Chapter 11 Revivor of Oil & Gas Leases

Transcription

1 CITE AS 25 Energy & Min. L. Inst. ch. 11 (2005) Chapter 11 Revivor of Oil & Gas Leases Brian M. Johnson 1 Greenebaum Doll & McDonald PLLC Lexington, Kentucky Synopsis Termination of Leases [1] Failure to Develop the Lease on a Timely Basis [2] Cessation of Production [3] Pooling Agreements Revivor of Leases [1] The Subsequent Execution of a Document [2] Late Payments [3] Revivor as a Result of Silence of the Lessor [4] Late Production and Tort Claims [5] Notice Required for Termination [6] Joint Tenancy Issues [7] Intervening Lienholders [8] Adverse Possession Conclusion This chapter discusses issues concerning the revivor and ratification of oil and gas leases. As revivor becomes an issue only after leases are terminated, it is important to understand some of the ways that leases may be terminated. This chapter, therefore, will first discuss the termination of oil and gas leases, and then turn to a discussion of the revivor of terminated leases Termination of Leases. The most obvious manner in which a lease may be terminated is simply by expiration of the term of the lease. Termination in this manner 1 Mr. Johnson is an attorney with the firm of Greenebaum Doll & McDonald PLLC, practicing in the litigation and dispute resolution section of the firm s Lexington, Kentucky office.

2 11.01 ENERGY & MINERAL LAW INSTITUTE may be subject to lease provisions allowing for the extension or renewal of the lease for a certain period of years. Leases may also be terminated for reasons not expressly stated in the lease document. [1] Failure to Develop the Lease on a Timely Basis. It is commonly held that the habendum provision in lease agreements contains an implied covenant that the lessee will actively develop the lease in order to produce oil or gas. 2 Some leases may contain a specific provision requiring production within a certain period of time after the execution of a lease agreement. In the absence of such a provision, however, courts will fall back on the habendum clause containing the implied covenant to produce. In such a circumstance, the court will determine whether production began within a reasonable period of time following the execution of the lease. Failure to produce the lease within what the court deems to be a reasonable period of time may result in a default under the lease. 3 With the understanding that the lease must be produced in order to prevent a default, the next issue becomes the amount of production that is necessary to sustain the lease. It is universally held that production must be in paying quantities, or commercial quantities. 4 Obtaining minuscule production from the lease will not be sufficient to sustain it. For example, in Jolynne Corp. v. Michels, 5 the lessee began to develop a lease but did not obtain paying quantities. The lessee did, however, provide free gas from a well drilled on the lease to the lessor. The lessor was not satisfied with merely receiving free gas, and sought to terminate 2 See Wellman v. Energy Res., Inc., 557 S.E.2d 254, (W.V. 2001); Tanner v. Reeves, 249 S.W.2d 526 (Ky. 1952); Union Gas & Oil Co. v. Gillem, 279 S.W. 626 (Ky. 1926). 3 See Tanner v. Reeves, 249 S.W.2d 526, 528 (Ky. 1952). 4 Doty v. Key Oil, Inc., 404 N.E.2d 246 (Ill. App. 1980); Fisher v. Grace Petroleum Corp., 830 P.2d 1380 (Okla. 1992). 5 Jolynne Corp. v. Michels, 446 S.E.2d 494 (W. Va. 1994). 326

3 REVIVOR OF OIL AND GAS LEASES the lease. The court agreed with the lessor, finding that production must be in paying quantities in order to sustain the lease. The Texas courts have set forth a number of factors to be used in determining whether the production from a lease is in paying quantities. In Cannon v. Sun-Key Oil Co., 6 the court outlined the following factors to be considered in making its assessment: the depletion of the reservoir, the price for which the lessee is able to sell its production, the relative profitability of other wells in the area, the operating and marketing costs of the lease, the net profit being obtained from the lease, whether the lease contains provisions relating to the requisite amount of production, and whether the lease appears to be held for production as opposed to speculation. 7 [2] Cessation of Production. Once production in paying quantities is achieved, there may be occasions in which there is a cessation of production. In certain circumstances in which production ceases, the lease may be considered to have terminated. Again, the first inquiry is whether the lease agreement contains a provision that addresses the cessation of production. For example, in Greer v. Salmon, 8 the lease contained a provision giving the lessee 90 days from the date of cessation of production in which to resume drilling operations. If drilling operations were resumed within this period, the lease would not terminate. Where a lease contains a provision dealing with temporary cessation, the terms of the lease will control over the common law factors for determining whether the lease may terminate. 9 6 Cannon v. Sun-Key Oil Co., 117 S.W.3d 416 (Tex. App. 2003). 7 Id. at Greer v. Salmon, 279 P.2d 294 (N.M. 1970). 9 Fisher v. Grace Petroleum Corp., 820 P.2d 1380 (Okla. 1992). 327

