OGL – Breach of a Covenant and/or a Condition?

OGL - Breach of a Covenant and/or a Condition?

Written by David Melton

Can you Automatically Lose an Oil and Gas Lease?

Most petroleum landmen are not that familiar with this situation. The simple answer to the question above is yes, but the process can be anything but simple. It all depends upon 1) how the oil and gas lease is written, 2) what caused the breach, 3) were there any proper notices provided, 4) are the party’s willing to work together to cure the issue, 5) how the courts interpret the matter, and 6) are these issues associated with a “limitation” and/or a “condition subsequent.” There are way too many scenarios regarding these breaches and surrounding circumstances to discuss in this article, but this can be a good ‘eye-opener’ as it comes to such things the non-payment of shut-in royalties.


Typically, a breach of a covenant allows the Lessee the chance to correct the issue before losing the oil and gas lease. A breach of a condition may allow for the automatic termination of the lease. Another issue to consider in the event of a forfeiture is properly being place on “notice” and what can happen to the lease before being place on notice. (See example below)


Conditions and Covenants – What’s the difference?


It is important for the petroleum landman to know the difference between a lease covenant and a lease condition to better help in the determination of when an oil and gas lease terminates. For instance, the breach of a covenant gives rise to a suit for damages while the breach of a condition can terminate the lease automatically. An example of a breach of a condition that can automatically terminate the lease is if a lessee fails to pay any lease renewal fees or delayed rental fees when due.


Because of the harsh consequences for breaching a condition, oil companies have tried to eliminate all conditions in revised oil, gas and mineral lease forms commencing in December 1979. These forms are easily recognized by noting the date in the upper lefthand corner of the lease. Typically, it will state "Producers 88" followed by a date in parenthesis, such as (7/69) or (4/76). When the date is (12/79) or later, payment of delay rentals and shut-in royalties are generally considered not to be a condition of the lease.

Most oil and gas leases, today, are drafted with mainly covenants. For example, the operator’s promise to pay royalties (including shut-in royalties), to pay surface damages and to clean up the wellsite and repair roads are all covenants. The mineral owner’s sole remedy for their breach is to sue the lessee/operator for damages. They are not grounds for terminating the lease.


Also, another critical issue for landmen to know is in determining a lease’s termination by way of understanding how the longevity of the lease is both stated and calculated.

 

Implied Covenants


A ‘covenant’ is an express or implied “obligation” listed in the lease.  W.T. Waggoner Estate, 19 S.W.2d at 29; see also Johnson v. Gurley, 1879 WL 7746, 52 Tex. 222, 226 (1879) (“A covenant is an agreement duly made between the parties to do or not to do a particular act.”); A.W. Walker, Jr., The Nature of the Property Interests Created by an Oil and Gas Lease in Texas, 8 TEX. L. REV. 483, 488 (1930) (a covenant is “anything that a Grantee, or Lessee, is under a duty to do, or to refrain from doing”).  The breach of an obligation—or “covenant”—in a lease “will not authorize the forfeiture of the lease.” W.T. Waggoner Estate, 118 Tex. at 29.  “The usual remedy for breach of a covenant is an action for damages, though, under extraordinary circumstances—where there can be no other adequate relief—a court of equity will entertain an action to cancel the lease in whole or in part.”  Id. 


An example of a “covenant” is the implied covenant for reasonable development of the oil-and-gas lease.  Id. The “promise to pay royalties are generally a covenant, which will give rise only to a remedy of damages.”  Vinson Minerals, Ltd. v. XTO Energy, Inc., 335 S.W.3d 344, 354 (Tex. App.—Fort Worth 2010, pet. denied).  Likewise, the “obligation to protect from drainage is a covenant …, and the lessor’s remedy for such failure is a suit for damages, not forfeiture.”  Mitchell v. Mesa Petroleum Co., 594 S.W.2d 507, 513 (Tex. Civ. App.—San Antonio 1980, writ ref’d n.r.e.).


Oil and gas leases do not generally include a duty “to drill, to continue production after oil or gas is discovered in paying quantities, or to commence new drilling operations after existing wells have ceased producing.”  Lynch v. S. Coast Drilling Co., 442 S.W.2d 804, 807 (Tex. Civ. App.—San Antonio 1969, no writ).  That’s why the failure to obtain production as necessary to perpetuate a lease is not considered a breach of contract, but instead will affect automatic termination of the lease “by force of … limitation.”  Id.  The occurrence “terminating [a] lease [is] not a breach of duty by lessees and create[s] no cause of action in [the] lessor.” Id.(citing A.W. Walker, The Nature of the Property Interests Created by an Oil and Gas Lease in Texas, 7 Tex. L. Rev. 1, 18 (1928)).


