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‘Canceling’ An Oil And Gas Lease – Holding Oil & Gas Leases Past Primary Term

North Dakota and New York

What we will discuss.

• In general, the duration of a lease may be extended without production by the following savings clauses found in nearly all oil and gas leases:

• (1) continuous drilling operations provisions,
• (2) shut-in royalty provisions,
• (3) dry hole provisions,
• (4) cessation of production provisions, and
• (5) the force majeure clause.

Things to know about interpreting oil & gas leases

– The same general rules that govern interpretation of contractual agreements apply to oil and gas leases.
• Johnson v. Mineral Estate, Inc., 343 N.W.2d 778, 780 (N.D.1984).

– A contract must be read and considered in its entirety so that all of its provisions are taken into consideration to determine the true intent of the parties.
• Miller v. Schwartz, 354 N.W.2d 685, 688 (N.D.1984).

– Words in a contract are construed in their ordinary and popular sense, unless used by the parties in a technical sense or given a special meaning by the parties.
• Grynberg v. Dome Petroleum Corp., 1999 ND 167, ¶ 10, 599 N.W.2d 261.

– We also construe contracts in light of existing statutes, which become part of and are read into the contract as if those provisions were included in it.
• Reed v. University of North Dakota, 1999 ND 25, ¶ 22 n. 4, 589 N.W.2d 880.

 (1) Continuous Drilling Operations

A lease without a continuous drilling provision may be extended by the lessee exercising reasonable diligence in the continuance of its operations on the leased premises.
– “Since repairs, breakdowns, and reworking operations are incidental to the normal operation of a lease, the parties must have contemplated that the temporary cessation of production caused by such events would not result in automatic termination of the lease.” Williams & Meyers, “Oil & Gas Law” § 604.4.
– A temporary cessation of production is allowed where no specific deadline is provided. Id.

The intent and diligence of the operator in restoring production is an important factor in determining whether a cessation of production is temporary.
– Whether a cessation of production is temporary is a question of fact that will depend on the individual circumstances. Watson v. Rochmill, 155 S.W.2d 783 (Tex. 1941).
• Producing well destroyed by fire and production not resumed for four years = temporary.
– Saulsberry v. Siegel, 252 S.W.2d 783 (Tex. 1941)
• Ceasing production for economic reasons = not temporary.
– Somont Oil Co. v. A & G Drilling, Inc., 49 P.3d 598 (Mont. 2002)

Egeland v. Continental Resources, Inc., 2000 ND 169, 616 N.W.2d 861.

Facts:
Plaintiffs enter into two similar leases, each containing a continuous drilling operations clause and a Pugh clause. The property covered by the leases is within an area designated by the Industrial Commission for the exclusive purpose of drilling horizontal wells.
• 5 separate spacing units, two horizontal wells allowed per unit. (640 acres)
• Continental obtained compulsory pooling orders from the Commission for each of the five spacing units.
Prior to the end of the primary term, the Commission issued permits authorizing Continental to drill one well
in each of the five spacing units.
>> Continental commenced operations on only ONE of the units prior to the expiration of the primary term.

Issue:
Does the Pugh clause terminate the entire lease when only one unit of a pooled area is in operation prior to the end of primary term?

Holding:
No. When land is pooled, the continuous operations clause applies to it all.
– “An oil and gas lease is generally indivisible by nature, and production or other operations on any part of the land will generally maintain the lease beyond the primary term for all of the land covered by the lease.”

Continuous Drilling Operations > Pugh Clause

• The main purpose of a Pugh clause “is to protect the lessor from the anomaly of having the entire property held under a lease by production from a very small portion,” and the clause is designed to “foster reasonable development of leased property.”
– Sandefer Oil & Gas, Inc. v. Duhon, 961 F.2d 1207, 1209 (5th Cir.1992).