4 11.01 ENERGY & MINERAL LAW INSTITUTE Many leases will contain a provision permitting the lessee to make a payment to the lessor that will prevent termination of the lease. 10 Typically, these rental payments will be sufficient to keep the lease alive during periods of non-production. In Kansas, however, the law appears to be somewhat different with respect to this issue. In Tucker v. Hugoton Energy Corp., 11 the lessee ceased production but began paying shut-in royalties. The lessor was not content with receiving the shut-in royalties, and instead wanted the lessee to produce the lease. As a result, the lessor sought a judicial determination that the lease had been terminated as a result of the cessation of production. The lessee argued that its compliance with the provision of the lease agreement enabling it to pay shut-in royalties during periods of non-production sufficed to keep the lease alive. The court disagreed, however. Specifically, the court found that there was a limited market for gas in the area around the lease, and that the payment of shut-in royalties in situations in which gas could be marketed from the lease was not sufficient to prevent a default. The court based this reasoning on the concept that the parties to lease agreements should actively produce from the leases where it is feasible and profitable. In the absence of an express provision describing the permissible period of cessation of production, the courts will consider a number of other factors. In McCullough Oil, Inc. v. Rezek, 12 the court noted that the factors to be considered in deciding whether a cessation of production was temporary include the length of time without production, the cause of the delay, and whether the lessee exercised reasonable diligence to resume production. Similarly, in Cannon, the court established a twoprong test for determining whether the cessation of production was temporary as opposed to permanent: (1) consider whether the lease has failed to yield a profit over a reasonable period of time; and (2) consider whether a reasonably prudent operator would have continued to operate 10 See Amoco Prod. Co. v. Carruth, 512 So. 2d 571 (La. App. 1987). 11 Tucker v. Hugoton Energy Corp., 855 P.2d 929 (Kan. 1993). 12 McCullough Oil, Inc. v. Rezek, 346 S.E.2d 788 (W. Va. 1986). 328

5 REVIVOR OF OIL AND GAS LEASES the well in the manner in which it was being operated for the purpose of making a profit, as opposed to merely for speculation. 13 [3] Pooling Agreements. Leases may also terminate in situations involving pooling agreements, in which multiple leases are consolidated to form a drilling or spacing unit. The issue that arises is whether failure to produce from one lease in a pooled unit results in a termination of the lease, even though the lessor is receiving royalties from the production of other leases within that same unit. Generally, the terms of the lease agreement and the pooling agreement will determine whether a lease terminates as a result of non-production from that particular lease. In Farrell v. Simms, 14 the lessor sought a termination of the lease after it was placed in a pooled unit and there was no production from that particular lease. The court found that the lack of production from that specific lease would not result in termination based upon the facts of the case. In particular, the pooling agreement provided that production from one lease in the unit would yield royalties for all leaseholders in the unit. The court also noted that the lessor had signed the agreement, thereby consenting to accept royalties from production of other leases as opposed to his own. Where lessors seek the termination of leases that are held in a pooling agreement, it is important to note whether the lessor has signed the pooling agreement. In the absence of the lessor s consent, the mere production of other leases within a pooled unit may not be sufficient to prevent the termination of that lessor s lease. 15 In Wilcox v. Shell Oil Co., 16 Shell put the Wilcox lease into a pooled unit without ever advising the Wilcoxes that it was doing so. Shell subsequently ceased production 13 Cannon v. Sun-Key Oil Co., 117 S.W.3d 416, 421 (Tex. App. 2003). 14 Farrell v. Simms, 26 So. 2d 143 (La. 1946). 15 See Hunt Oil Co. v. Moore, 656 S.W.2d 634 (Tex. App. 1983); Wilcox v. Shell Oil Co., 76 So. 2d 416 (La. 1954). 16 Wilcox v. Shell Oil Co., 76 So. 2d 416 (La. 1954). 329

