Most of us are familiar with the basic framework of an oil and gas lease. When cessation of production occurs after the end of the primary term, the lease automatically terminates by operation of the habendum clause which provides that the lease will be effective for a term of years “and for so long thereafter as there is production from the leased premises.” The habendum clause creates for the operator a “determinable fee” (as opposed to a fee interest) in that the estate granted to the operator is not perpetual but will terminate upon the happening of a particular event (e.g., the cessation of production or no production).
However, most oil and gas leases also contain certain “savings clauses,” such as shut-in royalty or “rework” clauses. The shut-in clause has traditionally been used when a gas well (that is capable of producing in paying/commercial quantities) is shut-in because of the “lack of a market”, generally due to the absence of a pipeline connection to the well. By making a shut-in royalty payment, the lease can be maintained in effect by “constructive production”, as opposed to actual production. The ability to utilize the shut-in clause is also often limited for a period of time (for instance, 2 years), after which the lease will terminate unless actual production commences.
The typical shut-in royalty clause, when written to apply to gas wells only and to the absence of a market, is limited to that very scenario. It cannot be utilized in other instances such as when mechanical or downhole issues lead to a cessation of production; such a cessation is known as a “temporary cessation of production.” If there is no rework provision in the lease, the courts have allowed the operator a “reasonable period of time” to rework the well and resume commercial production. However, most oil and gas leases contain a rework provision which expressly allows the operator to maintain the lease in effect by the commencement of reworking operations on the non-producing well within 60-90 days of the cessation of production. Once production is reestablished, the lease is maintained in effect by the restarted commercial production.
Shut in royalty clauses and rework clauses are both “savings clauses” because they save the lease from termination due to lack of commercial production. What happens, though, when production terminates due to the actions of the operator for reasons unrelated to the lack of a market on a gas well or the temporary cessation of production related to mechanical or downhole problems? What happens when production ceases because the operator has temporarily shut-in the producing well because, for instance, the price of oil has dropped to a point where production under the oil and gas lease becomes non-commercial and no longer in “paying quantities?” In the absence of a specific lease provision granting such authority, can the operator unilaterally shut-in a well for that reason? The answer to that question is in the negative.
A provision in the lease which can be utilized in such an event might be the force majeure clause. We generally think of the force majeure clause as a provision which is also a “savings clause” suspending for a time the performance of obligations by the lessee. The force majeure provision is traditionally used where an “act of God” occurs (something usually defined as an occurrence which is out of the reasonable control of the operator and which is not caused by the operator, but is instead unrelated to a human cause such as a natural disaster). Can it be altered to aid the operator in a low-price environment?
With our discussion above in mind, let’s look at what we are facing in our country and industry in the first half of 2020. Two catastrophic occurrences have hit the United States and the oil industry in a devastating way.
First, even as prices began to slide downward in the early part of 2020, Russia and OPEC declared an oil production war on each other by drastically increasing production in an already glutted world market for the purpose of crippling each other. Of course, we know that the big target for both was certainly U. S. shale oil producers who, due in large part to incredible oil production from the historic Permian Basin, had remarkably led to the United States becoming the largest producer of crude oil in the world. The scheme was ultimately designed to lower oil prices to levels where the U. S. shale drillers could no longer drill or produce economically, or, possibly, not produce at all. Most exploration companies in the Permian Basin cannot produce oil for a profit if the per barrel price dips below $35 (the “break-even point”). With the likelihood that the worldwide glut in oil supply will not disappear for the foreseeable future, the industry has been sent into a tailspin. The downward pressure on crude oil prices is immense and there is little optimism that the prices will increase any time soon.
When, on April 13, 2020, OPEC and Russia and other producing countries agreed to a significant curtailment of production, that downward pressure of crude oil prices lessened a bit, at least psychologically. However, what did not happen was a corresponding increase in crude oil prices which, instead, quickly dropped to unprecedented levels. As we are painfully aware, the benchmark price of crude oil (West Texas Intermediate) collapsed, for the first time in history, into negative price territory. This was, of course, due to the fact that the world oil glut, even with the potential of decreased worldwide production, is likely going to continue for the next 9-12 months, making a significant increase in crude oil prices unlikely. Production of Permian Basin shale oil at $10-$15 per barrel is clearly not going to be economical. With $40 oil a distant memory, rigs are being stacked and the financial outlook for U. S. oil producers has become dire.
The second occurrence is the World Health Organization’s declaration of the “COVID-19 Pandemic.” We have all heard of the word “epidemic,” but the declaration of a “pandemic” is something entirely different. The WHO defines a “pandemic” as an epidemic of disease that has spread across a large region, for instance on multiple continents or worldwide, affecting a substantial number of people. A widespread endemic disease with a stable number of infected people, such as recurrences of seasonal flu, is not a pandemic; these types of diseases are generally excluded as they occur simultaneously in large regions of the globe rather than being spread worldwide.
