Oil & Gas: Implied Covenants

Front 1

Implied covenants are unwritten promises that impose duties on Lessee and protect Lessor.

Back 1

May be negated by express clauses in the lease agreement.

Front 2

Standard of Performance [O&G leases]

Lessee acts as a reasonably prudent operator (RPO). Not a fiduciary standard. RPO's are profit-seeking business persons who care how much it costs to drill and produce, though lessors may not care (lessors get cost-free royalties).

Lessor has burden of proof in implied covenant cases to prove that it would be profitable for Lessee to do an act (usually drill a well). Thus, Lessor would have to prove that Lessee can recover o&g at a profit

Back 2

Does Lessee ever covenant to drill even one well under typical "unless" lease form? No, if Lessee does not drill, lease will eventually expire (absent delay rentals or a savings clause, etc.).

Note: "Unless" lease allows Lessee to pay delay rentals during the primary term. Express clause negates any implied covenant to drill a first well on the tract UNLESS the tract is being drained.

Front 3

Implied Covenant to Protect Against Drainage

Lessee act as an RPO to protect leased premises against drainage. Requires proof of 3 elements:

1) Substantial drainage
2) Lessee could drill profitable well to offset drainage
3) Damages

Back 3

Note: To prove profitability, Lessor must prove expected revenues from Lessee's working interest > drilling and production costs. Formula is different from the formula for determining if a well is PPQ under the habendum clause, where Lessee's revenues only had to exceed operating costs (because here the well has not been drilled yet).

Front 4

Implied Covenant to Market

Market o&g (1) within a reasonable time and (2) at best price realizable.

Both judged by what reasonably prudent operator would do.

Back 4

Note: Express "market value" royalty clause in a lease negates the implied covenant to base royalties on a higher contract price received by Lessee.

Front 5

Implied Covenant to Develop

In TX, implied covenant of reasonable development but not an implied covenant to explore. I/C to develop may be broad enough, in some cases, to include exploration.

Back 5

DO NOT WRITE THERE IS AN I/C TO EXPLORE!!!

Standard for breach of I/C to reasonably develop is whether lessor can prove a reasonable expectation of profit from additional drilling, regardless of whether proposed well is on an already proven tract or new strata.