6 11.02 ENERGY & MINERAL LAW INSTITUTE of the Wilcox lease, and the Wilcoxes sought to have the lease terminated. The court agreed that the lease should be terminated, finding that Shell was simply seeking to avoid paying a $2,700 annual rent in lieu of production on the Wilcox lease by producing from other leases within the unit. In addition, the court referred to a provision in the Wilcox lease specifically requiring production from that lease. Finally, the court found that the Wilcoxes acceptance of royalties from other leases within the pooled unit did not preclude them from seeking termination of their lease based upon Shell s lack of production Revivor of Leases. Once a lease is terminated, it may be revived under certain circumstances. This portion of the chapter addresses some of the means by which revivor may take place. [1] The Subsequent Execution of a Document. The execution of a document by the parties to a lease following the termination of the lease is universally recognized as a means of reviving the lease. It is important to note, however, that the subsequent document must specifically refer to the prior lease that has been terminated. 17 For example, in Cannon v. Sun Key Oil Co., the court found that the subsequent document did not refer to the terminated lease or recognize the validity of the terminated lease. Accordingly, the lease was found not to have been revived. In considering whether a subsequent document revives a terminated lease, it is important to recognize that the subsequent document need not be a new lease. For example, in Estate of Grimes v. Dorchester Gas Prod. Co., 18 the lease in issue terminated. The lease was subsequently 17 See Cannon v. Sun-Key Oil Co., 117 S.W.3d 416 (Tex. App. 2003); Natural Gas Pipeline Co. of America v. Law, 65 S.W.3d 121 (Tex. App. 2001); Wright v. E.P. Operating Ltd. Partnership, 978 S.W.2d 684 (Tex. App. 1998); McVey v. Hill, 691 S.W.2d 67 (Tex. App. 1985). 18 Estate of Grimes v. Dorchester Gas Prod. Co., 707 S.W.2d 196 (Tex. App. 1986). 330

7 REVIVOR OF OIL AND GAS LEASES placed in a pooled unit, and the lessors accepted royalties from gas produced on other leases within the unit. Despite receiving these royalties, the lessors subsequently claimed that the lease had terminated. The court disagreed, finding that the lessors agreement to include their lease within the pooled unit, combined with their acceptance of royalties from other leases within the unit, constituted a revivor. The pooling agreement, therefore, was the subsequent document that revived the lease. [2] Late Payments. An issue that has been addressed by a number of courts is whether revivor may be effected in cases in which there is no production from the lease, but the lessee tenders a rent payment after the deadline expressed in the lease for doing so. As noted above, leases may contain a provision enabling lessees to make rent payments to keep non-producing leases alive. In leases containing such provisions, the lessees will be obligated to do so by a specified date. The lease terminates if the payment is not made by that date and the issue becomes whether a late payment is sufficient to revive the terminated lease. The courts uniformly hold that the mere tender of a late rent payment is insufficient to revive a terminated lease. 19 Instead, the lessor must accept the late payment that is tendered in order for the lease to be revived. 20 A related issue, although it pertains to termination rather than revivor, is whether a lessor may refuse to accept a timely payment in order to effect the termination of the lease. This issue was addressed in 19 Doty v. Key Oil, Inc., 404 N.E.2d 346 (Ill. App. 1980); Bertani v. Beck, 479 A.2d 534 (Penn. 1984). 20 Griggs v. Parsons Leasing, Inc., 776 So. 2d 766 (Ala. 2000); Brannon v. Gulf States Energy Corp., 562 S.W.2d 219 (Tex. 1978); Walter v. Ashland Oil & Refining Co., 187 S.W.2d 425 (Ky. 1945)(as far as we are aware, in every instance in which the lessee has accepted the past due rental, or in which he has suffered the lessee to drill after the time had expired within which the lessee was required to drill, we have accepted the construction adopted by the parties and applied the rules of waiver and estoppel). 331

