Oil and Gas Outline (2023) - Audrey Helm PDF

Table of Contents {#table-of-contents.TOCHeading} ================= [OWNERSHIP AND CAPTURE 2](#termsland-descriptions) [ADVERSE POSSESSION 8](#_Toc151586897) [SLANDER OF TITLE 9](#slander-of-title) [THE OIL AND GAS LEASE 10](#the-oil-and-gas-lease) [THE GRANTING CLAUSE 11](#_Toc151586900) [OIL...

Table of Contents {#table-of-contents.TOCHeading} ================= [OWNERSHIP AND CAPTURE 2](#termsland-descriptions) [ADVERSE POSSESSION 8](#_Toc151586897) [SLANDER OF TITLE 9](#slander-of-title) [THE OIL AND GAS LEASE 10](#the-oil-and-gas-lease) [THE GRANTING CLAUSE 11](#_Toc151586900) [OIL AND GAS INCOME TAX PRINCIPLES 12](#_Toc151586901) [THE HABENDUM CLAUSE 13](#the-habendum-clause) [FORCE MAJEURE 16](#_Toc151586903) [SAVINGS CLAUSES 17](#savings-clauses) [POOLING CLAUSE 18](#pooling-clause) [IMPLIED COVENANTS 20](#implied-covenants) [DIVISION ORDERS 22](#division-orders) [TITLES AND CONVEYANCES 23](#titles-and-conveyances) [SHARED OWNERSHIP OF MINERALS 26](#_Toc151586909) [TERMINABLE INTERESTS 29](#terminable-interests) [THE EXECUTIVE RIGHT TO LEASE 30](#the-executive-right-to-lease) [OTHER MINERALS 31](#other-minerals) [FIXED V. FLOATING ROYALTY 32](#fixed-v.-floating-royalty) [OVERCONVEYANCES 33](#overconveyances) [CONVEYANCES AND INTERESTS IN LEASED LAND 35](#conveyances-of-interests-in-leased-land) Terms/Land Descriptions ======================= - **Legal Descriptions of Land** - [Metes and Bounds]: Describes the boundaries of a parcel of land. "Metes" is a mathematical description of the property lines around the perimeter of the property, and "bounds" states what each line is bordered by. - [Block (in a survey)]: A "block" is a subdivision of land surveyed using metes and bounds that may cross county boundaries. - [Section (of a survey)]: Nominally 1 square mile, containing 640 acres. - [320 acres]: Half section - [160 acres]: Quarter section - [80 acres]: Half of a quarter section - [40 acres]: Quarter of a quarter section Macintosh HD:Users:shelbyhall:Desktop:section.gifMacintosh HD:Users:shelbyhall:Desktop:locating-wells-3.jpg - [Township]: 36 sections on a rectangular grid. - Spanish/Mexican Land Grants - [Labor]: Spanish land unit measuring 177 acres (about a quarter-section) - [League]: Spanish land measurement of about 2.63 miles or 4428 acres (equal to about 7 sections) - [Vara]: (33 1/3 inches) about a yard - **Oil and Gas Terms** - [API] = American Petroleum Institute. The largest U.S. trade association for the oil and gas industry. - [BBL] (or barrel) = 42 gallons. The abbreviation of the standard oil barrel is said to stand for "blue barrel" and to have originated in the blue paint on barrels in the early days of oil production. - [BOPD] = Barrels of produced oil per day. - [Casing] = A hollow steel pipe cemented into position that is used to line a wellbore. - [Surface Casing:] Sufficient depth to go below the deepest potable groundwater zone - [Intermediate Casing:] Depth to oil-gas producing formation - [Production Tubing:] Depth to the actual formation to be produced (oil/gas travel up this pipe to the surface) - [Condensate] = Liquid hydrocarbons recovered by surface separators from natural gas. It is also referred to as natural gasoline and distillate. - [Christmas Tree] = A system of valves and gauges at the top of the well that controls the flow of gas - [Crude oil] = The basic oil in its raw state as it comes out of the ground. - [Dry Hole] = A well which has been drilled where no significant oil has been found. - [Flowlines] = Pipes connecting a wellhead to a manifold. Transport the product upwards towards the platform. - [Fugacious] = Transient (as in oil and gas). Moves from place to place. - [Fungible] = Indistinguishable (as in oil and gas). Difficult to know where it comes from. - [Gusher] = An oil well with so much pressure that oil flows out of the wellhead into the air. Not common anymore. - [Hydrocarbons] = An organic compound comprising hydrogen and carbon which can occur as gases, liquids, or solids. - [Natural gas] = Essentially, a naturally occurring mixture of hydrocarbon gases that is highly compressible and expansible. Methane is its main constituent. - [Porosity] = High porosity means that there is a relatively large area within which oil and gas might accumulate. - [Permeability] = High permeability permits petroleum, which is lighter than water, to float upwards through the original seawater contained in the pores of the permeable rocks to collect and flow towards a borehole. - NOTE: It is ideal to have *high* permeability and *high* porosity for extraction - [Recovery] - [Primary recovery] = The initial stage in the oil and gas extraction process. It involves placing increased pressure on the oil within wells to force it to the surface. Can be done by pumping water, or an oil rod, into the well. - [Secondary recovery] = Secondary techniques, such as the use of additional water injections, that force oil to the surface by applying more pressure. - [Tertiary recovery] = Involves altering the properties of the oil to assist in its extraction, through the use of heat, gas, and chemical injections, respectively.  - [Petroleum] = "Rock oil." A broad category that includes both crude oil and petroleum products. - [Sour gas] = Gas containing significant amounts of hydrogen sulfide. Extremely poisonous, highly corrosive, explosive, and foul smelling. - [Sweet gas] = Has very little or trace amounts of sulfide. - [Top lease] = A contingency lease covering the same acreage as an underlying lease. It activates if and when the underlying lease terminates. - *I.e.,* where a mineral interest owner is currently under a lease with somebody, so they are basically looking ahead, entering into another lease with a new lessee that will begin upon termination of the first lease. - May also convey a fractional interest in the lessor's interest arising under an existing lease - [Fracture Lengths] - Propped Length - [Effective Length:] The part that actually captures oil and gas from the reservoir. Shorter than its initial propped length. - Hydraulic Length - **History** - The first oil well in the U.S. was drilled in Pennsylvania 1859 and had a depth of 69 feet. - First producing oil well in Texas was drilled in 1866 in Melrose and produced 10 bbls/day - The gamechanger was Lucas \#1 near Beaumont, gushed 100 ft. in the air for 9 days (1901) - The U.S. Government owns about 28% of the total land in the U.S. - This is 644 million of 2.3 billion acres OWNERSHIP AND CAPTURE ===================== - **In General** - In most countries, the government owns the minerals - U.S. tradition of private ownership is unique - Eventually, the federal government realized what it was conveying away, so now the government owns: - 28% of the total U.S. land area - 644 million of 2.3 billion acres - **"Ad Coelum"** -- Common law doctrine that a landowner owned not only the ground, but everything above and below the ground, within the boundaries of his property. - The doctrine behind ownership-in-place states - **"Laissez Faire" Doctrine**---Old prevalent economic theory that emphasized a policy of rewarding the diligent worker to the ultimate benefit of society. - Supports the encouragement of production and diligence in capturing oil; a drive behind the law of ROC - **"Profit á Prende"**---a right to go on the land and take some part of the land or a product of it. - The doctrine behind non-ownership theory states; Texas doesn't follow - **Rule of Capture** - Common law doctrine based on the analogy to wild animals - Says that if you catch it while it's on your property, it's yours. - It's a rule of "non-liability" and self-help - The single most important doctrine in all oil and gas law - Substantially departs from the "ad coelum" doctrine - Oil and gas are "fugacious" (transient) and "fungible" (indistinguishable) - **[Public policy]**: Encourages people to go out and get oil. Encourages production and exploration. - **NOTE: In today's era there is now technology that can differentiate between different oils from different locations** - *Del Monte Mining & Milling Co. v. Last Chance Mining & Milling Co.* - **Issue:** Does a landowner have a right to follow a vein of silver and lead-bearing ore beyond the boundary of its mining claim on federal land and beneath the surface of another landowner's mining claim on federal land? - **Analysis:** Looked at common law and Spanish and Mexican mining law to determine that that the owner of a mine is confined to perpendicular lines on every side and cannot do slanted mining under another person's land. *Slanted drilling is trespass*. - **Rule of Capture Limitations** - \(1) Correlative Rights Doctrine - \(2) Trespass - \(3) Nuisance - \(4) Conservation Laws - **Correlative Rights Doctrine** - Protects owners from *negligent* or *wasteful* operations that injure or destroy the common source of supply. - Reciprocal rights and obligations shared with neighbors whose land overlies a common reservoir - Equality of opportunity - Co-equal rights - Fair share - *Eliff v. Texon Drilling Co.* (application of correlative rights doctrine) - **Background:** Texon had already drilled a producing well on the Elliff property. Texon then drilled a well on the adjacent (Driscoll) property and caused a blowout. Texon was the lessee on both properties. - **Supreme Court:** Found for the landowner. ***The Rule of Capture CANNOT protect the lessee from grossly negligent behavior***. It is limited by the correlative rights belonging to Elliff. - **Petroleum Ownership Theories** - **Ownership in Place Theory (TX):** The landowner owns all substances, including oil and gas, which underlie his land. But you don't really get it until you produce it. Ownership is qualified, in the case of oil and gas, but for the operation of the law of capture. If the oil and gas depart from beneath the owned land, ownership of those substances is lost. - **Exclusive Right to Take Theory**: The landowner does not own the oil and gas which underlie his land. He merely has the exclusive right to capture such substances by operations on his land. Once reduced to dominion and control, such substances become the object of absolute ownership, but, until capture, the property right is described as an exclusive right to capture. - *Kelly v. Ohio Oil Co.