September 11, 2018
Author: Michael E. Zimmerman
Organization: Michael E. Zimmerman PC
1) Evolution of Lease Form; Lessor-Lessee Perspectives of risk-benefit Allocation
a) Oil and gas operators obtain from mineral owners the right to explore, develop and produce oil and gas through an oil and gas lease – a document with characteristics of a deed and of a contract. The oil and gas lease grants to the Lessee the mineral executive right, the right to enter the land for to explore, discover, produce and sell oil and/or gas. In addition, the lease states the agreed terms defining the rights, privileges and obligations of Lessor and Lessee.
b) As emphasized by the Montana Court in an early case, oil and gas leases are not your typical lease form:
“oil and gas leases differ from ordinary and well known forms of leases in existence and heretofore construed … such as leases on city property and agricultural and gazing lands, in that, in the later classes of leases valuable property rights are at once acquired by the lessee and immediate possession usually yielded by the lessor, and the occupancy by the lessee either improves, or at least does not materially injure, the leased premises; he gets no right to take away any part of the soil, and during the term of the lease, in the absence of extraordinary circumstances, the value of the property remains reasonably stable, while, on the other hand, no particular value attaches to an oil and gas lease until after development and the production of oil or gas in paying quantities. The holding of a lease for this latter purpose, without prospecting or operating, inures only to the benefit of the lessee as a speculator, and possession of the premises is not usually yielded at once, and, when yielded, the lessor usually retains possession of the larger part of the surface ground. When the lessee finally takes possession and commences operations, the lessor’s lands may be riddled with holes and cluttered with derricks and other paraphernalia of the business, to the great detriment of the lessor and damage to the property, if oil or gas be not discovered. *** Again, the value of property declared in such a lease, is subject to violent fluctuations, and any substantial delay, either in commencing drilling operations or in prosecuting such operations thereafter with diligence, may render land theretofore extremely valuable for its potential oil and gas rights, absolutely valueless.”1
c) The modern lease form results from adaptions made following court resolution of Lessor and Lessee conflicts.
i) Lessee interest =
(1) Small capital investment.
(2) Right to keep lease so long as it is (i) productive or (ii) valuable for speculative purposes.
(3) Right to terminate without liability to Lessor.
ii) Lessor interest =
(1) Royalties.
(2) Early exploration and development.
(3) Limit time Lessee can postpone exploration.
d) Variant forms of the habendum clause and the drilling and rental clause reflect this conflict.
i) The first U.S. commercial well was drilled under a fixed-term lease. Given profitable production, this form of lease was entirely unsatisfactory, because the lease denied the operator an opportunity to earn a full return on invested capital.2
ii) Fixed-term leases did not work well for the Lessor either. The Lessee usually paid nominal consideration to lease the minerals. Since the lease did not provide for delay rental payments, the Lessor’s only means of earning income from the minerals required successful exploration. But, the Lessee was not obligated to drill.
iii) Later lease forms required the Lessee to drill within a short period or pay rental to continue the lease for another short period. The lease did not provide for a primary term; therefore, the Lessee could hold the lease with rental payments as long as he or she wanted.
iv) The “or” form of drilling or rental clause followed. It obligated Lessee to commence drilling or do something else; perhaps forfeit or surrender the lease.3 Most commonly, however, the “or” form of lease obligated the Lessee to pay rental. This clause, when added to the habendum clause, allowed the Lessor, upon Lessee’s failure to drill and to pay rental, to elect to sue for damages or for lease forfeiture.
v) The “unless” clause followed. The “unless clause’ does not impose any obligation on the Lessee; rather, it is a special limitation providing for lease expiration if the Lessee does not drill or pay rentals during the primary term. To the Lessee, the important feature is the Lessee is never liable for failure to commence drilling or failure to pay rentals, because the leasehold terminates automatically.
2) Habendum Clause
a) The habendum clause provides that the leasehold will endure for a prescribed number of years and so long thereafter as oil and/or gas are produced in paying quantities. The clause is designed to measure the duration of the oil and gas lease by the primary objective Lessor and Lessee assign to it – production of oil and/or gas. 4
b) Habendum clauses generally consist of two parts, the primary term, which establishes a definite period, and the secondary term which is of indefinite duration.5
c) Nature of the legal estate created by the habendum clause.
i) The habendum clause may create either a fee simple determinable with the possibility of a reverter or a fee simple subject to a condition subsequent.6
(1) If the estate is a fee simple determinable, upon occurrence of the limitation, the fee simple reverts to the Lessor – immediately, irrevocably and regardless of cause or Lessee’s good faith.
