Oil & Gas Leases: The Most

Important Contract in the Industry

Oil & Gas Contracts – Energy Law I – Fall 2023
Presented by Adjunct Professor, Amanda L. Clark, Esq., CPL
 Outline of Discussion
II. The Preston v. Chesapeake case –
I. Oil & Gas Lease Provisions sufficient/adequate legal description and the One
i. Term – Primary and Secondary Contract Rule
ii. Royalty/Bonus
iii. Timing/Method of Royalty Payments
iv. Delay Rentals
v. “Commence Operations”
vi. Shutin Royalties/Payments
vii. Pooling Clauses
viii. Options to Extend
ix. Pugh Clauses
x. Post-Production Costs/Royalty Deductions
xi. Continuous Operations Clause
xii. Depth Severances
xiii. Assignment Clause
xiv. Other Clauses
 Oil & Gas Leases (OGL)
No Lease, No Grease
An OGL is a contract between at least two parties, the Lessor (mineral owner) and the Lessee (oil & gas company or broker). It is a contract because it contains the
terms under which the minerals will be developed, the consideration (money) that will be given to each side, and the promises and obligations of both parties. Most
states also consider an OGL to be a conveyance of mineral rights from the mineral owner to the Lessee oil & gas company/operator. This is because as you will
recall, one of the characteristics of mineral ownership is the right to explore and develop the minerals as well as to use the surface to develop the minerals (the
mineral estate is dominant to the surface estate). The mineral owner leases or conveys these rights for a period of time to the oil & gas company so that the
company can develop the minerals and both parties will profit from it. They convey or grant the use of some of their rights in the mineral estate to the Lessee, so
the OGL is not only a contract, but a grant or conveyance of these rights from the mineral owner that is limited in time. As a conveyance of real property, it must
comply with the Statute of Frauds.
The oil and gas lease conveys this interest with a Granting Clause. A granting clause has three main parts and we have to ask ourselves, what three things must the
granting clause include in order to be valid? In order to be valid the granting clause must do the following:
1. It must identify the size of the interest granted. – Generally, leases will grant 100% of the interest to the minerals in the described tract even when the mineral
owner owns less than 100% of the minerals under the tract. However, leases are often taken without a comprehensive title search being performed due to the
nature of competition for leases. By leasing 100% the company does not risk losing out on minerals, though the mineral owner could be at risk of breaching a
warranty of title. Usually, a lease will also contain a lesser-interest clause where both parties acknowledge that the lease describes 100% of the interest, however,
the Lessor may not own 100% of the interest described and their payments will be reduced to whatever % they do actually own.
2. It must identify what substances are covered by the grant. Generally, a lease will include “oil, gas, other minerals, and all hydrocarbons produced therewith”.
The definition of minerals varies from state to state and has changed over the years causing a bit of confusion. For instance, does a lease that includes oil, gas,
and other minerals include coal? In some states the answer is yes, and in others it is no. Additionally, are the biproducts of oil & gas productions such as helium,
carbon dioxide, natural gas liquids, and sulfur included? It depends on the state laws unless the lease language is specific; the more specific the better.
3. What lands are covered by the lease? The lease must describe with legal sufficiency the lands conveyed. This means that like with a deed the legal description in
the lease must describe the lands so they can be located with reasonable certainty. They must also be able to be identified solely by reference to the public record
without outside information. This means you need to use the legal description system such as the Jeffersonian system, rectangular system, or metes and bounds
system that is common in your state. The best practice is to copy the legal descriptions from the deeds for the land you are leasing. Also, you want to be sure to
include any lands that the person owns which may be attached to the described lands, but mistakenly not described. This language is called a Mother Hubbard
clause or cover-all clause and generally says the lease is intended to include all lands owned by the landowner in a specific area. The goal is to protect the Lessee
from any inaccuracies in the legal description.
 Oil & Gas Lease Provisions
Term – Primary and Secondary
Once production is obtained, the Lessee wants the right to maintain the lease for as long as production is
economically profitable. They use the habendum clause in an OGL to accomplish this as well as shut-in payments or royalty
clauses in the lease. A habendum clause comprises the secondary term of the lease. The primary term is the initial period of
time the lease can be held without drilling. The secondary term is the period of time the lease will be held by production. A
habendum clause reads something like this “…for a period of three (3) years and for so long thereafter as oil & gas or other
minerals are producing in paying quantities…”. Not all habendum clauses are the same and you have to understand what
constitutes production in your state. (See also slide about production at the end of this slide show which is FYI and will be
covered as a case analysis later in class.)

Royalty/Bonus
Lessors get paid an up front per acre bonus and also are paid a percentage of the production called a royalty
payment. They are also entitled to bonuses and other payments for delay of drilling, shutting in wells, etc. The bonus and
royalty are generally based on fair market value in the area where you are leasing. This requires the person taking the lease
(Lessee) to have a good understanding of what is going on in the market around them. While the royalty is always spelled
out in the lease, the bonus generally is not and both are agreed upon in an offer letter agreement.