* - **Facts:** John Hastings owned a tract of land in Ohio. The plaintiff had a contracted-for right to the oil under Hastings's land. Ohio Oil Co. (OOC) (defendant) owned vast tracts of land surrounding Hastings's land. OOC built oil wells on its land only 25 feet from Hastings's land. The plaintiff brought suit, claiming that OOC's motive in building its wells so close to Hastings's land was to extract oil from Hastings's land.  - **Rule:** To drill an oil well near the line of one's land cannot interfere with the legal rights of the owner of the adjoining lands, so long as all operations are confined to the lands upon which the well is drilled. Whatever gets into the well belongs to the owner of the well, no matter where it came from. - **Analysis:** The right to drill and produce oil on one's own land is absolute, and cannot be supervised or controlled by a court or an adjoining landowner. So long as the operations are legal and confined to their own boundaries, reasonableness cannot be drawn in question. - **Correlative Rights Doctrine:** Limit to the "rule of capture." Protects owners from negligent or wasteful operations that injure or destroy the common source of supply. - **Public Policy:** Courts want to incentivize the production of oil---can't do this by micromanaging companies that are legally drilling on their own property. - **Three Types of Waste** - "[Economic]" = more wells are drilled than necessary for efficient and effective drainage. This happens when there is a race to produce as much oil as possible and beat someone else to it. - Leads to "tragedy of the commons" - Conservation laws tackle this problem (by enforcing "well spacing" laws and such) - "[Surface]" = too much extra equipment on the field, leads to more breakdowns and equipment waste - "[Underground]"--- leaving recoverable hydrocarbons in the ground due to inefficient dissipation of the reservoir - After you do this, you basically make it unrecoverable at least for awhile. - **Trespass** - **In General** - You can't hide behind rule of capture when you're trespassing - [Slant-hole drilling] - By its definition, ILLEGAL TRESPASS. - [Directional wells] - Accepted, *not* trespass, people know about it - [Fractures] - Texas has danced around it---would be too difficult to determine - Better left to the experts (RRC) to decide if it's trespass - There is already remedies for this---drill your own well to offset drainage, or sue for breach of the implied covenant to protect against drainage - Too hard to show damages on this too - [Geophysical surveys] - Geophysical exploration is an absolute right. - So far, Texas has taken the position that without an injury to the property, there can be no subsurface trespass for geophysical surveys. - Mere vibrations don't count. *Kennedy.* - However, damages can result through shooting over or onto the land, negligent explosions, throwing inflammable substances, blasting operations, etc. MUST cause an appreciable injury to get damages. - On the flip side, the surface owner cannot conduct seismic exploration when they do not also own the mineral state. ONLY the mineral owner can do this or grant permission. - [Unpermitted gathering of information] - Not trespass if the alleged trespasser does not physically use the surface overlying the mineral estate. *Villareal*. - However, if done unlawfully or outside of a lease, courts protect information gathering even if the info shows there is nothing to produce in part because it eliminates a mineral owner's ability to receive bonus payments. - Want to keep people from blowing mineral owner's cover - [Dry hole trespass] - Can be trespass - If the use of an expired lease finds a dry hole and causes a decrease in the FMV of the mineral holder's estate, the mineral holder can recover damages for the difference in market value. - Damages can only be obtained if it resulted from trespass in the first place - **Formula: (original FMV) x (number of acres) x (holder's interest in the mineral estate) = damages** - Assumpsit is also a favored remedy for this, because it allows a mineral owner to obtain the bonus they should have received - [Wet hole trespass] - When someone trespasses on someone's land and drills a hole that is "wet" or has oil/gas. - Where wrongful interference results in production, the most common remedies are trespass and conversion, coupled with the equitable remedy of accounting. - [Good faith trespass]: you will be able to recover your costs and get back the money you invested, not any future proceeds. - [Bad faith trespass]: You lose everything. Money invested AND future proceeds. - [Waterflooding] - Not trespass if it occurs beneath the neighboring lands - Must prove an actual injury. If not, then no trespass. - **NOTE: Plaintiff must prove injury and causation!** - Availability of damages - Good-faith trespassers - May only be liable for actual damages - Bad faith, intentional, or dangerous trespassers - May be liable for actual AND punitive (or exemplary) damages - This may require a heightened burden for proof of fraud, malice, or gross negligence - However, where injury is to property, Texas disapproves the awarding of mental anguish damages - Backup options - Where a claim for trespass fails, a property owner may have a claim for damages for breach of the implied covenant to protect against drainage, etc. - *Coastal Oil v. Garza* (application of trespass---does a mere fracture count?) - **Facts:** Coastal dug a well on Share 12 and began hydraulic fracturing (fracking), which had the effect of draining gas from Salinas's Share 13. Salinas brought suit for trespass, seeking damages for the gas that Coastal's fracking drained from Salinas's Share 13. He claimed a fracture extended into his property. - **Issue:** Is subsurface hydraulic fracturing of a natural gas well that extends into another's property trespass for which the value of gas drained as a result may be recovered as damages? NO. - **Rule:** The "rule of capture" bars recovery from trespass from hydraulic fracturing that extends into another's property. - **Analysis:** Salinas has alleged no illegal activity on the part of Coastal that would trump the rule of capture. In any event, under the implied covenant to protect against drainage, there is already a remedy for Salinas for drainage of Coastal breached that covenant. Additionally, it is the purview of the Texas Railroad Commission to regulate gas and oil production. A court permitting recovery for oil drainage resulting from fracking would improperly usurp this authority. Finally, determining the value of gas drained in this manner would be extremely difficult and is something for which courts are not equipped. Most importantly, there is no justification for not applying the rule of capture to hydraulic fracking. - **Public Policy:** - To consider every single fracture into someone's property would be difficult and highly technical - Courts aren't equipped to handle this - Better left to experts---the Railroad Commission - **Geophysical and Exploration Trespass (an absolute right!!!)** - *Enron Oil and Gas v. Worth* - **Issue:** Whether the owner of an unleased, undivided mineral interest may authorize a third party to enter surface of land owned by another to conduct seismic operations. - **Held**: Enron had a legal right to enter the defendants' land to conduct exploration. An owner of an undivided mineral interest may authorize geophysical exploration---***this is absolute***!!! - *Kennedy v. General Geophysical Co.* - **Holding:** For vibrations from geophysical blasting that does not cross the boundary of the plaintiff's land to constitute trespass, the vibrations must cause the plaintiff an appreciable injury. Mere annoyance doesn't count. - *Grynberg v. City of Northglenn* (surface owner conducting exploration) - **Injury:** Surface owner conducted exploration for minerals on a severed estate. Loss of market value of Grynberg's coal lease occurred as a result of the discovery and publication of information that the coal reserves really had no commercial value. - **Issue:** Whether the owner of a severed surface estate has the authority to grant permission to conduct drilling (as exploring) for mineral deposits. NO THEY DON'T. - **Holding:** Where the surface estate has been severed from the mineral estate, "it is clear from the decided cases *that **the mineral owner, rather than the surface owner, is the one who has the right to conduct geophysical operations***." - *Enron v. Worth* - **Holding:** Doesn't matter if there is a lease in effect or not---the mineral owner has control over decisions for geophysical exploration. NOT the surface owner. - If mineral owners don't have a right to access the minerals to have profits from them, there's no point. - You don't have to have a lease to empower an exploration company to do what you want to do. - ***There is no requirement for joinder of other mineral-interest owners on exploration decisions***. - **Dry Hole Trespass** - *Humble Oil and Refining Co. v. Kishi* - **Background:** A drilling company entered a lease after it had expired, but as a result of not finding oil, the value of the tract owned by the Plaintiff became essentially worthless. - **Rule:** The market value of the leasehold interest at the time Humble drilled is the measure of damages the plaintiff was entitled to recover: \$1,000 (original FMV) x 50 (number of acres) x ¾ (the plaintiff's interest in the leasehold). - **Nuisance** - **In General** - A lot of nuisance law hinges on location of the nuisance. Rural areas can see different results than urban areas, for example. - If a nuisance is dangerous and causes an injury, a surface owner can recover. - *Peoples' Gas Co. v. Tyner* - **Background:** Tyner (landowner) wanted an injunction to enjoin an operator from "shooting" a nearby well with nitroglycerin. - **Holding:** Obviously the Tyners didn't have a right to the gas that the operator was going to get after shooting the well. However, if the shooting would pose a danger to people on the surface, under the law of nuisance, the Tyners may be entitled to enjoin them. - **Note:** While the court held that this was nuisance, under different facts it may not be. For example, in a more rural area, this might be okay. - *Railroad Comm'n v. Manziel* - **TX Supreme Court Holding:** Rejected liability for nuisance or trespass where the drained party has refused what the court considered a "fair" proposal to participate in an enhanced-recovery program, and a state conservation agency has approved the program as necessary to prevent waste and maximize production. - **However, the rule of capture will not excuse ALL drainage.