(2) If the estate is a fee simple subject to a condition subsequent, the estate terminates only upon assertion and proof the subsequent condition.7
ii) In Montana, the oil and gas lease grants a fee simple determinable.8
iii) Upon cessation of production in the secondary term (the fee simple determinable limitation), regardless of the duration, the lease automatically terminates.
iv) This can be a very harsh result.
d) Equitable defenses against automatic termination upon cessation of production.
i) Lessor Interference with Lessee Operations.
(1) Interference is an estoppel of Lessor’s action to terminate lease.
(2) For example, Fey v. A. A. Oil Corp., 129 Mont. 300 (1955).
(a) Lessor alleged Lessee forfeited the lease, because Lessee did not perform timely.
(b) Lessee showed Court it had completed timely a producing gas well, but Lessor had prevented further drilling by refusing to grant permission for Lessee to come upon the leased land.
(c) The Montana Court reasoned, “The record is replete with efforts of defendants [Lessees] to get an explanation from plaintiffs [Lessors] as to why plaintiffs refused permission to defendants to go upon their lands to continue drilling and other operations of the lease and whether plaintiffs would permit defendants to do so; that defendants continually endeavored to obtain oil and gas drilling equipment and to interest a pipe line company to build into the structure and by the gas. The plaintiffs may not complain that defendant ... did not drill more wells when plaintiffs refused to allow defendants entrance to their lands to drill more wells. ‘No one can take advantage of his own wrong.’ [Citing current statute MCA (2013) §1-3-208] Where a lessee, as in this case, was ready, able and willing to drill further wells and develop the lessor’s property, an attack upon the lessee’s title by lessors will relieve the lessee of the duty either to proceed with the drilling operations or the payment of the delay rentals during the contest of his title.”9
ii) Lessor’s premature declaration of termination.
(1) Lessee would risk loss of investment if it drilled under a void lease.
(2) Lessee would also risk destruction of the speculative value of Lessor’s unexplored mineral rights if Lessee were to drill a dry hole.
(3) If Lessee has unequivocal notice that Lessor considers the lease terminated, even though Lessor has not sued for termination, the Lessee is excused from the production requirements of the habendum clause.10
e) Courts have addressed the fee simple determinable habendum clause, creating the temporary cessation of production doctrine. This doctrine recognizes, as a matter of reality, that mechanical repairs and equipment breakdowns cause temporary cessation of production; therefore, continuous production is not necessary, always, to continue the lease during the secondary term.11
f) The Montana Court recognizes the temporary cessation of production doctrine.
i) “In order to mitigate the harshness of automatic termination, we adopted the temporary cessation of production doctrine. Pursuant to this doctrine, once a plaintiff [Lessor] establishes that an oil and gas lease has halted production, the burden shifts to the defendant [Lessee] to prove that the cessation was temporary and not permanent. A temporary cessation in production will not trigger an automatic termination of the lease as contemplated in the habendum clause.” 12
ii) In a subsequent case, it wrote, “We further held in Somont I, that “[t]he diligent lessee who takes immediate steps to rectify a sudden halt in production will not lose his or her investment’ during such a temporary stoppage.”13
iii) “The test for determining whether there was sufficient production or whether the lessee was acting with reasonable diligence in producing and marketing the gas from the leased lands is the diligence which would be exercised by the ordinary prudent operator having regard to the interests of both lessor and lessee. This is a question of fact that will depend upon the facts and circumstances of each case.”14
g) Production necessary to continue the lease during the secondary term must be “paying production.”
i) Some courts will interpret liberally the clause “thereafter … so long as oil or gas is produced,” and any amount of production would continue the lease.15
ii) The vast majority of courts, however, require production commercially profitable to the Lessor and Lessee.16 Courts do not wish to allow the Lessee to hold the lease only for speculation.
iii) Montana equates habendum clause language reading “so long as oil or gas is produced” with language reading “so long as oil or gas is produced in ‘paying quantities.’”17 Montana lines up with the vast majority of states.
iv) What is “paying production”? Paying quantities is “the amount of production which would pay a small profit over the cost of operation of the well, excluding from consideration the initial cost of bringing the well into production.”18
4) Relationship of Habendum Clause and Savings Clauses in the Modern Lease Form
A modern lease form might combine the following provisions: [Habendum clause]
This lease shall be in force for a primary term of five years from the date hereof, and for as long thereafter as oil or gas or other substances covered hereby are produced in paying quantities or this lease is otherwise maintained in effect pursuant to the provisions hereof. [Unless drilling and rental clause19]
If on or before the first anniversary date hereof operations for the drilling of a well for oil or gas or other substances covered hereby have not been commenced on the leased premises or lands pooled or unitized therewith, or if there is no production in paying quantities from the leased premises … then … this lease shall terminate as to both parties unless Lessee on or before that date pays or tenders to Lessor … the sum of [$$$$] as rental covering the privilege of deferring the commencement of operations for the drilling of a well for a period of twelve months from said anniversary date. In like manner and upon like payments or tenders, the commencement of operations for the drilling of a well may be further deferred for one or more twelve month periods during the primary term of this lease.