Timing/Method of Royalty Payments – Sometimes within the royalty clause and sometimes a separate clause, this tells the
company how, when, and where they must make their payments of royalty. This clause can be modified by a signed Division
Order. If there is no timing listed (payment within so many days of production) then the timing is governed by state law. In
Oklahoma, it is 6 months from the date of first sale of production. See 52 O.S. 52-570.10 (2019)
https://law.justia.com/codes/oklahoma/2019/title-52/section-52-570-10/
 Oil & Gas Lease Provisions
Delay Rentals
Lessor’s goals are generally somewhat aligned with the Lessee. They are seeking to gain a profit from the
production of the minerals they own. They receive this in the form of bonus, rental, and royalty payments which are spelled
out and established by the lease. Where they can differ is that the Lessor wants to ensure the minerals are developed and
doesn’t want the Lessee to be able to “hold” their lease hostage while they decide whether or not to drill the lands. The
Lessor will add delay rentals which charge the Lessee a payment if they delay drilling.
Delay rentals in a lease provide a lessor with a payment for the delay of drilling the initial well under the lease
during the primary term. These are payments usually made yearly during the primary term to delay the drilling of a well.
Usually, the lease requires the Lessee to drill a well within a year or pay the rentals and has this same requirement each year
until a well is drilled or the primary term ends, whichever comes first.
Delay-rental clauses are very common in leases and until recently have been a very easy way to lose a lease. This
is because delay rentals can be written so that “unless” the rentals are paid (or a well is commenced), then the lease
terminates. This meant that making a delay rental payment even one day late could result in the automatic termination of the
lease. As you can imagine, Lessees did not like this type of clause. The initial answer to the problem was to include a
different type of delay rental clause, one that said the Lessee must either commence a well “or” pay the delay rental payments
“or” surrender the lease. Courts interpreted these types of clauses to give the Lessee an affirmative duty to make the
payments, but not to as a way automatically terminate the lease in the event they are not made on time.
These days, companies are just paying all of the delay rentals up front with the bonus payment (best practice is by a
separate check labeled “delay rentals”) so they do not risk losing the lease due to late delay rental payments. This is practical
because the delay rental cost is usually very small when compared to the cost of losing a lease. These pre-paid delay rental
leases are called Paid-Up Leases and are common practice in the industry now, though always read carefully to determine if
your lease is paid up or if you need to make delay-rental payments. Be sure you determine in the event your lease is not paid
up whether you are dealing with an “unless” delay rental clause or an “or” delay rental clause because it could make a big
difference in how you decide to pay delay rentals.
 Oil & Gas Lease Provisions
“Commence Operations”
Operations clauses in the lease define what needs to be done in order to “commence operations”
under the lease to extend the lease into its secondary term. The law in each state is different for what this
means, so you want to be sure you make it clear in the lease what the two parties mean by “commence
operations” because often drilling schedules are made based on when exactly a lease will expire and what
the company must do to hold it, i.e., move dirt, actually spud the well, drill to producing depth, etc. You
need to be sure to always read your lease so you know exactly what is required by the operator to extend
the lease to the secondary term

Shutin Royalties/Payments
OGLs can also contain shut-in clauses that allow a gas well to be shut-in for a period of time so long as
the company pays the Lessor a per acre amount specified in the lease on a yearly basis (usually). These
payments constitute a substitute for production and by making timely shut-in payments it as if the well is still
producing though it is shut-in. These can usually only be paid on gas wells and on wells that are working and
are capable of production, not broken wells. A broken well triggers the cessation clause in a lease and the
operator must get the well working and producing again in a specified amount of time or they forfeit the lease.
(See also the FYI slide following this one.)
 Oil & Gas Lease Provisions
Pooling Clauses
Pooling refers to the bringing together of small tracts or fractional mineral interests to drill a single well for primary
production on a spacing/drilling unit. (This is different from unitization which refers to combining leases and wells over a
producing formation for field-wide operations, usually for pressure maintenance, secondary recovery or tertiary recovery, but
NOT primary recovery.) Pooling clauses in leases give the lessee authority to commit the leased lands to a pooled unit and
adjust the rights of the lessor accordingly. This allows companies to pool leases together and to only need to pay the lessor
for their proportionate share of production. Otherwise, the lessor must drill on the lessor’s lands and must account to them
for 8/8ths of production. This is a problem with small tracts of land where it is not economic to drill on the lands.
Additionally, compulsory pooling means that a small tract owner can not hold up tract owners from pooling. It is also helpful
when owners cannot be found because they have disappeared or not properly conveyed their interests to the next successor in
interest. Without pooling clauses and compulsory pooling statutes, small mineral interests could never be drilled because it
would not be economic or efficient. Therefore, pooling helps prevent waste and protect correlative rights as well.

