1. Production in Paying Quantities
Houston Association of Professional Landmen
November 7, 2017
Don Hueske Steptoe & Johnson PLLC
(281)

2. Material Disclaimer
These materials are public information and have been prepared solely for educational purposes to contribute to the understanding of energy and oil and gas law. These materials reflect only the personal views of the author and are not individualized legal advice. It is understood that each case is fact-specific, and that the appropriate solution in any case will vary. Therefore, these materials may or may not be relevant to any particular situation.  Thus, the author and Steptoe & Johnson PLLC cannot be bound either philosophically or as representatives of their various present and future clients to the comments expressed in these materials. The presentation of these materials does not establish any form of attorney-client relationship with the author or Steptoe & Johnson PLLC. While every attempt was made to insure that these materials are accurate, errors or omissions may be contained therein, for which any liability is disclaimed.

3. Evolution of the ‘Standard’ Oil and Gas Lease
Pre-1930’s
No-term leases, kept in effect by production or rentals
Fixed term leases, kept in effect until expiration of a stated term, regardless of productive status on that date

4. Emergence of the Modern Lease
Provides a set primary term during which drilling may be delayed so long as rentals are paid annually. Production will extend the lease beyond expiration, so long as production in paying quantities continues.
The requirement of production in paying quantities may be negated by express lease provisions, ie., ‘capable of producing’.

5. Savings Clauses - Constructive Production
Commencement of Drilling Operations
Temporary Cessation of Production
Continuous Operations
Shut-in Royalty Provisions
Force Majeure

6. Commencement of Drilling Operations
‘If, at the expiration of the primary term, oil and/or gas is not being produced…but Lessee is then engaged in actual drilling or reworking operations…this lease shall remain in force so long as operations are prosecuted with no more than 120 consecutive days, and if they result in production of oil and/or gas, so long thereafter as oil and/or gas is produced in paying quantities from said land.’

7. Temporary Cessation of Production
‘If prior to discovery of oil or gas…Lessee should drill a dry hole or holes thereon, or if after discovery…the production thereof should cease from any cause, this lease shall remain in force as long as additional drilling or reworking operations are conducted upon said land…with no cessation for more than 120 days…’

8. Continuous Operations
‘This lease shall be for a term of 3 years and as long thereafter as operations, as defined herein, are conducted on the land with no cessation of more than 90 consecutive days, or this lease is maintained by any of its other provisions.’

9. Shut-in Royalty
‘If, at the expiration of the primary term, or at any time or times thereafter, there is a well on the leased premises…capable of producing gas only and all such wells are shut in…, Lessee may pay or tender, as shut-in royalty, One Dollar for each acre of land…on or before 90 days after completion of such shut-in gas well and annually thereafter.’

10. Force Majeure
‘If, while this Lease is in force at or after the expiration of the primary term, it is not being continued in force by reason of (1) any law, order, rule or regulation, or (2) any other cause, or force majeure…beyond the reasonable control of Lessee, the primary term shall be extended until the first anniversary date occurring 90 or more days following the removal of the delaying cause…’

11. Production in Paying Quantities
Garcia v. King, 164 S.W.2d 509 (Tex. 1942):
Production that does not permit lessee to pay operating expenses will not keep a lease in existence, even though the lease does not specifically require paying quantities but merely provides that the lease will continue for so long as ‘oil or gas is produced’.

12. Production in Paying Quantities
Clifton v. Koontz, 325 S.W.2d 684 (Tex. 1959) two-prong test:
Does income from a well’s production exceed operating and marketing costs? If yes, end of inquiry.
If no, under all relevant circumstances, would a reasonably prudent operator continue to operate in the same manner in hope of making a profit, and not for mere speculation?

13. Clifton v. Koontz
A ‘reasonable period of time under the circumstances’.
“There can be no arbitrary time period…as there are various causes for slowing up of production or temporary cessations of production…whether it be days, weeks or months...”

14. Clifton’s First Test – Net Profits
Gross revenue less operating and marketing expenses equals Net Profits.
What constitutes operating and marketing expenses?

15. Net Profits Chargeable costs are ongoing: Non-Chargeable costs:
Marketing and operating costs, royalties, taxes, overhead (with a caution), labor, repairs and depreciation on salvageable equipment
Non-Chargeable costs:
One-time capital expenses such as drilling, completion, equipping, reworking, overrides and book depreciation

16. Clifton’s Second Test – the Reasonable Prudent Operator
Whether, under all relevant circumstances, would a reasonably prudent operator continue to operate in the same manner in hope of making a profit, and not for mere speculation?
Answered on a lease by lease or well by well basis without regard to overall enterprise.

17. The Reasonable Prudent Operator
‘All relevant circumstances’
Consider quantity of production and capacity to market, including price to be received, operating and marketing costs, and relative profitability of competitors in the area; also reservoir dynamics, specific lease provisions and regulatory structure

18. Lease Provisions May offer definition or quantify; most do not.
May specify production levels/volumes
May provide means of calculation
May specify relevant time period

19. BP American Production Co. v. Laddex, Ltd. 513 S.W.3d 476 (Tex. 2017).
Production in Paying Quantities
1971 Lease, 5 year primary term. Lessee drilled one producing well. Production sharply dropped off in August 2005 and resumed in November Lessors granted top lease in 2007 and top lessee sued for termination on failure to produce in paying quantities.

20. Laddex Top Lease Language:
“The primary term of this lease shall commence (a) upon the date written releases are filed…or (b) upon the date a judgment of a court of competent jurisdiction terminating the base lease…becomes final and nonappealable…This Lease is intended to and does include and vest in Lessee any and all remainder and reversionary interest…”

21. Laddex
At trial, BP moved for summary judgment on grounds the top lease violated the Rule Against Perpetuities.
“No interest is valid unless it must vest, if at all, within 21 years after the death of some life or lives in being at the time of the conveyance.”