When land is pooled, the continuous operations clause applies to it all.
– “We see no irreconcilable conflict between the Pugh clause and the habendum and continuous drilling operations clauses of the lease. The Pugh clause is silent about continuous drilling operations.” Egeland at ¶ 27.
– “The language of the Pugh clause provides “[a] producing well” extends the lease “ONLY as to those lands” sharing in production. The word “ONLY” limits the lands held by production from a given well, not the methods for extending the lease.” Id.

Continuous Drilling Operations on Pooled Acreage

• The majority rule is governmental pooling and unitization orders do not divide a lease, and production anywhere on the pooled acreage holds all leases that may be wholly or partly in the unit.
– Mesa Petroleum Co. v. Scheib, 726 F.2d 614, 615 (10th Cir. 1984).

• Ordinarily, production from, or other operations on, any part of the land included in an oil and gas lease will perpetuate the lease beyond the primary term as to all of the land covered by the lease.
– SMK Energy Corp. v. Westchester Gas Co., 705 S.W.2d 174, 176 (Tex.Ct.App. 1985).

See also N.D.C.C. § 38-08-08(1) (“Operations incident to the drilling of a well upon any portion of a spacing unit covered by a pooling order must be deemed, for all purposes, the conduct of such operations upon each separately owned tract in the drilling unit by the several owners thereof.”)
– Statute cited in Egeland at ¶ 12.

Continuous Drilling Operations (NY)

• No NY cases.

• Although in 1882 New York became “the number one oil-producing state in the nation”, New York courts have long since ceded authoritativeness in oil and gas matters to “out-of-state ‘oil’ jurisdictions”.
– Beardslee v. Inflection Energy, LLC, No. 44 (N.Y. Mar. 31, 2015).

 (2) Shut-in Royalty Clause

• The shut-in royalty clause will permit the lessee to preserve the oil and gas lease when the lessee is unable to find a market for the oil or gas or when an existing market for oil and gas begins to decline.
– Howard R. Williams & Charles J. Meyers, Oil and Gas Law § 631 (2010).

• Texas and Oklahoma AGREE that a shut-in royalty clause or the payment of shut in royalties can operate to preserve the oil and gas lease when the lessee is unable to find a market for the oil or gas or when an existing market for oil and gas begins to decline.

– Shut in royalties are, “periodic payments for the privilege of deferring exploration and production after the primary term.”
• Amber Oil & Gas Co. v. Bratton, 711 S.W.2d 741, 743 (Tex. App. 1986)

– A shut in royalty clause “allows the continuance of the lease, without actual production and marketing of the shut-in product by the substitution of the stipulated payment for the royalties which would accrue to the lessor from actual production and marketing.”
• Gard v. Kaiser, 582 P.2d 1311, 1314 (Okla. 1978)

• However, from there the two dominant views diverge….

Two Competing Views: Shut-in Royalty

Texas: (majority)

• Interprets the leasehold estate as a fee simple determinable that automatically terminates upon the occurrence of the limiting condition.
– Stephens County v. Mid-Kansas Oil & Gas Co., 254 S.W. 290, 295 (Tex. 1923)

Most Important Factor = The passing of a specific date without payment or production.
• Royalty payment acts as a substitute for production which enables the lessee to extend or maintain the lease. If production or its substitute ceases, the lease terminates.
– Mayers v. Sanchez-O’Brien Minerals Corp., 670 S.W.2d 704 (Tex. Int. App. Ct. 1984)

Remedy for breach = Lease terminates automatically.

Oklahoma: (minority)

• Interprets the estate created by the habendum clause of the oil and gas lease as an estate on condition subsequent that does not automatically terminate upon a cessation of production or the occurrence of a condition.
– Danne v. Texaco Exp. & Prod., Inc., 883 P.2d 210, 213 (Okla. 1994)

Most Important Factor = Lessee’s diligence in securing payment or production.
• Neither failure to promptly pay royalty, nor failure to secure actual production prior to end of primary term will terminate the lease if the lessee is acting as a reasonably prudent lessee under the circumstances in securing actual production.
– Roye Realty & Dev., Inc., 791 P.2d 821, 823 (Okla. Civ. App. 1990)

Remedy for breach = Lessor must file an action for breach of contract.