Options to Extend
These are clauses that give the Lessee the option to extend the lease at the end of the primary
term, provided they do something, usually pay another bonus by a certain date. The clauses include
language about what must be done, by when, and how long the lease will be extended as well as
language regarding how to show in record title the lease has been extended – usually by filing a
Memorandum of Lease Extension stating that the lease has been extended and to when. These
Memorandums must be signed by both the Lessor and Lessee since they amend the original lease. (See
Chesapeake Lease Example)
 Oil & Gas Lease Provisions

Pugh Clauses - Limit the amount of acreage wells can hold.

Vertical Pugh Clause/Depth Severance Clause: This is a clause in the OGL that says at the end of the
primary term, the lease will expire as to certain depths vertically located under the earth. Usually, it is the deepest
producing formation, etc. The effect is that all depths outside the description in the Pugh clause expire (are no longer
held by the existing lease) at the end of the primary term and if the Lessee (or anyone else) wants to drill to those
depths, they will need to negotiate a new oil and gas lease with the Lessor/Mineral Owners. These are also referred to
simply as depth severances.
Horizontal Pugh Clause: This is what we traditionally think of as a Pugh Clause in an OGL. When a lease
covers more than one tract of land, the Pugh Clause says that the lands not drilled upon or included in a drilling unit
at the end of the primary term expire or are no longer held by the lease. The net effect is that a new lease must be
taken before the Lessor (or anyone else) may drill on those lands. Some states like Oklahoma has a Statutory Pugh
Clause that is implied on every lease. https://www.pagaslease.com/oil-gas-glossary/oklahoma-statutory-pugh-clause/

THIS IS A GOOD PLACE TO NOTE THAT YOU SHOULD BE AWARE OF ATTACHED EXHIBITS TO THE
LEASE WHICH MAY ALTER THE TERMS IN THE MAIN DOCUMENT
 Oil & Gas Lease Provisions

Post-Production Costs/Royalty Deductions – These clauses, sometimes contained within the royalty clause and sometimes
separate define what costs each party bears for the costs to get the oil and gas to market and into a sellable condition. These
vary greatly and are the subject of much of the oil & gas litigation we see in the courts. Absent a clause in the lease, state law
governs what can be deducted. See the FYI slide at the end for a discussion of what costs are deducted by law. This topic
could be its own class.

Continuous Operations Clause – These clauses (sometimes found in the Term clause) effective both at the end of the primary
term and during the secondary term address what happens if operations have started, but the well is not producing by the end
of the primary term, and what happens if operations cease at any time on the lease. They give a time limit for how long there
can be no operations on the leased lands prior to expiration of the lease. This is a nod to the reality that wells break down and
sometimes take time to fix. Parts must be ordered, contractors employed, etc. and this can take some time. You want to be
sure you give your Operator clients enough time to fix the wells, and if representing the mineral owner, you want to not give
the Operator too much time. These are usually anywhere from 30-90 day time limits and they begin once the well is no
longer capable of production. You should note however, that if more than one well is drilled in the drilling unit, then it is
most likely that production from those other wells will hold the lease and this clause will not kick in until ALL production
and operations on the lease has ceased. This is different from a Shutin clause which allows a company to shutin a well that is
still capable of producing for a period of time upon payment of rentals. The cessation clause deals with broken wells or wells
that are no longer capable of producing according to whatever definition the lease or state law provides about what
production is. (See What is Production FYI Slide at the end of this slideshow.)
 Oil & Gas Lease Provisions

Assignment Clause - The assignment clause tells the Lessee if they may assign the lease, to whom, and how they may assign
it. Sometimes an assignment clause includes an obligation that the Lessee receive consent to assign the lease from the
Lessor. (CLO leases in Oklahoma always have this as do BLM and BIA leases.) Most of the time there is a provision that is
the lease is assigned, the Lessee must give notice to the Lessee that this has or will happen. The assignment clause should
address whether or not the Assignor retains responsibility for the obligations under the lease. It should also state who the
lease may be assigned to without notice (such as affiliates, etc.). This would also be an appropriate place to mention that all
covenants and obligations are intended to run with the land and any successors or assigns are bound to those obligations and
covenants express and implied.

Other Clauses - Oil & Gas leases take many forms and can contain many additional clauses. The sky is the limit. Your
Forms Book has several examples of oil and gas leases and the different clauses available. I encourage you to read through
those pages 101-147 as well as the Division Orders at 148-161 and let me know what questions you have.

