interval based on some defined criteria, such as acreage or depth.[6] The impact of a Pugh clause “increases the burdens on the lessee who must take additional steps to maintain the lease as to the [non-producing portion]; this may include a return to delay rentals,” (if the lease is not a paid-up lease), “or initiation of drilling operations within a specified period.”[7] In other words, by including a Pugh clause in a lease, any production located on or attributed to leased lands will no longer be sufficient to extend the primary term for the entire leasehold. If the lessee takes no actions to extend the lease excluded by operation of the Pugh clause, the lease will expire as to these excluded lands. This provides an obvious benefit to lessors, who can once again make the forfeited lands available for lease. Since Pugh clauses are decidedly pro-lessor, they are “virtually always inserted into or attached to a lease at the insistence of the lessor’s attorney.”[8]

Horizontal and Vertical Pugh Clauses

It is important to note that Pugh clauses can be horizontal, vertical, or both.  A horizontal Pugh clause “has the effect of severing a leasehold as to the pooled and non-pooled portions on the basis of horizontal planes,” while a vertical Pugh clause “has the effect of severing a leasehold on the basis of vertical planes only.”[9] This means a Pugh clause can be structured by depth (e.g., severing all lands below 100 feet of a drilled well or the bottom of the producing zone), or by acreage.

Give Me An Example

Because there is no industry standard Pugh clause, there can be as many different forms of the clause as there are people drafting the clause.  The following is an example of a generic Pugh clause:

A producing well, or well capable of producing, will perpetuate this lease beyond its Primary Term ONLY as to those lands as are located within, or committed to, a producing or spacing unit established by Government authority having jurisdiction.[10]

This provision in an oil and gas lease operates to segregate the lease at the end of the primary term according to whether the leased lands were within a drilling or spacing unit established by the appropriate government agency. Any lands not located within a drilling or spacing unit would not be extended by production (keeping in mind, of course, that these lands could be extended by other provisions in the lease, such as those pertaining to drilling operations). As a title examiner, it’s not uncommon to see other triggering criteria in a Pugh Clause—such as one or two years after the end of the primary term, or when drilling operations on any portion of the leased lands cease for a specified amount of time.

It’s crucial to clearly specify how and when the clause will come into play, as illustrated by the following real-life Pugh clause:

Notwithstanding anything to the contrary herein, this lease shall terminate after the primary term as to all the lands not included within a drill site spaced unit as provided by the proper Governmental Authority….

This Pugh clause is poorly drafted because it segregates the leased lands only on the basis of whether they are within a “drill site spaced unit,” without clearly specifying that the spaced units must also be producing in order for the lease to be extended beyond its primary term for those lands.  Read literally, the provision raises the question of whether a lease would be extended for lands that are merely subject to a spacing order (and thus presumably within a drill site spaced unit) when there is no production within the drilling or spacing unit, assuming that there is production elsewhere on the lease lands, as was the case in this instance.[11] Although it’s likely that the parties to the lease intended that the clause include a production requirement, it’s uncertain how a court would rule if this clause was litigated, particularly since Pugh clauses tend to be strictly construed.[12]

Problematic Pugh clauses, such as the example above, often arise when the Pugh clause is merely copied and pasted from another oil and gas lease, which can result in omitted words or phrases, or inconsistencies with other provisions of the lease. Problems can also arise when a Pugh clause is drafted by a person who does not fully understand the impact of words or phrases included in, or excluded from, the provision.

Be Careful

As illustrated by the poorly drafted Pugh clause above, not all Pugh clauses are created equal, and it’s important to review and understand the specifics of a Pugh clause when negotiating an oil and gas lease, or when later evaluating how a Pugh clause affects the extension of a lease.

