Shearman & Sterling LLP multinational law firm headquartered in New York City, United States.

Oil Pump, Oil & Gas, Yukos

Apr 03, 2020

Lessee Considerations in Dealing with Oil and Gas Production in Low (and Plummeting) Price Environments

Subscribe

Jump to...

 

LESSEE CONSIDERATIONS IN DEALING WITH OIL AND GAS PRODUCTION IN LOW (AND PLUMMETING) PRICE ENVIRONMENTS

The novel Coronavirus (COVID-19) pandemic has significantly affected global oil demand, as travel restrictions and social distancing measures continue. Beyond the vanishing demand, oil markets are also feeling the effects of the Saudi Arabia–Russia price war, which has further flooded the market with extra supply. As a result, crude oil prices have plummeted in recent weeks, leaving many oil and gas companies to face difficult decisions. In particular, many oil and gas lessees will need to identify practical solutions to maintain their producing leasehold positions in this low-price environment.[1]

Know Your Lease

First and foremost, lessees need to have a firm understanding of the terms of their oil and gas leases. As with all contracts under Texas state law, unambiguous lease terms will be interpreted and enforced as written. This paper provides an overview of key lease provisions to review and consider in determining what lessees can do to preserve their leasehold positions during times of low (and plummeting) crude oil prices, as well as the application of current Texas law to such provisions.

Production in Paying Quantities

The first question for lessees to consider is whether current production from wells is sufficient to maintain each lease. Most contemporary oil and gas leases contain a habendum clause with a primary term for a set number of years, followed by a secondary term for an indeterminate duration whereby the lease is preserved “for so long as” oil or gas is produced in paying quantities from the leased premises.[2] This paper focuses primarily on maintenance of the lease during the secondary term.

Texas applies a two-prong test to determine if a well is producing in paying quantities:

Objective Test – Is the well producing in quantities sufficient to yield a profit, after deducting marketing and operating expenses, over a reasonable period of time?

If production from the well yields a profit, even small, over operating expenses, the well produces in paying quantities, even though it may never repay its capital costs, and the operation as a whole may result in a loss.[3] There is no set period of time considered when applying the “production in paying quantities” doctrine (“PPQ Doctrine”), and the time periods used by courts in determining profitability have been extremely fact specific. Texas courts have applied the test to time periods as brief as six months and as long as two years. Accordingly, if a well was otherwise profitable prior to the recent drop in commodity prices and the low-price environment continues for only a few months, then such well likely produces in paying quantities.[4] As time goes on and the current price environment continues, the determination becomes less clear.

However, a question remains as to whether the PPQ Doctrine applies in abnormal price conditions. The Texas Supreme Court in Garcia, the case creating the modern PPQ Doctrine, noted it was imposing the doctrine under “normal conditions.”[5] As such, it is possible that Texas courts will discount the unprofitability of wells during this time of extreme price volatility, giving greater weight to a well’s performance prior to, and expected performance after, the effects of the pandemic lessen and markets stabilize.

If the first prong of the test is satisfied, then a well is considered producing in paying quantities, and no further analysis is required. Otherwise, the second prong of the test must be employed:

Subjective Test – Even if a well is patently unprofitable, would a reasonable and prudent operator, under the same circumstances, continue to operate the well for profit and not merely speculation?

If under similar circumstances a reasonable and prudent operator would continue to operate the well for profit (and not merely speculation), a lease still may be producing in paying quantities.[6] Taking into account the historically volatile nature of the oil and gas industry, the court’s addition of the second prong to the PPQ Doctrine may have been to ensure that leases do not automatically terminate during long periods of low crude oil prices, so long as a prudent operator reasonably believes such production will be profitable in the future.[7] In Koontz, the court listed several factors to consider when evaluating the second prong, including: depletion of the reservoir and the price at which the lessee is able to sell its production, the relative profitability of other wells in the area, the operating and marketing costs of the lease, the lessee’s net profit, the lease provisions, a reasonable period of time under the circumstances, and whether or not the lessee is holding the lease for merely speculative purposes.[8] Because all such relevant circumstances will be examined, it is possible that courts will properly account for the unprecedented nature of the current market and give the benefit of the doubt to lessees continuing to produce through this downturn.

