Oil & Gas

Front 1

rule of capture

Back 1

The owner of a tract of land overlying an oil & gas reservoir has the right to capture all the oil & gas he brings to the surface through wells located on his own tract, notwithstanding that much of this oil & gas may be drained from beneath the surface of an adjacent landowner's property.

- Adjacent landowner's only remedy is to drill her own well.

- This is a rule of non-liability.

Front 2

theory of absolute ownership

Back 2

A landowner absolutely owns all of the oil & gas in place underneath his tract, even if it is not yet being produced and brought into possession at the surface.

=> allows mineral estates to be created, conveyed, recorded, mortgaged, and taxed just like any other estate in land

Front 3

doctrine of correlative rights

Back 3

- limits the rule of capture

- under this doctrine, every oil & gas owner has a right to a fair opportunity to produce oil & gas from a common reservoir underlying his or her property

- therefore, the rule of capture does not apply to:
(1) negligently drained oil & gas (e.g., blowout)
(2) illegally drained oil & gas
(3) stored gas (personal property of storer)
(4) willful injury to reservoir

Front 4

mineral interest

Back 4

- consists of the fee simple ownership of the oil & gas in place under a parcel of property (corporeal right; possessory estate in minerals)

- exclusive right to search for, [develop, & produce] (also self-development) oil & gas from the property

- executive right to grant oil & gas leases in exchange for:
(1) BONUS - upfront payment for signing lease, usu. based on number of acres leased
(2) ROYALTY - 1/8 of all the oil & gas produced cost-free
(3) DELAY RENTALS - compensation for deferring drilling during primary term of lease; paid on an acreage basis

Front 5

surface interest

Back 5

- what remains in the bundle of rights of land ownership after the mineral interest has been severed

- the surface interest includes ALL rights that are not part of the mineral interest

- the surface interest is subject to an implied easement of surface use by the dominant mineral interest owner

Front 6

dominant mineral estate

Back 6

After severance, the mineral estate is dominant and can use the surface estate as reasonably necessary to develop the oil & gas

- mineral estate owner cannot use or injure the surface estate in negligent ways

Front 7

accommodation doctrine

Back 7

- MIO is required to accommodate surface uses if the following conditions are met:

(1) surface owner has a pre-existing use of the surface

(2) MIO (lessee) has a reasonable alternative method of developing the oil & gas which is less destructive of the existing surface use, but still allows MIO to drill and produce economically (alternative cannot be unreasonably costly to MIO); AND

(3) reasonable alternative is available ON the leased tract

Front 8

oil & gas lease

Back 8

An oil & gas lease conveys a FEE SIMPLE DETERMINABLE from the lessor to the lessee.
(b/c lease may last forever ("as long as oil or gas is produced"), but may expire if there is no production at the end of a specified number of years or if delay rentals improperly paid)

In exchange for the bonus, royalty, and delay rentals (& a possibility of reverter in minerals), lessee gets all of the rights the lessor (MIO) had, e.g., exclusive right to explore, produce, and develop (so lessor can't drill her own well after leasing).

Lessee OWNS oil & gas underneath tract as corporeal (possessory) realty.

Front 9

interests created by an oil & gas lease

Back 9

- an oil & gas lease creates two sets of interests:

(1) working interest: the exclusive right to explore, develop, and produce from the property as well as the obligation to pay 100% of the costs of exploration, development, and production

(2) royalty interest: a share of production which is free of the costs of production

Front 10

oil & gas lease example

Back 10

Hypo: M, the owner of the mineral estate on Blackacre, grants all the oil & gas under Blackacre to Bigg Oil for "10 years & as long thereafter as oil & gas is produced" in return for usual lease benefits (royalty, bonus, delay rentals)

- Bigg Oil owns a fee simple determinable, all the gas underneath the tract as corporeal realty, and a working interest (the 7/8 of the oil & gas remaining after the 1/8 royalty is paid)

- M owns a possibility of reverter and a 1/8 royalty as incorporeal realty, bonus, and delay rentals

Front 11

royalty interest

Back 11

a nonpossessory, incorporeal, cost-free right to a share of the gross production or a share of the proceeds from the sale of the oil & gas production

* real property in TX

- royalty owner has no right to explore for, drill, or produce the minerals, nor to grant such right to others

- royalty owner has no obligation to pay any costs of production

Front 12

three kinds of royalty interests

Back 12

(1) landowner's royalty

(2) nonparticipating royalty

(3) overriding royalty

Front 13

landowner's royalty

Back 13

- the fractional share of production payable to the lessor in the royalty clause of the oil & gas lease

- created when a mineral interest owner leases the tract to an oil company

Front 14

nonparticipating royalty interest (NPRI)

Back 14

A NPRI is a royalty carved out of the LESSOR'S mineral interest that gives its holder the right to receive a royalty share from any production of oil & gas on the mineral estate owner's tract

- "non-participating" => NPRI owner does NOT have the right to lease or the right to bonus or delay rentals

- created by grant or reservation in a deed

Remember, whatever the NPRI gets comes out of the lessor's (MIO's) 1/8.

