Are Modern Compensatory Royalty Clauses Enforceable?

Modern Compensatory Royalty

Written by David Melton

Lessee beware!

Every petroleum landman should know that in order to avoid negative impacts on the Lessee's operations, the ‘compensatory royalty/offset drilling clause’ in an oil and gas lease must be carefully drafted. 

Negotiating and articulating all aspects of the clause is crucial to meet the Lessee's current and future operational needs while protecting the leasehold estate interests of all parties involved, as well as other Lessors in leases that are in a unit where the subject lease is located. For example, if a lease is lost that needs to be in place to satisfy the state’s spacing unit size for a new well and the other leases in place did not have an offset drilling clause, the one that did and had been lost will then have to be released before a well can be drilled. However, if such an event occurred in Oklahoma, for example, the state has a ‘forced pooling’ provision whereby the mineral owner can be forced into the unit, then a new well can be drilled.

This discussion delves into the impact of ‘compensatory royalty/offset drilling clause’ in oil and gas leases. Such provisions have a significant effect on financial returns, loss of oil and gas leasehold rights, and drilling locations.

Case Study: Santa Barbara County, California

An illustrative case is in a large lease (640 acres with one mineral owner) that was obtained by a landman in an acquisition from the previous operator. The subject lease was located in Santa Barbara County, Calif. and was in a known oil field with extensive data available from state and other reporting agencies on production decline rates, pressure, and overall recovered reserves from a multitude of oil wells in the field. The lease had a compensatory royalty/offset drilling clause that had a 90-day commencement period to drill a response well. This lease agreement in Santa Barbara County exemplifies the critical role that data plays in making informed decisions.

The issue arose by way of the offset operator drilling a horizontal well in a formation, that had not produced in the field, within the setback limit described in the lease’s offset drilling clause. The offset well’s IP was over 600 bopd. The mineral owner demanded that a response well be drilled, to which the Lessee responded that the 90-day response term was insufficient to gauge the production and pressure decline rates in an unknown formation. 

The mineral owner stated that the offset drilling clause was clear, and the Lessee would be liable for drainage, compensatory royalty payments, and potentially the loss of the leases or parts thereof. In compliance, a rig was located but it was not available for 5 months (2 months past the 90-day response term). The mineral owner was provided with this information, but to no avail. 

The result was that the offset well had a high decline rate and at the end of 45 days online, the well’s production was less than 15 bopd. By the time the rig was available, the offset well was plugged due to its production dropping to less than 1 bopd, which did not warrant a response well or any past compensatory royalty payments. However, this scenario could have been such that the offset well was plugged in 12 months instead, thus causing problems for the Lessee in having to make compensatory royalty payments and possibly losing parts, if not all, of the lease.

If there is sufficient data on the producing formations in the field where the leases are located, then calculated future results can make a compensatory royalty/offset drilling clause more feasible. But even that can present a problem. There could be faults that separate the response well from the offset well or where the Lessee has no access to any seismic data to back up its claim. Further, the formation in the offset well is a ‘channel sand’ deposition, which could result in the response well missing it entirely when drilled, which was the case in the example above. Such force majeure provisions should be considered in drafting a compensatory royalty/offset drilling clause. 

It's well known that the courts have long held that oil and gas leases have an implied obligation to drill an offset well to prevent a neighboring well from draining the hydrocarbons underneath the leased land. Therefore, it might be a good practice to apply the thought process and language behind ‘shut-in’ payments being considered a covenant to the lease, rather than a condition or obligation. An example of this language can be found in the AAPL 88 Special Rocky Mountain and Mid-Continent (except Texas) Revised 6/1/62 (“Any error or failure to make payment of any royalty payable under the provision hereof (including but not limited to the payment of shut-in gas royalty) shall not work a forfeiture or termination of this lease, nor cause the termination or reversion of the estate created hereby, nor be grounds for cancellation hereof in whole or in part, it being expressly understood that the obligation to make such payments, or any of them, shall constitute a covenant and not a condition.”), in that the Lessee should try to make the compensatory royalty/offset drilling clause a covenant rather than a condition or obligation of the lease. 

Why so? A failure under a covenant has monetary relief, but a failure under a condition can cause the lease to become void which could affect the other drill sites for wells to be drilled in the other known reservoirs, and could even affect any signed farmout agreements and their timelines. 

Therefore, are these types of clauses enforceable?

This question demands that a court analyze compensatory royalty provisions to determine if the Lessee is liable to drill a response well and to determine whether the amount of compensatory royalties due constitutes an unenforceable penalty or enforceable liquidated damages. As is often the case with implied covenants, the Lessors and Lessees responded by including explicit, negotiated duties in their leases to address potential drainage, which modify or displace the implied “offset” covenant.

With the exploitation of the major shale plays across the U.S., leases have modified or disclaimed the implied obligation to prevent drainage by including complicated express offset drilling clauses in their leases. These clauses take a variety of forms, but many include provisions that “deem” a well located within a certain distance of their property line to be draining from the lease, regardless of whether drainage is occurring. 

The word “deem” originally meant "to legally condemn." Deem continues to be used in contexts pertaining to the law but with the general meaning "to judge" or "to decide after inquiry and deliberation." However, outside of the law, deem usually means simply "to consider." So, if the word “deem” is used in the offset drilling clause, it should be clearly defined as to its meaning and how it applies to the compensatory royalty/offset drilling clause.

In the face of such “deemed” drainage, the Lessee should have the choice, but not the obligation to drill an offset well, provide geological or technical evidence that no drainage is occurring, to release acreage, or pay “compensatory” royalties. It should be noted that the Lessee has a vested interest in drilling a response well, but when it comes to horizontal wells, where the proximity of other wells could impact the response well’s performance. As stated earlier, this decision may have to be decided in court which should be based on sound engineering practices.

When drafting the compensatory royalty/offset drilling clause, careful consideration should also be given to making it subject only to the formation that is being produced in the offset well. That way if the lease is decided to be null and void due to a breach of the offset drilling clause, the Lessee would only lose the rights to that formation and not the other formations or leasehold. In addition, it may be a good idea to eliminate the term “in kind” as to the type of response well to be drilled (horizontal vs vertical). It may be less expensive to drill a couple of vertical response wells rather than a horizontal response well (as described in the example mentioned above) and depending on the location, something else to consider is the availability of horizontal drilling capabilities which may not be readily available and could further delay the response well.

The drilling clause in an oil and gas lease must be meticulously drafted to avoid adverse impacts on the Lessee's operations. It is imperative to ensure that all aspects of the clause are negotiated and articulated clearly to meet the Lessee's operational needs while protecting the interests of all parties involved in the lease agreement.

Finally, the force majeure provisions should state that the compensatory royalty payments should not have to be made during the correction of the force majeure; i.e., waiting on a rig or equipment.

For more in depth information regarding certain “landmines” regarding the oil and gas lease, you should take the Institute of Energy Management’s course “Concepts of the Oil and Gas Lease Essentials.”

Enroll today at

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