Part 1 - Introduction
Part 2 – Case Study – Coming in October
Shut-in royalty is a payment made by an oil and gas lessee to the lessor in order to keep a lease in force when a well capable of producing is not utilized. This is usually because there is no market for oil or gas or no pipeline ready to receive production. Generally, the lease will terminate at the end of the primary term unless actual production has begun. The shut-in royalty clause in most modern day oil and gas leases is designed to prevent the automatic termination rule.
Under the automatic termination rule, an oil and gas lease will expire after the primary term unless there is a well on the defined property which is producing “in paying quantities.” The termination rule, in a majority of jurisdictions, requires actual production and marketing of natural gas.
Where a gas well has been completed but no market exists for the gas, the shut-in clause enables a lessee to keep the non-producing lease in force by the payment of the shut-in royalty. Such payment serves as “constructive production” and avoids application of the automatic termination rule. The ability to declare a well shut-in and simply tender a shut-in royalty in lieu of a production royalty does not occur automatically. There is no inherent right to shut-in a completed well. Like other lease saving clauses, the shut-in royalty clause must be specifically negotiated as part of the lease. If no such clause appears in the lease, the lessee runs the risk of forfeiting the lease due to non-production.
The shut-in clause is not clear-cut on its face. Historically, courts have “implied” certain additional duties and obligations on every lessee, regardless of the express terms of the lease. Most jurisdictions recognize at least three implied covenants in every oil/gas lease: the implied covenant of reasonable development, the implied covenant to prevent drainage, and the implied covenant to market gas. The marketing covenant requires a lessee to use due diligence to market the gas and to obtain the best possible price.
In 1992 in a Colorado case, Davis v. Cooper, the court maintained that the implied duty to market is an obligation imposed upon a lessee to make a “diligent effort to market the gas in order that the lessor may realize a return on his royalty interest.” The covenant implies that if gas is discovered in paying quantities, the well will be operated so as to secure actual production royalties.
In a 1958 Oklahoma case, McVicker v. Horn, Robinson & Nathan, the court said the lessee must “begin marketing the product within a reasonable time” after completion of the well. Failure to diligently market the gas will result in the breach of the marketing covenant and possible forfeiture of the lease itself. The lessee’s obligation to market the gas is not relieved or suspended by the decision to shut-in a well. The lessee must still act as a reasonably prudent operator in attempting to market the gas. This includes completing the necessary down-stream facilities such as pipelines and compressors.
A 1983 Kansas court noted in Pray v. Premier Petroleum, “[T]he fact that the lease is held by payment of shut-in gas royalties does not excuse the lessee from his duty to diligently search for a market…” Thus, even if the lessee’s initial shut-in of a well was valid and legitimate, the lessee cannot ignore or neglect its duty to market the gas. It must make some effort to market the gas after completing the well. Mere payment of the shut-in royalty will not negate this duty.
Other cases in various jurisdictions have applied the covenant to market in various ways, with varying standards.
Shut-In Clause vs. Marketing Clause:
The express terms of the shut-in royalty clause can often create tension with the marketing covenant. Many shut-in clauses contain no time limitation and arguably allow the lessee to maintain the shut-in status indefinitely.
Implied covenants are not clearly defined in their development and application. The lessee must only act as a “prudent operator.” Implied covenant cases are therefore often prohibitively expensive for a lessor to pursue except in the most egregious circumstances. At some point, after a well has been shut-in for several years, the marketing covenant will be impacted and the lessee will be required to explain and justify the prolonged shut-in status.
Many modern-day leases have included express provisions that supplement or replace the implied covenant obligations of the lessee with express obligations regarding development. These provisions are intended to give more certainty to the intentions of the contracting parties by expressing their intent. They also provide objective criteria for compliance and express remedies for breach.
While there have been relatively few cases addressing the issue of shut-in vs. the implied covenant to market, this may change in the near future. Many wells have been drilled and hydraulically stimulated but remain shut-in due to the lack of pipelines. These leases cannot be maintained forever by the simple payment of the shut-in royalty. Landowners may soon challenge the validity of these leases by asserting a breach of the marketing covenant.
Next month, Part 2: PNP Petroleum I, LP v. Taylor. San Antonio Court of Appeals rules on shut-in royalty clauses.