Shut-in Royalties in NY

Follows Majority Rule:
Actual production required to extend lease beyond primary term.

• “Shutting in” and paying royalties on a non-producing well will NOT extend the lease beyond the primary term.
– “Production” requires actual production and marketing to extend the lease beyond its primary term.
• Peckham v. Dunning, 125 N.Y.S.2d 895 (N.Y. Int. App. Ct. 1953).

• Unless, the lease is extended by another clause (duh).
– Shut-in royalties need not be paid to prevent termination of a lease if the lease is preserved by operation of another clause.
• Oag v. Desert Gas Exploration Co., 659 N.Y.S.2d 654 (N.Y. App. Div. 1997).

• In Oag, landowners brought an action for damages against the assignee of a portion of an oil and gas lease for failure to pay shut-in royalties for that portion of the lease. In rejecting the landowner’s argument, the court stated “the habendum clause, and modifying clauses of the habendum clause such as the well completion, continuous drilling, shut-in royalty, and dry hole clauses, are treated as indivisible.” As such, shut-in royalties were not owed by the assignee because the lease was held by producing wells on the acreage retained by the assignor pursuant to the habendum clause.

Shut-in Royalties for ND

• No reported cases. (But maybe follows minority view).

• The ND Supreme Court’s holding in Feland v. Placid Oil Co. that a cessation of production does not automatically terminate a lease in the secondary term, seems in accord with Oklahoma’s (minority) approach to the secondary term of the lease.
– In Feland, the court looked to the reasonableness of a 9 month delay in production caused by a full salt water disposal pond.
• Holding 9 months was a reasonable cessation of production given the facts and circumstances at hand.
• However, payment of a shut-in royalty was not at issue in Feland.

– By considering “reasonableness” as a primary factor in its determination, Feland could be interpreted as following the minority view reflected in Roye Realty and other Oklahoma cases.

• At this point, however, it remains unclear whether North Dakota courts will find the minority view persuasive on the application and interpretation of shut-in clauses.

 (3) Dry Hole Provisions

• No New York or North Dakota cases reported concerning dry hole provisions.

 (4) Cessation of Production Provisions

Common Issues:
1. Defining production.
2. Determining whether cessation is temporary or permanent.

Background information:
•. Operates similarly to a dry-hole provision.
– Perpetuates a lease for a stated grace period if a well ceases production in a circumstance where the lease
would otherwise terminate.
•. Generally perpetuates the lease at least until the end of the primary term.
• Triggered by complete cessation of production, not merely a decline in production below paying quantities.
– If not, courts will generally give a company reasonable time to increase production above the paying-quantities threshold.
Source: Mineral Lease: Saving Clauses, North Dakota State University. David Saxowsky. Found at:
https://www.ag.ndsu.edu/ndoilandgaslaw/mineralowners/savingclauses.

Cessation of Production: Defining Production

• Before the expiration of the primary term:
– Production = any production
• Gives the lessee an opportunity to explore and develop the leasehold.

• After the expiration of primary term:
– Production = production in paying quantities
• Policy suggests that a lessee should not be allowed to maintain a
lease in the secondary term for purely speculative reasons.

Source: Steven L. Holcombe, The Cessation of Production Clause and Less Than Paying Production in the
Secondary Term: Hoyt v. Continental Oil Co., 16 Tulsa L. J. 71 (1980).

Cessation of Production: Temporary vs. Permanent (ND)

• Whether the cessation is temporary or permanent is a question of fact.
– In making that determination, the ND court will
consider the following factors:
(1) the period of time cessation has persisted
(2) the intent of the operator
(3) the cause of cessation; and
(4) the totality of the circumstances.
» Adopted by the North Dakota Supreme Court in Greenfield v. Thill, from a decision of a Kansas court in Wagner v. Sunray Mid-Continent Oil Co.