[Dry hole clause]
If Lessee drills a well which is incapable of producing in paying quantities (hereinafter called “dry hole”) on the leased premises or lands pooled or unitized therewith … then in the event this lease is not otherwise being maintained in force it shall nevertheless remain in force if Lessee commences further operations for reworking an existing well or for drilling an additional well or for otherwise obtaining or restoring production on the leased premises or lands pooled or unitized therewith within 90 days after completion of operations on such dry hole … or should the lease be within the primary term, if Lessee commences such further operations or pays rental on or before the next rental payment date (if any) next ensuing after the expiration of said 90-day period ….
[Cessation of production clause]
If all production … permanently ceases from any cause … then in the event this lease is not otherwise being maintained in force it shall nevertheless remain in force if Lessee commences further operations for reworking an existing well or for drilling an additional well or for otherwise obtaining or restoring production on the leased premises … within 90 days after cessation of all production, or, should the lease be within the primary term, if Lessee commences such further operations or pays rental on or before the next rental payment date (if any) next ensuing after the expiration of said 90-day period; provided that should … cessation of all production occur during the last year of the primary term or less than 90 days before the last rental payment date, no rental payments or further operations shall be required to maintain this lease for the remainder of the primary term.
[Drilling operations clause]
If, at the expiration of the primary term of this lease, oil and/or gas is not being produced on the leased premises but lessee is then engaged in drilling for oil or gas, then this lease shall continue in force so long as drilling operations are being continuously prosecuted on the leased premises.
[Continuous drilling operations clause]
if after the expiration of the primary term, production on this lease shall cease, this lease nevertheless shall continue as long as said operations continue or additional operations are had, which additional operations shall be deemed to be had where not more than sixty (60) days elapse between abandonment of operations on one well and commencement of operations on another well, and if production is discovered this lease shall continue as long as additional operations are had.
[Shut-in royalty clause]
While there is a gas well on this lease or on an acreage pooled therewith but gas is not being sold or used, Lessee may pay as royalty at monthly intervals a sum equal to one-twelfth (1/12) of the amount of the annual rental payable in lieu of drilling operations during the primary term on the number of acres subject to this lease at the time such payment is made, and if such payment is made or tendered, it will be considered that gas is being produced from this lease in paying quantities.
5) Dry Hole, Cessation of Production and Drilling Operations Clauses
a) Dry Hole Clause.
i) Reasons for Use of the Clause20
(1) If Lessee drilled a dry hole or a non-paying well during the primary term, may the Lessee hold the lease for the balance of the primary term without additional operations or additional rental payment?
(2) If the answer to #1 above is “yes,” must the Lessee continue with exploration during the primary term?
(3) When does the next rental become due if the dry hole does not excuse payment of rentals for the balance of the primary term?
(4) If Lessee must commence new drilling operations to preserve the lease after completing a dry hole, what period of time may elapse before such operations are commenced?
ii) Dry hole clauses, generally, provide that upon completion of a dry hole during the primary term, the lease will terminate unless the Lessee resumes specified operations or makes a specified payment or tender of rentals.21
iii) What is a dry hole?22 Is a well a “dry hole” if it produces oil or gas in nonpaying quantities? What if it can produce in paying quantity, but there is not market?
b) Cessation of Production Clause.
i) Representative Clause =
“If after the discovery of oil or gas the production thereof should cease from any cause, this lease shall not be terminated thereby if lessee commences drilling or reworking operations within ninety (90) days thereafter or (if it be within the primary term) commences or resumes the payment or tender of rentals on or before the rental paying date (if any) next ensuing after thirty (30) days following the cessation of production.”
ii) What is meant by “cessation of production?”
(1) Upon cessation of paying production, the Cessation of Production Clause would become operative and Lessee may elect to commence drilling a new well or reworking the existing well within the allotted period.
(2) In a clause applicable to the primary term, the words “cessation of production” need not mean cessation of ‘paying’ production, but may instead mean “complete” cessation of production.23
iii) What is “production?”
(1) “The term ‘production’ has come to be a word of art in some jurisdictions in that it carries a meaning broader than its literal meaning. The problem arises with respect to whether the term ‘production’ is construed to require actual removal of the oil or gas from the earth and whether it is also construed to require marketing the oil or gas.”24
(2) In Montana, if the well is capable of producing in paying quantity, but is shut-in for want of market, the well is “producing.\"25
iv) Is there production if gas is flared?
(1) Williams & Meyers, in their treatise, did not think Lessor and Lessee reasonably would have meant for flaring to be “production.”
(2) They concluded “the word ‘production’ means that minerals have been ‘produced, saved and sold’ or ‘produced, saved and consumed.’”26
v) If the new operations do not result in the completion of a producing well, may the lessee hold the lease by additional operations thereafter commenced or by the payment of rentals?
