The Oil and Gas Addendum

The modern producing gas well is a sophisticated and complex piece of equipment.  The basic well head itself consists of several meters, valves and other components, each of which is under constant stress and pressure.  In addition to the well head, the producing gas well will be connected to an active network of gathering and transmission pipelines.  Proper maintenance is a necessary and ongoing activity at any well site.  Such maintenance, however, often requires the producer to take the well temporarily out of production.  Moreover, unexpected breakdowns can and do occur over the life of a well.  These breakdowns inevitably also take the well out of production.

In the absence of a specific clause in the applicable lease, it is unclear under Pennsylvania law exactly how much “time” a producer has to repair or rework the well before the entire lease will be declared terminated due to non-production.  Pennsylvania has historically applied the “automatic termination rule” during the secondary term of a gas lease.  Under this harsh rule, the secondary term of a lease will automatically expire unless there is a well producing gas “in paying quantities.”  See, Cassell v. Crothers,44 A. 446 (Pa. 1899) (“the moment she failed to produce oil in paying quantities, that moment the tenancy became a tenancy at will . . . “); Brown v. Haight, 255 A.2d 508 (Pa. 1969) (“when oil and gas were not produced in paying quantities, the grantee’s fee interest terminated automatically . . .”); White v. Young, 156 A.2d 919 (Pa. 1963) (failure to produce gas in paying quantities results in termination of lease after primary term expired); See also, Non-Production During Secondary Term Results in Termination of Lease (November 2011).

As such, any cessation of production during the secondary term, even one for routine maintenance or repair, will theoretically trigger the “automatic termination rule” and terminate the lease.  In order to mitigate application of this rule, many oil and gas leases contain what is known as a “temporary cessation of production” clause (“TCOP”).  Such clauses recognize that it is nearly impossible for a driller to operate a lease continuously without any interruptions.  A TCOP clause “presumes that the parties understand that mechanical problems, re-working operations or other similar events would inevitably interrupt production from time to time”.  See, Natural Gas Pipeline Co. v. Pool, 124 S.W. 3d. 188, 204 (Texas 2003).  Most TCOP clauses give the driller a fixed time period to remedy the mechanical breakdown and restore production.  But what happens if the driller does not commence the re-working operations within the designated time period?  The North Dakota Supreme Court recently addressed this issue and ruled that the underlying leases expired because the driller did not engage in timely reworking operations.  This is potentially good news for landowners with a dilatory and lethargic driller.

At issue in Zavanna LLC v. Gadeco LLC, et al. (North Dakota Supreme Court, No. 2022-0265, August 2, 2023) were several competing oil and gas leases encumbering 1,280 acres in McKenzie County, North Dakota (the “Subject Property”).  Gadeco LLC (“Gadeco”) and Continental Resources each held leases on the Subject Property (the “Bottom Leases”).  The Bottom Leases were subsequently pooled into the Golden Unit.  In May 2012, Gadeco drilled and completed the Golden 25-36H well (the “Golden Well”).  The Golden Well was the only well producing oil and gas in the Golden Unit.  On July 14, 2014, the electronic submersible pump (“ESP”) located within the Golden Well failed and, as a result, the Golden Well ceased producing hydrocarbons.  The Bottom Leases all contained a similar cessation of production clause which generally provided as follows:

If after discovery of oil or natural gas on said land or on acreage thereon, the production thereof should cease from any cause after the primary term of this lease, this lease shall not terminate if Lessee commences additional drilling or re-working operations within ninety (90) days from date of cessation of production or from date of completion of dry hole.

In 2019, Zavanna obtained “top leases” on the Subject Property[1].  Shortly thereafter, Zavanna brought suit claiming that the Bottom Leases had expired.  Specifically, Zavanna contended that Gadeco failed to commence reworking operations on the Golden Well within ninety (90) days of July 14, 2014.  Zavanna argued that after the ESP failed, the only way to restore production was to arrange for a workover rig to pull the failed ESP out of the Golden Well and replace the failed ESP with a new pump.  Zavanna alleged that Gadeco did not even order the new ESP until October 8, 2014.  And the workover rig did not arrive at the Golden Well until December 4, 2014.  The new ESP was not installed until February 2015. Based on these facts, Zavana contended that reworking operations did not commence within the requisite 90 day window.  As such, Zavanna argued that the Bottom Leases expired due to non-production on October 12, 2014 (i.e. day 90).