 

[1] 1 Bruce M. Kramer and Patrick H. Martin, The Law of Pooling and Unitization, § 9.01 (LexisNexis Matthew Bender 2015), hereinafter referred to as “Pooling and Unitization,” citing Robin Forte, “Helpful Hints: The ‘Pugh’ Clause,” 42 Landman 9 (May/June 1997) (“Just as there is no standard oil and gas lease, today there is no standard ‘Pugh’ clause.”).
[2] Adams, James W., Jr., “Lease Issues for Opinion Purposes,” Nuts and Bolts of Mineral Title Examination, Paper 11, Page No. 517 (Rocky Mt. Min. L. Fdn. 2015), hereinafter referred to as “Lease Issues”.
[3] Id.
[4] Pooling and Unitization § 9.01.  For a discussion on the implied covenant to develop as it relates to Montana law, see Miller, Adrian, “The Implied Covenant to Drill and Develop in Montana,” available at:  https://www.hollandhart.com/implied-covenant-to-drill-and-develop-in-montana.
[5] Pooling and Unitization § 9.01, ft. 3.
[6] Patrick H. Martin and Bruce M. Kramer, Williams & Meyers, Oil and Gas Law § 669 (LexisNexis Matthew Bender 2015), hereinafter referred to as “Oil and Gas Law.”
[7] Pooling and Unitization § 9.01.
[8] Pooling and Unitization § 9.04.
[9] Oil and Gas Law § H Terms. According to one commentator, the terms “horizontal Pugh clause” and “vertical Pugh clause” are often mistaken with one another and, as a result, are used somewhat interchangeably within the industry.  Consequently, the commentator suggests that Pugh clause should clarify whether the provision affects depth or acreage. See http://landmaninsider.com/pugh-clauses/.
[10] This example is given in Lease Issues, p. 518.
[11] The question regarding this Pugh clause’s operation might be even more muddled in some states, such as New Mexico, which have standard spacing requirements.  See N.M. Admin. Code 19.15.15.
[12] Pooling and Unitization § 9.01. The treatise notes, however, that “strict construction is by no means uniform,” and “a few courts have seemed almost eager to interpret such provisions in favor of the lessor through readings that do not appear entirely reasonable.”  Id.

The Mother Hubbard Clause

Fee Lease 101 Series, Lease Provisions, , , ,

Imagine a scenario in which the property description in one of your leases, meticulously transcribed from a document in the record chain of title, is later found to describe only a portion of the lands thought to be included. You are suddenly at risk of losing part, if not all, of your investment. What do you do? The answer depends on whether the lease contains a “Mother Hubbard clause.”

What is a Mother Hubbard Clause?

The “Mother Hubbard” or “cover-all” clause is a common provision in an oil and gas lease1 that provides a mechanism to include lands not adequately described in the lease or certain interests that vest after the lease has been issued.2 It was primarily designed to protect against the loss of small strips of land that were unintentionally omitted from the property description. But it was also meant to ensure that certain types of after-acquired interests, such as those acquired through adverse possession, were covered by the lease.3 At its core, the Mother Hubbard clause is an insurance policy.

Although many variations exist, the Mother Hubbard clause typically consists of two basic components. The first is a property catch-all. For example, the property description might state that “in addition to the described premises the lease covers adjoining, contiguous, or adjacent lands owned by the lessor.” The second component is meant to cover any interests that vest in the lessor after the lease has been issued. This language will likely include a statement that “the property includes any interests which the lessor may hereafter acquire by revision, prescription or otherwise.” Most modern Mother Hubbard clauses include both of these safeguards. (more…)

But My Husband (or Wife) Doesn’t Need to Sign: Spousal Joinder Issues

Royalty Issues, , , , , ,

When obtaining an oil and gas lease from an individual mineral owner, it is a common practice for landmen to obtain a signature on the lease not only from the record title owner but also from that person’s spouse. That is done for good reason. Given the various legal principles that may require spousal joinder – such as community property rights and homestead laws as discussed in this article – obtaining spousal joinder on a lease often is required, and is a very good precaution even in situations where it may not be required.1

Obviously, a lease isn’t the only place where spousal joinder issues crop up. The chain of title to mineral property may include a number of deeds that were executed by individuals who held record title at the time and that were not executed by the spouses, if any, of such persons. Often there is nothing in the abstract confirming whether or not the grantor was married at the time a deed was executed. When it comes to conveyances that were executed in the past, a landman doesn’t readily have the ability to cause the grantor’s spouse to execute the deed and thereby eliminate the risk that a required spousal joinder was not obtained. So when is joinder in a conveyance by the non-record title owning spouse required?