Front 15

production payment

Back 15

The right to receive a "sum certain" payable solely out of production, without any obligation to share in the costs of production

- Cf royalty: production payment is measured by a fixed amount and ceases once payment has been made in full; a royalty may be perpetual and is measured as a fractional share of production from the lease & there is no ceiling

Front 16

overriding royalty

Back 16

a royalty interest carved out of the LESSEE's interest under an oil & gas lease

- The override is "carved out" of the 7/8 working interest. It is in addition ot the landowner's 1/8 royalty.

Front 17

mixed blends of royalty & mineral interests

Back 17

Hypo: X deeds to Y "an undivided 1/2 mineral interest in Blackacre, but X reserves the executive right (right to lease) on all of Blackacre."

- Y is a nonparticipating mineral interest owner (NPMI) b/c he lacks the right to lease his minerals.

- when X leases all of Blackacre on behalf of both X & Y, 1/2 of all lease benefits (royalty, bonus, and delay rentals) will go to X and the other 1/2 to Y.

Front 18

cotenancy

Back 18

Every cotenant can drill and produce or lease his undivided share w/o the consent of the other cotenants, but must account to the others for their rightful share of the profits from production. A non-consenting cotenant may NOT enjoin a producing cotenant from leasing or the lessee from drilling or producing.

Profits are revenues minus costs. Costs include all reas. drilling and operating costs on productive wells. However, dry holes (doesn't produce O&G) may NOT be assessed against the unleased cotenant.

Front 19

cotenancy example

Back 19

Hypo: Peter owns a 3/4 undivided mineral interest in Blackacre; Lois owns a 1/4 undivided mineral interest and refuses to lease to anyone [non-consenting cotenant]. Peter leases the entire mineral interest to Bart Oil for a 1/8 royalty. Bart drills a dry hole costing $700K. Bart then drills a good well at a cost of $500K. The well produces $400K of oil a year in revenues, w/ operating costs of $50K/year. What does Bart owe Peter in Lois for the first year?
- Peter gets 3/4 x 1/8 x $400K
- Lois gets 1/4 x profits = 1/4 ($400K - $550K) = less than 0

A non-consenting cotenant cannot receive any profit from the well until the costs chargeable to her interest have been recovered from production. This may delay for a long time the non-consenting cotenant's right to recover.

Front 20

ratification by non-consenting cotenant

Back 20

Because of the delay in receiving a profit share, a non-consenting cotenant can always ratify the underlying lease (if the lease purported to cover his interest) and receive a royalty share from the date of ratification. However, once ratified, he cannot change his mind and seek a profit share as an unleased mineral owner later on.

So, in the above hypo, if Lois ratifies the lease, Bart will owe Lois 1/4 x 1/8 x $400K. That is, her undivided interest in the cotenancy multiplied by the royalty (1/8 of all O&G produced cost free).

Front 21

partition

Back 21

A TX cotenant has an absolute right to partition property. Partition is a judicial proceeding, and partitions can be granted either in kind (divide the property) or by forced sale (order the property sold and divide the proceeds).

Partition in kind is favored over partition by sale. Partition by sale occurs only upon proof that partition in kind is inequitable.

Ex: Peter owns a 3/4 undivided mineral interest in Blackacre (1000 acres); Lois owns a 1/4 undivided mineral interest. If Peter won't lease Blackacre, Lois should seek a partition so that it may be developed.
- partition in kind would give Peter 750 acres of, say, the northern tract, and Lois 250 acres of the southern tract, as separately owned estates
- if the mineral estate is partitioned by sale and the highest bidder buys it for $100K, Peter will get $75K, and Lois will get $25K.

Front 22

life tenants: leasing

Back 22

Neither a life tenant nor the remainderman can grant a valid oil and gas lease w/o the other.

- life tenant cannot grant a valid lease as this would commit waste against the remainderman

- remainderman cannot grant a valid lease b/c he has no present interest

Front 23

life tenants: apportionment of lease benefits

Back 23

C/L: If a lease is executed by both the life tenant and the remainderman owning legal interests, the life tenant generally receives the delay rentals. Bonus and royalty are invested as corpus (principal), w/ interest from the investment paid to the life tenant, and the corpus distributed to the remainderman upon the life tenant's death.

Exceptions:

(1) The C/L may be varied by the grant creating the interest or by agreement b/w the life tenant and remainderman.

(2) Open mine doctrine: when a lease has been executed prior to creation of a life estate, the life tenant is entitled to all bonus payments, delay rentals, and royalties paid under any lease in effect prior to creation of the life interest (even if the lease has no producing wells on it). But, life tenant cannot execute a new lease if the first one ends, absent express authority.

