Texas Appellate Court Rules that Lease Terminated Due to Twelve Months of Non-Production

July 18, 2021

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. Can a brief cessation of production terminate an oil and gas 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 expire and terminate due to non-production. Pennsylvania has historically applied the “automatic termination rule” during the secondary term of a gas lease. Under this 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).

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. Most modern oil/gas leases recognize the inflexibility of this rule and contain what is known as a “temporary cessation of production” clause (“TCOP Clause”).  These clauses, however, are often used by drillers to justify extended and unreasonable periods of non-production that are unrelated to legitimate maintenance or repairs. A recent appellate court in Texas rejected the driller’s reliance on the TCOP Clause in the parties’ lease and ruled that the underlying lease expired due to twelve (12) months of non-production.

At issue in Gramrich Oil & Gas Corporation, et al  v. William C. Meng ( No. 11-19-00022-CV, May 28, 2021),  was a 1996 Lease covering 2,000 acres in Throckmorton County, Texas. The driller, Gramrich Oil & Gas Corporation (“Gramrich”), pooled portions of the 1996 Lease into three forty (40) acre production units- Unit #2, Unit #4 and Unit #7. Gramrich drilled one well in each Unit. The lone wells in Unit #2 and Unit #7 ceased production in September 2014 and the well in Unit #4 ceased production in June 2015. The 1996 Lease contained a TCOP Clause which provided as follows:

[1] If, after the expiration of the Primary Term, production shall cease on any unit, or units, Lessee shall have the right at any time within sixty (60) days from the first of such cessation to begin drilling or reworking operations in the effort to make any or all such units again produce oil or gas, in which event this Lease shall remain in force thereon so long as not more than sixty (60) days shall elapse between the completion of one such operation and the beginning of another, and if production of oil or gas is therefore resumed, so long thereafter as oil or gas is produced from the subject units.  [2] However, in the event of said cessation, if sixty (60) days elapses during which no such operation is executed, this Lease shall terminate as to any unit designation on which there has been no production of oil or gas for said sixty (60) days, save and except ½ acre around the wellhead for a period of one year. [3] After the Primary and any Extension of this Lease, the term “reworking operations”, as operative in this clause, shall be more exactly construed to mean “major overhaul or replacement of pump-jack or engine, or working in the bore-hole.[”]  [4] Furthermore, yet not to include shut-in gas wells, if twelve (12) months shall elapse during which a unit does not produce in paying quantities, this Lease shall terminate on any such well.

In 2016, Gramrich filed suit claiming that the landowner, Meng, was interfering with its operations. Meng defended the suit on the grounds that the 1996 Lease had expired due to non-production and that Gramrich had no right or authority to enter upon the property. In support of his claim, Meng argued that with respect to the wells on Unit #2 and Unit #7, it was undisputed that there was no oil or gas production after September 2014. Given this undisputed evidence and the last sentence of the TCOP Clause, Meng argued that the 1996 Lease expired as to Unit #2 and Unit #7 in September 2015. Likewise, with respect to the well on Unit #4, Meng argued that the 1996 Lease expired as to that acreage in August 2015- sixty (60) days after the cessation of production in June 2015. Because Gramrich had not commenced re-working operations during the sixty (60) day window mandated by the TCOP Clause, Meng argued that the 1996 Lease automatically expired and terminated at the end of that sixty (60) day period. Meng moved for summary judgment. The trial court agreed and terminated the 1996 Lease and dismissed Gramrich’s suit.  Gramrich then appealed to the Eleventh Court of Appeals of Texas.

On appeal, Gramrich argued that the trial court applied the wrong test when evaluating Meng’ summary judgment motion. According to Gramrich, the trial court erred by failing to consider evidence regarding the economic capability of each well. Gramrich contended that because it offered evidence demonstrating that the subject wells were theoretically “capable” of producing oil and gas in paying quantities, the 1996 Lease did not expire and Meng’s motion should not have been granted. Gramrich further argued that the trial court erred when it ignored production data and evidence after August and September 2015.

The Eleventh Court of Appeals partially agreed with Gramrich’s argument. The panel noted that when examining whether a marginally productive well has ceased to produce in paying quantities, the “profitability [ of that well ] must be measured over a reasonable period of time”. The panel further noted that under Texas law, production in paying quantities “means the production is sufficient to pay the lessee a profit, even small, over operating and marketing expenses….” Finally, the panel agreed with Gramrich that the test to be applied when evaluating whether a lease expired due to cessation in paying quantities is two-fold: i) the proponent must establish that production over a “reasonable time” did not yield a profit over operating expenses and ii) a prudent operator would not continue operating the well for mere speculation. But, the panel disagreed with Gramrich on one significant point: this test does not apply when there is a complete cessation of production.

The Eleventh Court of Appeals correctly made a distinction between a marginally producing well and a well that produces nothing. With respect to the latter, profitability is not a required element of the landowner’s lease expiration claim:

“[W]hen there has been a total cessation of production, the two-prong cessation of production in paying quantities analysis does not apply….Simply put, production in paying quantities cannot occur if production ceases. Accordingly, Meng did not need to address the profitability of obtaining production from Unit No. 2 and Unit No. 7 because he alleged, and the record establishes, a complete cessation of production for over twelve months…”

Given the total cessation of production, the panel affirmed the trial court’s finding and held that the 1996 Lease expired and terminated as to Unit #2 and Unit #7 in September 2015. Although Gramrich argued that the last sentence in the TCOP Clause required the court to evaluate whether the wells could produce “in paying quantities”, the panel rejected this construction because “production in paying quantities does not occur when there is no production.” The author submits that the rationale adopted by the Eleventh Court of Appeals was and is correct: a well that produces nothing should be treated differently than a marginally producing well.

The panel also held that the 1996 Lease expired and terminated as to Unit #4. The first and second sentences of the TCOP Clause required Gramrich to commence re-working operations within sixty (60) days of the cessation production. Here, it is was undisputed that the well in Unit #4 ceased production in June 2015. Gramrich made no effort to resume production or commence re-working operations over the next sixty (60) days. The panel correctly ruled that the express terms of the TCOP Clause were not satisfied and that such non-compliance resulted in the automatic termination of the 1996 Lease.

In sum, the Gramrich decision is good news for landowners. Although not binding on Pennsylvania courts, the logic and rationale espoused by the Gramrich panel is persuasive and compelling. When evaluating lease expiration claims, Pennsylvania courts should make a distinction between wells that are marginally producing from those that produce nothing.

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