Some other common clauses are – Surface Use, Off-Site Drilling, Favored Nations, Arbitration, Liquidated Damages,
Alternative Dispute Resolution, Warranty of Title, Use of Gas, Water, and On-Site Resources such as Timber, Force Majeure
(acts of God), Drilling Obligations, Minimum Royalty, Offset Wells, Reclamation & Recovery, Insurance, Definitions, Well
Information, Indemnification, Liens, Release of Lease, Top-Lease Clauses, and Forfeiture Clauses.
 Comparing Lease Language:
The following excerpts are taken from two leases that I handed out to you in class & I will refer to them
as the “Chesapeake” lease and the “Rebellion” lease.

The purpose of these slides is to provide a couple of examples of how various clauses can be written so
you may learn to recognize the language related to those clauses.

Knowing and understanding lease language will help you understand your client/employer’s rights and obligations
under the lease and to inform your advice given in your role with your company/client.
Rebellion Lease – Granting Clause Chesapeake Lease – Granting Clause
 Rebellion Lease – Primary Term and Secondary Term (Habendum Clause)

Chesapeake Lease – Primary Term and Secondary Term (Habendum Clause)

Rebellion Lease – Royalty Clause is #1 and clause # 2 the Shut In Provision which allows SI Royalties,
and explains how to pay them all within the same clause.
Chesapeake Lease – Clause No. 3 is the Royalty Clause which also includes the Shut In Provision Allowing SI Royalties.
How the shutin royalties are to be paid is in the next clause (4).
 Rebellion Lease - Commence Operations Clause

Chesapeake Lease – Commence Operations and Cessation of Production Clauses All-in-One.

Recall also Part (c) of the SI Clause.
Rebellion Lease – “Pooling” Clause (Unitize and Pool are two different things in OK)
Chesapeake Lease – Pooling Clause
 Rebellion Lease – Lessor Interest Clause

Chesapeake Lease – Lessor Interest Clause

Rebellion Lease – Assignments Clause

Chesapeake Lease – Assignments Clause

Rebellion Lease – Top Lease Notice Clause

Chesapeake Lease – Top Lease Notice Clause

Rebellion Lease – Option to Extend (CHK lease doesn’t have one)
Oklahoma Statutory Pugh Clause
 ASSIGNING OIL & GAS LEASES

Oil and gas leases (OGL) are frequently transferred in the industry. There are many reasons for this. Mostly companies are
trying to put together acreage blocks, so they may sell out of an area to acquire more in another area where they are more likely to
drill. Companies and promoters often sell portions of the working interest to investors in exchange for cash to drill the wells.
Additionally, industry professionals are often assigned small pieces of the interest such as an overriding royalty interest in a well
as compensation for their jobs. Assigning portions of the leases spreads the risk and cost of drilling.
Like most real property, lease interest are freely assignable unless reasonable limitations are placed on them in the
documents that created the interest. An example of a reasonable limitation may be that the lessor requires the lessee to obtain its
consent before assigning the lease to a new lessee. This is often the case with state and federal leases. Most leases contain
language in them that permits or reasonably limits assignment of the lease. At common law, when a lease is assigned, the original
lessee (transferor) remains liable for any breaches of the lease. Language in the lease itself or assignment of the lease can change
this common law rule. The person who receives the assignment of lease (transferee) will now be responsible for all provisions
that “run with the land.” Those are provisions which 1. Were intended to run with the land by the original parties, 2. Pertain to
matters that touch and concern the land, and 3. Where there is privity of estate between the original lessor and transferee. Most of
the provisions of an OGL have been deemed to “run with the land.” Transferee assumes all of these obligations and any additional
obligations the assignment may include.

Assignments of OGLs can take many forms and are often preceded by a sales agreement such as a purchase and sale
agreement, a joint venture, or a farmout agreement. OGLs may be assigned in whole or in part. The assignment can be limited to
a percentage of the leases, a wellbore, a term, or to formations. Only an overriding royalty interest or a production payment from
the leases may be assigned. The point is the owner can retain portions of the lease or leases as they see fit.
 ASSIGNING OIL & GAS LEASES

Common Assignments in the Industry Include:

Full Assignment (ASN) – An assignment of all right, title, and interest in and to the lease or leases described in the ASN.
Partial Assignment – An assignment of only a portion or percentage of the lease or leases described in the ASN. This can also
include limitations on which formations or substances are being assigned in the leases as well.
Wellbore Assignment – An assignment limited to the rights held in a specific well or wells. Often you hear the phrases, X
owns the leases in the wellbore and Y still owns them outside the wellbore.
Term Assignment – An assignment limited to a period of time. It usually contains some sort of drilling obligation and the
rights to “earn” the leases indefinitely in whatever wells are drilled during the term. There may also be language granting
the Assignee the right to extend the term so long as they keep drilling wells.
Assignment of Overriding Royalty Interest/Production Payment/Carried Interests – These are assignments not of the leases
themselves or the rights to explore and produce under them, but to payments due under the lease for production, drilling,
etc.
 ENFORCING A CONTRACT TO ASSIGN
Preston Exploration Company, L.P. v. GSF, LLC and Chesapeake Energy Corp., 669 F.3d 518 (C.A.5[Tex.] 2012)
As mentioned before, Assignments are usually preceded by some sort of deal and contract memorializing that deal. This
agreement is generally executed with all of the terms and what leases will be assigned and a form of the Assignment itself may be
attached as an Exhibit to that deal contract (PSA, farmout, joint venture, letter agreement). Once the deal is done and the money
changes hands, then we “paper up” the deal by creating an assignment of the leases to file with the local county courthouse (or all
of the county courthouses where the leases are located) to transfer title and give notice to the world of the new owners. The
Assignment is the vehicle for doing this. Of record title, no matter what the deal says, title is not officially transferred until the
assignment is filed in the courthouse. The Preston case is an example of what happens when the deal is nearly done, but one party
decides to back out before the deal is “papered up” that is, before an assignment is filed.
PROCEDURAL POSTURE: Appeal from the ruling of the trial court in favor of Chesapeake (CHK) that the pre-assignment
contract did not comply with the statute of frauds as none of the Purchase and Sale Agreements (PSAs) or their attached exhibits
had a means or data by which to identify the leases to be conveyed with reasonable certainty (no sufficient or adequate legal
description).
FACTS: June of 2008, prelim negotiations for the sale of certain oil & gas leases from Preston to CHK. Letter of intent to
purchase the leases was entered into with a closing date of August 20, 2008. The closing date eventually was pushed back by
agreement to October 7, 2008. By then (after conducting some due diligence) the parties were not yet ready to proceed with
closing and decided to enter into some PSAs for the leases. (For some reason, the letters of intent were not enough. PSAs should
contain more terms and detail.) The PSAs and attached exhibits were exchanged via email. Preston and CHK executed the PSAs
which provided for a November 7th closing date. CHK did not complain about the attached exhibits at the time, though they would
later argue that the exhibits were incomplete.
 ENFORCING A CONTRACT TO ASSIGN
Preston Exploration Company, L.P. v. GSF, LLC and Chesapeake Energy Corp., 669 F.3d 518 (C.A.5[Tex.] 2012)
RULE: The Texas SOF says to be valid the conveyance must have a sufficient description of the property to be conveyed. This
means the writing must furnish within itself, or by reference to some other existing writing, the means or data by which the particular land
to be conveyed may be identified with reasonable certainty. Wilson v. Fisher, 144 Tex. 53, 188 S.W.2d 150, 152 (1945). It also states that
the writing need not be contained in one document. Padilla v. LaFrance, 907 S.W.2d 454, 460 (tex. 1995) (citing Adams v. Abbott, 151
tex. 601, 254 S.W.2d 78, 80 (1952)).
ANALYSIS: The PSAs contained a granting clause stating that the properties to be conveyed were “all of Seller’s right, title, and
interest in and to all oil and gas leases…[as] defined in Exhibit “A” attached and made a part hereof…” Exhibit “A” contained a list of
leases with 10 columns for each lease description including: Lease ID, Lease Name, Lessee, Effective Date, Gross Acres, Net Acres,
Royalty, ORRI, NRI to be conveyed, and Value of Net. The PSAs also had a provision that said “…title thereto shall be delivered at the
Closing…”. It also contained a provision stating that the Seller would deliver an assignment and attached a form of the assignment as
Exhibit “C”. Additionally, the PSAs contained a complete agreement clause stating that the PSA and the exhibits attached thereto
constituted the entire agreement. Finally, it contained a due diligence clause that allowed for post-closing adjustment of the purchase based
on having to cure any lease title, and a provision that Seller make available all title files to CHK.
The trial court erred when they found that the PSAs standing alone did not contain a sufficient legal description because the PSAs
specifically included the provision that the leases were defined in the attached Exhibit “A” documents. CHK argued that they did not
consider the Ex. A to be a part of the PSA because it was not yet finalized. This led the trial court to find that no meeting of the minds had
occurred as to which properties were to be conveyed. The appellate court said that is not where we should look for the meeting of the
minds in this case because the due diligence clause clearly expressed that both parties knew that more title work was to be done and title
could change, however the meeting of the minds came in agreeing to convey some leases by a certain time and date for a certain price. In
fact, without this meeting of the minds, there is no contract and the SOF argument would be moot.
 ENFORCING A CONTRACT TO ASSIGN
Preston Exploration Company, L.P. v. GSF, LLC and Chesapeake Energy Corp., 669 F.3d 518 (C.A.5[Tex.] 2012)
ANALYSIS: The one contract rule in Texas tells us that multiple writings pertaining to the same transaction will be construed as one
contract and that an unsigned paper may be incorporated by reference into the paper signed by the party sought to be charged. Also, that
“[o]ne writing may be construed with another either expressly or by necessary inference because of internal evidence of the subject matter
and occasion, that is, that they relate to the same transaction.” Oliver v. Corzelius, 215 S.W.2d 231, 237 (Tex.Civ.App. – El Paso 1948)
(Reversed on other grounds.)
CONCLUSION: Here it was clear the parties intended to convey those leases that passed muster under the due diligence standards.
The exhibits were specifically incorporated into the contract, and their lack of finality did not constitute an insufficient legal description to
void the contract. The exhibits themselves did contain sufficient legal descriptions for the most part. The court found that Preston was
entitled to specific performance for the leases listed on the attached Exhibit C Form Assignment’s Ex. “A” limited to those leases which
contained recording information in the description. This means CHK had to pay for those leases and Preston had to assign them to CHK.
TAKEAWAYS –
Be sure you have all of the contracts related to the transaction when you are reviewing an issue. Assume all of the contracts make up
one document, especially if they are referenced in the final executed contract.
Include a sufficient legal description in your contract. If including leases, this must include the recording information for those
leases.
Practical Tip – Include page numbers, 1 of ___, to show how many pages you consider the contract to include. Include the exhibits
in that count.
2008 was when there was a downturn in oil & gas, probably why CHK wanted to back out of the deal. I was an intern there the
summer of 2008 and they had layoffs. Made me wonder if I was in the wrong place…but it worked out and I was there for 10 years.
 ASSIGNMENT OF OGLs