Front 24

accounting when creation of LT is by trust

Back 24

The Trust Act applies if the life tenancy was created in trust and the trust is silent about how receipts are to be allocated by the trustee b/w the life tenant and the remainderman.

Trust Act for trusts existing BEFORE 1/1/2004:
- LT gets delay rentals PLUS 72.5% of bonus and royalty PLUS interest on the other 27.5%.
- remainderman gets corpus of this 27.5% of bonus and royalty

Trust Act for trusts created after 1/1/2004:
- LT gets 100% of all nominal delay rentals [PLUS any interest on production payments (if the agreement provides for such interest)] PLUS an equitable share (85%) of all other proceeds, such as royalty, bonus, shut-in royalty, delay rentals which are not nominal, and production payments that bear no explicit interest factor.
- remainderman gets [corpus of production payments (upon which LT is paid interest) PLUS] equitable share (15%) of all proceeds (royalty, bonus, delay rentals which are not nominal, and production payments that bear no interest factor).

Hint 24

** if the agreement does not specifically provide for interest on production payments, ignore what is in brackets

Front 25

mortgagor/mortgagee: foreclosure of lessee's interest

Back 25

If an oil & gas lease precedes the execution of a mortgage, the lessee's rights will be superior to those of the mortgagee b/c the mortgagee lent $ w/ knowledge of the existing lease.

Conversely, if the mortgage is executed before the lease, the lessee's interest will be subject to the mortgage lien. However, a foreclosing mortgagee must attempt first to satisfy the mortgage out of the proceeds of a sale of the surface rights. If the sale of these rights is insufficient, the lessee's interest may then be sold to satisfy the mortgage. [If the lessee wants to keep the lease, he will have to repurchase it at the foreclosure sale.]

For this reason, lessees leasing land subject to a mortgage often seek subordination agreements from the mortgagee. [e.g., mortgagee gets share of bonus or other lease payments in consideration for agreement to give lessee first priority]

Front 26

trespass

Back 26

One who wrongfully enters and possesses another's mineral estate will be liable to the rightful owner for trespass. Types of trespass:

(1) ordinary trespass

(2) slant well drilling

(3) drilling dry well

(4) geophysical or seismic trespass

** It is NOT trespass and no injunction will issue to stop authorized secondary recovery operations (e.g., repressuring operations approved by the RR Commission) [but, damages may be available].

Front 27

trespass: ordinary trespass

Back 27

Ordinary trespass occurs when one enters and possesses the mineral estate w/o the right to do so.
- e.g, lessee's lease has expired, but he stays on tract and continues to drill)

Remedy: injunction and damages (possible punitives)

Front 28

trespass: slant well drilling

Back 28

E.g., Bigg Oil starts drilling a well on the surface of Whiteacre but slants it underground and bottoms it under Blackacre; Bigg Oil is trespassing on Blackacre.

Remedy: injunction and damages (possible punitives)

Front 29

trespass: drilling dry well (damage to the speculative lease value)

Back 29

Wrongful lessee enters and drill a dry hole on tract and lessor loses the lease value that he could have received before the world found out his land was dry.

Remedy: the lost bonus

Front 30

trespass: geophysical or seismic trespass

Back 30

A potential geophysical or seismic trespass occurs when explorer never enters mineral estate but acquires some seismic info about its mineral potential by seismic work on a nearby land.

Remedy: sue in assumpsit (on the K which should have been entered into) for the market value of the rt to do seismic exploration

Held: "mere vibrations" passing through another's land do NOT constitute trespass when the explorer never enters upon the surface of an unpermitted tract [and doesn't gain or exploit useful data]

Note: While there has not been a TX case on point, arguably, a geophysical trespass will result if the explorer gains useful data from the seismic info. Counterargument: the rule of capture should apply to the acquisition of seismic data. Argue both sides.

Front 31

hydraulic fracturing

Back 31

Hydraulic fracturing is fracturing a well by cracking the underground formation w/ massive fluid injections

Fracturing a well physically alters the formation and can result in cracks that extend across lease lines and cause drainage from ANOTHER owner's tract.

Held: oil drained through fracturing is protected under the rule of capture and is not a trespass

Front 32

trespass damages: good faith/bad faith

Back 32

A trespasser enters land in good faith if he had an honest and reasonable belief in the superiority of his title. A good faith trespasser is liable for the value of oil produced on the land, but will be credited for any reasonable costs incurred (e.g., costs of drilling and operating well; NOT cost of dry holes) in production so long as the costs benefited the rightful owner.

A bad faith trespasser will be liable for the gross value of the production from the well w/o any deduction for costs.

In TX, a trespasser is held to be in bad faith as a matter of law if he drills during pendency of a lawsuit over the title to the land, UNLESS the trespasser is also a cotenant to an undisputed fractional interest of the mineral estate.