** - The rule of capture should be used to protect operators that are using secondary or tertiary recovery methods reasonably to maximize production. - However, using those methods to sweep away resources from a neighboring property should not be protected. - **Conservation Laws** - Rule of capture does not apply if there is a regulation or state agency controlling a certain area - Nor will it protect against the violation of a state agency regulation. - *Wronski v. Sun Oil* - **Background:** Plaintiff was arguing that Sun Oil was illegally overproducing from their wells past a regulatory limit in place. (And, thus, taking oil that should be theirs, which is where the injury comes in). - **"Fair Share Principle":** Within reasonable limits, each operator should have an opportunity equal to that afforded other operators to recover the equivalent of the amount of recoverable oil underlying his property - This doesn't "do away with" the Rule of Capture, but it limits proper application of it. - **Long Story Short: *Police power overrules the Rule of Capture.*** If you break the law, you're fully liable, period. - Here, the state agency set maximum production limits at 75 bbl/day/well. Sun Oil's violation was akin to a bad faith trespasser. - **"Forced Pooling" laws** - When a small-tract owner is dealing with drainage from a nearby bigger tract, conservation laws will oftentimes provide them a right to join in a share of production of the well that causes the drainage. - **Ownership After Extraction** - **Main Concepts** - In Texas, once out of the ground, the property converts from **real** property **personal** property. - This applies to all ownership-in-place states - Once produced, the oil and gas remain the personal property of the producer---unless abandoned. - Texas recognizes abandonment of oil and gas, but not abandonment of title to it. - It takes *a lot* of evidence to show abandonment. Abandonment must be intentional + voluntary. - *Champlin v. Western Bridge* (Okla. case) - **Holdings:** - Once oil is produced, it belongs to the company that owns it and from whom the oil had leaked, *unless* there is a clear indication of abandonment - *I.e.*, loss of possession is not loss of title, unless the owner demonstrates an intent to abandon it. - Oil and gas in the ground in their native, unproduced condition = real property - Oil and gas, once produced = personal property - Once produced, it remains the personal property of the producer---***unless abandoned*** - **Stored/Injected Gas** - *Texas Am. Energy v. Citizens Fidelity* - **Background:** Tex. Am. was arguing that the stored gas was personal property so it must be secured under the UCC. Fidelity was arguing that the stored gas was real property so it had to be secured by a mortgage. - **Holding:** Tex. Am. is right. ***Stored gas remains the [personal] property of the injector.*** - **This applies to gas stored underground as well.** Just because it's placed back in the ground doesn't mean it magically converts back into real property. - **Attributes of Mineral Ownership** - **Fee Simple** - Surface Estate - Mineral Estate - Severance---act of dividing the fee simple estate. - **The Five Essential Attributes (Sticks of the ME)** - [(1) The right to develop] (ingress/egress) - Because this is necessary to exploit the minerals - [(2) The right to lease] ("alienate"; execute leases---"executive right") - [(3) The right to bonus] - [(4) The right to delay rentals] - If they can't drill the well on time, the lessee may be liable to pay some amount of money - [(5) The right to royalty ] - Ongoing form of compensation - The right to a share of production, free of (pre) production costs - **Royalty Interests (Three types)** - **LRI**---lessor typically retains "lessor" or "landowner" or "lease" royalty interest - Non-cost bearing - Non-executive - Reserved in an oil-and-gas lease - **ORI**---Lessee can carve an "overriding royalty interest" out of its working interest - *Example:* An oil and gas lessee may assign the lease, reserving an overriding royalty, or simply convey an overriding royalty to a third party. - Frequently used to compensate landmen, lawyers, geologists, etc. who have helped structure a drilling venture - Ends when lease terminates (creature of a lease) - **NPRI**---Is carved out of the mineral interest; doesn't relate to a particular lease, so it doesn't end when the lease ends, but is tied generally to the land; does not share in lessor's bonus and delay rentals - May be limited to a term or perpetual - Depends on intent of the parties at the time of its creation - **Cf. Production Payment (not royalty)** - A share of oil (or other minerals) produced from a described tract of land, free production costs at the surface, and terminating when a specified time period or sum of money from the sale of the oil has been realized. - **Cf. Net Profit Interest (not royalty)** - Similar to production payment, except it is only paid if there is a net profit from production. - **Royalty Distinguished From Other Interests** - \(1) It does not have the right of surface use - Not a right to a produce, just a right to a share in the revenues - \(2) It is not profit-sharing or cost-bearing - Free of costs of production - \(3) It does not have the right to lease - Mere royalty owners do not have a right to enter a lease - \(4) It does not share in other lease benefits - **Other Considerations** - ***Title to an oil and gas lease in Texas cannot be abandoned*** (unlike actual oil can) - [Abandoned Oil]: Waste oil permitted by an operator to escape the wells after production. In some instances, this is treated as abandoned, and surface owners can recapture it in pits or pick-up stations. - **If it is a real property interest, you cannot abandon.** - If it is a non-ownership approach, it can be abandoned because it is NOT considered a real estate property interest. - *I.e.,* once oil is produced it becomes personal property and CAN be abandoned. - [Elements of Abandonment]: (1) lack of use, and (2) intent to abandon - **Liberative Prescription:** In other states, it's called a "dormant mineral act" - At common law, this is a means of creating or extinguishing an incorporeal *interest* in land, such as an easement. - Incorporeal means a mere right to "use" of the property, not possession from it - In Louisiana, it is a means of creating or extinguishing some right. - Texas doesn't use this. - **Texas: Unclaimed Property Statute** - Prop. Code. Sec. 75.001, et seq. - After three years of unclaimed mineral proceeds, the owner's underlying right to receive those mineral proceeds are presumed abandoned. - After three years, the unclaimed property escheats to the state. - **Estate Misconception Theory** - In the olden days, lessors thought they retained only 1/8 of the entire mineral estate, so they would have to often attempt to convey all of their interests in the mineral estate by conveying 1/8 thereof. - Therefore, many times, old references to 1/8 presumptively refer to the entire mineral estate, they don't necessarily just imply a reference to a royalty. - The use of one-eighth in a double fraction is some evidence that the parties were operating under the estate misconception theory. - []{#_Toc151586897.anchor} ADVERSE POSSESSION ================== - **Elements:** - \(1) Actual possession - \(2) Open and notorious - \(3) Continuous - \(4) Hostile - \(5) Exclusive - **Entry *Before* Severance of Mineral Interest** (severance after adverse possession begins) - If a mineral interest has not been severed from the surface ownership, adverse possession to the surface will include limitation title to minerals. - **Entry *After* Severance of Mineral Interest (severance before adverse possession begins)** - If a mineral interest is severed from surface ownership prior to the adverse possessor's entry, activities on the surface will NOT establish title to the severed mineral interest. - You MUST go out and assert ownership privileges like drilling a well---act like you own the minerals! You have to take some sort of physical action to assert title to the minerals! - *Diedrich v. Ware* - **Takeaway:** After severance of the mineral rights from the surface rights, it is possible for the surface owner, or even a person with no interest, to acquire title to the minerals by adverse possession. - **Dissent:** Believed that adverse possession in oil or gas is limited to the oil or gas which is produced by the wells that have been drilled. - **CONTROL/DOMINION TEST:** You have to have some *affirmative action* to "penetrate" the minerals. - **Note:** - ***The adverse possessor takes possession of everything the previous owner owns*** - OR whatever area is described by the instrument (if under color of title) - **Doctrine of Relation Back** - Title relates back to the time the adverse possession began - **Color of Title** - When an adverse possessor receives the property through title from another adverse possessor - The limitations period is "tacked on" in this situation - **Adverse Possession in Leases** - Typically, adverse possession has to be possessory (i.e., royalty could not be adversely possessed) - But, under a lease, someone can adversely possess a working interest SLANDER OF TITLE ================ - **Slander of Title Elements** - \(1) Publication - \(2) Falsity - \(3) Malice - Doesn't have to have evil intent, just that they had deliberate conduct without reasonable cause - Reasonable cause is present when the slanderer has a good faith belief in the superiority of their claims---courts tend to define this restrictively - \(4) Interest in property slandered - \(5) Financial damage - \(6) Loss of specific sale - Usually requires showing of a lost contract or opportunity to sell or lease - **Damages** - Where someone meets these elements of proof, they may be liable for damages to the owner. - **Assumpsit** = An equitable action brought to enforce an implied contract - *I.e.,* payment for the right of entry that a trespasser should have obtained. - *Kidd v. Hoggett* - **Background:** Company with a lease drilled a well, but it wasn't producing a marketable amount. Lessors asked them to leave (release), but the defendants didn't. The tract lost value. - **Malice:** Ill will, bad/evil motive, or gross indifference/reckless disregard (for punitive damages) - **Cloud vs. Slander** - Cloud on Title = basically clearing up confusion. Remedy is clear title. - Slander = Confusion caused someone damages. Requires proof of a lost sale/opportunity. - **Shut-In:** - Suggests that you have a producing well, but you can't do anything with it yet, but you also don't want to lose the lease. - **Malice** - Malice for actual damages must be differentiated from punitive damages: "The act or refusal was deliberate conduct without reasonable cause"!!! It doesn't carry the emotional aspect that punitive damages require. - [Actual damages]: "Deliberate conduct without reasonable cause" is enough to support a finding of malice for actual damages - [Punitive damages]: "Malice" must be more---ill will, evil motive, gross indifference THE OIL AND GAS LEASE ===================== - **In General** - Central document in oil-and-gas development - There is no standard form - It is a conveyance AND a contract - Typically *drafted* by lessee but *construed* in lessor's favor! - Why? public policy. Lessor typically doesn't know much about business and can be more easily taken advantage of. - Lessee has probably drafted the form already. - The conveyance is a ***fee simple determinable*** (in Texas). It's subject to limitations. - Not only is there no standard form for a lease, oftentimes they are hastily patched together. - The lessor typically receives bonus, delay rentals, and royalty. - A lease is more like a "deed" than a "lease" in the landlord-tenant sense - **Ownership Theory** - Ownership-in-place states call it a "fee simple determinable," like Texas; it is possessory, corporeal - Corporeal = possessory; tangible. You can hold it. - Rights to oil and gas are corporeal in states embracing the ownership-in-place theory and cannot be abandoned. - A *royalty interest*, however, is an *incorporeal right* if and when oil is produced---there is no present right of possession - In *non*-ownership states (not Texas), it's viewed as a "license" OR "profit-a-prendre" - Incorporeal = non-possessory - Interest can be abandoned - Trespass and ejectment are not applicable - **Lessee's Goals** - Lessee wants: (1) the right to develop without obligation, for (2) as long as is economically profitable. - **Three Basic Clauses** - [(1) Granting Clause] - [(2) Habendum Clause] - [Primary Term:] The lessee has designated amount of time to start developing before the lease expires. - Number of years used to be 10. Now it is typically 3. - [Secondary Term]: You can continue to have this lease so long as there is production. - [(3) Royalty Clause] - **Conveyances** - To be effective, five formalities are generally required: - ([1) Must be in writing] (SOF) - [(2) Contain words of grant] - [(3) An adequate legal description] - Not a high threshold - Legally valid if you can locate the property with reasonable certainty - [(4) Properly designate the parties], and - Just be able to identify the parties with reasonable certainty - Must have capacity to enter conveyance (right age, competent, etc.) - [(5) Must be properly executed ] - Signature, attestation and acknowledgement, delivery and acceptance, and recording - **Special Note About Bank Drafts** - A bank draft is different from a check because it is conditioned. - Try to avoid them - Three-part process: - \(1) Ask - \(2) Say yes - \(3) Think about it again---lessee has a chance to back out if they want []{#_Toc151586900.anchor} THE GRANTING CLAUSE =================== - **Three Factors to Look At:** - \(1) What [rights] are given? - \(2) What [substances] are covered? - \(3) What [land or interests] are subject to it? - **Surface Uses Granted By the Lease** - *Hunt Oil v. Kerbaugh* - **Background:** Kerbaugh (landowner) was upset because prior seismic activities, conducted on his land, caused damage to the surface estate. He wanted to enjoin more seismic exploration, arguing that companies don't have an unlimited right to do this on their property. - **Holdings:** - The mineral estate is *dominant*; the surface estate is *servient*. - The mineral owner has a right to explore for minerals as ***[reasonably necessary]*** - The burden of proof is on the *surface owner* to show that under the circumstances, the use of the surface is not reasonably necessary, and there are *other reasonable alternatives available*. - Thus, lessee has the right to do what is lawful and reasonably necessary, even if it causes damage!!! - NOTE: They may still be liable for damages though. - **The Accommodation Doctrine** (*Hunt*---used for surface owner) - [(1) Existing use of the surface] - [(2) Proposed use must preclude/impair that use] - [(3) Existing reasonable alternative to Lessee] - [(4) No existing reasonable alternative to surface owner] - **Lessee's Implied Surface Use Rights** - [(1) Occupy land to develop and operate lease] (blanket easement) - [(2) At chosen locations] - [(3) To use whatever resources is necessary for developing the minerals for purposes of the lease] - **Limiting Principles to Dominant (Mineral) Estate** - [(1) Only use what is reasonably necessary!] - Negligently caused pollution = excessive waste - Abandoned wells, equipment, and cement foundations = nuisance and excessive use - [(2) You cannot violate the accommodation doctrine] - Urban development: Tex. Nat. Tes. Code Sec. 92.001-7 - [(3) Use must be related to the minerals] - Using the surface for solely the benefit of other tracts violates this principle. - If a lessee wants to use one surface estate for the benefit of another, they must obtain an *express* easement - [(4) State's police power] - Surface Damage Acts - These are controversial, these legislations are being pushed by surface owners who believe it is their right to be compensated for damage to the surface estate in the extraction of minerals by lessees - [(5) Express language in the lease]---if under contract, you can do anything the contract says - **Remedies for Surface Owners** - Damages - Injunction - **Remedies for Lessee** - Injunction - Damages - Obstruction doctrine (toll primary term) - Predicated upon the implied covenant of quiet enjoyment - Ordinarily obstruction doctrine tolls the running of the primary term - BUT, if obstruction occurs close to the end of the primary term, the court may extend the lease for a period it deems reasonable - **Lands & Interests Granted By The Lease** - Because land descriptions may be inaccurate and titles uncertain, oil & gas leases often include "protective terms." These include: - [(1) "In gross" provisions] - Payments provided for in the lease are for the gross acreage described, rather than being calculated on a per acre basis - An "in gross" provision protects the lessee against lease failure if it turns out the lease inaccurately describes the number of acres in the property. - [(2) "Mother Hubbard" (or cover-all) provisions] - Included in lease in areas where property descriptions are likely to inaccurately locate boundaries - Generally, provides that the lease is intended to cover all of the land owned by the lessor in the area - NOT supposed to convey a significant interest or swallow everything else that grantor may own. - They are meant to clean up any leftover scraps that are left out of the specific grant of the deed. Think small, miscellaneous interests. - [(3) "After-acquired title" provisions] - Gives lessee the right to lessor's future acquisitions - "It being the purpose an intent of lessor to lease, and lessee does hereby lease, all strips or parcels of land now owned by lessor or hereafter acquired which adjoin." - [(4) Warranty] - Lease warranty clause permits the lessee to recover damages from the lessor if there is a failure of title. - [(5) Proportionate reduction] - Protects the lessee against being required to pay twice for the same lease interest - "If Lessor owns an interest in the oil, gas, or other hydrocarbons in or under said land less than the entire fee simple estate, then the royalties and rentals to be paid Lessor shall be reduced proportionately." - Permits the lessee to reduce benefits to the extent that the lessor owns less than the full mineral interest described. - [(6) Subrogation provisions] - Empowers the lessee to protect its interest by paying taxes or mortgage encumbering the property and then step into the shoes of the former creditors. []{#_Toc151586901.anchor} OIL AND GAS INCOME TAX PRINCIPLES ================================= - **Three Important Concepts** - **(1) Pool of Capital** - The