Because Assignments are transfers of real property, they most comply with the Statute of
Frauds.
In order to be effective as a grant, they must contain words of conveyance and an adequate
legal description.
Also keep in mind your clients may be subject to federal laws regarding conveyances.
If you are dealing in KS, the rules may be different due to KS tendency to classify OGLs as
personal property.
 APPENDIX
What is Production? (FYI SLIDE)

As we discussed earlier, the lease contains a secondary term that is based on the length of time that that the well is producing. Now, one would think that production means the same thing in every
state, however, that is not the case. There are three main theories or rules for determining what the words “produced” or “production” mean in an oil and gas lease which is past it’s initial/primary
term and into its secondary term.
1. In most states, actual production is required to extend the life of the oil and gas lease. This means any amount of production so long as the well is actually producing. This position implicitly
requires marketing as well. Texas requires actual production and marketing to extend the life of the oil and gas lease by production. 2.
2. One of two minority views (shared by Oklahoma) is that an oil & gas lease shall not terminate so long as the Lessee discovers oil or gas prior to the end of the primary term. This does not
require actual production; however, discovery requires completion of a well that is capable of production and the Lessee must make diligent efforts to market the oil & gas.
3. There are some cases in Montana, Wyoming, Kentucky, and Tennessee that suggest that discovery of gas is enough to extend the lease, but for oil, you have to have actual production to extend
the lease, therefore, if a well only produces gas, discover is enough, but if a well produces both oil and gas or just oil, then actual production is needed. The reason is that oil can be easily
stored and marketed where gas cannot. It is not the same with gas. With gas you need a pipeline near the well to transport the gas. Many times there is not enough pipeline or if there is one,
there is not enough capacity to be able to add your gas to the line, so marketing gas can take more time.