Front 33

slander of title

Back 33

An owner may recover against a 3d party who maliciously and knowingly asserts a false claim to the land in question if the slander of title results in the loss of a SPECIFC sale to the real owner.
- elements: (1) publication of a false claim; (2) malice; AND (3) loss of a specific sale

Damages for slander are measured by the difference b/w the market value of the lease at the time of the slander and its value at trial w/ the cloud of title removed.

Front 34

adverse possession

Back 34

Where possession begins PRIOR to severance, adverse possession of the surface will give the adverse possessor title to BOTH the surface and mineral estate.

Where possession begins AFTER severance, possession of the surface will not give the adverse possessor title to the mineral estate. The adverse possessor must separately establish title to the mineral state by a separate act of possession (e.g., drilling a well).

Front 35

oil & gas lease: the granting clause

Back 35

The granting clause sets forth the rights given by the lessor to the lessee as well as a description of the property.

Sometimes the description will be followed by a "Mother Hubbard" clause: "This lease also covers and includes all land owned by the lessor adjacent to the land described above."

The purpose of the MH clause is to convey to the lessee SMALL STRIPS of land not included in the granting clause b/c of inaccuracies (incorrect surveys or land descriptions, AP b/c of misplaced fences, etc).

In TX, however, the MH clause does NOT operate to convey large contiguous tracts of land that the parties have chosen not to grant in the lease.

Front 36

habendum clause

Back 36

The habendum clause sets from the duration of the lessee's interests in the premises. Typically there is a PRIMARY TERM which is a fixed period during which the lessee has no obligation to conduct drilling operations and a SECONDARY TERM which is indefinite but is normally linked to production.

A typical habendum clause states: "The lease shall be for X years from this date [primary term] and as long thereafter as oil, gas, or other minerals are produced [secondary term]."

Front 37

meaning of "produced" in an habendum clause: PPQ

Back 37

In TX, "produced" means actual production in paying quantities (PPQ). Failure to have actual PPQ terminates the fee simple determinable; the lessor gets the oil & gas back via the possibility of reverter, and the lease ends.

PPQ = Revenues MINUS the lessor's royalty in the lease MINUS operating costs

operating costs include: labor, electricity for pumping, repairs, depreciation on producing equipment

* drilling costs are NOT included in the calculation; but lessee may have to pay severance taxes

Front 38

C/L exceptions to PPQ

Back 38

(1) "temporary cessation" doctrine

(2) the marginal well doctrine

(3) doctrine of repudiation

Front 39

"temporary cessation" doctrine

Back 39

Once PPQ is established, a temporary cessation of production due to a "sudden stoppage of the well or some mechanical breakdown or the like" will NOT terminate the lease.

Key factors: (1) a short temporary shut down [prob. no more than 3 mos]; (2) which the lessee acts diligently to fix; and (3) which is due to a "mechanical breackdown or the like."

Front 40

the marginal well doctrine

Back 40

Some wells only produce paying quantities some months during the year. The test for a marginal well is "whether a reasonably prudent operator would continue to operate the well to make a profit, not merely for speculation."

As long as the well is still producing some oil or gas (and is not completely shut in), TX cts give lessees a reasonable amount of time (as much as 17 mos of intermittent monthly profits and lossess) to show that the well is capable of profitable production.

Front 41

doctrine of repudiation

Back 41

The doctrine of repudiation tolls the time period provided under the habendum clause for the fulfillment of the lessee's duties for as long as the lessor contests the validity of the lease.

Thus, if the lessor repudiates or obstructs the lease (e.g., by refusing to let the lessee onto the tract), courts will add the period of the delay to the lease.

Front 42

delay rental clauses

Back 42

Delay rental clauses authorize a lessee to delay drilling or commencing production during the primary term of the lease by periodically paying a stipulated amount to the lessor.

Payment of delay rentals cannot be made after the primary term expires. Only PPQ will hold a lease after the primary term ends.

Front 43

"unless" delay rental clauses

Back 43

The "unless" clause provides that "if operations for drilling are not commenced w/n one year from the date of this, the less shall terminate UNLESS the lessee pays delay rentals of X dollars to the lessor."

The "unless" language creates a CONDITION. As such, the lease will AUTOMATICALLY TERMINATE for the failure to pay delay rentals (1) on or before the due date; (2) in at least the proper amount; (3) to the proper parties; AND (4) in the manner provided.

Front 44

"or" delay rental clauses

Back 44

Under an "or" delay rental clause, the payment of a delay rental is structured as a contractual obligation--a COVENANT (a promise). The "lessee agrees to either drill a well OR pay delay rentals during the primary term."

A lease w/ an "or" delay rental clause will NOT terminate automatically if the lessee fails to commence drilling operations or pay rentals properly. Instead, the lessor may sue for breach of contract to recover damages for the unpaid rentals.

Front 45

late delay rentals

Back 45

If the lessor accepts a late delay rental payment, the lessor is held to have revived the lease under some sort of loose theory of estoppel or ratification.