idea that everything is in "time-out" mode until activity actually gets going - Certain transactions are NOT treated as taxable events - A person who contributes services or property to the exploration or development of a mineral property in exchange for an interest in the mineral property does not have taxable income on the receipt of the mineral interest. - Instead, the taxpayer is deemed to have a nontaxable investment in the venture rather than a taxable sale of goods or services. - The IRS is not going to tax every step of the way, they're just going to let it pool and then start the taxing process. - **(2) Intangible Drilling Costs** - A reference to everything you spend money on that goes towards drilling a well that is not a tangible asset - Rental costs, labor costs, etc. - About 70 percent of drilling a well is intangible costs - Immediately deductible costs that are incurred necessarily as a result of drilling and developing a well site - Gets accelerated recovery or deduction - [The fundamental test is:] do the items have salvageable value? If not, they are intangibles. - **(3) Percentage Depletion** - Cost depletion you can recover your basis according to a formula over a number of years - Percentage depletion made on the theory that what's being invested in is a declining asset, and want to encourage further investment - There is no finite end to percentage depletion, as opposed to cost depletion - You would continue to declare a percentage of your adjusted basis - **Treatment of Payments under IRC** - [Lessor] - Bonus, royalty, delay rental, shut-in royalty, terminal right of way = **ordinary income** - Perpetual easement, surface damages = **basis, excess is capital gain** - [Lessee] - Bonus = **capital expenditure** - Royalty = **excluded from gross income** - Delay rental, shut in royalty = **deductible as current expenses** - Easements = **capital expenditure** - Surface damages = **deductible as current expenses** - **States/Local Taxation (in Texas)** - **Severance (production) Tax** - Unit-based on amount produced (0.10/bbl) - Ad Valorem---based on value of production (7.5% of the market value at the wellhead) - **Texas Rates** - Oil---4.6 percent of MKV of oil produced - Natural gas---7.5 percent of MKV of gas produced - Condensate---4.6 percent of MKV - **Economic Stabilization Fund (Rainy Day Fund)** - Started in 1989 - Based on a reference amount of severance tax revenue generated in 1987 THE HABENDUM CLAUSE =================== - **Habendum Clause** - The clause in the oil and gas lease that defines how long the interest granted will extend. - Texas defines "production" in the habendum clause as (2) actual production as well as (2) marketing. - **Primary Term:** A fixed number of years - Originally, longer primary terms led to the imposition of an implied covenant to drill, which resulted in the creation of "delay rentals" - Every lease has an implied covenant to test/drill - Delay rental is a stick in the bundle of rights - **Delay Rentals** - Historically, one duty of lessee is the *implied covenant to test* - Delay rental clauses are essentially a replacement for this - They specifically provide that the lessee may maintain through the primary term, without testing or drilling, by paying periodic delay rentals. - **Types of Delay Rental Clauses** - ["Unless" clause] = automatic lease termination (special limitation) - In Texas, this is the most prevalent. Modern leases are "paid up delay rental leases: will write a full check for the amount of delay rental charges for all the entire lease." - ["Or" clause] = no automatic termination - Less common - The "or" clause imposes an affirmative duty upon a lessee to commence drilling *or* pay rentals *or* surrender the lease prior to the due date - Some states have statutes that provide for lease termination if rentals are not paid under an "or" clause. - Modern "or" clauses often contain a forfeiture clause, which gives the lessor the option to forfeit the lease if the lessee does not pay delay rentals. - ["No term"] = Indefinite extension by continued payment of delay rentals (not favored by courts) - ["Paid up"] = Increasingly more common - *Schwartzenberger v. Hunt Trust Estate* (unless clause/delay rental) - **Background:** Schwartz executed a lease with Hunt that had an unless/delay rental clause that stated that "if drilling wasn't commenced within the first year, the lessee would have to pay a certain amount based on surface acreage." Hunt negligently failed to discern some information in the records and did not pay the full amount on time, so the lease terminated. - **Rule:** Upon failure of the lessee to commence drilling operations within the limited time, such a lease terminates *ipso facto* without any notice or demand upon the part of the lessor unless delay rentals are paid as provided by the lease. - **Takeaways:** - An "unless" clause is a SPECIAL LIMITATION. This means that under the law, ***it immediately terminates if the conditions are not met***. - Be suitably concerned about the harsh consequences of delay rentals. - "A day late and a dollar short" - **Delay Rental Traps** - [(1) Proper amount] - *Young v. Jones* (\$2 short = automatic lease termination) - [(2) On or before the due date] - *Gillespie v. Bobo* (Box 43 instead of Box 43(a)) - *Ford v. Cochran* (sick family excuse automatic lease termination) - [(3) To the proper person] - *Jones v. Sonat* - [(4) In the right manner] - *Keller v. Dunbar* (telegraph company screwed up delivery automatic lease termination) - **Primary Term---Maintaining Lease By Drilling** - Beginning performance will not satisfy the lessee's alternative option of paying delay rentals. - **"Commence drilling operations"** differs---doesn't require actual production. Look for this language in a lease. - Actual drilling is unnecessary to "commence" a well - **Activity on site, performed in good faith, followed by continuous operations until a well is completed, satisfies the "commencement" requirement** - **Three things to consider** (*Breaux v. Apache*): - [(1) Physical acts on property] - [(2) Diligence] - [(3) Good faith] - *Examples*: - Looking for a borehole with a searchlight at 10pm on the last day = **ok** - Dragging a backhoe across the grass to build a road on the last day = **not ok** - No drilling permit or drilling contract before the last day, plus lessee's interest in the well next door (bad faith) = **not ok** - Horizontal well doesn't cross vertical plane of subject property before last day = **ok** - Case law follows "contract rule", *i.e.,* **"day" = end of day** - Does waiting until the last day raise an inference of bad faith? - Cases generally say "no." - **Protections/Excuses** - There are some out there, but just put them in the back of your mind because they RARELY WORK. - ***Always boils down to: "What does the lease say?"*** START EACH QUESTION WITH THIS!!! - Cases that preserve "unless" leases after a failure to pay delay rentals may be divided into at least four classes: - [(1) Those in which the lessor causes late payment or underpayment]; - If the lessee reasonably misconstrues an ambiguous assignment of the lessor. - [(2) Those in which payments are inadequate or incorrect and the lessor knowingly does not notify the lessee of its mistake until the anniversary date is past;] - Where a lessor knows that the lessee has made a mistake in paying delay rentals, some courts have held that the lessee continues in effect unless the lessor notifies the lessee of his mistake - [(3) Those in which the lessor knowingly accepts a late payment (waiver/estoppel);] and - If the lessor accepts a late or inadequate payment, some courts may. Hold that estoppel or waiver prevents the lessor from asserting termination of the lease. - [(4) Those in which the failure is due to the failure of an independent third party], usually the postal service (beyond lessor's control) - *Oldfield v. Gypsy Oil Co.---*court found that timely mailing of a delay rental check in a properly addressed and stamped envelope was sufficient to preserve the lease even though the check was erroneously delivered by the post office. - [(5) Revivor---parties intend that the lease continue] - An interest that has been terminated for no payment may be "revived" if the parties to the lease act as if it were still valid. - **Lease Clauses to Protect Lessee** - [(1) Payment to an Agent] - *E.g.,* If a payment agent screws up fails to accept the rental, Lessee will not be held in default for failure to make payment until 30 days after the problem is fixed. - [(2) Notice of Assignment Provisions] - Provides that a lessee may rely upon its records in making delay-rental payments - Saves them from mistake due to change of ownership that they didn't know about, etc. - [(3) Notice-of-Incorrect Payment] - A lease will not terminate until the lessor gives the lessee notice of the incorrect payment and allows a reasonable time for the lessee to correct the error. - [(4) The Dry-Hole Clause] - Addresses whether delay rentals are due after a lessee has drilled a dry hole on the leased premises during the primary term. - Always specifically affirms the lessee's right to maintain the lease for the remainder of the primary term by paying delay rentals. - Gives lessee a chance to rework the well or commence operations after finding a dry hole for 60 days or so - **How Much Production is Required: "Paying Quantities"** - Generally, courts have held that toe secure production during the primary term and extend into the secondary term, production must be in "paying quantities." - From the perspectives of the parties, a lease is a profitable venture. When it is no longer profitable, it should terminate. - Production in paying quantities ceases only when a lease is losing money and there is no reasonable expectation that it will become profitable. - **[Standard]** (*Clifton v. Koontz*): "The standard is whether or not under all the relevant