Temporary Cessation in North Dakota

• Follows general rule.
– “We agree with the general rule that temporary cessation of production will not, in and by itself, terminate the lease.”
• Feland v. Placid Oil Company, 171 N.W.2d 829 (N.D. 1969)

• Based upon equitable principles.
– as a result of “the large expense incident to the work of exploration and development, and the fact that the lessee must bear the loss if the operations are not successful,” it would be “harsh and inequitable to automatically terminate the lease in all cases of cessation.
• Id. at 836. (citing Clifton v. Koontz, 325 S.W.2d 684, 695 (Tex. 1959)).

Feland v. Placid Oil Co., 171 N.W.2d 829 (N.D. 1969)

Facts:
Oil well in question was shut-in for 9 months because the salt water disposal pit was full.
– Operator claims it was not reasonable under the circumstances to make other arrangements for salt water disposal.
• Lessor refused permission to dig another pit.
• Not economically feasible to connect to a salt water disposal system.

Issue:
Was nine months a reasonable time in which to resume production under the circumstances? If not,
did the lease automatically terminate?

Holding:
Nine months was a reasonable cessation of production given the facts and circumstances at hand.
– “Ultimately, the nine-month period of cessation had a favorable effect on the over-all production of the well and, in light of all the evidence in the record, the shut-in period cannot be said to have been unreasonable.”

Factors for lessor to consider:
• How long would production be halted because of salt water problem? Temporarily (< 1 year).
• Would the additional pit be required in the future to make the well productive? No.
• Would alternatives (digging new pit) result in detriment to lessors’ land? Yes.
Factors for court to consider:
• Any indication of lack of good faith? No.
• Any indication that the operator intended the cessation to be permanent? No.

Temporary Cessation in New York

• Unlike Texas, NY appears to acknowledge the inability to market as acceptable grounds for temporary cessation in certain circumstances. (Hill Rule).
– Hill v. Trenkle: market conditions and the refusal of bank financing resulted in lessee being unable to produce. The NY court refused to hold that the lease had terminated and found the lessee had been prevented from producing by circumstances outside their control and that the cessation was temporary.
• 297 N.Y.S. 1020 (N.Y. App. Div. 1937).

– Peckham v. Dunning: a lessee failed to produce in paying quantities for multiple years during the secondary term as required by habendum clause. As a result, the lessor sought termination of the lease. Despite citing the Hill rule that a “temporary cessation of production does not terminate a lease,” the court did not find a temporary cessation and held the lessee’s failures to produce paying quantities for multiple years during secondary term was not “from causes not within control of the lessee.”
• 125 N.Y.S.2d 895 (N.Y. App. Div. 1953).

Source: R Pierce, K Milenkovski, R Bundy, The Quick and the Dead: Cessation of Production and Shut-Ins
During the Secondary Term of an Oil and Gas Lease. 727 N.D. L. Rev. 88 (2012).

 (5) Force Majeure Clause

• The primary purpose of force majeure is to “relieve a party from its contractual duties when its performance has been prevented by a force beyond its control or when the purpose of the contract has been frustrated.”
– Phillips Puerto Rico Core, Inc. v. Tradax Petroleum, Ltd., 782 F.2d 314, 319 (2d Cir.1985).

• As the party invoking the doctrine, defendants carry the burden to establish force majeure. Id.

• Under force majeure, “[m]ere impracticality or unanticipated difficulty is not enough to excuse performance.”
– Phibro Energy, Inc. v. Empresa De Polimeros De Sines Sarl, 720 F.Supp. 312, 318
(S.D.N.Y.1989).

• Finally, “a force majeure clause must include the specific event that is claimed to have prevented performance.”
– Id. (citing Kel Kim Corp., 70 N.Y.2d at 902-03, 524 N.Y.S.2d 384, 519 N.E.2d at 296).

• The common law doctrine of force majeure has, in most instances, fallen by the wayside in favor of the specific terms bargained for by the parties to the lease.
– Joshua A. Swanson, The Hand of God: Limiting the Impact of the Force Majeure Clause in an Oil and Gas Lease. 2013.