8 11.02 ENERGY & MINERAL LAW INSTITUTE Mitchell v. Simms, 21 a case dealing with the issues of termination and revivor related to the payment of rent. In Mitchell, the lease terminated for failure of the lessee to pay rent by the date specified in the lease. The lessee subsequently tendered a late payment, which the lessors accepted. After accepting the payment, the lessors advised the lessee that they considered the lease to have been terminated for failure to make a timely rent payment. In addition, the lessors advised the lessee that they would not accept any future rent payments that were tendered. The lessee filed a declaratory judgment action seeking a declaration that the lease was not terminated and that it could make future rent payments in order to keep the lease alive during the period of non-production. When the time came for the next payment of rent, the lessee did not tender the rent payment based upon the lessors representation that they would not accept any future rent payments that were tendered. The court found that the lease had previously terminated because of the lessee s failure to make the payment by the date specified in the lease. The lessors subsequent acceptance of a late payment, however, was found to have effected a revivor of the lease. In addition, the court found that it was unnecessary for the lessee to have tendered the next rent payment that was due because it would have been a useless act based upon the lessors statement that they would not accept any such payments. [3] Revivor as a Result of Silence of the Lessor. The courts are split as to whether a lessor can sit by and watch a lessee develop a lease, albeit late, then successfully claim that the lease was terminated as a result of late development. In Kentucky, for example, the courts hold that lessors are estopped from claiming a termination of the lease in situations in which they do not object to the late development of the lease. For example, in Wabash Drilling Co. v. Ellis, 22 the lessee began to develop the lease after the time for doing so as specified in the 21 Mitchell v. Simms, 63 S.W.2d 371 (Tex. App. 1933). 22 Wabash Drilling Co. v. Ellis, 20 S.W.2d 1002 (Ky. 1929). 332

9 REVIVOR OF OIL AND GAS LEASES lease agreement had expired. The lessor was aware that the lessee was beginning to develop the lease after it had already terminated, but made no objection. When the lessor subsequently sought a termination of the lease, the court found that he was precluded from doing so because of his failure to object to the late production. Similarly, in United Fuel Gas Co. v. Jude, 23 the lessor was aware that there was a flaw in the execution of the lease agreement. Nonetheless, the lessor actively assisted the lessee in developing the lease and never raised any objection based upon the flaw in the execution of the document. The lessor s subsequent claim that the lease was invalid as a result of a flaw in the execution of the document was rejected by the court, which found that the lessor was estopped from claiming that the lease was invalid because of his silence regarding the flaw and his active assistance in developing the lease. Texas, on the other hand, takes the opposite position and finds that lessors are not precluded from claiming termination, even when they sit by and watch post-termination development take place. 24 The courts that recognize that lessors are estopped from claiming termination of the lease because of their failure to object to late development essentially recognize that revivor is a subset of the doctrine of estoppel. The courts may consider this estoppel argument in two ways. First, they may view the situation from the standpoint of the lessor, finding that the lessor s silence constitutes an implicit recognition that the lease is valid. Alternatively, the courts may view the situation from the standpoint of lessees, finding that they should not be punished for developing the lease after it has terminated in the absence of objections from the lessors. The reasoning underlying such a viewpoint is likely based on the concept that parties to lease agreements intended for there to be production, otherwise they would not have executed the agreement. 23 United Fuel Gas Co. v. Jude, 355 S.W.2d 664 (Ky. 1962). 24 See Freeman v. Samedan Oil Corp., 78 S.W.3d 1 (Tex. App. 2001). 333

10 11.02 ENERGY & MINERAL LAW INSTITUTE [4] Late Production and Tort Claims. In some cases, production may occur after a lease has been terminated. The subsequent production, in the absence of any type of action of the lessor, will not be sufficient to revive a lease. 25 In cases in which this late production occurs, lessees should be wary of whether there may be tort claims asserted against them. This situation occurred in Plymouth Fertilizer Co. v. Balmer, 26 in which the court found that late production after the termination of the lease constituted a trespass by the lessee. Similarly, in Mayhew v. Callard, 27 the court found that the lessee under a forfeited lease had no rights to the minerals, and production after the forfeiture of the lease constituted conversion of the minerals. [5] Notice Required for Termination. It is generally held that the lessor is not required to provide the lessee with notice of termination in the absence of a provision in the lease agreement providing for a cure period. 28 The common theme underlying the inquiry as to whether a lease may be revived is that the lessor must take some type of action, or fail to act under certain circumstances, in order to assist the lessee in reviving the lease. A lessee may not unilaterally revive a lease without some means of assistance from the lessor. Thus, even if the lessor gives notice that a lease has been terminated, there is nothing that the lessee can do to revive the lease. For this reason, courts find that notice is not required. 25 See Tucker v. Hugoton Energy Corp., 855 P.2d 929 (Kan. 1993). 26 Plymouth Fertilizer Co. v. Balmer, 488 N.E.2d 1129 (Ind. App. 1986). 27 Mayhew v. Callard, 312 F.2d 295 (7th Cir. 1963). 28 See Griggs v. Parsons Leasing, Inc., 776 So. 2d 766 (Ala. 2000); McCullough Oil, Inc. v. Rezek, 346 S.E.2d 788 (W. Va. 1986); Lone Star Producing Co. v. Walker, 257 So. 2d 496 (Miss. 1971). 334