circumstances a *[reasonably prudent operator]* would, for the purpose of making a profit and not merely for speculation, continue to operate a well." - [(1) Litmus test] - Looks at operating revenues and operating costs over a reasonable time period to determine whether the operations have been "profitable." - Before a court will find that a lease has terminated, the history of nonpaying production must be sufficiently long to suggest that the lessee's continued operations are speculative. - [(2) Legal test] - If the first test is answered in the negative, the court then asks whether there is any reason that a reasonably prudent operator who expected to make a profit from the lease would continue operating it. - Any factor that suggests that a reasonably prudent operator might continue to operate the lease, though it is presently unprofitable, may. Be considered at this stage. - Lease terminates only if answers to both steps of analysis are negative. - *Stanolind Oil and Gas v. Barnhill* (application of "paying quantities") - **Issue:** Whether or not the Lessee satisfied the terms of the lease to produce in "paying quantities" when they only were able to produce "sour gas" for which there was no market. - **Rule:** Although the Lessee discovered gas to an extent and in a quantity that would have complied with their obligation had there been a market available, there was not, so they couldn't produce in "paying quantities." It's not the job of the courts to make contracts for the parties, but to construe them as they make them for themselves. - **In Texas, it is implied that if you're producing, you have to not only produce, *but also try to sell and have a market for it*.** - Production = produced AND marketed (Majority in Texas) - **Minority View** (OK) You don't have to have a market to satisfy the production obligation. - *Pack v. Santa Fe Minerals* ("production" include marketing???) - **Issue:** Santa Fe (Lessee) drilled a well capable of production, but was not marketing or producing the oil during the summer months in order to obtain the highest price for the gas and meet regulatory production limits. Pack argued that the term "production" in the lease means and includes marketing. - **Rule:** Court said not marketing is different from producing. It's all about the ABILITY of the well to produce. - *Klifton v. Koontz* (defined "paying quantities") - **Issue:** Was there any evidence to sustain the finding of the trial court that production in paying quantities had not ceased? - **Lessors:** Argued that after the primary term, the ordinary oil and gas lease absolutely terminates when its income no longer exceeds the cost of its operation - **Court Held:** You do two things to define "paying quantities" - \(1) Look back: Do revenues exceed costs over time? - \(2) Look ahead: Would a reasonably prudent operator continue to operate the well to make a profit, and not just for speculation? - DON'T include depreciation in costs - DO include ORIs in income - **Factors to Consider:** - Income (include everything *but* royalty) - Expenses (exclude capital costs, drilling/equipping the well) - Time frame (not less than a year usually) - *Freeman v. Magnolia Petroleum Co.* (Shut-in) - **Issue:** Magnolia "produced" oil but did not sell it and pay royalty to the Lessor---was it actual production under the terms of the lease? - **Lease:** Lease said "while royalty is so paid, so said well shall be held to be a producing well"---so it follows that while royalty was not paid, the well could not be held as a producer. - **Holding:** The lease rightfully terminated if respondents wanted to prevent lapse for nonproduction, they could have easily done so by paying \$50 under the lease before the end of the primary term. - **Timeline:** - 04/07/1930: 10-year primary term begins - 12/22/1939: Well completed (capable of paying quantities, but doesn't produce) - 04/07/1940: Primary term ends - 08/07/1940: Lessee tender shut-in royalty - *Rogers v. Osborn* - **Holding:** The lessees could not avail themselves of the "dry hole clause" in the lease because well 1 was not dry. They could not avail themselves of the "if production ceases" clause because there was never production, and they could not utilize the "reworking" clause since there was no finding on the date of termination and no definite evidence of reworking and with no production after reworking from well 1. Well 2 couldn't be tacked onto this. - **Timeline:** - 09/21/1942: Lease begins - 05/15/1947: Drilling starts on Clopton \#1 - 07/30/1947: Clopton \#1 completed - 09/21/1947: Primary term (5 years) ends - **Secondary Term:** Extended period based on continued condition. - In most states, actual production is required to extend a lease to its secondary term and maintain it - The majority position typically requires marketing as well SAVINGS CLAUSES =============== - **In General** - A savings clause is language in a lease that prevents termination - Protects the lessee - In lieu of actual production (i.e., constructive production) - **Types of Savings Clauses** - \(1) Shut-in Royalty Clause (viewed as a condition) - \(2) Cessation-of-production Clause - \(3) Dry Hole Clause - \(4) Force Majeure Clause - \(5) Well-completion Clause - \(6) Continuous-operations clause - **Lease Termination Analysis:** - \(1) Always look at lease first, then ask: - \(2) "Is there actual production?" - \(a) "In paying quantities?" (satisfies Koontz) - \(b) "Being sold?" - \(3) If no actual production, ask: "Is it constructive production?" - \(a) Is there a savings clause in the lease? - \(b) If so, have the requirements in the relevant savings clause been met? - **Force Majeure Clause** - A type of savings clause designed to enable a lessee to preserve a lease when circumstances beyond its control prevent it from operating or producing. - It defines events that cause a lessee to fail to perform specific actions a substitute for production. - Courts interpret these strictly - **Constructive Production** - Analytically, a force-majeure clause will provide constructive production to maintain an oil and gas lease if: - \(1) The event complained of is defined as a force-majeure event by the language of the clause; - \(2) Production is excused by the event defined as force majeure; - \(3) There is a causal relationship between the event defined as force majeure and the failure of production; and - \(4) The lessee gives timely notice, if the clause requires it. - *Perlman v. Pioneer Limited Partnership* - **Issue:** Perlman's process for drilling tapped into Wyoming/Montana water supply. Wyoming was concerned and required him to meet regulations and consult w/ a hydrology expert which would cost lots of \$\$\$. Perlman invoked force majeure clause of his lease saying he was hindered and was no longer bound to perform his end of the lease or surface agreement. - **Holding:** It was clear that no actual hindrance resulted from the regulations because Perlman made no effort to obtain the permits or begin drilling the wells. Mere possibility/speculation as to what may happen isn't enough. - **Takeaway:** - \(1) There must be a MATERIAL HINDRANCE before performance is excused. - \(2) You must ATTEMPT TO OVERCOME the purported hindrance. - **Shut-In Royalty Clause** - Shut-in royalty payments are typically drafted as a "special limitation." - The point is to act as a substitute for the "actual production" required to hold a lease - If, instead, the lease defines shut-in wells as "constructively" producing, the special limitation may not apply because the well is constructively producing. - Enforceable only if the subject well is *capable of production* - In states that equate production to actual production and marketing, a well that is shut in waiting for a pipeline connection to make marketing possible will not maintain the lease. - Some leases expressly provide that a shut-in may only occur when there is no market (not for any other reason) - But if there's no such provision, it is normally alright to assume that a well shut-in for any reason will apply so long as it is done in good faith for a business purpose. - Therefore, most modern oil and gas leases contain a "shut-in" royalty clause providing that the lease will be maintained if a well capable of producing is shut-in. - *Freeman v. Magnolia Petroleum* - Where production from a gas well had no market, lease provided alternative; pay shut-in royalty in lieu of "production" - Lessee did not make the payment on or before the end of the primary term = lease termination - Like delay rentals, shut-in royalty payments are typically drafted as a "special limitation." - Different result if: - Drafted as a "covenant" - "Production" is defined as "capable of production." - Generally, when a shut-in royalty clause does not specify the time that the shut-in payment is due, it is due *before* the well is shut-in - **Temporary Cessation of Production Doctrine** - Three things to look at: - [(1) How long]? p.258 - 4 months is okay - 6 months is not okay - [(2) Cause] - When cessation results from circumstances beyond a lessee's control, for example, a long cessation is more likely to be considered temporary than when the lessee could have kept the well producing by acting diligently. - [(3) Diligence ] - If a lessee is slow to act, the more likely it is going to be considered permanent. - **Cessation of Production Clause** - "Cessation of production" clause in the lease operates to replace the implied "temporary cessation" doctrine because express beats implied. - Usually states that the lease will be maintained so long as production does not cease for more than a stated period of time, usually 60 to 180 days. - So where a lease clause provides "60 days" and lessee takes 73 days to resume production = lease termination (*Samano v. Sun Oil*) - **Dry Hole Clause** - The clause always specifically affirms the lessee's right to maintain the lease for the remainder of the primary erm by paying delay rentals. - They were developed to avoid disputes over whether a lessee who drilled a dry hole could maintain the lease for the remainder of the primary term - It bars the implication of condemnation or abandonment of a lease from the drilling of an unproductive well. - **Well-Completion Clause** - An operations clause that permits only completion of operations begun before the end of the primary term. - **Continuous-Operations Clause** - An operations clause not restricted to completion of a well in progress at the end of the term. - Continuous-operations language permits a lessee to commence a well before the end of the primary term, abandon it after the end of the primary term, and continue to hold the lease by starting another well. - ANY operations counts---doesn't have to be the same well. POOLING CLAUSE ============== - **In General** - Gives a lessee the right to combine leases, or parts of leases, covering tracts or fractional mineral interests for drilling and to apportion production to each interest - It functions as a "savings" clause - A lessor gets royalties in accordance with how much of his land is in the pool - **Three Things a Pooling Clause Does** - [(1) Allows a lessee to pool his lease with other leases] - [(2) If there is production anywhere on the pooled acreage that has been brought together in this pool, then it counts as productions on all acreage/everywhere] - *I.e.