Oil & Gas leasing: Montana Supreme Court discusses “production in paying quantities”
August, 2006
Recently the Montana Supreme Court interpreted a clause common in oil and gas leases – the "Habendum Clause" – which controls whether a Lessee/Producer can automatically extend an oil and gas lease beyond the initial term of the lease. In Somont Oil Company, Inc. v. A & G Drilling, Inc., 332 Mont. 56 (2006), the Montana Supreme Court refined and reaffirmed long-standing interpretations on the meaning of the phrases "production in paying quantities," and "temporary cessation of production." These interpretations, discussed in more detail hereafter, are also consistent with similar cases in California and Oregon. While Nevada and Washington do not report cases on this question, given the similarity of oil and gas lease forms used in all of these states, it is likely that all of these courts would apply the same reasoning as the Montana court.
The Habendum Clause
The Habendum Clause in an oil or gas lease governs whether a lease can be extended beyond the primary term (to a secondary term). The primary term is a fixed number of years during which the Lessee has the opportunity to explore, drill, and produce oil or gas. If no oil or gas is produced at the end of the primary term, the lease terminates. However, if oil or gas is produced (typically "in paying quantities), the lease is automatically extended into the secondary term.
Normally, the Habendum Clause contains two requirements to keep the lease alive:
1) What is generally referred to as the "thereafter clause", which states "as long thereafter as oil or gas is produced in paying quantities from the land." And,
2) So long as there is no permanent cessation of production.
In Somont, the landowner sought to terminate the oil and gas leases on the basis that the oil company had failed to produce oil or gas from its wells in paying quantities, so that the company's lease ended due to cessation of production. The company raised issues of economics generally in the oil & gas industry, and various other considerations to explain or justify temporary lapses in production over the life of the lease. The Montana Supreme Court addressed the two key questions.
Has there been "Production in Paying Quantities?"
The Montana Court defined paying quantities as the production of oil or gas from the land in some quantity that would pay a small profit over the cost of operation, but not including the initial cost of establishing the well. If that element is met, the inquiry stops there. However, if the landowner/Lessor establishes that the Producer/Lessee failed to produce in paying quantities because production has stopped, another question must be answered.
What happens if Production Ceases?
The question here is whether the cessation in production is determined to have been permanent or temporary. Like many things in the law, this is not necessarily a simple question. The Montana Court said that truly permanent cessation, for any reason, will automatically terminate lease if it is beyond the primary term. A temporary cessation, however, gives the Lessee an opportunity to resume production and continue the secondary term. The Court said in the Somont case that a temporary cessation occurs only when it is caused by a "sudden stoppage of the well or a mechanical breakdown of the equipment used in connection with the well, or the like." In that situation, the Lessee has the burden of proving that the cessation is short-term, and that diligent steps are being taken to correct the mechanical errors. If the Lessee meets that burden, a Court will be hesitant to deprive the company of its investment on the land by terminating the lease. In the Somont case, the Lessee failed to provide sufficient evidence on this issue, focusing more on market conditions as opposed to on-site conditions for example, and therefore failed to meet its burden. Therefore, the Court decided in favor of the landowner and terminated the lease.
California and Oregon
California courts have ruled in much the same way. In San Mateo Community College District v. Half Moon Bay Limited Partnership, 65 Cal.App.4th 401 (1998), the producer argued that it satisfied the Habendum Clause to justify automatic extension into a secondary term by discovering oil and gas during the primary term. The California Court rejected that argument and ruled that to extend the lease, oil or gas must be produced in paying quantities before the end of the primary term. The Court said that production in paying quantities meant "sufficient quantities each year as will return a profit to the lessee over and above his operating, but not his drilling or equipping costs in producing the oil and gas." This language was taken from an earlier California case, Montana-Fresno Oil Co. v. Powell, 219 Cal.App.2d 653 (1963), which also said that a producing well, not just discovery of oil or gas, is required. California has also refined the "paying quantities" issue by noting that if there is production in the secondary term, the court will measure revenue over a longer period of time to determine if the well is producing at a profit. (Transport Oil Co. v. Exeter Oil Co., 84 Cal.App.2d 616 (1948). The Court also commented that a highly profitable lease may at times be operating at a temporary loss, but that would not necessarily mean it is not "producing in paying quantities."
The Oregon Supreme Court appears to have been influenced by California's decisions as well. In Fremont Lumber Company v. Starrell Petroleum, 228 Or. 180 (1961), the landowner wanted to end the lease because the Lessee waited until the last month of the primary term before beginning exploration. The Oregon Supreme Court also found that production must begin before the end of the primary term to extend the lease into a second term. The Oregon Court also focused on finding some measure of profitably in making that determination.
Washington and Nevada
We did not find a reported case for these states involving an Habendum Clause, but mineral exploration and production companies typically use boilerplate form leases in all five states discussed in this article. These leases do not vary significantly from state to state. A typical Habendum Clause may not necessarily use the term "paying quantities" (although many do) and may look similar to this: "It is agreed and understood that this lease shall remain in force for a term of five years from the date hereof, hereinafter called the ‘primary term,' and as long thereafter as oil or gas, or either of them is produced from said land." It is highly likely, therefore, that a Washington or Nevada Court deciding a dispute over whether an oil and gas lease should be extended beyond the primary term would be guided by cases from Montana and the other states that have reported decisions.
Conclusion
Due to the rising cost of energy, there is a resurgence of interest in exploration and production of natural gas, in particular, in the western United States. Energy exploration and production companies are approaching landowners with increasing frequency in areas that may not previously have received much attention. Landowners should be cautious in signing lease forms offered by these companies, as they will affect fundamental rights of land or mineral ownership. This discussion highlights but one area of many that could be a concern for the land or mineral interest owner. To be safe, landowners should contact legal counsel with knowledge and experience in the area of mineral or oil and gas leasing for advice before signing a lease form.