(1) Williams & Meyers concluded that authority is sparse.
(2) Nevertheless, they would answer “yes.”27
6) Drilling Operations Clause
a) Representative drilling operations clause =
“If at the expiration of the primary term oil, gas or other mineral is not being produced on said land but lessee is then engaged in drilling or reworking operations thereon, this lease shall remain in force so long as operations are prosecuted with no cessation of more than thirty (30) consecutive days, and if they result in the production of oil, gas or other mineral so long thereafter as oil, gas or other mineral is produced from said land.”
b) Leases with a drilling operations clause will usually also state a dry hole and a cessation of operations clause.28
c) A “drilling operations” clause is distinguished from a “continuous drilling operations clause.” The later clause holds the lease even if the immediately prior drilling operations did not result in a well producing in paying quantities.
d) Representative continuous drilling operations clause =
“If at the expiration of the primary term, Lessee is conducting operations for drilling a new well or reworking an old well, or if, after the expiration of the primary term, production on this lease should cease, this lease nevertheless shall continue as long as said operations continue or additional operations are had, which additional operations shall be deemed to be had where not more than ninety (90) days elapse between abandonment of operations on one well and commencement of operations on another well, and if production is discovered, this lease shall continue so long thereafter as oil, gas or other mineral is produced and as long as additional operations are had.”
e) The words “drilling operations,” “commencement of drilling operations,” “commencement of a well” are not words of art with clearly defined meanings.29
f) Williams & Meyer report, “in general it appears that the courts have been ready to find the commencement of operations (or the pursuit of drilling operations) where only the most modest of preparations for drilling have been made.”30
g) Further, “drilling operations may be described as any work or actual operations undertaken or commenced in good faith for the purpose of carrying out any of the rights, privileges or duties of the lessee under a lease, followed diligently and in due course by the construction of a derrick and other necessary structures for the drilling of an oil and gas well, and by the actual operation of drilling in the ground.”31
h) The Montana Court examined meaning of words “commence drilling operations for oil” in Solberg v. Sunburst Oil & Gas, Co., 73 Mont. 94 (1925). It observed:
i) “The phrase ‘spudded in,’ as employed and understood by oil operators, denotes the first abrasion of the soil by the drill, or that of first entrance into the ground … the word ‘drill’ is defined [by Webster] to mean ‘to pierce; to bore by means of drilling;’ and the word ‘drilling’ as the action of one that drills’ … ‘Operation’ is defined by Webster as the ‘act, process or effect of operating,’ the ‘method or way of operating or working; mode of action or form of ‘activity;’ the ‘state of being operative or in action, as the new railroad will be soon in operation;’ the ‘act of operating, or putting into or maintaining in action; as the operation of a machine.’”32
ii) “the words ‘commence drilling operations’ denote unmistakably the first movement of the drill in penetrating the ground. We think the contracting parties had in mind the ‘spudding in’ of a well as the terms are general understood in the parlance of those engaged in the exploration and development of oil.”
iii) The Court distinguished “commence operations” from “commence drilling operations” … “commence operations” would be satisfied by work done preliminary to actual drilling “commence drilling operations” requires “spudding in”… ”33
7) Shut-in Royalty Clause
a) The requirement to shut-in a well for want of a market is most commonly a problem associated with a gas well. Gas wells require construction of dehydrating facilities, gathering lines, compression facilities and, from time-to-time, transmission pipelines.
b) Lessors anticipate this problem with the shut-in royalty clause.34
c) Representative clause =
“Where gas from one or more wells producing gas is not sold or used, lessee may pay as royalty $500.00 per year, and upon such payment it will be considered that gas is produced within the meaning of [the habendum clause].”
i) Some clauses appear to be equally applicable during the primary and secondary term.
ii) Other clauses apply only to the primary term.
iii) Most shut-in royalty clauses are applicable only to gas wells.
d) If a well capable of paying production is shut-in during the primary term, must the Lessee pay shut-in royalty for the balance of the primary term to hold the lease?
i) Most shut-in royalty clauses are silent as to this question.35
ii) Controlling principles stated by Williams & Meyer include:
(1) Lessee normally has no duty to pay shut-in royalty.
(2) Construction of other lease clauses will affect the answer. For example, a cessation of production clause would allow the Lessee to resume delay rental payments or resume operations on the lease. If some other clause will extend the lease, there is no need to trigger the shut-in royalty clause.36
iii) When drafting a shut-in royalty clause, consider:
(1) If the lease is not a paid-up form of lease, the shut-in royalty amount should be the same as the delay rental amount.
(2) If shut-in royalty is paid on per/acre basis or if pooling or unitization is authorized, it may be advisable to provide for a minimum shut-in royalty payment.