11 REVIVOR OF OIL AND GAS LEASES [6] Joint Tenancy Issues. In situations involving joint ownership of a lease, one lessor may revive the lease even if the other joint lessors do not wish to revive it. For example, in Swiss Oil Corp. v. Hupp, 29 some of the joint lessors encouraged the lessee to develop the lease after it had terminated, and the lessee began to develop the lease at a considerable expense. Subsequently, the other joint lessors claimed that the lease had terminated because of the lessee s late development activities. The court disagreed, finding that the fact that some of the joint lessors had encouraged the lessee to begin production effected a revivor of the lease notwithstanding the wishes of the objecting joint lessors. Similarly, in Union Gas & Oil Co. v. Gillem, 30 two joint tenants signed a new division order related to a terminated lease. The other joint tenants, however, claimed that the lease had been forfeited. The court disagreed, finding that the division order constituted a subsequent document executed in such a manner as to revive the lease, and that a forfeiture could not be declared by one joint tenant where the other joint tenants wished for the lease to continue. In Texas & Pacific Coal & Oil Co. v. Kirtley, 31 the lessor conveyed a 1/4 interest in the minerals underlying the lease to other parties, retaining 3/4 of the interest. The lessee did not begin production on the lease within a reasonable time, and the lease terminated for failure of production. The lessee subsequently tendered a late rental payment that was rejected by the original lessor. The original lessor did, however, negotiate a new lease without including the owners of the 1/4 interest in the mineral rights. The owners of the 1/4 interest subsequently sought to terminate the lease. The court refused to do so, however, finding that the new lease revived the previously terminated lease despite the fact that the 1/4 mineral interest owners did not execute the lease. 29 Swiss Oil Corp. v. Hupp, 22 S.W.2d 1029 (Ky. 1928). 30 Union Gas & Oil Co. v. Gillem, 279 S.W. 626 (Ky. 1926). 31 Texas & Pacific Coal & Oil Co. v. Kirtley, 288 S.W. 629 (Tex. App. 1926). 335

12 11.03 ENERGY & MINERAL LAW INSTITUTE [7] Intervening Lienholders. Another issue that may arise is the effect of a revivor of a lease on a lien that is filed against the lease during the time in which it was terminated. The situation arose in Swiss Oil, 32 where a third party filed a lien on the lease after it was terminated and before it had been revived. The court found that the lien was still effective and that the lienholder could, therefore, file an action to enforce the lien and acquire the property despite the fact that the lease was subsequently revived. [8] Adverse Possession. After a lease is terminated but the lessee continues to operate on the lease, an issue that may arise is whether the lessee may acquire the lease through adverse possession. This situation occurred in Natural Gas Pipeline v. Pool, 33 in which the lessee held over after the lease was terminated and continued to produce from the lease. This situation continued for a period of years until the lessors sought a declaration that the lease had been terminated. The court found that the pipeline company had acquired the lease through adverse possession, as its act of taking minerals from the property was hostile to the lessors ownership interest in those minerals. The court noted, however, that the interest the lessee may acquire through adverse possession could be no greater than the interest that it previously held Conclusion. Many of the theories underlying revivor of leases are consistent among courts throughout the country. For example, courts universally find that the execution of a document specifically referring to a terminated lease will revive the lease, while the mere tender of late royalty payments will not. As discussed above, however, different courts may not recognize 32 Swiss Oil, 22 S.W.2d Natural Gas Pipeline v. Pool, 124 S.W.3d 188 (Tex. 2003). 336

13 REVIVOR OF OIL AND GAS LEASES a theory for revivor at all (see, for example, Section 11.02[5]) or may require proof of specific or additional elements in order to revive the lease (for example, a subsequent document that would be acceptable in one jurisdiction may not contain the necessary specificity in its referral to a terminated lease in another jurisdiction). It is very important, therefore, to review the case law addressing these issues in the jurisdiction in which a dispute arises. 337