For land in a community property state, any conveyance by a married individual without joinder of that person’s spouse raises the issue of whether any potential community property interest of a non-record title owner spouse was conveyed, or even whether the conveyance by the spouse owning record title was valid. Of the western states, Arizona, California, Idaho, Nevada, New Mexico, Oregon and Washington are community property states. Statutes in several of those states specifically require joinder of a husband and wife in execution of a conveyance of community property.2 Generally speaking, when a married individual living in a community property state acquires mineral rights or other real property interests in that state using funds generated by the joint effort of both spouses, the property is community property. Both spouses have an equal, presently vested interest in such real property. On the other hand, real property interests acquired by either spouse before marriage or after entry of decree of dissolution of marriage, and real property acquired by either spouse by gift, bequest, devise or descent, is separate property. The issue of what constitutes community property or quasi-community property is state specific and fact specific and is beyond the scope of this article.

Community property issues can’t be ignored entirely with respect to real property in common law jurisdictions either. A number of western states, including Colorado,3 Montana,4 Utah5 and Wyoming,6 have adopted the Uniform Disposition of Community Property Rights at Death Act. Under these statutes, the community property rights of a surviving spouse that resided in a community property state are recognized as to real property located in the applicable common law state. If both spouses are living, these statutes are not a concern. However, execution by a non-record title owing spouse is needed when conveying real property in the common law state that was owned by a deceased resident of a community property state, except as to real property that is separate property under the laws of the community property state.7 The statutes do protect purchasers for value from a personal representative, heir or devisee of the record title holder that has apparent title to the property against claims of the surviving spouse.

Other spousal joinder requirements arise out of state laws requiring that both spouses must join in instruments affecting real property when the land is a homestead. In Montana,8 Nevada,9 South Dakota10 and Utah,11 homesteads are created by a filing or a declaration in accordance with the applicable state statute, and spousal joinder is required to convey or encumber homesteads of married persons so created.12 In other states such as Nebraska,13 New Mexico,14 North Dakota,15 and Wyoming,16 a homestead right can arise without the filing of a homestead certificate. In Colorado, homesteads created automatically under the statutory provisions can be conveyed or encumbered free and clear of homestead rights by the record owner alone, but if the owner and spouse file a homestead declaration, the signature of both spouses is required to convey or encumber the property.17

In states where a homestead filing is required, if the title data is sufficient to determine that there was no homestead filing, a landman or title examiner can conclude that no spousal joinder was required in a conveyance. In jurisdictions where a homestead can be created without filing, spousal joinder generally should be obtained due to the difficulty of determining whether the land falls within the statutory definition of a homestead such that spousal joinder is required.18 However, given the provisions of the various homestead statutes, an out of state owner or the owner of a severed mineral interest would not be in a position to assert a homestead claim. As a result, the lack of joinder by the spouse of the record owner on a deed conveying such an interest would not be a title defect unless spousal joinder was needed for reasons other than the homestead statute.

In addition to the statutes discussed above, most states have adopted probate laws which guarantee that a surviving spouse will receive a fraction of the total value of the spouse’s estate. These statutes also permit the surviving spouse to attack certain conveyances made prior to death if the reduced estate and other assets are not there to satisfy the survivor’s share. The most common form of forced share provision is the augmented estate provision of the Uniform Probate Code (UPC). In order to protect the surviving spouse against transfers made before death, the effect of which is to reduce the estate and therefore the statutory guaranteed share, the UPC allows augmenting the estate to include certain property dispositions made by the decedent alone during a specified period (usually two years) before death. The augmented estate provisions of the UPC have been adopted in various forms in Colorado,19 Montana,20 Nebraska,21 North Dakota22 and Utah.23 These statutes are relevant only as to conveyances that were made by a married record owner without spousal joinder during the specified period before his or her death, when the issue has not been rendered moot by subsequent probate or intestacy proceedings which clarify that the surviving spouse did not elect to take under the augmented estate provisions.

