The Oil and Gas Addendum

The recently filed Hobe Minerals Limited Liability Company v. Bonanza Creek Energy Operating Company, LLC, et al lawsuit in a Colorado trial court challenges whether intermittent cryptocurrency mining can maintain an oil and gas lease beyond its primary term. While lawsuits seeking determinations that oil and gas leases have terminated are nothing new, the cryptocurrency mining angle in Hobe Minerals poses an interesting question and highlights the need for oil and gas owners to be aware of things like cryptocurrency mining and its impacts on an oil and gas lease.

Hobe Minerals is an oil and gas owner that leased thousands of acres to Bonanza, an oil and gas driller, in Weld County, Colorado, north of Denver. [Complaint ¶ 18]. The Complaint alleges that Bonanza originally intended to include the Hobe Minerals leasehold into an extensive development, with dozens of horizontal wells across eight units, but Bonanza only drilled eight wells - one in each unit. [Complaint ¶¶ 32-37]. After these wells were drilled, Hobe Minerals acknowledged that oil was regularly produced and sold, thereby generating royalties; the associated produced gas was flared and no royalties were paid on the gas. [Complaint ¶ 38]. According to Hobe Minerals, Bonanza did not connect the wells to a gas gathering system. [Complaint ¶ 39].

After several years of flaring the associated gas produced with the oil, Colorado’s regulatory agency apparently denied Bonanza the ability to continue flaring the gas. [Complaint p. 46]. As a result, Hobe Minerals claims that Bonanza stopped producing oil and gas from the wells. [Complaint ¶ 47]. Then, according to Hobe Minerals, Bonanza attempted to restart production on a rotating basis by paying a cryptocurrency mining company to move portable trailers containing cryptocurrency mining equipment to well sites. [Complaint ¶¶ 50-51]. The cryptocurrency mining trailers would generate electricity for the mining operation by burning gas produced from the wells. [Complaint ¶¶ 50-52]. Hobe Minerals claimed that it was paid de minimis royalties for this gas consumed in cryptocurrency mining, rather than the value it should have received if the gas was marketed or sold. [Complaint ¶ 50-52]. Hobe Minerals also alleges that, as part of the cryptocurrency mining operations, wells were only operational for a fraction of the time that they had been previously, and produced substantially less. [Complaint ¶ 53].

Hobe Minerals sought varied relief in its Complaint under a number of theories. The court’s treatment of the different theories advanced by Hobe Minerals is worth further study in and of itself. But, relevant to this discussion are the contentions that the subject leases terminated because they were intermittently and uneconomically operated [Complaint, First Claim for Relief] and that Bonanza breached implied covenants to diligently develop, produce, protect against drainage, prudently operate and prudently market the gas because other operators would have installed a gas gathering system to sell the gas versus flaring it or disposing of gas in intermittent cryptocurrency mining activities. [Complaint, Third Claim for Relief].

Notably, Hobe Minerals did not claim that cryptocurrency mining was a problematic use of gas under the lease. Indeed, Hobe Minerals suggests in its Third Claim for Relief other operators would have installed a gas gathering pipeline or utilized cryptocurrency mining equipment at each well site, in order to avoid turning wells on and off, which allegedly impacted reservoir pressure. [Complaint ¶ 135].

The Hobe Minerals case is at its early stages but its partial focus on cryptocurrency mining raises an issue that will likely become more widespread. Cryptocurrency mining uses massive amounts of computing power to verify blockchain transactions on computer networks. Significant amounts of energy are needed to power the "mining" computers and to keep the computers cool. Since natural gas is burned to generate electricity, oil and gas well sites can be attractive sources of gas for cryptocurrency miners to power their cryptocurrency mining operations. Likewise, other large energy consumers, like computer data centers, may find oil and gas well site areas to be attractive for similar reasons.

Well site cryptocurrency mining presents several issues that oil and gas owners should be aware of. On one hand, the existence of bona fide, commercial sales at well sites to cryptocurrency miners could help establish an actual price for gas at the well, rather than relying on the logically suspect "net back" calculation method to calculate wellhead values. But, oil and gas owners should confirm that appropriate royalties are paid. In early 2023, a federal government report indicated that drillers failed to pay hundreds of millions of dollars in royalties to the federal government because, instead of being sold, gas was being used to generate electricity for computers involved in cryptocurrency mining.

If drillers are paying a cryptocurrency mining operation to take the gas, as Hobe Minerals alleges, valuing that gas for royalty purposes is not straightforward and the pricing values are unreliable. Moreover, if drillers are selling gas at substantial discounts to well site cryptocurrency mining, or paying cryptocurrency miners to take the gas, that impacts the driller's lease operating expenses and warrants further inquiry into whether the leasehold is producing in paying quantities.

Consuming gas for cryptocurrency mining operations on the leasehold where the well site is located raises other questions that implicate lease validity. If a lease requires a royalty to be paid on gas marketed and sold off the leased premises, a driller may attempt to argue that consumption of gas on the leasehold for cryptocurrency mining operations does not trigger a royalty obligation. But, in Pennsylvania, that should run afoul of the minimum royalty obligation under law.

The Pennsylvania Guaranteed Minimum Royalty Act identifies the minimum royalty requirement a lease must contain in order to be valid. It states that:

A lease or other such agreement conveying the right to remove or recover oil, natural gas or gas of any other designation from the lessor to the lessee shall not be valid if the lease does not guarantee the lessor at least one-eighth royalty of all oil, natural gas or gas of other designations removed or recovered from the subject real property.

58 P.S. § 33. So, in order to be valid, an oil and gas lease must guarantee at least a one-eight royalty of all of the oil and gas removed or recovered. In Kilmer v. Elexco Land Services, Inc., 990 A.2d 1147 (Pa. 2010), the Pennsylvania Supreme Court construed the GMRA’s “removed or recovered” requirement to be determined at the physical wellhead, where oil and gas is removed or recovered from the ground. The natural gas used to generate electricity for cryptocurrency mining operations is unquestionably “removed or recovered” from the ground. Therefore, a lease must guarantee that the driller pays royalties on that gas if the lease is to be valid. But, oil and gas owners should remain aware of the types of oil and gas activities occurring on the leasehold in order to ensure that they are being paid correctly.

Cryptocurrency mining and other on-site uses of oil and gas offer new potential commercial opportunities for drillers and can benefit oil and gas owners as well. However, as the Hobe Minerals case indicates, oil and gas owners should be vigilant about where and how gas is sold and whether operations are being conducted in compliance with the lease. If you have questions regarding compliance with your oil and gas lease, contact attorney Brendan O’Donnell at 412-288-2226.