In response, Gadeco argued that it did commence reworking operations within the 90 day time frame. Gadeco disputed and denied that reworking operations could only “commence” by having a workover rig at the Golden Well. Gadeco argued that the commencement of testing and other preparatory steps must qualify as reworking operations. For example, Gadeco argued that the initial troubleshooting and investigation of the ESP failure conducted in early August 2014 were essential components of the reworking operations and therefore satisfied the 90 day clock. Moreover, because Gadeco needed a custom replacement ESP, time had to be spent consulting with the manufacturer and designing the new pump. In essence, Gadeco suggested that merely diagnosing the problem and formulating a solution constitutes the commencement of reworking operations. Finally, Gadeco argued that market conditions in North Dakota during this time impacted the availability of an appropriate workover rig and that it nonetheless proceeded with due diligence.

The matter proceeded to a bench trial in June 2021.  In March 2022, the trial court issued its findings of fact and conclusions of law and entered judgment against Gadeco and in favor of Zavanna. The trial court concluded that the Golden Well ceased production on July 14, 2014 and that Gadeco was fully aware of the ESP failure by August 1, 2014. Nonetheless, Gadeco did not order the replacement ESP until late October and did not have a workover rig at the site until December 4, 2014. Based on these facts, the trial court opined that Gadeco did not make a bona fie effort to commence reworking operations within the 90 day period. The trial court noted that for activities to constitute reworking operations, equipment must actually be at the site “that was both physically impacting the Golden Well and resolving the physical difficulty that caused the Golden Well to cease production.”  Gadeco did not meet this test until December 4, 2014. As such, the Bottom Leases expired and terminated as a matter of law. Gadeco filed an appeal to the North Dakota Supreme Court.

The threshold issue before the North Dakota Supreme Court was defining exactly what constitutes reworking operations as opposed to rudimentary drilling operations. This distinction was crucial because a different standard applies to the commencement of drilling operations. The Supreme Court noted that the term itself was not defined in the Bottom Leases. Given this omission, the High Court was compelled to examine prior North Dakota caselaw as well as cases from other oil and gas jurisdictions to develop a practical and objective rule. For example, the panel noted that jurisdictions such as Texas and Alabama have observed that “[O]perations or activities which are not designed to revitalize a well, or restore lost production, do not constitute reworking” and that the purported operation “must be intimately connected with the resolution of whatever physical difficulty caused the well to cease production.” Along those lines, the Supreme Court re-affirmed and clarified the definition of “reworking operations” under North Dakota law:  

While it is clear that routine maintenance procedures, such as the periodic starting of the pump on the lease to keep it in running operation, do not constitute reworking operations, testing and other essential preparatory steps conducted on the well site and directly related to resolving the difficulty can constitute under certain circumstances the commencement of reworking operations.  However, inherent within the concept of “reworking operations” is a duty to continue operations with due diligence after “commencement,” the activities must be conducted in a bona fide effort to restore the well to production as soon as possible.  In other words, minimal preparatory steps taken within the [reworking] period followed by a lengthy period of inaction would not constitute the “commencement” of reworking operations.

Unlike the test utilized when analyzing whether drilling operations have commenced, remote, off-site preparatory steps are generally not enough to qualify as reworking operations. The Supreme Court held that merely diagnosing the ESP failure and then working with the manufacturer was not enough: “[T]he district court found Gadeco’s diagnosing the ESP failure, assisting Baker Hughes in designing the new ESP, ordering the ESP from Baker Hughes were ‘minimal preparatory steps’ and were not continued with the required diligent efforts….”.  Given these facts, the Supreme Court affirmed the trial court’s findings and concluded that the Bottom Leases expired on October 12, 2014.

Although not binding on Pennsylvania courts, the Zavanna opinion provides an objective and pragmatic test to evaluate when a driller actually commenced reworking operations. As noted by the Zavanna court, this is a different and somewhat more strict test than the one employed when evaluating whether initial drilling operations have commenced on a new well. In other words, the standard to restore and restart production on an existing well is higher than when evaluating whether a driller has commenced drilling operations on a new well (i.e. whether a lease may have expired at end of primary term due to non-production). The hallmark of this test is clear:  mere preparatory work performed off-site is not enough. The driller must actually be at the site and physically engage the well and the problem on a consistent and diligent basis. If you have an oil and gas lease and you are concerned that your driller is not engaging in diligent operations, please call Robert Burnett at 412-288-2221.

[1] A “Top Lease” is a lease granted by a landowner during the existence of a recorded lease which is to become effective if and when the existing lease expires.