As the discussion above indicates, there is no simple, across-the-board answer to the question of when spousal joinder is required in a conveyance. Whether the lack of spousal joinder in a deed in the chain of title resulted in an outstanding interest that was not conveyed may depend on facts not available in an abstract examined. Clearly one needs to understand the statutes and case law of the applicable state as the starting point in making that determination.

1If an individual executes a lease alone, the lessee frequently includes a recital stating the reason given by the lessor as to why joinder by a spouse was not needed. For example, the lease may recite that the lessor is a single person, or is a widow or widower. When the spouse of a record owner who is married does not sign a lease, the lease may recite that the lessor is dealing with his or her separate property. Inclusion of self-serving recitals such as these may make a company more comfortable in accepting a lease that has not been executed by the record owner’s spouse, but there is a risk in relying on such recitals without further confirmation since they are not proof of the facts stated. The “facts” recited may be incorrect. At most, they qualify the recited facts as prima facie evidence or create a rebuttable presumption that they are true. See, e.g., Colo. Rev. Stat. § 38-35-107 (recitals instruments recorded for 20 years are prima facie evidence of facts recited therein); S.D. Codified Laws § 43-28-19 (recitals are prima facia evidence on questions of marital status, homestead and identity when recorded); N.D. Title Standards 2-03 (permits reliance upon a recitation of single status, including widow or widower, if no evidence of marriage appears in the record).
2Ariz. Rev. Stat. Ann. § 33-452; Ida. Code § 32-912; N.M. Stat. Ann. § 40-3-13 (also applies to leases if the initial term, together with any option or extension, exceeds 5 years, or if the term is indefinite); and Rev. Code Wash. Ann. § 26.16.030(3). Under New Mexico law, for example, if a spouse fails to join in the conveyance, mortgage, assignment, or lease of community property, the instrument is void and of no effect, unless ratified by the spouse in writing. N.M. Stat. Ann. § 40-3-13; Hannah v. Tennant, 589 P.2d 1035 (N.M. 1979). In fact, an instrument purporting to convey a community property interest that is signed by only one of the spouses may not even be effective as to the spouse who signed the instrument. Either the joining or non-joining spouse can subsequently assert a claim that the conveyance was void. See Marquez v. Marquez, 513 P.2d 713 (N.M. 1973); McGrail v. Fields, 203 P.2d 1000 (N.M. 1949).
3Colo. Rev. Stat. § 15-20-101 et seq.
4Mont. Code Ann. § 72-9-101 et seq.
5Utah Code Ann. § 75-2b-101 et seq.
6Wyo. Stat. Ann. § 2-7-720 et seq.
7The statutes list rebuttable presumptions relating to community property and separate property.
8Mont. Code Ann. § 70-32-105.
9Nev. Rev. Stat. § 115.020.
10S.D. Codified Laws § 43-31-8.
11Utah Code Ann. § 78B-5-504.
12See Mont. Code Ann. § 70-32-301; Nev. Rev. Stat. § 115.040; S.D. Codified Laws § 43-31-17; Utah Code Ann. § 78B-5-504(4).
13Neb. Rev. Stat. § 40-104.
14N.M. Stat. Ann. § 42-10-9.
15While N.D. Cent. Code §§ 47-18-19 through 20 provide for execution and recording of a homestead declaration, N.D. Cent. Code § 47-18-17 provides that failure to make such a declaration shall not impair the homestead right.
16Wyo. Stat. Ann. § 34-2-121 (in addition to spousal joinder, requires language stating: “Hereby releasing and waiving all rights under and by virtue of the homestead exemption laws of this state” to convey or encumber homestead). Under Wyo. Stat. Ann. § 34-8-101 et seq., a defective deed is cured by operation of law after it has been of record for 10 years, however. 17Colo. Rev. Stat. § 38-41-202.
18As noted above, homesteads created automatically in Colorado are the exception since the record owner alone can convey or encumber the property.
19Colo. Rev. Stat. § 15-11-201 et seq.
20Mont. Code Ann. § 72-2-222.
21Neb. Rev. Stat. §§ 30-2313 – 2314 (period extended to 3 years).
22N.D. Cent. Code § 30.1-05-01.
23Utah Code Ann. § 75-1-201 et seq.

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.