Production in Paying Quantities in Texas€¦ · ENERGY IS THE CENTER OF EVERYTHING WE DO Texas...

Production in Paying Quantities in Texas

Benjamin B. Holliday

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Holliday Energy Law Group PC

Holliday Energy Law Group PC is an energy law firm focused onadvising exploration and production companies in theiroperations across the United States. We actively engage with ourclients throughout all stages of a drilling program, fromacquisition through drilling, and eventually to divestiture.

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Texas Overview

• In Texas, production = production in paying quantities (implied)

• General Rule: Production in paying quantities means that gross operatingrevenues must exceed your operating expenses

• Texas Supreme Court established a 2-Part PPQ Test in Clifton v. Koontz

• CAVEAT: Specific lease language can modify everything we are about todiscuss

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Overview• PPQ is determined by the Clifton v. Koontz 2 Part Test

• Test 1: Is Income from Production > Marketing + Operating Expense?• If Yes – PPQ is present. No further inquiry / If No – Move to Test 2

• Test 2: Would a Reasonably Prudent Operator, under the specificcircumstances, continue to operate the well in the manner it wasoperated for the purpose of making a profit and not speculation?

• Party alleging that lease has expired for lack of PPQ has Burden of Proof• No finite time period that demonstrates lack of profitability

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The Basics – Texas Oil & Gas Lease is a Fee Simple Determinable Grant

• In Texas, an OGL is a Fee Simple Determinable grant (FSD)• In FSD, the estate granted (leasehold) will end automatically when the

stated event or condition (lack of production) occurs• TX Lessee receives a fee simple determinable grant of the mineral estate

for a term of years (OGL primary term), and so long thereafter as there iseither production or a negotiated substitute (OGL secondary term)

• TX Lessor retains a negotiated royalty interest (known as the participatingroyalty or lease royalty) and the right of reverter

• Upon the pre-determined condition – for OGL a lack of productionfollowing the end of the primary term – the mineral estate automaticallyreverts to the grantor/lessor or her heirs and the lease terminates

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The Basics – OGL’s Habendum Clause Fixes Duration of Grant

• Habendum Clause (HC) is the portion of the instrument that tells us howlong FSD grant lasts

• Note that the HC is impacted by other provisions in OGL (e.g. substitutes forproduction in secondary term, shut-in royalties)

• “…this lease shall remain in force for a term of three ( 3 ) years from thisdate (called "primary term"), and as long thereafter as oil, gas, or othermineral is produced from the leased premises or land pooled therewith, orthis lease is maintained by virtue of some other provision hereof.”

• HC creates two distinct terms – PRIMARY and SECONDARY terms

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The Basics – Two Distinct Terms of the OGL’s HC - Primary and Secondary Terms

• Primary Term – Fixed term established by OGL“…this lease shall remain in force for a term of three ( 3 ) years fromthis date…”

• Secondary Term – Following expiration of primary term, OGL must beperpetuated by production or a valid substitute

“… and as long thereafter as oil, gas or other mineral is produced fromthe leased premises…”

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The Basics – Two Distinct Terms of the OGL HC - Primary and Secondary Terms

• Timeline reflects the business deal underlying the OGL (Joseph Shade &Ronnie Blackwell, Primer on the Texas Law of Oil & Gas, (5th ed. 2013)

• During PRIMARY TERM, Lessee wants the option, but not theobligation, to explore

• If production is established, Lessee wants to hold the lease into theSECONDARY TERM as long as profitable to maximize returns oninvestment, whether or not the well ultimately ‘pays out’

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The Basics – HC Creates OGL’s Primary and Secondary Terms

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The Secondary Term

• Many ways to perpetuate lease into Secondary Term common to TX OGLsoutside of production

• Continuous Development operations across end of PT• Shut-In Royalty• Force Majeure

• TX HC generally states that following the end of the primary term, OGL willlast ‘so long thereafter as oil and gas are produced from the lands’

• Must have either Production or a Substitute for Production to maintainlease into secondary term

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The Secondary Term – Meaning of Production in Texas

• What does “Production” mean?