If, however, the lessor accepts a late ROYALTY payment, courts will look at the formal elements of estoppel and ratification to determine whether an invalid lease is revived.

Front 46

notice of assignment clause

Back 46

e.g., "either party may assign the rights under the lease, but no change in ownership is binding on lessee until 30 days after lessee has received by registered US mail a certified copy of the recorded assignment."

Hypo: Lessor sells an undivided 1/2 mineral interest in Blackacre to assignee, who doesn't send a copy of the deed to lessee. Lessee TIMELY PAYS delay rentals due on Blackacre to lessor.
- the lease is still valid as to lessor AND assignee, and the notice of assignment clause relieves lessee of liability to the assignee.

Hypo: Same facts, except lessee sends lessor a LATE delay rental check. Lessor accepts the check.
- under a loose estoppel/ratification theory, the lease is still valid as to the lessor's 1/2 interest
- but, b/c assignee never accepted any rental payments, lessee cannot rely on an expired notice of assignment clause to save the lease on the assignee's 1/2 interest
- as such, the assignee is a COTENANT w/ the lessee (she can lease to others, drill herself, or wait for lessee to drill good wells and take 1/2 of the profits)

Front 47

"commencement of drilling" clause

Back 47

The delay rental clause may state "if operations for drilling and not COMMENCED on or before the anniversary date of this lease, the lease shall terminate unless . . . [lessee opts to pay delay rentals]."

commencement requires two elements:
(1) Objective physical acts done on the leased premises (e.g., starting to build a road to bring in the rig, cutting down trees for the platform, drilling a water well to use the water in the drilling operation for oil and gas)
(2) Done w/ subjective good faith intent to continue to pursue the drilling operation to find oil and gas

Front 48

defensive clauses

Back 48

To hold a lease beyond the primary term, the lessee needs PPQ. If delay rentals are not holding the lease, then the lessee must satisfy a defensive clause (or "savings" clause). A properly drafted defensive clause will maintain the lease, and such clauses may be tacked together to further extend the lease.

The most common defensive clauses are shut-in royalty clause, dry hole clause, operations clause, cessation of production clause, and force majeure clause.

** Examiner will have to give you the clause; apply the clause

Front 49

defensive clause: shut-in royalty clause

Back 49

e.g., "While there is a gas well on this lease, but gas is not being sold, used, or marketed, lessee may pay as a royalty, on or before 90 days after the date on which the well is shut-in, and thereafter in monthly intervals, the sum of $10, and if such sum is paid, the lease shall not terminate and it will be considered that gas is being produced from this lease in paying quantities."

A shut-in royalty clause in effect provides that when a well that is capable of producing gas is shut-in for lack of market, the lessee can hold the lease by paying shut-in royalties.

Shut-in royalties can only be paid on wells that are capable of producing in paying quantities (such as a good well that awaits a pipeline connection).

Front 50

defensive clause: dry hole clause

Back 50

A dry hole clause provides that if a lessee drills a dry hole, he can keep the lease alive by starting to drill another well on the leased property w/n the stated period of time.
- e.g., "If lessee drills a dry hole, the lease shall not terminate if lessee commences another well w/n 60 days or resumes paying delay rentals."

Front 51

defensive clause: operations clause

Back 51

A continuous operations clause covers the situation where, at the end of the primary term, operations have commenced and were continuing but there was not yet actual production.
- e.g., "If at the end of the primary term, oil or gas is not being produced, but lessee is then engaged in drilling or reworking, the lease remains in force so long as operations are prosecuted w/ no cessation of more than 90 consecutive days."

Front 52

defensive clause: cessation of production clause

Back 52

A cessation of production clause provides that if a well ceases producing, the lessee can nevertheless keep the lease alive provided the lessee commences repairs w/n the stated period of time.
- e.g., "If production ceases, the lease shall not terminate if lessee commences additional drilling or reworking w/n 60 days."

Front 53

defensive clause: force majeure clause

Back 53

A force majeure clause excuses performance, or extends the time for performance, b/c of unforeseeable factors beyond the lessee's control.

The act of force majeure has to be identified in the lease, and that event has to prevent performance.

-e.g., "Should lessee be prevented from complying with any express or implied covenants, from conducting drilling operations, or from producing oil or gas by reason of scarcity of material or by operation of FORCE MAJEURE, or of any laws or orders, then while so prevented this lease shall be extended."

Hint 53

A typical force majeure clause will NOT excuse late delay rentals in an "unless" delay rental clause lease b/c such delay rentals are a condition of a fee simple determinable.

Front 54

pooling clause

Back 54

The pooling clause is a powerful defensive clause b/c it allows a lessee to place the leased tract into a larger unit created by combining acreage from adjacent tracts. Production from ANY WELL on the pooled unit will operate as production from the leased tract, even if the well is not on the leased tract itself.