*, will hold a lease during the primary term - [(3) Impacts the lessor's royalty] - If it produces on his land, the lessor loses a bit of \$\$ - If it produces on someone else's land, the lessor gets what he wouldn't ordinarily get - **Two Threshold Questions** - \(1) Have the terms of the pooling clause been complied with? - \(2) Was the lessee acting in good faith? - **Results when Pooling is *Invalidated*** - If well is on lessor's property, lessor is entitled to 100% royalty - If well is on pooled acreage but not lessor's property, well will not hold the lease - **Exercising in Accord With the Pooling Clause Terms** - Some common issues are: - Has the lessee complied strictly with the terms of the pooling clause? - Has the lessee exercised its pooling power when the lease is still effective? - Lessee cannot pool a lease that has already expired - Even though pooling clauses are "savings clauses," you cannot circumvent or sneakily get around other clauses - **Implied Covenant of Good-Faith Pooling** - Arises from the broad nature of the lessee's authority under the pooling clause coupled with the recognition that the pooling clause coupled with recognition that the pooling clause tends to favor the lessee's interests more than the lessor's. - *Amoco Production v. Underwood* (good faith) - **Issue:** Last-minute pooling done to "hold majority of leases" before the close of the primary term which prevented lessor from leasing to other persons, gave diluted royalty, etc. - **Timeline:** - 05/20/1975: Letter from VP of operator/unit designation - 05/21/1975: Test done - 05/27/1975: Unit designation filed - 05/29/1975: Primary term expired - **Holding:** The additional pooling here was unnecessary and done in bad faith at the expense of the lessors of the 8 leases - You can't just take "pieces" of other leases just to hold them - **Other scenarios:** - Pooling after production = *not necessarily* bad faith - Pooling just before expiry of primary term = *not necessarily* bad faith - Gerrymandering = *not necessarily* bad faith - *Humble Oil* - **Holding:** Lessee cannot pool a lease that has already expired; lessee needed to have started additional operations, not just pool, within the 60-day grace period. - **Lease Limits on Pooling Authority** - **Pugh Clause (Freestone rider):** Operations on the pooled portion of the lease won't preserve the whole lease (so unused portion will be released) - "Can't hold the rest of my lease based on that pooling" - Example---takes 10 acres out of 160 into pool. Lessor will get back from the lease what was not in the pool. - Lessor doesn't want all of his acreage tied up in a pooling situation, when not all of his acreage is being pooled. - NOTE: Can be vertical or horizontal - Vertical, between lessee and lessor (take 10 into pool, give 160 back) as to acreage as opposed to depth) - Horizontal, deals with different layers of underground formation, as to depth as opposed as to acreage - **Retained Acreage Clause:** Operates independently of the pooling clause and automatically divides the lease, as drilling units are formed. - AKA continuous-development clause - **Anti-Dilution Provision:** Lessor wants all (or as much) of his property included in pool (and any unused portion released) - You have to contribute a certain amount of your property to join pooled acreage - This is because, when pooling, you get royalties in accordance with how much land is in the pool. - *Piney Woods v. Shell Oil* (Royalty) - **Background:** (Mississippi) - Shell entered into long-term contracts with utility companies, and the worth in the contract was much lower than what the gas was worth - Lease said the "royalty sold off the premises \[is\] to be...the market value at the well...provided that on gas sold at the wells it shall be...the amount realized from such sale." - **Issue:** How do you construe this lease under the facts? - **Vela approach:** Market value is the value of comparable gas at the time of production (Texas) - **Tara approach:** K price. Oklahoma follows, Texas doesn't. - **"At the well":** necessarily means before any post-production costs have incurred (Texas rule) - **"Market value":** Question of fact. Considerations include (1) actual sales price at the wellhead, (2) comparable sales at other nearby wells, and (3) sales of processed gas, minus processing costs ("work-back" method): (Current market value) -- (post-production costs) (raw gas market value at wellhead) - **Production v. Post-Production:** Lessee responsible (solely) for production (up to when well starts flowing oil), Lessor/Lessee both responsible for post-production - **Other Considerations** - Gas no longer sold under long-term contracts, but short-term - Gas is typically sold at "market bubs," like where a whole lot of pipelines operated by a number of different companies converge - When is "production" complete for marketing purposes - **"At the well" -- Piney Woods, TX, LA, MS, NM** - "Marketable product"---Garman, KS, CO, OK - ***In Texas, post-production costs are allocated to the royalty owner*** - In Texas, some express terms aren't enough: - Don't use "market value at the well" if you're trying to have royalty based on the value/price of the end product without deducting post-production costs IMPLIED COVENANTS ================= - **In General** - Since modern oil and gas leases are usually drafted and prepared by lessees to protect their interests, courts will recognize that they are bound to implied terms in addition to those that are written in the leases. - These are trumped by express provisions in a lease. - **Generally, damages are the remedy for breach of these** - Some jurisdictions allow lease cancellation - However, the general rule is that courts may cancel leases as a remedy for breach only upon a showing that damages are *wholly inadequate*. - Punitive or exemplary damages are not generally awarded for breach of implied covenants - Courts will make an exception if there is a "special relationship" (i.e., fiduciary) or tort liability - **Basis (Major Schools of Thought)** - **Implied in fact** - They reflect the unexpressed intent of the parties - Courts complete an incomplete K - Courts "interpret" - **Implied at Law** - Relation of the parties - Implied at law to correct an imbalance of bargaining power between lessors and imbalance of bargaining power between lessors and lessees. - Courts will make an unfair K "fairer" - Judge decides that he doesn't like the effects of this contract, so he steps in and fixes it - **Reasonably Prudent Operator Standard** - Underlies all of the implied covenants - The test generally applied to determine a lessee's compliance with implied lease covenants. - Refers to what a reasonable, competent operator in the oil and gas industry, acting with good faith and economic motivation, and considering the lessor's interests as well as his own, would do under the circumstances. - Originally formulated to make it clear that a lessee's obligation is less than that of a fiduciary but more than a mere obligation to act in good faith. - Three main considerations: - [(1) Good faith] - Presumed; burden of proving bad faith is on the lessor - Generally know bad faith when you see it - [(2) Competence] - Failure to operate competently and diligently may trigger liability. - [(3) With Due Regard for the Lessor's Interests] - Must consider lessors' interests while pursuing its own - Based upon business reality - **Implied Covenants Recognized by Courts** - **[(1) The Implied Covenant to Market]:** two kinds. - Implied Covenant to Market Within a *Reasonable Time* - Implied Covenant to Market at an *Appropriate Price* - **[(2) The Implied Covenant to Test]** - **[(3) The Implied Covenant to Develop]** - Fixed by delay rentals - **[(4) The Implied Covenant to Protect Against Drainage]** - **[(5) The Implied Covenant to Explore Further]** - Not in Texas - **(1) Implied Covenant to Market** - [(1) Within a reasonable time] - In states where "marketing" requires only the *capability of production* (not Texas) - This covenant is still applicable in Texas because of the shut-in royalty clause, which protects a lessee from losing a lease for failure of production, but not to excuse his obligation to market the product - This determination depends on the facts and circumstances. May be a long time. Courts have found time periods of 3.5 to 8 years to be a reasonable time to market. Varies on facts, markets, and business. - If lessee is using due diligence to obtain the best price reasonably available, then this can be good. - Remedy is usually damages - [(2) At an appropriate price] - "The best current price reasonably available." - **Making it a "Marketable Product"** - Capture-and-hold rule (Texas) - The Supreme Court of Texas held squarely that the implied covenant to market does not apply to a market-value royalty "because the lease provides an objective basis for calculating royalties that is independent of the price the lessee actually obtains, the lessor does not need the protection of an implied covenant." - NOT the value at the wellhead - It is the lessee's obligation to market the product and it is also his obligation to prepare it for the market. No part of the costs of marketing or of preparation for sale is chargeable to the lessor. - **Texas Rule** - **Vela Approach:** Market value is the value at the time of production and delivery instead of the value at the time the contract was made. - **["At the well"]** (Texas): Necessarily means before any post-production costs have incurred. - **In Texas, production is complete for marketing purposes at the well.