The COVID-19 Pandemic’s global impact has led to worldwide economic chaos. That chaos is on display in the world’s largest economy, too. The gross domestic product in the United States for the second quarter of 2020 will nosedive. It also seems likely that the unemployment rate by June will reach 20-25%, an unprecedented level which was not seen even in the Great Depression of 1929. Governmentally declared “social distancing” policies and ordinances have effectively ground almost all economic activity to a halt, not only in America, but throughout the world. Only “essential businesses” are being allowed to operate which further collapses the U. S. economy. The very presence of a pandemic would have been enough to cause crude oil prices to quickly collapse, but, when coupled with the worldwide glut of crude oil supply, has created the perfect storm endangering the existence of the U. S. oil industry. Widespread industry layoffs are inevitable along with the looming prospect of bankruptcies among oil and gas exploration and production companies. Even as the country starts “re-opening”, the economy will remain crippled.
And, should this pandemic not be a seasonal occurrence, but a chronic, difficult to control disease, how will the potential shortage of experienced field and in-office employees of these oil and gas exploration companies be addressed? Will the potential lack of qualified employees limit the company’s ability to operate at “normal” levels?
In the midst of all this chaos and bad news, the negative consequences of long-term depressed crude oil prices will continue to become more and more apparent. With the likelihood that prices will stay at or below the $20 level, the reality is that production under oil and gas leases may no longer be deemed to be “in paying quantities” potentially leading to the automatic termination of leases. Quick and decisive action on the part of oil and gas exploration companies is vital.
In addition to these pricing issues, another significant threat to the validity of oil and gas leases is the possibility that crude oil buyers may refuse to buy oil once current contracts expire. Should this occur, operators will be forced to shut-in affected wells. Failure to be proactive in addressing the risk of lease terminations will lead to huge losses in assets and capital, further crippling the industry.
The purpose of this Memorandum is to come up with an innovative and timely approach to the crisis all of us in the oil and gas industry are facing not only today, but for the foreseeable future. To put it succinctly, how can we utilize current lease provisions to allow for the temporary shutting-in of oil wells during this period of depressed crude oil prices? And, if no such provisions can be utilized, how can operators and mineral owners/lessors come to an agreement to amend their leases to allow for the temporary shutting-in of oil and gas wells? Inaction will lead to disastrous results.
As discussed above, we believe the provisions that can be utilized in addressing the maintenance of leases during these price-depressed times are (1) the shut-in clause and (2) the force majeure clause. It is our view that the vast majority of these provisions in current oil and gas leases will be of no help in maintaining leases due to their limited focus. Even if production in this low-price environment is sufficient to be classified as production in “paying quantities”, the loss of income and reserves at these prices will be huge. Is there a way to shut-in oil wells temporarily so that (1) production will be curtailed which will help with the oversupply of crude oil and (2) reserves will not be sacrificed at these historic low prices? In other words, can we pause production without losing the lease until crude oil prices increase to at least $35 per barrel? What will it take to accomplish this?
We propose that oil and gas operators make a concerted effort to amend their leases by obtaining from all mineral owners/lessors amendments to the leases which will allow for the temporary shutting-in of production (by paying shut-in royalty to all mineral/royalty owners) while at the same time maintaining the leases in full force and effect by “constructive production.”
We have created the “RashChapman Lease Rescue Packet” which is now available to oil and gas operators in the Permian Basin. We believe these materials, which include numerous oil and gas instruments, letter agreements, and sample letters to mineral owners/lessors, will help you in proactively addressing all of your lease maintenance issues.
An example of an approach an operator might take to avoid losing its oil and gas leases is an Amendment & Ratification of Oil and Gas Lease (which is included in the Packet). This instrument will amend a lease by replacing its current shut-in royalty clause so that it becomes an effective “savings clause” to enable the lease to be deemed to be producing in paying quantities without the necessity of actual production. Here is a sample revised shut-in royalty clause:
Shut-in Royalty. If a well (classified either as an “oil well” or “gas well” and capable of producing oil and/or gas, whether or not in paying quantities) located on the leased premises or on lands pooled or unitized with all or part of the leased premises, is at any time shut-in and production therefrom is not sold or used off the premises, such shut-in well shall, upon payment of shut-in royalty as provided in this paragraph and notwithstanding the terms governing the expiration of the primary term as set forth in Paragraph ____ above [the habendum clause], be considered for all purposes and for a period of one (1) year from the date of the shutting-in of such well, as a well producing oil and/or gas in paying quantities. In lieu of any implied covenant to market, Lessee expressly agrees to market oil and/or gas produced from Lessee’s wells located on the leased premises or on land pooled or unitized therewith, but Lessee does not covenant or agree to sell or market such oil and/or gas under terms, conditions or circumstances which in Lessee’s discretion are uneconomic or otherwise unsatisfactory or cause Lessee to bear more than Lessee’s revenue interest share of the costs and expenses incurred to make the production marketable.
