By Bryan J. May and Mark C. Matula
We have previously discussed shut-in, force majeure, continuous drilling, cessation of production, and commencement of operations lease provisions, which are known as lease savings clauses. This brief note discusses production in paying quantities, which is often the issue determining the need to invoke one or more lease savings clauses.
Production in Paying Quantities:
Oil and gas leases are typically for a certain term of years and then for “so long as oil or gas is produced from the land.” Maralex Res., Inc. v. Gilbreath, 76 P.3d 626, 630 (N.M. 2003). Texas and New Mexico Courts have held that “the terms ‘produced’ and ‘produced in paying quantities’ mean substantially the same thing.” Id. citing Garcia v. King, 164 S.W.2d 509, 511 (1942). Therefore, in addition to actual production, a lessee must produce in paying quantities to maintain an oil and gas lease beyond its primary term.
The Two-Pronged Test:
Whether a well has produced in paying quantities is determined in hindsight by considering a two pronged test that first looks to whether the well “pays a profit, even small, over operating expenses … though it may never repay its costs, and the enterprise as a whole may prove unprofitable.” Id. And second, it looks to “whether or not under all the relevant circumstances a reasonably prudent operator would, for the purpose of making a profit and not merely for speculation, continue to operate a well in the manner in which the well in question was operated.” Clifton v. Koontz, 325 S.W.2d 684, 691 (1959).
The first prong considers whether the entire income attributable to the working interest created by the original lease exceeds the operating and marketing expenses, which include taxes, overhead charges, labor, repairs, and depreciation on salvageable equipment, but not costs or expenses in connection with the original drilling of the well. Peacock v. Schroeder, 846 S.W.2d 905, 908 (Tex. App.—San Antonio 1993, no writ).
The second prong broadly considers factors such as depletion of the reservoir, price of the produced product, relative profitableness of other wells in the area, operating and marketing costs, net profit, lease provisions, whether the lessee is holding the lease merely for speculative purposes, and whether there is a reasonable basis for the expectation of profitable returns. BP Am. Prod. Co. v. Laddex, Ltd., 513 S.W.3d 476, 484 (Tex. 2017).
Reasonable Time Period:
The time period for determining whether a well has produced in paying quantities is “a reasonable period of time under the circumstances.” BP Am. Prod. Co. v. Red Deer Res., LLC, 526 S.W.3d 389, 394 (Tex. 2017). The time period is a fact question. One Texas Court considered 12 months and 21 months to be reasonable considering the facts of the case. Peacock at 909–10. The Texas Supreme Court held that an instruction limiting the jury to consider “fifteen months of slowed production” was in error, because it “did not allow the jury to consider the well’s return to profitability following that window.” Laddex at 484. The Court stated that “there can be no limit as to time, whether it be days, weeks, or months, to be taken into consideration in determining the question of whether paying production from the lease has ceased.” Id at 483. If challenged, a court should review profitability over a long term, not just during a few months of low prices. And, the operator should be prepared to show that it acted as a reasonable and prudent operator would have acted under similar circumstances.
Temporary Cessation:
During times of low commodity prices operators often consider reducing or temporarily halting production to reduce losses. While production is required to maintain an oil and gas lease beyond its primary term, a reasonable temporary cessation is permissible when there is no cessation of production clause. Amoco Prod. Co. v. Brauslau, 561 S.W.2d 805, 809–10 (Tex.1978). And, when a lease has a defined cessation of production clause, that period has been held to be the definitive period of permissible temporary cessation. Bachler v. Rosenthal, 798 S.W.2d 646, 649 (Tex. App.—Austin 1990, writ denied). If an operator temporarily halts or reduces production, it is critical that it do so for the purpose of making a profit and not merely for speculation.
Conclusion:
In summary, it is likely that producing intermittently with no cessation of longer than the period described in the cessation of production clause would be permissible. The safer approach, however, may be to reduce continuous production volumes. In either scenario, the operator must do so for the purpose of making a profit, which will be judged over a period of time that is hopefully longer than a downturn in commodity prices. Before implementing a production strategy, the operator should seek input from land, legal, operations, and other functional groups to determine the impact of the proposed strategy on the long range productivity and profitability of the well or field. And, the operator should keep detailed production, sales, and expense records.