• Majority Rule (Texas) – Production means that oil/gas isbeing actually produced and marketed

• We’re extracting oil and gas out of the ground AND we’re selling it

• Minority Rule (Oklahoma) – Production means ‘capable ofproduction’

• The well could produce but isn’t necessarily for any number ofreasons

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The Secondary Term – Meaning of Production in Texas

• HYPO: XYZ Oil & Gas completes a well during the PT that is capable ofproducing high volumes of natural gas. Unfortunately, the nearest pipelineis over 60 miles away. There is no way to produce the well until at least agathering line is laid [example from Joseph Shade & Ronnie Blackwell, Primer on the Texas Law of Oil & Gas,

(5th ed. 2013)]

• Oklahoma: Lease is maintained into secondary term because well iscapable of production

• Texas: OGL would expire at the end of the PT for lack of productionUNLESS a specific substitute for production – i.e. a Savings Clause –addressed the situation

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The Secondary Term – Impact of Savings Clauses on HC

• HC is harsh in its application – binary yes or no – we’re producing andselling or we’re not

• Savings Clauses Modify/Mitigate the HC1. Provide ways for OGL to survive after the primary term has expired but where there

is not actual production being sold2. Known as Constructive Production3. Negotiated substitutes for production that will keep the OGL alive in certain

common and foreseeable circumstances

• Examples: Force Majeure, Continuous Development, Shut-In Royalty, Re-Work provisions

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The Secondary Term – How Much Production Do We Need?

• It is not enough to simply produce and sell oil/gas• Must have Production in Paying Quantities• In Texas, courts interpret “Production” to mean “Production in Paying

Quantities”• When you see production, it means ‘production in paying quantities’

• RULE: In order to preserve OGL into the secondaryterm, lessee must have production in payingquantities (or a valid substitute therefore)

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Production in Paying Quantities

Production in Paying Quantities = OperatingRevenue > Operating Expenses over a reasonableamount of time

• Reflects the underlying business deal – to produce profitably• If production isn’t profitable, the FSD grant should end

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Production in Paying Quantities – Basic Example

• HYPO: Roadrunner O&G operates the Wiley Coyote #3 well, whichcurrently produces 10bbl/mo. Production is marketed at $58/bbl.

• 10bbl/mo x $58/bbl = Operating Revenue of $580/mo• ABC has operating expenses of $700/mo.• Net Loss of $120/mo• Would this lease expire for lack of production in paying quantities?• Maybe… Look to the Clifton v. Koontz 2 Part PPQ Test

Example from Joseph Shade & Ronnie Blackwell, Primer on the TexasLaw of Oil & Gas, (5th ed. 2013)

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Production in Paying Quantities – Clifton v. Koontz Two Part PPQ Test

• Clifton v. Koontz: Texas Supreme Court adopts the two-part PPQ test

• Part 1: Accounting Test – Is Operating Revenue > OperatingExpense?

• If YES – PPQ is established. Inquiry Over.• If NO – Proceed to Part 2 – RPO Test

• Part 2: Reasonably Prudent Operator Test – Would a reasonablyprudent operator, for the purpose of making a profit and not merespeculation, continue to operate the well at a loss under the samecircumstances?

• Who has “Burden of Proof?” - Party alleging that a lease has terminateddue to a lack of production in paying quantities has burden of proof

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PPQ Test – Part 1: Accounting Test

• Part 1: Accounting Test – Is your OperatingRevenue > Operating Expense?

• If YES – PPQ is established. Inquiry Over.• If NO – Proceed to Part 2

• Accounting Test looks back in time at what has occurredpreviously

• Sufficient if the well “pays a profit, even small, over operatingexpenses,” Clifton v. Koontz

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PPQ Test – Part 1: Accounting Test

• What IS Required for PPQ? Op. Revenues > Op. Expense

• What IS NOT Required for PPQ?• “Well Payout”

• There is no requirement that the well has or will ‘payout’• Profit on total investment• Demonstration that costs will be recovered

• No requirement that lessee demonstrate that the original capital investment willbe recovered – Acquisition, Drilling, Completion Costs

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PPQ Test – Part 1: Accounting Test

• Why such a ‘low’ standard?• We want to encourage exploration• Goal is to allow Lessees to recoup as much investment as

possible• Rule allows lease to continue to produce – and earn back some of the

investment – even though well may never “pay out”

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PPQ Test – Part 1: Accounting Test

• Favors continued production from marginal wells• This is in keeping with Texas oil and gas jurisprudence and regulatory

approach that encourages exploration

• Grants considerable deference to the operator

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PPQ Test – Part 1: Accounting Test – What is Operating Revenue?