The royalty (typically 1/8) will usu. be apportioned to the different landowners whose land was combined into the pooled unit on the basis of surface acreage.

Front 55

pooling clause example

Back 55

"Lessee has the right to pool all or any part of the acreage covered by this lease w/ other land in the immediate vicinity . . . . Operations for drilling on or production from any part of such a pooled unit shall be considered as operations on or production from the land covered by this lease, whether or not the well be located on the lease . . . . Royalties shall be allocated on a surface acreage basis."

Hypo: If Bigg Oil has leased 30 acres from X and 10 adjacent acres from Y and both leases contain pooling clauses and 1/8 royalty clauses, Bigg Oil can pool the separate tracts into a 40 acre unit. A well drilled anywhere on the 40 acres will hold both leases (as long as the well produces in paying quantities).
- X's royalty = 30/40 x 1/8
- Y's royalty = 10/40 x 1/8

Note, if Bigg Oil's leases did not have pooling clauses, Bigg would have to drill wells on both X's and Y's tract to keep both leases in effect.

Front 56

pooling only a portion of the leased land

Back 56

Hypo: X owns 600 acres and leases to Bart Oil; Y owns an adjacent 40 acres and also leases to Bart Oil. Both leases have pooling clauses. Bart Oil pools X's 600 acres and only 15 of Y's 40 acres, to form a 615-acre unit, and then drills a well on X's tract.
- Y's lease is kept alive on ALL 40 acres b/c under the typical pooling clause, pooling holds all the "land covered by this lease"--all 40 acres, even though only 15 of the 40 acres are put into the pooled unit.
- BUT, Y will only get a 15/615 x 1/8 royalty

To avoid the above result, the lessor may insert a "Pugh clause" so that Y's lease is kept alive only for the 15 pooled acres; the remaining 25 acres are severed.
- e.g., "If only part of the acreage under lease is pooled, this lease shall be maintained only as to land included in the pooled unit."

Hint 56

Assuming that lease contains a Pugh clause in addition to the pooling clause, if the lessee wanted to hold the lease in effect with respect to the unpooled acres (the 25 acres in the hypo), the lessee would have to something else to the unpooled acres, such as: (1) pay delay rentals on it, if the lease is still w/n the primary term; (2) drill a well on the unpooled acres and get PPQ from that well; or (3) pool the unpooled acres into another unit.

Front 57

pooling in good faith

Back 57

Because a pooling clause gives the lessee great discretion and power, courts require that pooling be exercised in good faith. As such, when a lessee, acting in bad faith, pools a lessor's interest, the pooling may be set aside.

ex: a lessee who pools parts of 8 different leases into a gerrymandered unit w/ a very odd shape, just days before the leases are to expire, and who does not have a good faith intent to drill a well in the near future will probably be found to have acted in bad faith, and the pooling will be invalid.

Front 58

pooling clause and NPRIs

Back 58

The executive right owner (the mineral estate owner w/ right to lease ) has NO power to pool the NPRI, even though the executive right owner has the power to lease the NPRI.

Hypo: Y, the mineral estate owner of a 40 acre tract (15 acres of which is part of a pooled 615-acre unit), sells an NPRI interest of "1/2 of all royalties" to S.

If a well is drilled on the 15 acres of the pooled unit, S as the NPRI will get a 1/2 x 1/8 share of royalty b/c he is not bound by the pooling agreement.

If, however, a well is drilled on the 600 acres of the pooled unit (that Y is not the mineral estate owner of), S will get a royalty of ZERO. But, S may ratify the pooling agreement and receive a share of royalty from the adjacent well. If S ratifies, he will get 1/2 x 1/8 x 15/615 of all production from the well.

Front 59

royalty clause

Back 59

The royalty clause is the main provision of the oil and gas lease for compensation of the lessor. The "normal" royalty is 1/8. However, royalty fractions are negotiated and may be higher.

The typical lease states that royalties are to be paid based on production valued "at the well," w/ the result that royalties are free of the costs of production, but NOT post-production costs. Thus, costs subsequent to production are proportionately shared b/w lessor and lessee absent contrary language in the lease. This means that the lessor of a 1/8 royalty must pay 1/8 of post-production costs.

Front 60

royalty clause and the "market value" issue

Back 60

Many oil and gas leases contain provisions for royalty payments based on the "market price at the well" or "market value at the well" where the gas is sold or used OFF the premises.

The "market price" or "market value" of gas is defined as the price that similar gas currently sells for in the spot market at the time the gas is produced."

e.g. the lease's royalty clause reads as follows: "(i) on gas sold or used off the premises, the market value at the well of 1/8 of the gas; (ii) on gas sold at the well, 1/8 of the amount realized from such sale."

Hint 60

These questions are pretty easy; just read the royalty clause carefully.

Multiply the 1/8 royalty by either the market value or the contract price depedening on whether the gas was sold off the premises or at the well

Front 61

division orders (D/O)

Back 61

A division order tells the lessee or well operator or purchaser how to divide the proceeds from a well among all the various lessors and NPRIs and working interest owners (such as other cotenant lessees or mineral interest owners).

