Oil and Gas Lawyer Blog
Over the last 100 years courts have developed a body of case law in disputes between lessors and lessees of oil and gas leases. Courts have held that certain provisions are “implied” in the contracts, even though there is no language in the lease to support those provisions. The rationale behind these implied provisions goes back to cases interpreting hard mineral leases, and back to the cradle of the oil industry, Pennsylvania. The idea behind these implied provisions is that they are necessary for both parties to get the benefit of their bargain and to make the lease work as intended. Because the lessee has control over what operations are conducted under the lease, most of these implied provisions are intended to benefit the lessor, who generally has less bargaining power in negotiation of the lease and no say in whether and how the lease is developed.
An example: oil and gas leases generally provide that the lease will remain in effect for the primary term and for as long thereafter as oil or gas is produced from the leased premises. Courts have implied a requirement that, for the lease to remain in effect, the production must be in “paying quantities.” The production must be sufficient for the lessee to realize a profit over operating costs.
Another example: what if the well on the lease temporarily ceases production at some point after the end of the primary term. Does the lease terminate, even if the well can be repaired and restored to production? Courts developed the implied provision that a “temporary” cessation of production will not cause the lease to terminate, as long as the lessee acts with reasonable diligence to restore production.
Cases have also imposed implied obligations on the lessee — obligations that are not expressed in the lease. In Texas, the Supreme Court has described those implied obligations as a duty “(1) to develop the premises, (2) to protect the leasehold, and (3) to manage and administer the lease.” Amoco v. Alexander, 622 S.W.2d 563, 567 (Tex. 1981). Other commentators have described these implied obligations as a duty to (1) develop the lease, (2) protect the lease against drainage, (3) market production, and (4) act as a reasonably prudent operator. Courts have held that these obligations are implied in every lease unless the lease expressly disclaims the duties.
Whole books have been written about these implied covenants, the most recent of which is an excellent book by John Burritt McArthur, “Oil and Gas Implied Covenants for the 21st Century” (Juris Publishing, Inc. 2014). Courts in different states differ on the scope and meaning of these implied covenants, but they are generally recognized in every oil-producing jurisdiction — and they are fertile ground for litigation.
A recent example of courts’ differing interpretations of implied covenants is evidenced by recent cases involving the covenant to market. It is generally recognized that the lessee has a duty to market oil and gas from the leased premises once it has been discovered, including the duty to obtain the best price obtainable. In some jurisdictions, courts have interpreted this duty to require the lessee to put the production into marketable condition for sale. Because most oil is marketable in the condition it is in when produced, this “marketable condition” requirement applies mostly to gas. Gas usually has to be treated, compressed, processed and/or transported to become “marketable.” Courts who have adopted this “marketable condition rule” have held that all costs incurred to make the gas marketable must be borne by the lessee, unless the lease provides otherwise. No such costs can be charged to the royalty owner.
Many producing states have now adopted the marketable condition rule, including Colorado, West Virginia, Oklahoma, Kansas, Arkansas, Alaska, Virginia and perhaps New Mexico. Nevada, Wyoming and Michigan have barred the deduction of downstream field costs by statute. Cases vary on which costs are deductible from royalties.
Texas, on the other hand, along with Louisiana, Kentucky, Mississippi, Montana, Pennsylvania, North Dakota, Utah and California, although agreeing that the lessee has the obligation to put gas in marketable condition, hold that downstream costs must be borne in part by the royalty owner under the typical oil and gas lease. Texas has gone so far as to say that, if a lease provides for royalties based on the market value “at the well,” the lease must inevitably allow deduction of post-production costs from royalties, regardless of what else the lease may say. The seminal Texas case is Heritage v. NationsBank, 939 S.W.2d 118 (Tex. 1996), reh’g denied, 960 S.W.2d 619 (Tex 1997). In his book, John Burritt McArthur criticizes Heritage as taking an “absolutist approach [that] treats ‘at the well’ as magic words that fully determine what deductions are allowed, as the beginning and end of the analysis, and that when present leave no room for other terms no matter how specific they are.”
Although implied covenants do provide protections for the lessor, they are necessarily very general in their development and application, and provide no bright lines for measuring the lessee’s conduct. 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.
Modern lease forms drafted by landowners’ counsel have crafted express provisions that supplement or replace the implied covenant obligations of the lessee with express obligations regarding development, protection against drainage, marketing, and management and administration of the lease. The express provisions are intended to give more certainty to the parties by expressing their intent and providing objective criteria for compliance and express remedies for breach.