• “Indeed, it’s scope and application, for the most part, is utterly dependent upon the terms of the contract in which it appears.”
– Sun Operating Ltd. P’ship v. Holt, 984 S.W.2d 277, 282-83 (Tex. App. – Amarillo 1998, pet. denied)

• When the parties have themselves defined the contours of force majeure in their agreement, those contours dictate the application, effect, and scope of force majeure.”
– Id.

Remember: Oil and gas leases are highly technical, employing distinct terminology. For these reasons an oil and gas lease must be construed with reference to both the intention of the parties and the known practices within the industry.
– Howard R. Williams & Charles J. Meyers, Oil and Gas Law §§ 601, 603, 605 [2003 ed].

Force Majeure in New York

• “A force majeure event is an event beyond the control of the parties which prevents performance under a contract and may excuse non-performance.”
– Kel Kim Corp. v. Cent. Mkts., Inc., 70 N.Y.2d 900, 902, 524 N.Y.S.2d 384, 519 N.E.2d 295, 296 (N.Y. 1987).

• However, recent developments illustrate the complexities of a once “basic” clause.

Force Majeure Clauses & Govt. Regulations

• “Under the force majeure clause, rules or regulations of governmental authority which prevent the lessee from complying with the lease covenants constitute an excuse for non-performance.”
– Schroeder v. Snoga, 04-96- 00489-CV, 1997 WL 428472 (Tex. App.—San Antonio July 31, 1997, no writ).

• However, if a lessee’s violation of Commission rules or regulations results in a shut-in order, “courts are unwilling to allow the lessee to gain the benefit of the force majeure clause when the shut-in order was due to the lessee’s action or inaction.”
– Id.

Beardslee v. Inflection Energy, LLC, No. 44 (N.Y. Mar. 31, 2015).

Facts:
Governor Patterson orders formal public environmental review of combined use fracking and horizontal drilling. (July 23, 2008 – infamous NY moratorium on fracking)
– No more permits are issued.
– At the end of the primary term oil companies argue each lease was extended by operation of the force
majeure clause.

Issue:
Does a mandated environmental review addressing the impact of hydraulic fracturing and horizontal drilling constitute a force majeure event under the leases?
– Sub-issue: Does the force majeure clause modify the habendum clause and extend the primary term of the
lease?

Holding:
The language in the force majeure clause stating that “the time of such delay or interruption shall not be counted against Lessee” does not refer to the habendum clause with specificity. Thus, the habendum clause is not expressly modified or enlarged by the force majeure clause.
• “To read the force majeure clause as applying to the primary term would be to interpret the leases in a manner contrary to the plain intent of the parties.”
– The force majeure clause deals with lease termination, not expiration. Lease termination, and thus the force majeure clause relate only to the secondary term.

Post- Beardslee

• Mineral owners should anticipate that oil and gas companies will seek to expand the terms and scope of the force majeure clause in their leases by giving a broader definition to those force majeure qualifying events, saving a lease from expiring despite a lack of production and drilling operations.

• Mineral owners can protect themselves by being diligent in reviewing language in a proposed lease and by pushing for a very specific and narrowly-defined force majeure clause limiting what is considered a force majeure qualifying event.

Source: Joshua A. Swanson, The Hand of God: Limiting the Impact of the Force Majeure Clause in an Oil and Gas Lease, 224 N.D. L. Rev. 89 (2012).

Force Majeure in North Dakota

• There is limited case law in North Dakota to guide litigants as to whether the force majeure clause
operates to hold their lease.

• However, the much publicized cases in NY dealing with the state’s moratorium on fracking indicate the
force majeure clause in oil and gas leases may not be as broad as oil companies envision them.