The lessee prepares the D/O w/ its own calculations of the fractional interest that ea. owner should receive and then mails the D/O to ea. owner. Ea. owner checks the calculations and, if the fractional amt appears correct, signs the D/O and returns it to the lessee. The lessee then pays the owners their checks on the basis of the division orders.

The D/O was intended as a housekeeping device to aid in the administration of lease payments, and yet the D/O begins to have the power to contradict and amend the terms of the lease.

D/Os have their own set of C/L and § law governing their legal effect.

Front 62

C/L approach to D/O

Back 62

Under the C/L D/Os were BINDING until REVOKED even if the provisions of the D/O might differ from the lease language.

However, a lessor could ALWAYS revoke a D/O that differed from the lease and receive the correct payments from that point forward.

Front 63

The 1991 D/O Act (applies to D/Os executed after 8/26/1991)

Back 63

A D/O is binding until revoked and it can "clarify" methods of paying royalty, but it is NOT binding to the extent it changes or contradicts a lease (except in market value cases).

The lessee/payor owing the royalty payments can withhold royalty payments w/o owing interest on the withheld money ONLY if:
(1) there is a title dispute that affects the distribution payments or a reasonable doubt that the payee has clear title; OR
(2) a payee refuses to sign a standard D/O

But, lessee/payor has NO right to withhold payment to a royalty owner who refuses to sign the D/O b/c it contains items not authorized in the §. Interest accrues on such withheld payments.

Front 64

faulty D/O: contradicting the underlying deed

Back 64

Hypo: Tom owns an undivided 40% of Blackacre and Diane owns the other 60%. Both lease to Exxon. By mistake, Exxon sends Tom 50% of the royalties and Diane the other 50%. In the 7th year, Diane realizes the mistake and demands the correct amt due her (60%, not 50%).

- Diane can revoke the D/O and 60% of the royalty in the future
- But, Diane CANNOT recover the past 7 years of underpayments b/c a D/O is binding until revoked; Diane can sue her cotenant Tom b/c he was overpaid w/ some of her share

Front 65

faulty D/O: contradicting the underlying lease

Back 65

Hypo: Lessor owed a 1/6 royalty under a lease from Bart Oil. Bart sends lessor a D/O stating lessor is to receive a 1/8 royalty . Lessor signs the D/O and receives a 1/8 v. 1/6 royalty for two years until noticing the mistaking and revoking the bad D/O.

- b/c a D/O CANNOT contradict the underlying lease, Bart (lessee) owes Lessor for the past underpayments.

Front 66

implied covenants

Back 66

Implied covenants are unwritted promises that impose duties on the lessee and protect the lessor. However these implied covenants may be negated by express clauses in the lease agreement. Types of implied covenants:

(1) reasonably prudent operator standard of performance

(2) the implied covenant to protect against drainage

(3) implied covenant to market

(4) implied covenant to develop

Front 67

implied covenant: RPO standard of performance

Back 67

Oil and gas leases contain an implied covenant that the lessee acts as a reasonably prudent operator (RPO).

Lessor has the burden of proving that the lessee has failed to do what a reasonably prudent lessee would and should have done under similar circumstances. Thus, the RPO standard usu. requires that the lessor prove that it would be PROFITABLE for the lessee to do a particular act (usu. drill a well). As such, a lessor would have to prove that the lessee can recover oil and gas at a profit (a value in excess of all reas. costs of drilling, producing, and marketing the oil or gas).

Front 68

the implied covenant to protect against drainage

Back 68

The covenant to protect against drainage requires that the lessee act as a RPO to protect the leased premises against drainage. It requires proof of 3 elements:

(1) substantial drainage
(2) lessee could drill a profitable well to offset drainage
(3) damages

To prove profitability, lessor must prove expected revenues from lessee's working interest exceed drilling & production costs.
- Cf. PPQ = revenues - lessor's royalty - operating costs

Remedies:
- damages equal to amt of royalties that lessor would have received if lessee had drilled a profitable offset well
- a conditional decree from the ct directing lessee to either drill or forfeit that area of the lease being drained

Front 69

implied covenant to market

Back 69

A lessee has an implied covenant to market oil and gas (1) w/n a reasonable time and (2) at the best price realizable. What is a reasonable time and the best price realizable are judged by what a reasonably prudent operator would do.

Note: the express "market value" royalty clause in a lease negates the implied covenant to base royalties on a higher K price received by the lessee

Front 70

implied covenant to develop

Back 70

In TX, there is an implied covenant of reasonable development, but NOT an implied covenant to explore. However, the I/C to develop may be broad enough, in some instances, to include the latter.

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

Hint 70

On the exam, DO NOT WRITE THAT THERE IS AN I/C TO EXPLORE!