(3) If Lessee desires a shut-in royalty applicable after the primary term, consider:
(a) The amount of shut-in royalty required.
(b) When the first payment and any subsequent payment is due.
(c) Whether the period during which the lease may be held should be limited.
(d) Whether the shut-in royalty clause should be limited to “gas only” or to “gas and distillate” or a well producing “oil and/or gas.”
(e) Whether the shut-in royalty clause should be applicable whenever a well is shut-in without regard to reason or only where the well is shut in for inability to market the product.
(f) Whether the acreage that may be held or the time the lease may be preserved by shut-in royalty payment should be limited.37
8) Royalty Clause
a) To the Lessor, the royalty clause is the most important clause in the lease.
b) The importance of royalty in the lease transaction is emphasized in a Louisiana case, which merits attention:
“The terms of a mineral lease are neither intended to, nor capable of, accommodating every eventuality. … Under the facts before us, a search for the parties’ specific intent in relation to the obligation to pay royalty … would prove fruitless … Accordingly, we look at the parties general intent in entering an oil and gas lease, viz, the lessor supplies the land and the lessee the capital and expertise necessary to develop the land for the mutual benefit of both parties. In this manner, the royalty clause is given an expansive reading, reflecting the mutuality of objectives and sharing of benefits inherent in the lessee-lessor relationship … Consequently, we endeavor to ascertain the meaning of the royalty clause in a manner consistent with the nature and purpose of an oil and gas lease, … having due regard for: (1) the function of the royalty clause; and (2) the lessee’s implied obligation … to market diligently the gas produced.
The lessor-lessee relationship ensues from a synallagmatic contract in which the obligation of each party is the cause of the other … Where royalty is conferred by the lease, royalty is the reason or cause for the lessor to obligate himself thereto … Stated differently, royalty is the compensation or ‘consideration’ the lessee pays to the lessor to secure the privilege of exercising the right to explore and develop the property for production of oil and gas.
By virtue of the beneficial relationship between lessee and lessor, the former avoids having to pay up front for the privilege of exploration, and the latter, assuming a passive role, is guaranteed participation in any eventual yield accruing from the lessee’s entrepreneurial efforts, unconstrained by the financial and operational responsibilities … Inherent in the concept of lease as a bargained-for exchange is the recognition a lessor would not relinquish a valuable right arising from the leased premises without receiving something in exchange …
[W]e conclude an oil and gas lease, and the royalty clause therein, is rendered meaningless where the lessee receives a higher percentage of the gross revenues generated by the leased property than contemplated by the lease. The lease represents a bargained-for exchange, with the benefits flowing directly from the leased premises to the lessee and the lessor, the latter via royalty. An economic benefit accruing from the leased land, generated solely by virtue of the lease, and which is not expressly negated … is to be shared between the lessor and lessee in the fractional division contemplated by the lease …”38
c) Variants in the royalty clause include:
i) The amount of royalty;
ii) The “price” or “value” of royalty oil and/or gas;
iii) The expenses to which the royalty is subject; and
iv) Royalty on minerals other than oil and gas.
d) The amount of royalty.
i) Market driven
ii) Subject to negotiation.
iii) Influenced by the nature of the play:
(1) Speculative
(a) Virtually no past or present drilling activity
(b) Little or no competition
(c) Lessee’s risk is high
(2) Exploration
(a) Past or present drilling indicates potential for success
(b) Competition develops among Lessees
(c) Still … Lessee’s risk is high
(3) Production
(a) Oil and gas operators realized success
(b) High degree of knowledge regarding potential for success
(c) Lessee’s risk is low39
iv) “Price” or “Value” of the oil and/or gas subject to royalty.
(1) Typical lease provides for oil royalty “free of the cost of production.”40 This implies that the royalty interest may be subject to cost incurred subsequent to production.
(2) The question may be put in one of the following forms:
(a) When does cost-free production cease and some other cost-bearing activity begin?
(b) What are costs of production as distinguished from costs subsequent to production?
(c) At what place must the Lessor’s royalty share of the oil or gas (or the value of its proceeds) be delivered?
(3) Lessee’s expenses =
(a) Cost of geophysical surveys.
(b) Drilling costs.
(c) Operating costs.
(d) Costs for testing, completing, reworking a well, including the Christmas tree installed at the wellhead.
(e) Secondary recovery costs.
(4) Lessor/Lessee shared expenses =
(a) Gross production and severance taxes.
(b) Transportation charges or other expenses.
(c) Expenses of treatment required to make the mineral product salable (e.g., dehydration).
(d) Compression expenses necessary to deliver gas into the transmission line.41
(5) A lease may describe royalty as a share of the “proceeds” of production as opposed to w proceeds “at the well” [gross proceeds] or proceeds “at the place of sale” [net proceeds].42
(6) A lease may describe royalty as a requirement for Lessee to deliver the Lessor’s royalty share “free of cost in the pipe line to which Operator may connect his wells.” (Emphasis added.)