If a well on the leased premises or on lands pooled or unitized with all or part of the leased premises, is shut-in, then within 30 days after the date on which such well is shut-in, Lessee may pay or tender, as royalty, directly to Lessor, or to Lessor’s credit in ____________________ [bank or other financial institution], or its successors, as Lessor’s agent, the lump sum (payable in the official currency of the United States) set forth opposite Lessor’s name and address on Exhibit “A” attached to this Amendment.
This shut-in royalty payment may be made by check or wire transfer, at the option of Lessee, and such successful wire transfer or the depositing of such check in any post office, with sufficient postage and properly addressed to Lessor, or said [bank or other financial institution], within 30 days after such well is shut-in, shall be deemed sufficient payment as herein provided. A like payment may be made on or before the one (1) year anniversary of the date of the shutting-in of such well, which shall maintain this lease in force for an additional one (1) year period. It is understood and agreed that this lease may not be maintained in effect solely by the payment of shut-in royalty as provided in this paragraph for a period in excess of two (2) years after any well located on the leased premises or on lands pooled therewith is shut-in.
The provisions of this paragraph shall apply to any and all wells located on the Lands on a well-by-well basis.
The Amendment can also include a broadened force majeure provision which would replace the current clause in a lease. Not only are the events of force majeure being expanded, but a particular paragraph can also be added to the force majeure provision which activates the clause when the event of force majeure relates directly to the suspension or cessation of production of oil, gas or associated hydrocarbons under the lease. A sample revised force majeure clause:
Force Majeure. Lessee shall not be liable for any failure or delay in performance of its express or implied obligations or covenants under this lease arising out of or caused, directly or indirectly, by circumstances beyond its reasonable control, including, without limitation, acts of God; acts of foreign or domestic enemies; national emergencies; earthquakes; landslides; lightning; fires; tornadoes; typhoons; hurricanes; floods; washouts; wars (whether declared or not); explosions; acts of war; nuclear catastrophes; civil or military disturbances; acts of terrorism; sabotage; embargoes; blockades; strikes; acute and unusual shortage of labor; insurrections; shortage of supply, breakdowns or malfunctions, interruptions or malfunction of computer facilities, or loss of data due to power failures or mechanical difficulties with information storage or retrieval systems; computer viruses; damage cause by internet hacking; labor disputes, lockouts or other labor difficulties or disturbances; civil unrest; epidemics; pandemics; pestilences; quarantines and governmental orders or ordinances for social distancing, stay-at-home, or shelter-in-place; riots; civil commotions; power failures; computer failure and any such circumstances as may cause interruption, loss or malfunction of utility, transportation, computer (hardware or software) or telephone communication service; accidents; acts of civil or military authority, whether governmental or not; arrests and restraints of rulers and people; arrests and restraints of the government, federal or state or local; governmental actions including actions or orders from any governmental agency having jurisdiction over operations under this lease; inability to obtain labor, material, equipment or transportation at market prices or costs; failure of suppliers and manufacturers; shortages of fuel, power, raw materials or components; inability to obtain permits by federal, state or local authorities or agencies having jurisdiction; disruption of imported goods or equipment; interruptions by court orders; actions of Lessor; partial or entire loss of market for oil, gas or associated hydrocarbons, including the refusal or failure by purchasers of oil and gas production to take delivery of oil, gas or associated hydrocarbons produced under this lease; mechanical breakdown; failure of plant or machinery; failure or default of public utilities or common carriers; destruction of production facilities or materials by fire, earthquake, storm or like catastrophe; shortage of credit, capital or finance; and any other cause similar or dissimilar to any of the foregoing (the foregoing being known hereinafter as a “Force Majeure Condition.”
In the event of the occurrence of any Force Majeure Condition, the time for performance of any and all obligations under this lease shall be extended for a period equal to the time lost by reason of the Force Majeure Condition. Lessee shall, as soon as reasonably practicable after the occurrence of a Force Majeure Condition, (a) provide written notice to the Lessor of the nature and extent of any such Force Majeure Condition; and (b) use commercially reasonable efforts to remove or ameliorate any such causes and resume performance under this lease as soon as reasonably practicable.