In some oil and gas producing states, like Oklahoma and Texas, the courts do not promote a forfeiture of the lease, rather they look for ways to correct the underlying issue in order to promote the continuation of production and development of the minerals providing the operator can operate the lease as a prudent operator.


DID YOU KNOW: There is an oil and gas lease called the 88 Special Rocky Mountain and Mid-Continent Revised 6/1/62 Lease that was used a lot in the 1960s and 1970s, which addressed the non-payment of the shut-in royalty. This same lease was modified and was being used in the early to mid 2000s. This lease form had language added to change the payments of shut-in royalties from a ‘condition’ to a ‘covenant’ which would then allow the Lessee the chance to pay any back payments that may be due, rather than lose the lease. Here is what the 88 Special Rocky Mountain and Mid-Continent Revised 6/1/62 lease states:


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.”


You’ll notice that in that statement, it mentioned “payment of any royalty payable” which goes beyond the shut-in royalty payments. It was interesting to see lessors agreeing to this language, and as a petroleum landman, if you are not aware of this language in an oil and gas lease, it can cause you to miss important issues regarding the validity of the lease beyond its primary term.


IMAGE THIS SCENARIO:

Since there is no way to determine that any payments of shut-in royalties have been (other than having the lessee provide proof), determining whether an oil and gas lease is still valid after the primary term can be somewhat questionable and next to impossible for an unaware petroleum landman doing courthouse research for a leasehold cursory or ownership report.


For example, let’s say you, as a petroleum landman, have been hired to perform a ‘leasehold cursory report’ on some tracts in Oklahoma. You check the courthouse records for old unreleased oil and gas leases and for any new oil and gas leases.


You see where two large tracts, equaling 640 acres, had an older oil and gas lease that covered both tracts and that the primary term had expired 10 years prior to your research. This lease had one mineral owner. The lease had no set time limit for the shut-in royalty payments to cease (such as a maximum time limit of 5 years). In addition, you saw that the mineral owner’s son (the son had not signed the original lease) had filed an ‘affidavit of non-production’ on the leases.


You also see that the son (on his own) had leased the minerals to another company on a 3-year lease with a 2-year extension clause that had an effective date equal to the date of the filing of the affidavit of non-production. In addition, you noticed that the lease had the clause regarding the payment of shut-in royalty payments mentioned above. You decide to do a “drive by” to see if there was any activity on the lease and you noticed a ‘workover rig’ on two of the wells.


You turn in your report as to what you found that was filed of record. Next you receive a call that your findings were fine but there was a concern as to the validity to the new leases. Can you see what the problem may be?


THIS HAPPENED TO ME:

As an independent petroleum landman doing courthouse and corporation commission research, I’ve experienced this exact scenario. The first time I was aware of this amended covenant clause in a current oil and gas lease was back in 2005 when a gentlemen called me and asked for advice as to what to do regarding a situation involving his leases, a deceased mineral owner, and the decease mineral owner’s son who was trying to terminate the lease due to the lack of shut-in royalty payments. The original lease was signed in the 1995.


The original mineral owner signed the lease that had the amended ‘shut-in royalty covenant clause’ mentioned above and the lessee drilled three wells on his property. There was a period, when natural gas prices were such that it was not profitable to produce the gas so the lessee shut-in the wells. The lessee did not produce the wells for over 10 years. In addition, the oil and gas lease did not have a time limit or restraint on how long the leases could be valid by paying shut-in royalty payments and the lease did not state any ability for the lease to be determined in the absent of shut-in royalty payments not being made.


In 2005, the son of the deceased original mineral owner filed of record an ‘affidavit on non-production.’ In addition, the son never called or wrote the lessee to put him on ‘notice’ of any kind for demand of back due payments to correct the violation of the ‘covenant.’


After filing the affidavit of non-production, the son leased the minerals to another company. In turn, that company, after filing their new leases, started re-working the wells and never contacted the original lessee. The original lessee just happened to go by the lease to check on his wells and their locations when he saw a workover rig over one of his wells.


The result was after looking into the matter, the original lessee filed a restraining order against the other company to stop their reworking of the wells. In addition, the original lessee contacted the son’s attorney and told him, by doing what he did and did not do, he caused a ‘cloud on the title’ of his leasehold estate and that he, in fact, had the ability to pay all back royalties that were past due because of that lease provision being a ‘covenant’ and not a ‘condition.’


After paying the past due shut-in royalties, the original lessee then contacted the other company who had taken the new leases. After the other company removed their new filed leases, the original lessee then sold his leasehold estate to the same company which made him a lot of money and released him from the plugging liability of the wells. Unfortunately, the son had to return the lease money to the other company and did not profit from the transaction.


To learn more about oil and gas contracts and agreements and the petroleum landman’s role, visit our website at www.InstituteOfEnergyManagement.com. View our course catalog and click on the Concept of the Oil and Gas Lease.

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