What does it mean to produce “in paying quantities?” Well, to determine this the courts subject each well to two tests developed for determining whether there has been enough production to
extend and OGL past its initial term. When we are in Oklahoma and we are discussing whether or not a well is capable of producing in paying quantities, you would first need to determine if the
well is capable of production at all. That is, is it broken or able to produce hydrocarbons in its current mechanical condition. If it is broken, then it is not capable of production in paying quantities
and you would want to look at the cessation clause of the lease to see how fast you need to fix it. If the well in its current mechanical condition is capable of producing hydrocarbons, then we
have to ask is it capable of producing them "in paying quantities." To determine what production in paying quantities is, the court has two tests: the litmus test and the legal test. First, the court
looks at the math of the well and compares the operating revenues against operating costs over a reasonable lookback period of time (usually over the past year). The uncertainty here is about
which costs they count as operating costs. Two of the costs they will count are well repair costs and pumper's salaries. When the court compares operating revenues to operating costs over a
reasonable period of time (usually the past year), if the well comes out making money (or in the black) then the well is said to be capable of producing in paying quantities and the court will not
move on to the second test. If the well fails the litmus test because the costs are greater than revenues, the court will move on to the legal test to determine if the well is still able to hold the leases.
For the legal test the court will consider "all matters which would influence a reasonable and prudent operator" and will say that the "lease continues in existence so long as the interruption of
production in paying does not extend for a period longer than reasonable or justifiable in light of the circumstances involved." Some people thought this meant that a court has to issue a ruling to
determine when a lease terminates due to failure to produce in paying quantities, but a recent case held "a lease terminates automatically by its terms when a lack of paying quantities extends for an
unreasonable time." Some states who follow the minority view of production in paying quantities analysis only use the litmus test and never get to the legal test (Kansas for example). However, in
Oklahoma, we use both tests. Texas does not follow these rules at all and subscribes to a different view of what production is, they just need actual production in any amount. So in other words,
Oklahoma is a very pro-operator state and will not automatically terminate a lease simply because the well is not profitable. They also have to ask if a reasonable and prudent operator would
continue to operate the well. The biggest limits on that which we know of are one, length of time without production in paying quantities, and two, that continuing to operate the well to hold a
lease for speculation purposes is not reasonable or prudent. An operator cannot continue to operate an unprofitable well to hold a lease simply because they plan to use the lease to drill another
well or a new play pops up and they want to hold the lease because it is now worth more money. That is for speculation purposes.
 APPENDIX
(FYI Slide – SI vs. Cessation of Production Clause)
A shut-in clause in an oil and gas lease allows a lessee to substitute payment of shut-in royalties for production when a gas well is shut-in. The payment of rentals is a substitute
for production or is "constructive production." This rule evolved because the majority of states follow the rule that says you need actual production and marketing of that
production to extend a lease into it's secondary term. Because it is common practice to need to shut-in gas wells after they are completed to wait on a pipeline to be built so the
gas can be marketed, it is difficult to achieve actual production and marketing of that production for gas wells in those majority view states such as Texas. The SI clause allows
the operator to pay rentals which serve as a substitute for production (basically, by contract redefining what production is when a gas well is shut-in to alter the majority rule).
Operators need these clauses so they are not penalized for having to wait on a pipeline being built to extend a lease into it's primary term. Without them, gas wells would likely
never get drilled in majority view states. In states observing the majority rule, the failure to pay shut-in payments on time or in the right amount can result in the termination of the
lease depending on the lease language. In states like OK where all that is needed is the mere discovery of oil or gas and a well capable of producing in paying quantities, failure
to pay SI payments is not something that will terminate a lease unless the lease language specifically says it will. Otherwise, failure to pay them results in a debt owed. Rather
than a lease termination in Oklahoma, the lessor is just owed his SI payments. It is s debt owed, not a terminating factor (unless the lease specifically says otherwise).
It should be noted that if a well is classified as an oil well in a majority view state, you cannot shut the well in and pay SI payments because one, they usually only apply to gas
(unless the lease says oil which it usually will not, but hey read it and see) and two, there is always a market for oil because you can always pull up a truck to the tank and cart it
away. There is no waiting on an oil pipeline to market. In Oklahoma, technically, you could SI an oil well, but remember that discovery requires completion of a well, capability of
production, and diligent efforts to market. Since you should always be able to market oil, you cannot hold a lease even in OK with just an oil well (unless the SI clause includes
oil wells). Remember, to be shut-in, a well must be still capable of producing hydrocarbons, usually gas, so if the well is broken, you cannot use the SI clause to hold the lease.
You have to look at the cessation clause and the continuous operations clause or possibly force majeure clauses or implied covenants in the lease to save it if the well is broken.

When asked to determine if a well can be SI, your analysis as a Landman looks like this:
1. Find out from the technical team if the well is broken or still capable of production.
2. If broken, move to other clauses and advise you cannot "shut-in" a broken well so you have to advise about the cessation of production clauses and continuous ops clauses.
3. If not broken, ask why they want to shut it in. Are they waiting on a market, etc.?
4. Check your lease for a shut-in clause to see what is covered. Determine how your well is classified, oil or gas. See if the SI clause applies and read it carefully.
5. Know where you are. If in OK, you can probably SI the well and even be late on SI payments on most leases. If there is a time limit on SI payments in the lease or instructions
regarding payment, let them know. In Texas, if it is a gas well and the lease has a shut-in clause, I promise you it is very specific about what you have to do to have SI payments,
so follow those instructions to the letter because unless you do it right, the courts will say your payments did not qualify as a substitute for production or constructive production,
so you lose the lease. Federal, Indian, and State leases also have special rules you will want to get to know as well.
6. ALWAYS READ YOUR LEASE!! The rules we learn in class are common law and general rules, all of which can be altered by the language of the lease (contract) or by
statute.
 Appendix
(FYI Slides)
[AC1]

Post-Production Costs and Rules

Most courts distinguish between costs of production and post-production costs. While the lessee is obligated to pay for all production costs, lessors are generally
responsible for their share of post-production costs because they are incurred after production and usually enhance the value of the products. Examples of post-
production costs that a Lessor may be responsible for:
1. Transportation of produced gas
2. Dehydration of gas
3. Compression of gas
4. Processing of gas
5. Cleaning of gas
6. Severance taxes
7. Gross production taxes
Courts are split about when (and where) production occurs. There are two general rules:
• The majority view followed by Texas and other states such as Mississippi is based on the Piney Woods case and says that production occurs for royalty calculation purposes
when oil or gas is captured and held at the wellhead or on the lease. In this view, the costs of transporting, compressing, processing, cleaning, severance taxes and gross-
production taxes are charge proportionately against the royalty interest where the gas is sold or valued downstream from the lease. So, royalty is valued on the unimproved
product and then the costs to improve it are deducted proportionately so the lessor is not unjustly enriched by paying them on the value without deducting the cost to improve
the gas.