22. Laddex
SJ denied, jury found lack of production in paying quantities between August 2005 and November 2006, and that a reasonably prudent operator would not have continued to operate the well for profit.
BP appealed, claiming (1) top lease violated RAP; (2) no evidence of lack of PPQ or that an RPO wouldn’t continue to operate; and (3) jury charge allowed consideration of incompetent expert testimony.

23. Laddex Appellate Court: Reversed and Remanded.
Lease not violative of RAP since Texas leases create a fee simple determinable with the lessor retaining a possibility of reverter, which is a vested future interest.
However, the trial judge erred in limiting the jury’s consideration of profitability to a specific fifteen month period, preventing consideration of the fact of profitability before and after.

24. Laddex Issues for the Supreme Court:
Can a top lease be saved from the RAP by purporting to convey a ‘possibility of reverter’ which may never revert to lessor?
Can a jury consider profitable production post- lease expiration?

25. Laddex
Held:
Top lease not violative of RAP; relying on a rule of construction, Court assumed grantor intended to create a legal document. Top lease conveyed lessors’ possibility of reverter.
Improper to limit jury’s consideration to specific time period; remanded for new trial.

26. BP America Prod. Co. v. Red Deer Res. , L. L. C. , No. 15-0569, __S. W
BP America Prod. Co. v. Red Deer Res., L.L.C., No , __S.W.3d __, 2017 WL (Tex. April 28, 2017).
PPQ; Shut In Royalties: 1962 lease, 2113 acres, 5 year term. Last producing well P&A’d April 2009, #11 was producing <10mcf/day by Between March and June 2011, Red Deer acquired top leases. Eight day cessation began June 4, 2012, BP shut well in June 12 and tendered shut-ins June 13.

27. Red Deer
Red Deer filed suit after waiting over 60 days from shut-in of the well, alleging termination since:
well had not produced in paying quantities on June 12, and
ineffective payment of shut-in royalties because the well was incapable of producing in paying quantities on June 13.

28. Red Deer Temporary Cessation of Production Provision:
“If production… should cease…this lease shall not terminate if lessee commences mining, drilling or reworking operations on or before the expiration of sixty days from…cessation of production”

29. Red Deer Shut In Provision:
“Where gas from any well capable of producing gas…is not sold or used after the primary term…, lessee may pay or tender…on or before the end of each twelve month period during which gas is not sold or used…, and if such shut in royalty is so paid… it shall be considered that gas is produced in paying quantities, and this lease shall remain in force…”

30. Red Deer
Jury charge:
(1) From 4/27/2009 to 6/12/2012 did the lease fail to produce oil or gas in paying quantities?
(2) Would a RPO not continue, for the purpose of making a profit and not merely for speculation, to operate the lease in the manner in which it was operated between the relevant dates?
(3) Was the well incapable of PPQ on June 13, 2012?
(4) If the well were turned on without additional equipment or repairs, would an RPO would not, for profit and not speculation, operate the #11 well in the same manner?

31. Red Deer
Jury answers: (1) From 4/27/2009 to 6/12/2012 did the lease fail to produce oil or gas in paying quantities? (NO) (2) Would a RPO not continue, for the purpose of making a profit and not merely for speculation, to operate the lease in the manner in which it was operated between the relevant dates? (N/A, because of answer above) (3) Was the well incapable of PPQ on June 13, 2012? (YES) (4) If the well were turned on without additional work, would an RPO not, for profit and not speculation, operate the #11 well in the same manner? (YES)

32. Red Deer
Jury found that lease did NOT fail to produce in paying quantities on June 12, 2012, BUT that a Reasonable Prudent Operator would not continue to operate the well. Appellate Court: Affirmed.

33. Red Deer Issues for the Supreme Court:
WHEN is a well’s ability to PPQ determined?
over a reasonable production period up to/including shut-in date?
over last few months leading to shut-in date?
whether well could flow in PQ on the date after shut-in?
prospectively into the future following shut-in?

34. Red Deer
Held:
TCOP analysis inapplicable, since no effort to restore production;
Shut-in provision in lease allows shut-in payment within one year after last sale or use of gas;
Retroactive shut-in clause allows constructive production to relate back to last sale or use.

35. Conclusion and Takeaways
Developing departure from rules of construction; discern contract’s plain meaning from its four corners, Wenske v. Ealy, No , 2017 WL (Tex. June 23, 2017).
Know the interplay between all of your lease terms, and between leases in a unit.
Plan for disruptions in production.

36. Some Sample Lease Provisions
“Subject to the other provisions herein, this lease shall remain in force for a term of 3 years and as long thereafter…As used in this lease, ‘produced in commercial quantities’ means that as to a given date, the revenue from production…exceeds operational expenses for the 12 month period immediately preceding such date.”

37. Sample Lease Provisions
“If at the end of the primary term or at any time or time thereafter one or more wells on the leased premises…are capable of producing oil or gas…or such wells are waiting on hydraulic fracture stimulation, but such well or wells are either shut-in or production therefrom is not being sold by Lessee…Lessee shall pay shut-in royalty of $1.00 per acre…”

38. Sample Lease Provisions
“Lessee’s rights…for the payment of shut-in gas royalty shall not extend the lease beyond 2 years from the expiration of the primary term or a maximum of 5 years from the date of shut-in of any given well, whichever is later. Only 1 year shut-in time will be permitted after expiration of the primary term”.

39. Don Hueske Steptoe & Johnson PLLC
(281)