Front 71

executive right: duty of "utmost good faith"

Back 71

In most cases, an executive interest owner owes a duty of "utmost good faith and fair dealing" to non-executive interest owners (NPRIs, NPMIs).

This standard requires the executive to act w/ due regard for the interest of the non-executive and to be willing to execute a lease on the same terms and conditions as a reasonably prudent landowner would do if there was no non-executive interest.

Front 72

executive right: fiduciary duty

Back 72

In cases in which the executive engages in egregious self-dealing, courts have imposed a fiduciary standard upon the executive, meaning the executive must subordinate his interests to that of the non-executive.

A breach of this duty may include cancellation of the executive right, cancellation of other leases that violate the duty, actual damages and exemplary damages.

** courts have only imposed this heightened fiduciary duty when the executive engaged in egregious self-dealing; otherwise apply the "utmost good faith" standard.

Front 73

Who owns the minerals?

Back 73

Step 1: Is the substance one of the 9 that belongs to the SURFACE as a matter of law?
- the nine: gravel, iron ore, limestone, (near surface) lignite, sand, building stone, caliche, surface shale, water [GILLS BCS W(in)]

Step 2: If not, look at the date of the ambiguous conveyance that severed the minerals
- if BEFORE June 8, 1983, use "surface destruction" test
- if AFTER June 8, 1983, use "ordinary and natural meaning" test

Front 74

ownership of minerals: surface destruction test

Back 74

Under the surface destruction test, if ANY reasonable method of producing the substance would destroy the surface, then the minerals belong to the SURFACE OWNER (unless the mineral estate owner expressly reserved the particular mineral)

Front 75

ownership of minerals: ordinary and natural meaning test

Back 75

Under the ordinary and natural meaning test, if the substance at issue is within the "ordinary and natural meaning" of the word "mineral" then it belongs to the MINERAL ESTATE OWNER.

While the mineral estate owner may own the mineral, the surface owner should be compensated for damages to the surface. Also, existing surface uses should be accommodated if there is a reasonable, practical method of doing so.

Front 76

nonapportionment rule

Back 76

Under the nonapportionment rule, when property is subdivided after an oil and gas lease covering the land has been entered into, the owners of the subdivided interest are NOT entitled to an apportioned lease royalty payment. They are entitled, however, to an apportioned delay rental.

Hypo: X has leased 40 acres to Exxon. X then sells 10 of the 40 acres to Y. What has Y bought?
- a possibility of reverter in the mineral estate on 10 acres as well as the surface of 10 acres (subject to Exxon's reas. use), the rt to delay rentals on the 10 acres, if any, and the rt to royalty from any well on the 10 acres. b/c royalties are not apportioned, Y does NOT have the rt to a royalty from a well on X's 30 acres

Hint 76

Note, the nonapportionment rule may be changed by an entirety clause in the lease to enable royalties to be shared.
- e.g., "If the lease premises are ever owned severally or in separate tracts, all royalties shall be treated as an entirety and paid to the separate owners on a surface acreage basis."

Front 77

mineral interest pooling act (MIPA)

Back 77

MIPA is the TX compulsory pooling act. Without MIPA, the C/L applies.

Two basic rules to trigger MIPA:
(1) MIPA applies only to fields discovered after March 8, 1961
(2) Y must first make a fair and reasonable offer to pool voluntarily.

Hypo: X has leased 40 acres to Exxon. X then sells 10 of the 40 acres to Y. A well is drilled on X's 30 acres. Y is definitely being drained by this well.
- Y may try to invoke MIPA to force her way into the well on the 30 acres.

Hint 77

Note, Y may also allege Exxon has breached the I/C to develop the entire 40 acres, but this will be difficult to prove.

Front 78

community lease

Back 78

A community lease occurs when several landowners of adjacent tracts sign a single lease granting mineral rights in the combined acreage owned by all the lessors to a single lessee. The execution of the lease will be treated as an agreement to pool, and each lessor will be entitled to share in production from the combined acreage. If the lease does not specify how the royalty on oil and gas produced by the lease is to be allocated amonf the lessors, allocation will be made on the basis of surface acreage contributed to the unit.

Hypo: X owns 10 acres and Y owns 30 contiguous acres. Both X & Y sign a SINGLE LEASE, leasing the entire tract to Exxon. Exxon drills a well on X's 10 acre tract. The lease is silent on how royalties are to be distributed. What distribution of royalties?
- b/c X & Y have a community lease, X & Y share royalties: X gets 10/40 x 1/8; Y gets 30/40 x 1/8

Hint 78

Note: the community lease is the only example in TX O&G jurisprudence of an IMPLIED pooling effect. Otherwise, pooling occurs only if:

(1) express pooling power is exercised in a lease clause;
(2) compulsory pooling occurs by statute (MIPA); OR
(3) there is ratification of a pooling agreement by an NPRI

Absent pooling, the Rule of Capture applies.