(a) Related questions =
(i) Must the Lessee bear the burden of treating the product so it is marketable; the burden of compressing the gas so that it is deliverable; or the burden of transporting the product to the pipe line?
(ii) The weight of authority concludes the Lessor must share the expense of treating oil or gas or of compressing gas to make it deliverable. The Lessee’s duty to market the Lessor’s share of production does not include the burden of bearing the expense of treating, compressing or
transporting the royalty share.43
(b) Where a lease describes the royalty as a requirement for Lessee to deliver the Lessor’s royalty share “free of cost at the pipeline or other delivery point,” courts have imposed the obligation to transport the oil and/or gas to market upon the Lessee.44
(7) Even though leaseholds may be in the same area, the market price for gas may vary. Factors affecting market price are: pressure of the gas; availability and expense of gathering facilities; and the cost of extracting liquid hydrocarbons.
(8) Where “market price” is the standard for setting value for royalty, the wellhead is the place where the “market price” will be determined.
(9) “Market value” means the same as “market price.”
(10) “Proceeds” lacks precise meaning; the term implies a sale (there can be no proceeds without a sale). If there is no sale, “fair value” becomes the standard.45
9) Granting Clause and Bonus Provision
a) Typical Clause =
“Lessor in consideration of Ten and No/100 dollars ($10.00) … of the royalties herein provided, and of the agreements of Lessee herein contained, hereby grants, leases and lets exclusively unto Lessee for the purpose of investigating, exploring prospecting, drilling and mining for and producing oil, gas and all other minerals, laying pipe lines, building tanks, power stations, telephone lines and other structures thereon to produce, save, take care of, treat, transport and own said products … the following described lands ….”
b) Williams & Meyer report that the vast majority of decisions interpreting granting clauses hold that the owner of “gas” is the owner of coal bed methane. Further, they believed, “the courts generally do not read grants of oil and gas rights in a lease restrictively so as to limit them as to substance, depth or method of recovery.”46
c) Gases such as helium and sulfur are usually produced with oil and natural gas. The lease should address the royalty share and value associated with these byproducts.
d) Oil and gas leases customarily provide for payment other than royalty – the bonus.
i) Measure of bonus payment depends on the nature of the Lessee’s play.
ii) Payment historically made by “draft,” however, a better means would be “Order for Payment.”
iii) Bonus payment is conditioned upon “approval of title” and is made on the basis of “net mineral acres.”
iv) Bonus payment is desirable, because …
(1) Gives Lessee the benefit of the doctrine of estoppel by deed;47
(2) It prevents the implication of a resulting use or trust; and
(3) Prevents creditors from voiding the conveyance.48
10) Pooling Clause
a) Typical Clause =
“Lessee may pool or communitize all or any part or parts of said lands with other lands to comprise one or more development units of not more than [number] acres each, and drilling operations or production on any such unit shall constitute compliance herewith on the lands hereby leased. Lessor shall participate in the royalty from any such unit in the proportion that the number of acres owned by him within the unit bears to the total number of acres therein. Lessee shall at all times keep Lessor informed of the lands embraced in any unit of which the lands hereby leased form a part.”
b) Questions regarding whether Lessee has a duty to deal fairly with the Lessor when Lessee pools the leasehold with other interests arise when …
i) Committing the leasehold interests to a unit shortly before the expiration of the primary term when the timing of the act may cause Lessor to believe Lessee’s motivation was perpetuation of the lease – not conservation.
ii) Committing the leasehold interests to a unit in which Lessee has an economic interest when the act may cause Lessor to believe Lessee’s motivation was increased financial return to Lessee – not conservation.
c) Williams & Meyers expressed belief that the “subjective good faith standard for pooling clauses has shown to be an effective method for reining in the discretion expressly delegated to the lessee under a pooling or unitization clause.”49
11) Assignment Provisions
a) Oil and gas leases generally recognize that Lessor or Lessee may freely assign their lease interests.
b) To avoid possibility of dispute concerning assignability, typical lease form includes a clause authorizing assignments.
c) Typical assignment clause includes important provisions applicable to assignment by the Lessor.
i) Lessor’s assignment may not increase Lessee’s obligations.
ii) Lessor/Assignee must give Lessee notice of the assignment before Lessee is bound by the assignment.
d) But, failure to give Lessee notice of the assignment does not excuse Lessee’s failure to make timely payment of delay rental or liability for breach of express or implied lease
covenants.50
12) Forfeiture
a) Most leases are drafted by the Lessee; therefore, they contain provisions designed to protect Lessee from forfeiture.