•Oklahoma and a minority of other states such as CO, WV, and KS and the federal government, follow the Marketable Product Rule (MPR). The MPR says production is not
complete until a lessee has both captured and held the product and made it marketable. These cases rely on the implied covenant to market in the lease to say that companies
owe the lessor a marketable product. The cases say the implied duty is not just to find a market, but to make the product marketable. Thus, costs such as compression,
transportation, and processing gas to transform the gas into a marketable product MAY NOT be deducted as an expense in calculating royalty. Even in the minority states there
is a split on WHEN to apply this rule. CO & WV says that the product needs to both made marketable and be brought to a market, so transportation costs are also not
deductible. Oklahoma and KS however say that the producer must make the product marketable in quality, but once that happens, costs to move it to market are chargeable to
both lessor and lessee. These are of course general rules that can be modified by lease language (unless a statute says otherwise like federal statutes or Nevada and Wyoming
statutes). Many royalty disputes arise over language added to a lease in an attempt to modify these general rules of what is a deductible post-production cost.
 Appendix
(FYI Slides)
The Oklahoma case of Mittelstaedt v. Santa Fe Minerals, Inc., contained a three-part test to determine whether a lessor may bear a proportionate share of certain
postproduction costs. It is an Oklahoma case which addresses the issue of what post-production costs may be charged to the royalty owner, that is, which costs must
they bear their proportionate share of? We talked before about how the royalty is cost free. This is true as to the drilling, completion, and cost to actually produce the
minerals. However, given the nature of natural gas and how it is sold off premises and actually has to have several processes done to it to make it usable (marketable),
the issue arose where in the chain of events do we calculate the royalties for the gas? Most states say at the wellhead and give it a value based on the price a reasonable
person would pay for the gas in the condition that it is in when it comes out of the ground. States like Oklahoma follow the Marketable Product rule which says that
the implied covenant to market in an oil and gas lease requires the company to get the gas into a marketable product, so the costs that are associated with getting it to
that state are part of drilling, completion, and production (not chargeable to the royalty owner). Basically, they lump marketing in with production, which makes sense
when you think about how the OK courts said discovery includes production and a diligent effort to market. This issue only comes up in the context of natural gas
because it is sold off premises, so there is the question of where to value it. Oil is traditionally sold at the wellhead.
The Mittlestadt case tackled the question of what costs (if any) qualified as post-production costs which the royalty owner should share a portion of. The court there
ruled that "the lessee has the burden of showing (1) the reasonableness of the cost, (2) the proportional increase in revenues to the royalty interest, and (3) that
the cost was incurred to alter a marketable product. The lessee must show that the cost was a post-production cost."
https://caselaw.findlaw.com/ok-supreme-court/1428600.html (Links to an external site.) In summary, the Lessee has the burden to show that by expending reasonable
costs, they increased the overall value of the royalty interest (increased the value of the gas) and that the cost was incurred in order to improve the value of an already
marketable product. The Court here makes clear that the cost to make the gas marketable cannot be charged to the royalty owners (lessors), but once it is in a form
that is marketable, if the lessee reasonably spends money to enhance the value of the marketable gas and does actually enhance the value of it, then those costs can be
charged to the royalty owner. The idea is that yes, lease royalty is cost free as to drilling, completion, and production and production in OK includes making a
marketable product, but any reasonable costs spent beyond that to enhance the value of the marketable product should be born proportionately by the royalty owners
who benefit from the enhance in value.
Side Note - Justice Opala who was my Civil Appellate Professor wrote a concurring opinion suggesting that a different test should be used. He cites the man who was my Oil & Gas Professor and
Mentor, Owen Anderson, for his theory on how and where gas royalties should be calculated. It is very cool to me that I got to learn from both of these men who are experts in their respective
fields. Owen is also a Mentor of Monika Ehrman who once ran the Oil & Gas program at OU Law and the MLS program for Oil& Gas as well. The link I gave you above to the case includes
Justice Opala's concurring opinion at the end. Concurring opinions are written by a Justice when they think the Court only got things partly correct. Here, he agrees post-production costs can be
deducted, he just disagrees with the test to determine which costs qualify.
 Appendix
(FYI Slides)