The Problem with Force Majeure

• Example of an overly-broad boilerplate force majeure clause:

– “In the event lessee is rendered unable in whole or in part, by a force majeure to carry out its obligations under this lease, other than to make payments of amounts due hereunder, its obligations so far as they are affected by such force majeure shall be suspended during the continuance of an inability so cause. The term ‘force majeure’ as used herein shall be Acts of God, strikes, lockouts, or other industrial disturbances, acts of the public enemy, wars, blockades, riots, epidemics, lightning, earthquakes, explosions, accidents or repairs to machinery or pipes, delays of carriers, inability to obtain materials or rights of way on reasonable terms, acts of public authorities, or any other causes, whether or not of the same kind as enumerated herein, not within the control of the lessee and which by the exercise of due diligence lessee is unable to overcome.”
• See Aukema v. Chesapeake Appalachia, 904 F. Supp. 2d at 206, (N.D.N.Y 2012).

Recommendation(s) on Force Majeure

• “Mineral owners should anticipate that oil and gas companies will seek to expand the terms and scope of force majeure by giving a broader definition to those force majeure qualifying events.”
– Joshua A. Swanson, The Hand of God: Limiting the Impact of the Force Majeure Clause in an Oil and Gas Lease, 224 N.D. L. Rev. 89 (2012).

• Mineral owners can protect themselves by being diligent in reviewing language and demanding a very specific and narrowly defined force majeure clause.
– Oppose anything caused by the oil company’s lack of diligence and economic hardships and any other broad force majeure terms.

• Remember: A force majeure qualifying event is whatever the lease says it is.
– “The historical underpinnings have fallen by the wayside. Force majeure, is now little more than a descriptive phrase without much inherent substance. Indeed, its scope and application, for the most part, is utterly dependent upon the terms of the contract in which it appears.”
• Sun Operating Ltd. Partnership v. Holt, 984 S.W.2d 277, 283 (Tex. App. 1998).

Key Force Majeure Requirement

• Written Notice!
– Ex: “Lessee shall notify Lessor in writing within fifteen (15) days of the first occurrence of any claimed events defined herein which prevents or hinders any compliance, such notice required in order for said event to qualify as force majeure.”
• Joshua A. Swanson, The Hand of God: Limiting the Impact of the Force Majeure Clause in an Oil and Gas Lease, 224 N.D. L. Rev. 89 (2012).

• Keep in mind: Not even 9/11 terrorist attacks will automatically qualify as a force majeure event unless it is specifically contemplated by the parties.
– “Mere impracticality or economic hardship is not enough to trigger the force majeure clause and excuse performance.”
• OWBR, LLC v. Clear Channel Commc’ns, Inc., 266 F. Supp. 2d 1214, 1223 (D. Haw. 2003)

Ending Notes on Force Majeure

• Be familiar with express terms. After the lease is executed, one of the most effective strategies to avoiding a termination suit is simply being familiar with the express terms of the applicable lease, including any definition of an industry term, the type of activity and/or production required to perpetuate the lease, and what additional options (ie, pooling, shut-in royalties, savings clauses) are made available by the lease and how to exercise them.

• Prepare the lease properly. When negotiating an oil and gas lease a lessee should keep in mind potential issues that may arise. For instance, if the lessee is in an area where it will be difficult to get the necessary people or equipment, the lessee may want to draft any “operations” broadly. A lessee should also consider whether the force majeure clause should be triggered by events like the unavailability of service companies and/or drilling rigs. Additionally, the availability of a market (or lack thereof) may impact how the shut-in royalties clause should be drafted.

• Remain vigilant in understanding the lease terms and diligent in conducting operations to accomplish the principal purpose of the lease, to make money for the lessor and lessee from the production and sale of oil and gas.

Source: Christopher L. Halgren, Oil & Gas Perpetuation: Operating, Reworking, Maintaining, and Production. Found at:
http://www.mcginnislaw.com/images/uploads/news/Article_-_Lease_Perpetuation.pdf

The End.

• Thank you.
• I would like to acknowledge and thank Zach Coccoli Esq. for his work on this presentation.

David Ganje of Ganje Law Offices in Rapid City practices in the area of natural resources, environmental and commercial law.