Savings Clauses

If a lease is not producing in paying quantities as described above, lessees may find relief in other provisions within their oil and gas leases that maintain such contracts in effect even when the lessee lacks production during the secondary term. Such “savings clauses” operate to hold the leases in the absence of actual production. The underlying policy is to encourage exploration and production and prevent the inequities that would result if a lease were to terminate while the lessee is investing time and capital into exploring for oil and gas.

Cessation of Production Clause

The “temporary cessation of production” doctrine provides protection to the lessee in the event that a well temporarily ceases to produce. While historical case law suggested the doctrine only applied to “sudden stoppage of the well or some mechanical breakdown of the equipment used in connection therewith, or the like,” Texas courts more recently have stated that the doctrine should apply in “a wide variety of circumstances,” which suggests that it may apply to shutdowns for economic reasons.[9] Accordingly, even if lessees have a lease without a savings clause applicable to this situation, brief cessations in production during this time of extreme market volatility are unlikely to terminate the lease.

That said, modern oil and gas leases typically include cessation of production clauses, which are savings clauses that set forth the circumstances and manner in which a lease may be preserved despite a lack of production.

Such clauses override the common law temporary cessation of production doctrine. And instead of being focused on the cause of the cessation of production, most such clauses require the lessee to begin work on restoring production within a specified time frame.[10] As stated previously, the courts will give effect to the unambiguous language of the lease, so having a firm understanding of the requirements in a cessation of production clause is critical before a producer intentionally shuts in a well or otherwise significantly curtails or periodically stops production.

Shut-In Royalty Clause

A shut-in royalty clause is a savings clause within an oil and gas lease that allows a lessee to shut in a well but continue to maintain its lease by paying the lessor certain royalties identified in the lease. This capability typically exists so long as such well (i) has produced in paying quantities, over a reasonable period of time, as of the date the well is shut in, (ii) is operationally capable of producing in paying quantities at the time the well is shut-in (i.e., the well would flow if turned “on”), and (iii) is the type of well (i.e., gas or oil) identified in the shut-in provision. Lessees should consider the following key issues in the application of shut-in royalty provisions:

  • Producing in Paying Quantities

Texas courts require that a shut-in well produce, and once shut in be capable of producing, in “paying quantities” for a shut-in royalty provision to be triggered. This requirement applies even if the provision in the individual lease does not expressly state a production in paying quantities requirement. Lessees should carefully review historical production from a well and make a determination as to its profitability and ability to produce prior to relying on a shut-in royalty provision to shut in a well.

  • Timing Concerns

Texas case law is not entirely settled as to what point in time a shut-in well must be producing in paying quantities to satisfy the shut-in royalty provision (i.e., on the actual date of shut-in, when the shut-in royalty is paid, or over some other period of time). Recent Texas case law suggests that the determination would be whether the shut-in well was producing in paying quantities, over a reasonable period of time, as of the date the well is shut-in.

  • Grounds for Shut-In

Most shut-in royalty clauses do not specifically designate the reasons for the shut-in. Not having a specific reason is generally thought to provide flexibility to the lessee to shut in a well due to the lack of an “acceptable” market. However, lessees should carefully consider the language in their leases to confirm there are no limitations as to what events trigger the lessee’s right to shut-in wells.

  • Type of Well

Many shut-in royalty provisions, particularly in older leases, apply only to “gas wells” or wells capable of producing “gas only.” In such case, oil wells likely cannot be shut in. The language of the shut-in provision should be reviewed carefully to determine the type of wells covered.

  • Payment Timing

The timing of a shut-in payment depends entirely on the language in the lease, so a careful review of the lease in question will be necessary. If the lease does not provide a set period of time to pay a shut-in royalty, the courts have generally held that the payment must be made before the well is actually shut in. In Texas, the time when the shut-in royalty payments must be tendered is critically important because there must be actual or constructive production in order to extend or maintain the lease beyond the primary term. Failure to timely pay could result in automatic termination of the lease. In other states, such as Oklahoma, the remedy is less severe for the lessee; there is no automatic termination, but the lessee would be liable for breach of contract.

  • Amount of Royalty Payment

The amount of the shut-in payment also depends entirely on the language in the lease. Much like the timing of the shut-in payment, errors in the amount of the shut-in payment also could result in termination of the lease. As such, in the event of uncertainty as to amount, lessees should consider erring on the side of overpayment to ensure the lease does not terminate for underpayment.