b) Most common provisions are notice and demand clauses and judicial ascertainment clauses.
c) In Montana, the Lessor seeking Lessee’s forfeiture of an oil and gas lease must first demand the Lessee perform the obligation triggering the right to forfeiture.51
d) Lessee’s clause might read:
“No litigation shall be initiated by Lessor for damages, forfeiture or cancellation with respect to any breach or default by Lessee hereunder, for a period of at least 90 days after Lessor has given Lessee written notice fully describing the breach or default, and then only if Lessee fails to remedy the breach or default with such period. In the event the matter is litigated and there is a final judicial determination that a breach or default has occurred, this lease shall not be forfeited or cancelled in whole or in part unless Lessee is given a reasonable time after said judicial determination to remedy the breach or default and Lessee fails to do so.”
e) Force majeure is another clause that insulates Lessee from forfeiture of the lease. Governmental action or other matters beyond Lessee’s control may be the reason Lessee has failed to perform the contemplated drilling and production operations.
f) Authority establishes force majeure clauses may vary from “approximately fifty words to five or six hundred words.”52
i) A typical force majeure clause may read:
All terms and express or implied covenants of this lease shall be subject to all Federal and State Laws, Executive Orders, Rules or Regulations, and this lease shall not be terminated in whole or in part, nor Lessee held liable in damages for failure to comply therewith, if compliance is prevented by, or if such failure is the result of any such Law, Order, Rule or Regulation.
ii) Variants are:
(1) Provide for the extension of the primary term when the force majeure occurs during the primary term.
(2) The force majeure clause may be applicable only to particular covenants in the lease.
(3) Force majeure may be defined by non-government action, such as floods and winter storms.
(4) The clause may provide that after cessation of the force majeure the lease continues for a reasonable time, for some specified time, or for a period equal to the duration of the force majeure.
(5) Some clauses may substitute words like “unreasonably burdensome” for words like “preventing” performance or “impossibility” of performance.53
13) Title Covenants
a) The most frequently encountered covenant of title in oil and gas leases is a general warranty.
b) Williams & Meyer’s treatise suggests other covenants included from time to time are good title to convey, quiet enjoyment, or other assurances.
c) Generally accepted rules applied to alleged breaches of covenants of title in oil and gas leases include:
i) Before Lessee may establish Lessor’s breach of covenant of warranty or quiet enjoyment, Lessee must prove eviction; however, eviction may be constructive. The
Lessee must show the eviction was “rightful.”
(1) Lessee was never given possession of the leased premises.
(2) Lessee yields to an assertion of outstanding tile by taking a top lease.
ii) Failure of Lessor’s title is not a breach of the covenant of warranty or quiet enjoyment unless Lessee suffers loss because the title failed.
iii) Lessee’s notice of a defect in title when the lease is delivered does not waive the defect in title or bar Lessee’s recovery for breach of the covenant of title.
iv) Given a complete or partial failure of title, Lessee should be entitled to recover all (or a prorate share) of bonus, rental, royalty payments or other payments made out of production.
v) Lessee should not be entitled to recover from Lessor any part of the drilling or other costs of exploring or developing the leased premises.54
1 Solberg v. Sunburst Oil and Gas Co., 76 Mont. 254 (1926). Much has changed, however. Today, the Lessee is unlikely to own the surface estate.
2 The lease at issue in the Solberg v. Sunburst Oil and Gas Co. case expressed a 20-year fixed term.
3 See McDaniel v. Hager-Stevenson Oil Co., 75 Mont. 356 (1926). [“Under the provisions of the ‘or’ type the lessee is obligated to either ‘drill or pay’; under the ‘unless’ type he is not obligated to do either.”]
4 See Sandtana, Inc. v. Wallin Ranch Co., 318 Mont. 369, 377 (2003) where the Court observed, “The habendum clause in an oil and gas lease allows production or operations anywhere on the leased lands or lands pooled therewith to perpetuate the lease beyond the primary term as to all of the leased lands.” Also see Williams & Meyers, Oil and Gas Law – Abridged Second Edition at §§603 and 604.
5 Somont Oil Co., Inc., 310 Mont. 221, 229 (2002).
6 Bruce M. Kramer, The Temporary Cessation Doctrine: A Practical Response to an Ideological Dilemma, 43 Baylor Law Review 519, 520 (1991).
7 Ibid. at 522
8 Somont Oil Co. v. A&G Drilling, Inc., 310 Mont. 221, 230 (2002) “oil and gas leases transfer to the lessee a fee simple determinable estate with the lessor retaining a possibility of reverter.”
