The Oil and Gas Addendum

This is a familiar but troubling issue for a growing number of landowners throughout the Marcellus Shale fairway. Imagine you own 145 acres in Tioga County, Pennsylvania. You sign a lease with a modest signing bonus in 2007. You soon realize that your signing bonus is considerably less than your neighbor who signed after you. You contact the landman and inquire why. He tells you not to worry because a Marcellus well will soon be drilled on your property and the monthly royalties will be “tens of thousands” of dollars.

After months of inactivity, operations finally commence in the summer of 2009 and the vertical well bore is completed that August. Your landman enthusiastically tells you that the vertical shaft has “bottomed-out” at 8,175 feet and will be “perforated” soon. The horizontal well bore is then completed and is hydraulically stimulated in September. You are excited. You anticipate paying off that farm loan and growing your children’s college fund. And then nothing happens. For months.

You then receive an unusual check in the amount of $1,225.00 the following September. You now receive that same check every September. There has been no activity at the well pad site in years. The closest pipeline is several miles away. The primary term of your modest lease has expired but the gas operator refuses to surrender the non-producing lease, citing the September “shut-in” royalty payment. Your excitement has been replaced with frustration and anger. How long can the well remain shut-in? Does the gas operator have any obligation to actually market “my” gas? These questions involve two unique oil/gas concepts that are often at odds with one another: the implied covenant to market and the typical shut-in royalty clause.

This rule, in a majority of jurisdictions, requires actual production and marketing of natural gas. Unlike oil, natural gas cannot be produced and then stored or transported in railroad cars or tank trucks – post-production facilities such as pipelines, compressors and dehydrators are generally required to process and deliver the gas to market. In such circumstances where a gas well has been completed but no market exists for the gas, the shut-in clause enables a lessee to keep the non-producing lease in force by the payment of the shut-in royalty. See, Tucker v. Hugoton Energy Corp., 855 P.2d 929, 936 (Kansas 1993)(“…upon payment of the shut-in royalty it will be considered as if gas is being produced within the meaning of the habendum clause…”). Such payment serves as “constructive production” and avoids application of the automatic termination rule.

The ability to declare a well shut-in and simply tender a shut-in royalty in lieu of a production royalty does not occur automatically. There is no inherent right to shut-in a completed oil/gas well. Like other lease saving clauses, the shut-in royalty clause must be specifically negotiated as part of the parties’ lease. If no such clause appears in the parties’ lease, the lessee runs the risk of forfeiting the lease due to non-production if the well is taken out of operation.

Unlike the shut-in royalty clause, an implied covenant to market gas exists regardless if such an express “marketing” clause is set forth in the parties’ lease. What are implied covenants? Implied covenants in oil and gas leases originated in the 1890’s as a means of “filling in the gaps” that the express terms of the lease failed to address or even consider. In Stoddard v. Emery, 18 A. 339 (Pa. 1889), in one of the first implied covenant cases, the Pennsylvania Supreme Court noted that “[H]ad there been nothing said in the contract [on the duty to drill additional wells] there would of course have arisen an implication that the property should be developed reasonably…” Stoddard, 18 A. at 339. Since Stoddard, courts have “implied” certain additional duties and obligations on every lessee, regardless of the express terms of the lease. Most jurisdictions recognize at least three (3) implied covenants in every oil/gas lease: the implied covenant of reasonable development, the implied covenant to prevent drainage and the implied covenant to market gas.

The marketing covenant requires a lessee to use due diligence to market the gas and to obtain the best possible price. The implied duty to market is an obligation imposed upon a lessee to make a “diligent effort to market the gas in order that the lessor may realize a return on his royalty interest.” See, Davis v. Cooper, 837 P.2d 218 222 (Colo. App. 1992). The covenant implies that if gas is discovered in paying quantities, the well will be operated so as to secure actual production royalties. The covenant requires the lessee to “begin marketing the product within a reasonable time” after completion of the well. See, McVicker v. Horn, Robinson & Nathan, 322 P.2d 410 (Okla. 1958). Failure to diligently market the gas will result in the breach of the marketing covenant and possible forfeiture of the lease itself.

The lessee’s obligation to market the gas is not relieved or suspended by the decision to shut-in a well. The lessee must still act as a reasonably prudent operator in attempting to market the gas. This includes completing the necessary down-stream facilities such as pipelines and compressors. As one court noted:

“[T]he fact that the lease is held by payment of shut-in gas royalties does not excuse the lessee from his duty to diligently search for a market…”

See, Pray v. Premier Petroleum, 662 P.2d 755, 758 (Kan. 1983). Thus, even if the lessee’s initial shut-in of a well was valid and legitimate, the lessee cannot ignore or neglect its duty to market the gas. It must make some effort to market the gas after completing the well. Mere payment of the shut-in royalty will not negate this duty.

The express terms of the shut-in royalty clause can often create tension with the marketing covenant. Many shut-in clauses contain no time limitation and arguably allow the lessee to maintain the shut-in status indefinitely. At some point, after a well has been shut-in for several years, the marketing covenant will be impacted and the lessee will be required to explain and justify the prolonged shut-in status. While there have been relatively few cases addressing this issue, this is likely to change in the near future. Throughout the Marcellus fairway many wells have been drilled and hydraulically stimulated but remain shut-in due to the lack of pipelines. These leases cannot be maintained forever by the simple payment of the shut-in royalty. Litigation is inevitable.

In order to mitigate this tension in the future and avoid litigation, landowners and gas operators alike should consider revising the shut-in royalty clauses in their leases. The clauses should clearly define the permissible reasons for shutting-in a well and, more importantly, they should place a reasonable limit on how long the shut-in period can last. For example, a clause that reads as follows balances the need for shut-in capability with the obligations mandated by the marketing covenant:

“It is understood and agreed that this Lease as to its entirety cannot be maintained in force solely by the payment of the shut-in royalty for a period in excess of two (2) years…”

Alternatively, a landowner that is concerned with an unduly long shut-in can request and negotiate a “stepped-up” royalty, which increases the royalty as the marketing delay continues. These clauses often provide for a significantly higher annual shut-in royalty in years two (2) and three (3) of the shut-in period. Such clauses serve as a disincentive to prolong the shut-in period and encourage compliance with the marketing covenant. A third, albeit more dramatic, shut-in limitation mechanism is the acreage severance clause. These clauses obligate the lessee to release and sever the undeveloped lease acreage if the shut-in period exceeds a fixed time period, usually three (3) to four (4) years. Again, such clauses encourage the lessee to actively find a market for the gas or face possible severance of undeveloped acreage.

The shut-in royalty clause is a necessary and integral component of any oil/gas lease. The ability to shut-in a well, however, must be balanced with the obligation to diligently market the gas and generate production royalties. Both concepts can and should be harmonized to mutually benefit both the landowner and the gas operator.