Force Majeure Clause

Force majeure clauses can be found in some oil and gas leases, especially those with more burdensome drilling and development obligations. A force majeure clause typically provides that a lessee will be excused from performing its obligations under the lease, and the lease will continue in effect, if the lessee is unable to perform its obligations due to circumstances outside of its control. Typical events or circumstances covered include acts of God, war, labor shortages, government interferences, and the like. Lessees should review force majeure provisions to determine whether pandemics and downstream interruptions (e.g., a transporter or refinery refusing to accept deliveries) fall within the circumstances covered. Additionally, even if specific circumstances are deemed force majeure under the lease, lessees may need to show a nexus between such event and their inability to perform.

Pooling Clause

The pooling clause permits the lessee to pool multiple tracts of land to create a pooled unit, whereby production from any location on the pooled unit will be treated as production as to the entire pooled unit. While the pooling provision may not be as directly tied to current market conditions as the shut-in royalty provision or force majeure provision, lessees should not forget its usefulness as another savings clause to keep their leases in effect.

Shut-In Agreements

In the absence of production in paying quantities or an applicable savings clause, lessees may consider proposing shut-in well agreements, whereby lessors agree that, during the continuance of the pandemic and low commodity prices, lessees may shut in its wells (regardless of type) and maintain leases in effect. While the terms of the agreement will vary, setting some sort of “strike” price for crude oil upon which lessee will return its wells to production seems the most equitable approach. Taking this route will give lessees confidence that their actions will not result in a foot fault under, and a termination of, their various oil and gas leases. And given that lessors and lessees alike make more money with more profitable wells, such agreements would be in all parties’ best interests.

Conclusion

Given the recent fall of crude oil prices, lessees may be searching for ways to preserve their oil and gas leases. The first step in doing so is to conduct a thorough review of their oil and gas leases. Many lessees may continue to produce their wells and find relief in production in paying quantity provisions, while others may need to rely on savings clauses within their leases to hold acreage. If the terms of their leases do not provide an avenue to holding acreage, lessees should consider negotiating shut-in agreements with lessors to carry them through the current low price environment.

Footnotes

[1] This paper addresses key considerations for lessees grappling with how to preserve producing acreage despite plummeting crude prices. It does not focus on how to maintain leases that have not yet been developed, nor does it address the existence of lease provisions that, despite existing production, require drilling within certain periods or continuously. Lessees should identify such provisions within their leases and carefully consider their impact.
[2] Under Texas law, the word “produce” in a habendum clause means “producing in paying quantities.” Garcia v. King, 164 S.W.2d 509, 511-512 (Tex. 1942).
[3] Aycock v. Paraffine Oil Co., 210 S.W. 851, 853 (Tex. Civ. App. 1919).
[4] This assumes that the wells in question were profitable prior to recent drastic decrease in oil prices.
[5] Garcia, 164 S.W.2d at 512. (“It should be noted that we are here dealing with a situation in which under normal conditions, all of the wells on the lease in question at the time of the termination of the primary period were not producing enough oil or gas to pay a profit.”).
[6] Clifton v. Koontz, 325 S.W.2d 684, 691 (Tex. 1959).
[7] Charles R. “Skip” Watson, Production in Paying Quantities in a Low Price Environment at 9.
[8] Koontz, 325 S.W.2d at 691.
[9] See Ridge Oil v. Guinn, 152 S.W.3d 143, 148 (Tex. 2004).
[10] Most oil and gas leases can be held with “reworking” operations; however, courts vary on their interpretation of the term “reworking” (if not otherwise defined in the lease). The term has been interpreted very broadly as “any and all actual acts, work or operations in which an ordinarily competent operator, under the same or similar circumstances, would engage in a good faith effort to cause a well . . . to produce oil or gas in paying quantities.” Cox v. Stowers, 786 S.W.2d 102, 112 O.&G.R. 308 (Tex. App. – Amarillo 1990, no writ).

Authors and Contributors

Hugh Tucker

Partner

Mergers & Acquisitions

+1 713 354 4899

+1 713 354 4899

Houston

Jeremy Kennedy

Partner

Mergers & Acquisitions

+1 713 354 4895

+1 713 354 4895

Houston

Angela Heywood Bible

Counsel

Mergers & Acquisitions

+1 713 354 4882

+1 713 354 4882

Houston

John M. Craven

Associate

Mergers & Acquisitions

+1 713 354 4894

+1 713 354 4894

Houston

Delanah Davis

Associate

Mergers & Acquisitions

+1 713 354 4860

+1 713 354 4860

Houston