Case Study Part 2 of 2
See Part 1 here.
The appeal arose from a dispute over whether the term of an oil and gas lease was extended by a payment made by the lessee under the shut-in royalty clause. The lease provided that the lessee could pay a “shut-in well royalty payment” to extend the term of the lease “[i]f, at the expiration of the primary term there is located on the leased premises a well or wells not producing oil/gas in paying quantities.”
On June 1, 2009, Ms. Taylor and Ms. Herbst (mineral owners) entered into an oil and gas lease with PNP Petroleum, providing for a one-year primary term and stating that it would continue “as long thereafter as oil and/or gas in paying quantities is produced from and sold from the land subject to this lease.” At the time, there were 13 non-producing wells on the property under an old lease with another party that had expired. The lease between PNP and the mineral owners also contained a shut-in royalty clause that provided:
“SHUT-IN ROYALTY (Saving) If, at the expiration of the primary term there is located on the leased premises a well or wells not producing oil/gas in paying quantities, Lessee may pay as royalty a sum of money equal to $20 per proration acre associated with each well not producing. The shut-in well royalty payment will extend the term of the lease for a period of 1 year….”
PNP wrote to the mineral owners stating that it intended to extend the lease term pursuant to the shut-in royalty clause and provided a check for the required amount. The mineral owners claimed that the shut-in royalty clause was inapplicable and that the lease was automatically terminated on June 1, 2010. PNP filed the lawsuit seeking a declaration that their payment of the shut-in royalties extended the lease term.
PNP argued that because there were 13 existing wells on the property that were not producing oil and gas, the shut-in royalty clause extended the lease. PNP offered a red-lined version of the lease agreement in which the language of the shut-in royalty clause was modified. Initially, the proposed shut-in royalty clause contained the words “capable of producing oil /gas in paying quantities”, but during the negotiations these words were stricken from the agreement. PNP argued that this was evidence the parties did not intend for the clause to apply only if there were wells capable of producing oil and gas (even though that is the standard understanding in the industry of a shut-in royalty clause), but instead to apply if there were any non-producing wells on the property per the parties’ agreement, whether or not they were capable of producing.
Mineral Owner’s Position:
The mineral owners argued that under Texas law a shut-in royalty clause applies only when there was a lease capable of producing in paying quantities. They argued that this was the industry meaning of the term “shut-in royalty” and that the lease should be interpreted in accordance with the common use in the industry. The mineral owners also argued that the evidence of prior drafts of the lease and the negotiations is inadmissible under the rules of evidence.
Trial Court Ruling:
The trial court sided with the mineral owners, applying the industry standard to the lease, and finding that the shut-in royalty clause was inapplicable and that the lease terminated. The trial judge also found that PNP’s evidence of prior drafts of the lease agreement was inadmissible.
The issues raised by PNP to the San Antonio Court of Appeals challenged the trial court’s sustaining of objections to summary judgment evidence and its construction of the lease clause regarding shut-in.
Basic Law Regarding Interpretation of Oil and Gas Leases:
Texas courts seek to use standard principles and to determine the parties’ intentions as expressed in a lease. See Heritage Res., Inc. v. NationsBank, 939 S.W.2d 118, 121 (Tex. 1996). Under Texas law, if a lease term has a generally accepted meaning in the oil and gas industry, that meaning is used by the court to construe the lease. See BP Am. Prod. Co. v. Zaffirini , 419 S.W.3d 495, (Tex. App. – San Antonio 2013) (pet. filed).
Generally, an oil and gas lease is written such that it contains a primary and a secondary term. The primary term is generally a set number of years. The secondary term generally provides that the lease shall continue in effect at the conclusion of the primary term if oil and gas is being produced in paying quantities at the end of the primary term. There are, however, certain “savings clauses,” such as the shut-in royalty clause, common in oil and gas leases that allow an oil company to extend a lease beyond the primary term even if there is no production in paying quantities. Certain conditions must be met. The shut-in royalty is considered constructive production and will maintain the lease if its terms are satisfied.
Court of Appeals Decision:
In a lengthy opinion, Judge Catherine Stone rendered the verdict of the court of appeals and reversed the trial court. First, the court found that PNP’s evidence of prior drafts of the lease agreement was admissible under the rules of evidence and should have been considered by the trial court. Next, the court reasoned that generally, a shut-in royalty clause would be interpreted in accordance with the general principal and only applied to wells capable of production. In this case, however, the evidence that “capable of” producing in paying quantities was stricken from the lease by the parties, changed that general principal. The parties’ negotiations and agreed upon lease deviated from the general law that would have implied the “capable of” requirement in the lease because the parties expressly removed this agreement in the signed lease.
Therefore, the court determined that it was not the parties’ intent to apply the generally accepted meaning of “shut-in royalty”. Because there were wells located on the leased premises that were not producing oil and gas at the end of the primary term as required by the parties’ agreement, and because PNP paid the required shut in royalties, the lease continued after the primary term.
Bottom Line - Reversed and Rendered:
The appellant court concluded that the trial court erroneously sustained the objections to the summary judgment evidence and consequently erred in its construction of the lease. They reversed the trial court’s judgment and rendered judgment that the term of the lease was extended by the lessee’s payment.
Review the full opinion here.