In addition, and notwithstanding the provisions of Paragraph ___ above [the habendum clause], in the event of the occurrence of a Force Majeure Condition which leads directly to the suspension or cessation of production of oil, gas or associated hydrocarbons under this lease, this lease will not terminate and the primary term of this lease shall be extended and this lease shall be maintained in full force and effect for a period equal to the time of such suspension or cessation of production.
We have also included in the Packet a Memorandum that discusses current case law in Texas pertaining to the force majeure clause.
Another important provision in the Amendment is a revised habendum clause which allows for the maintenance of the lease after the end of the primary term by the payment of shut-in royalty:
Without reference to the commencement, prosecution, or cessation at any time of drilling or other development operations, or to the discovery, development, or cessation at any time of production of oil, gas, or other minerals, and notwithstanding anything else contained in this Lease to the contrary, this Lease shall be for a term of THREE (3) years from the effective date stated above (the “Primary Term”) and as long thereafter as oil, gas, or other minerals are produced from the leased premises, or other lands with which the leased premises are pooled; or as long as any wells on the leased premises, or other lands with which the leased premises are pooled, are shut-in by Lessee in accordance with the shut-in royalty provision set out in Paragraph ___ below; or this Lease is continued in effect as otherwise provided by the terms of this Lease.
These sample provisions would, of course, need to be revised to fit your specific lease scenario, as each lease contains unique provisions and there is no “one-size-fits-all” solution. The examples above can be used when your leases cover lands owned by individuals, partnerships, and corporations. However, when dealing with leases covering lands owned by the States of Texas or New Mexico or by the federal government or lands governed by the Relinquishment Act in the State of Texas, the Amendment & Ratification will be customized to fit the various lease forms. Our Packet includes sample Amendments for each unique lease form.
Another part of the Packet is a sample letter to use when seeking execution of the Amendment & Ratification from the lessors. This sample is really a starting place as your unique approach in negotiating with your lessors will be important.
You will also likely deal with mineral owners/lessors who will not agree to amend their leases. An approach that can be taken in this situation is a Letter Agreement between lessor and lessee. A sample portion of a Letter Agreement included in the Packet is as follows:
Due to the loss of market for oil, gas or associated hydrocarbons caused by the COVID-19 pandemic, including the refusal or failure by purchasers of oil and gas production to take delivery of oil, gas or associated hydrocarbons produced under the Lease(s), it is the desire of Owner to allow a temporary shut-in of the Subject Wells. By execution of this Letter Agreement, Owner authorizes the Lessee named above to immediately shut-in the Subject Wells and Owner additionally agrees to waive the shut-in royalty associated with the above referenced Lease(s) in accordance with the terms of this Letter Agreement.
Notwithstanding any provisions of the Lease(s) to the contrary (including but not limited to, Paragraph 2 pertaining to the Lease Term, Paragraph 6 pertaining to Minimum Royalty, Paragraph 8 pertaining to Shut-in Royalties, and Paragraph 18 pertaining to Lease Covenants), Owner agrees as follows:
- It is agreed and understood that Lessee shall shut-in the Subject Wells and the shut-in royalty as provided in Paragraph 8 of the Lease(s) shall be waived by Owner until such time as both of the following have occurred: (a) the West Texas Intermediate Benchmark Price for crude oil price has stabilized at or above $35.00 per barrel for a period of sixty (60) consecutive days (the “Price Stabilization Period”); and (b) from the end of the Price Stabilization Period there is thirty (30) consecutive days of continuous production from the Subject Well(s) (the “30-Day Production Period”). (Together, the Price Stabilization Period and the 30-Day Production Period shall be referred to herein as the “Waived Fee Shut-In Period”). At the time there has been 30 days of continuous production from the Subject Well(s), the Waived Fee Shut-In Period shall be deemed terminated and the terms of the Lease shall resume.
- It is agreed and understood that the Lease(s) shall be maintained in full force and effect for the length of time of the Waived Fee Shut-In Period notwithstanding the lack of production or constructive production from the Lease(s) and such Waived Fee Shut-In Period shall not be counted against any time limits set forth in the Lease.
- It is agreed and understood that the Minimum Royalty as provided in Paragraph 6 of the Lease(s) shall also be waived for the length of time of the Waived Fee Shut-In Period.
We are continuing to develop and expand the Packet by adding additional instruments and agreements to address the ongoing needs of our clients.
In spite of the tough place in which we all find ourselves, those of us who have been around for quite some time know from experience that while we will all suffer bumps and bruises and breaks in the next months, this downturn will, before too long, morph into an upturn. We will be there for our clients in the “before” times as well as in the “after” times.
-Mark K. Leaverton, Managing Partner – Rash Chapman Schreiber Leaverton & Morrison LLP