9 Fey v. A.A. Oil Corp., 129 Mont 300, 317 (1955).
10 Williams & Meyers, Oil and Gas Law – Abridged Second Edition at §603.
11 William & Meyers, Oil and Gas Law at §604.4.
12 Somont Oil Co. v. A&G Drilling, Inc., 310 Mont. 221,231 (2002).
13 Moerman v. Prairie Resources, Inc., 371 Mont. 338, 341 (2013).
14 Ibid.
15 Williams & Meyers, Oil and Gas Law – Abridged Second Edition at §604.5. See Berthelote v. Loy Oil Co., 95 Mont. 434 (1933) where the Montana Court, evaluating a jury instruction offered “on the theory that [under a ‘thereafter’ habendum clause] the production of oil or gas in any quantity is sufficient to continue it in existence beyond the fixed term” said, “Some courts have held that under a similar ‘thereafter’ clause, any production which is capable of being divided is a sufficient compliance to continue the life of the lease,” … “we are not impressed with the reasoning in the cases so holding and decline to follow them.”
16 Ibid.
17 Berthelote v. Loy Co., 95 Mont. (1933).
18 Somont Oil Co., Inc. v. A & G Drilling, Inc., 310 Mont. 221, 230 (2002).
19 With the exception of State of Montana lease forms, I do not see rental clauses in lease forms; Lessees prefer paid-up primary terms.
20 Ibid. §612.
21 Ibid.
22 These questions are taken directly from Williams & Meyers, Oil and Gas Law – Abridged Second Edition at §§614 and following.
23 Severson v. Barstow, 103 Mont. 526 (1936).
24 Sandtana, Inc. v. Wallin Ranch Co., 318 Mont. 369, 378 (2003).
25 See Severson v. Barstow, 103 Mont. 526 (1936) and Moerman v. Prairie Resources, Inc., 371 Mont. 338, 341 (2013).
26 Williams & Meyers, Oil and Gas Law – Abridged Second Edition at §616.1.
27 Ibid. at §616.3
28 Ibid. at §617.
29 Ibid. at §618.1.
30 Ibid.
31 Ibid.
32 Solberg v. Sunburst Oil & Gas Co., 73 Mont. 94 (1925)
33 Ibid.
34 In Sandtana, Inc. v. Wallin Ranch Co., 318 Mont. 369, 380 (2003), the Montana Court observed, “It is common for a well to be completed and ready for production but shut in waiting for a market. Since the majority view is that a lease terminates at the end of the primary term unless there is actual extraction and marketing, even though there is a capability of production, 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. A shut-in royalty clause provides for ‘constructive production,’ typically in the form of shut-in royalty payments. The effect of the shut-in royalty clause is to provide for a substitute for production under the habendum clause.”
35 Williams & Meyers, Oil and Gas Law – Abridged Second Edition at §633.1
36 Ibid.
37 Ibid.
38 Cited and quoted in Williams & Meyers, Oil and Gas Law – Abridged Second Edition at §641.
39 In the Bakken Play in North Dakota, information shows the oil and gas operator has a 90% or higher opportunity for success in a production play. An exploration play presents a 50% opportunity for success.
40 In Marias River Syndicate v. Big West Oil Co., 98 Mont. 254 (1934), the Montana Court observed, “In cases where oil and gas leases are involved, it is quite universal to refer to the lessor’s portion of the oil, or the proceeds thereof, as ‘royalty,’ and in these instances it is likewise universally provided in leases that the lessor shall receive his portion or per centum of the oil produced, free and clear of all costs of discovery and production. The lessor’s portion of the oil or royalty in the case of an oil and gas lease is free and clear of the cost of discovery and production, by reason of the express provisions of such oil and gas leases.”
41 Williams & Meyers, Oil and Gas Law – Abridged Second Edition at §645.2.
42 Ibid. at 646.1
43 Ibid. at 646.2
44 Ibid.
45 Ibid. at 650.2. One should incorporate language requiring an exchange of the product between Lessee’s affiliates
to result in value comparable to value resulting from an “arms-length” transaction.
46 Williams & Meyers, Volume III, Oil and Gas Law, §665.3.
47 The Montana Court, in Midland Realty Co. of Minnesota v. Halverson, 101 Mont. 49 (1935), describes this doctrine as, “whatever the form or nature of the conveyance, if the grantor recites on the face of the instrument, either by express terms or necessary implication, that he is seized or possessed of a particular estate which the deed purports to convey … the grantor and all persons in privity with him are estopped from afterwards denying the same or asserting the title subsequently acquired by the grantor would not inure to the benefit of the grantee.”
48 Williams & Meyers, Volume III, Oil and Gas Law, §665.3.
49 Williams & Meyers, Oil and Gas Law – Abridged Second Edition at §645.2.
50 Ibid. at 677.4.
51 Fey v. A.A. Oil Corp., 129 Mont. 300, 316 (1955).
52 Williams & Meyers, Oil and Gas Law – Abridged Second Edition at §683.1.
53 Ibid.
54 Ibid. at §685.1