This Lease is HBP, Right? Factors to Consider When Maintaining an Oil and Gas Lease in its Secondary Term Presented By: Travis P. Brown, Shareholder Mahaffey & Gore, P.C.

“Marginal” Wells -Defined as wells which require a higher price to be profitable due to poor production and/or high operating costs ~771,000 Marginal Wells Currently in Production in the United States ~20% of Total Yearly American Production Derived from Marginal Wells Source: National Stripper Well Association

“Held By Production” The Basics Almost always, Oil & Gas Lease will survive “for so long as oil or gas is produced” as stated in Habendum Clause “ Production” under Habendum Clause is defined as: 1. Actual production or capability to produce and 2. In Paying Quantities James Energy Co. v. HCG Energy Corp., 1992 OK 117, 847 P.2d 333

Part 1: “Production”  “Capability” has not been defined by the Oklahoma Supreme Court.  Texas Definition (adopted by Oklahoma Court of Civil Appeals in an unpublished opinion): “Well is turned on and it begins flowing without additional equipment or repair.” Chesapeake Exploration v. Concorde Resources Corp., No. 106,005 (Okla. Civ. App. Feb. 27, 2009) (unpublished) - Defined as actual production or capability to produce. Pack v. Santa Fe Minerals, 1994 OK 23, 869 P.2d 323

Part 2: “In Paying Quantities” “In Paying Quantities”: Production of quantities of oil and gas sufficient to yield a profit to the lessee over operating expenses.” Hininger v. Kaiser, 1987 OK 26, 738 P.2d 137 No Court order is required to terminate a Lease. It expires by its own terms when it fails to produce in paying quantities for a period stated in OGL or, if OGL is silent, for an unreasonable period of time. Baytide Petroleum, Inc. v. Continental Res., Inc., 2010 OK 6, 231 P.3d 1144 Revenues Operating Expenses Paying Quantities

Operating Expenses What Is Included? Costs of Operating Pumps Pumper’s Salaries Costs of Supervision Gross Production Taxes Royalties Payable to the Lessor Electricity Telephone Charges Repairs Other Incidental Lifting Expenses Depreciation of Equipment Used in Lifting Operations Saltwater Disposal Payments Stewart v. Amerada Hess Corp., 1979 OK 145, 604 P.2d 854, Note 11 * Not an exhaustive list

Operating Expenses Cont’d What Is Excluded? Drilling Costs – Stewart v. Amerada Hess, 1979 OK 145, 604 P.2d 854 Equipping Costs – Hininger v. Kaiser, 1987 OK 26, 738 P.2d 137 Completion Costs – Stewart v. Amerada Hess, 1979 OK 145, 604 P.2d 854 Overriding Royalties – Hininger v. Kaiser, 1987 OK 26, 738 P.2d 137 Administrative Overhead – Hininger v. Kaiser, 1987 OK 26, 738 P.2d 137 “District Expenses” – Mason v. Ladd Petroleum, 1981 OK 73, 630 P.2d 1283 Depreciation of Casing, Tubing and Tree – Mason v. Ladd Petroleum, 1981 OK 73, 630 P.2d 1283

How Long Can A Well Be Noncommercial Before Expiration? Express Time Period Established in OGL If OGL is silent: A “reasonable period of time” – State ex rel. Comm’rs Land Office v. Amoco Prod. Co., 1982 OK 14, 645 P.2d 468 – How Long is “Reasonable?”

What Is A “Reasonable” Period of Time? With a few exceptions, 6 months to 1 year is usually “reasonable” Anything more than 1 year is usually “unreasonable” absent compelling equitable circumstances

What Is A “Reasonable” Period of Time? Cont’d “The longest period permitted in Oklahoma judicial history for temporary cessation after expiration of the primary term of an oil and gas lease was…probably six months but could not have been over 12 months.” Jath Oil Co. v. Durbin Branch, 1971 OK 127, 490 P.2d 1086, 1091

Defenses: Equitable Circumstances “Voluntariness” of the Cessation Lessee’s Attempt to Correct Problem Lessee’s Attempt to Restore Production Mechanical Difficulties Whether period of cessation is reasonable “is viewed in light of all the circumstances” McClain v. Ricks Exploration Co., 1994 OK CIV APP 76, 894 P.2d 422

Defenses: Equitable Circumstances Cont’d Most Common Mistake: “Low Commodity Price Is An Equitable Circumstance Which Might Save the Lease” WRONG! Oklahoma Supreme Court Expressly Rejected This Theory in Smith v. Marshall Oil Corp., 2004 OK 10, 85 P.3d 830: “Fluctuating market prices do not rise to the level of an equitable consideration, or an excuse for [Lessee]'s failure to produce in paying quantities.”

Defenses: Other Potential Equitable Circumstances Accepting Royalty Payments (Waiver/Estoppel) – Danne v. Texaco Exploration and Production, Inc., 1994 OK CIV APP 138, 883 P.2d 210 Allowing Lessee To Drill New Well After Knowing Of Old Well’s Non-Commerciality (Estoppel) – McClain v. Ricks Exploration Co., 1994 OK CIV APP 76, 894 P.2d 422

Final Takeaways READ YOUR LEASE! – Terms differ – Language differs Monitor Commodity Prices – Minor declines in price can make marginal wells no longer profitable WATCH YOUR WELLS! – Non-commercial wells can be spotted and reworked to avoid losing leases HIRE A GOOD LAWYER!

This Lease is HBP, Right? Factors to Consider When Maintaining an Oil and Gas Lease in its Secondary Term Presented By: Travis P. Brown, Shareholder Mahaffey & Gore, P.C.