** - **["Market value":]** Question of fact. Considerations include (1) actual sales price at the wellhead, (2) comparable sales at other nearby wells, and (3) sales of processed gas, minus processing costs (the work-back method) - Since the lessee owes the lessor a duty of good faith (Amoco), they are to be treated like they're the only lessor. If the lessee is not marketing, there must be a good faith business reason. - *Amoco Production Co. v. First Baptist Pyote* - You owe lessor a duty of good faith---treat them like they're your only lessor! - Where their interests diverge, "closer supervision of his business judgment will be necessary" - Lessee can't pursue its general interest to the detriment of its individual Lessors' interest - The collective good of a Lessee and its many Lessors is not more important than the individual good of a particular Lessor - Note \#4, pp. 341-42 (TX): ***Implied covenant will always be trumped by express language in a lease that addresses that issue***. - **(2) Implied Covenant to Test** - The creation of the "delay rental" has basically rendered this moot - Originally required lessees to test the leased premises within a reasonable time after the lease grant. - **(3) Implied Covenant to Develop** - Applies in the secondary term; corollary to the Implied Covenant to Test - Once a lessee discovers oil or gas, courts recognize an implied obligation to continue to develop reasonably. - A stumbling block for this is a disclaimer or express limitation in the lease - Total lease cancellation is extremely rare. - *Superior Oil Co. v. Devon Corp.* - Lease cancellation is improper where there has been no notice or demand first - Law abhors a forfeiture - Cancellation is an equitable remedy, so equity demands notice and demand first - No development for years doesn't waive lessee's right to notice and demand. - **(4) Implied Covenant to Protect Against Drainage** - While a lessee doesn't have an *obligation (per se)* to drill during the primary term, this covenant says that a lessee's discretion does not extend to permitting drainage. - Says the lessee needs to act to avoid this - However, modern drilling and spacing rules lessen the need for this. - Includes a need to protect against local OR field-wide drainage. - This obligation may require a lessee to drill additional or replacement wells, to reword existing wells, or to seek voluntary or compulsory unitization, etc. - Lessor has the burden of proof. - The remedy is typically damages for lost hydrocarbons - **Elements (must prove):** - \(1) Substantial drainage from the leased premises, and - \(2) Probability that an offset well would be profitable, and - \(3) Proof that a reasonably prudent operator would have taken action. - *Amoco v. Alexander* - **Issue:** Lessor alleged breach of the implied covenant to protect against damage, BUT it wasn't the actual "local" drainage, it was "field-wide drainage" - **Holdings:** - The implied covenant includes field-wide drainage - Because doing so is still acting like a reasonably prudent operator as to that lessor - Lessee could have done a lot of things to protect Lessor, but didn't - The Lessee could have demonstrated that their "reasonably prudent" duties wouldn't have been profitable as a defense, but they didn't. - **(5) Implied Covenant to Explore Further** - NOT IN TEXAS - **(6) The Implied Covenant to Operate Diligently and Properly** - A "catch-all" category - Whether the lessee operated in good faith - Implied covenant of diligent exploration/operation includes seeking the necessary zoning variance, under these circumstances - Lessee cannot substitute the "suspension" clause for his failure to act - Forfeitures are generally disfavored, but this is an exception DIVISION ORDERS =============== - **In General** - Refers to a "scoresheet that determines who is entitled to what amount of royalty, what their ownership interest is, etc. - In a division order, all parties who may have a claim to the proceeds of sale---working interest owners as well as royalty owners---agree to how the proceeds will be divided. - Remember that production costs are distinguished from post-production costs. Post-production costs CAN be factored into royalty, but production CAN'T be (in Texas) - Lessees use them to protect against claims of improper payment - Royalty interest owners sign them to confirm that they are correct - Royalty owners should be responsible for ensuring they are correct, or else ***it's binding*** - *Gavenda v. Strata Energy* - **Background:** Gavenda (mineral owner) sold to Feinstein and reserved a 15-year, ½ non-participating royalty interest (NPRI) (i.e., Gavenda gave away all of his "stick" except for PART of the royalty "stick" for only 15 years from date of conveyance). Feinstein sold to Blaha; Blaha (who now owns all the "sticks") executes lease and is given a 1/8^th^ royalty under the lease. Several ORIs are given on the way. Strata/Northstar (lessees) drill wells. - **Issue:** Is Gavenda's ½ NPRI ("fixed") or 1/16 (i.e., ½ of 1/8) ("floating)? Attorney concludes that it's floating. Strata sends division order to Gavenda and they sign it, and then later go back and dispute it. - **Holding:** Court agrees with Gavenda, Strata has been wrongly paying Gavenda 1/16 and failing to pay them the other 7/16, o the tune of \$2.4 million. Rule of thumb: most lessees don't want to invest in a property unless they have 75% of the mineral interest on the lease. - Division orders themselves do not convey, change, or rewrite royalty interests provided for in a lease or deed. - But you're bound until you revoke it. - Underpaid royalty owners can sue to recover underpaid royalty, but only if there has been an unjust enrichment. AND they can only sue the lessee. (check on this) - **Remedies for Failure to Pay Royalties** - Texas law treats an oil and gas lease as a conveyance of an estate in real property. As such, it cannot be repudiated/cancelled by the failure to pay royalties unless there is a specific clause in the lease to the contrary. - If it is clear and the language is specific enough in the lease, you can cancel a lease for failure to pay royalties. - Must be the intent of the parties and must be *very specific* language. - Difference between failure to pay royalties and failure to pay delay rentals? - Lease cancellation as a remedy - Covenant v. Special Limitation - *Cannon v. Cassidy* - **Background:** The lease required quarterly payments of 1/8 royalty. The Lessee failed to pay for 11 months. The Lessor was owed, but not paid, \$1,693. - **Holding:** The remedy is ONLY money damages, NOT lease cancellation (absent express language that says so)!!! - **Exception:** Contrast Hitzelberger case. Got cancellation as a remedy because there was express language in the lease that said unpaid royalty would cancel the lease. - **Other Considerations** - Can a lessee refuse payment unless the lessor signs a division order? - NO. Lessor still entitled. - A lessee can still receive payments if haven't signed a division order. - Would a royalty owner be inclined to want to sign a division order? - Some companies may not buy their oil unless a division order is signed. - **Miscellaneous Royalty Problems** - Casinghead gas/wet gas - Generally, a lessee has no duty to extract this, so no royalty would be owed; but, in reality, liquids from "wet gas" have value, so leases these days typically provide for royalties on extracted liquids. - Overarching consideration will always be the "reasonable, prudent operator" standard. - Use of produced gas by lessee in operations - No royalty owed - Use of produced gas by lessor/surface owner - Once was common; not so much anymore - Liability for lessee - "Fixed-gas" royalty---PA statute guarantees a minimum of 1/8 royalty. - **Tex. Natl. Res. Code § 91.402** - BUT, this statute requires a landowner to do this. - BUT ALSO, terms of a division order DO NOT operate to change/alter the terms of the lease. TITLES AND CONVEYANCES ====================== - **Interest (Review)** - Interest in real property - Transfer must satisfy the Statute of Frauds - Must be in writing - Must contain words of grant - Identify parties - Adequately describe property - Signed - **Three Steps of Judicial Construction** - [(1) Ascertain the parties' intent ] - Harmonize the provisions - Look at the four corners of the document - You look at the full document, but NOT outside of it - You want to stay on this step - [(2) If still uncertain, use canons of construction ] - Examples: - Largest estate possible conveyed - Against the drafting party - Handwritten/typed language over print form - Granting clause over other clauses - Specific language over general language - [(3) If still uncertain, allow in extrinsic/parol evidence] - **Standard Rules of Construction** - Largest estate possible conveyed