• Operating Revenue = All income attributable to the workinginterest

• NRI or Net Revenue Interest

• Operating Revenue DOES NOT include landowner royalty• Operating Revenue EXCLUDES

• Participating Royalty• Non-Participating Royalty

• Very few cases address this issue

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PPQ Test – Part 1: Accounting Test – What is an Operating Expense?

• Operating Expense = Periodic cash expenditures incurred inthe daily operation of a well

• CONSISTENT & REPEATED costs• AKA Lifting Costs

• These include…• Taxes (Ad Valorem, Severance)• Labor• Pumping• Routine Repairs• i.e. What it costs to keep the well going

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PPQ Test – Part 1: Accounting Test – What is an Operating Expense?

MAJOR ISSUE: What about OVERHEAD expenses?

Can we we factor in overhead expenses to the well to determinePPQ?

Tread lightly: Overhead Charges tied to the specific well CANBE CONSIDERED operating costs, BUT….

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PPQ Test – Part 1: Accounting Test – What is an Operating Expense?

Overhead Charges tied to the specific well CAN BE CONSIDEREDoperating costs, BUT….

• CAUTION: District or area wide administrative expenses ARE NOTconsidered operating costs where they would be incurred whether or not theparticular well in question was produced. Ladd Petroleum v. Eagle Oil andGas Co., 695 S.W.2d 99 (Tex. App. Fort Worth 1985, writ ref’d n.r.e.) (Jan. 15,1986)

• Guiding Principle: Administrative and supervisory expenses should beallocated to a well ONLY to the extent that they would be reduced byeliminating the well in question

• PROCEED WITH CAUTION IN ASSESSING OVERHEAD CHARGES

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PPQ Test – Part 1: Accounting Test – What is an Operating Expense?

• Depreciation• General Rule: Actual Depreciation on salvageable equipment is an

operating cost…• Exception: UNLESS it was included as part of the original drilling and completion

costs, Bates v. Delhi-Taylor Oil Corp., 362 S.W.2d 388 (Tex.Civ.App. – SanAntonio 1962, writ red’f n.r.e.)

• NOTE: Permissible amount of this is likely to be small

• Outstanding ORRIs (reduce NRI on a regular/consistent basis)• Clifton v. Koontz, 160 Tex. 82, 325 SW2d 684, 79 A.L.R.2d 774 (1959); Morgan v.

Fox, 536 S.W.2d 644 (Tex.Civ.App. – Corpus Christi 1976, writ refused n.r.e.)(Oct. 6, 1976)

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PPQ Test – Part 1: Accounting Test – What is an Operating Cost?

• Additional Texas cases discussing operating costs for PPQAnalysis

• Evans v. Gulf Oil Corp., 840 S.W.2d 500 (Tex.App. – Corpus Christi1992, writ denied) (April 14, 1993);

• Pshigoda v. Texaco, Inc., 703 S.W.2d 416 (Tex.App. – Amarillo 1986,writ ref’d n.r.e.) (May 28, 1996)

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PPQ Test – Part 1: Accounting Test – What is NOT an Operating Cost

• Non-Operating Costs = CAPITAL EXPENDITURES• These are not considered as costs against revenue in a PPQ analysis• One-time investment expenses• Drilling, Completion, and Equipping the Well

• Clifton v. Koontz, 160 Tex. 82, 325 S.W.2d 684, 79 A.L.R.2d 774 (1959); Peacock v. Schroeder, 846 SW2d 905 (Tex.App. – San Antonio1993, no writ); Evans v. Gulf Oil Corp., 840 SW2d 500 (Tex. App. – Corpus Christi 1992, writ denied) (April 14, 1993)

• Re-Working Costs• Abraxas Petroleum Corp. v. Hornburg, 20 S.W.3d 741 (Tex.App. – El Paso 2000, no pet.); Peacock v. Schroeder, 846 SW2d 905 (Tex.

App. San Antonio 1993); Pshigoda v. Texaco, Inc., 703 S.W.2d 416 (Tex. App. Amarillo 1986), writ refused n.r.e. (May 28, 1996)

• Depreciation on original investment costs• Clifton v. Koontz, 160 Tex. 82, 325 S.W.2d 684, 79 A.L.R.2d 774 (1959)

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PPQ Test – Part 2: Reasonably Prudent Operator Standard

If Operating Expense > Operating Revenue….

Then we move to 2nd inquiry – the RPO Test

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PPQ Test – Part 2: Reasonably Prudent Operator Standard

• Part 2: Reasonably Prudent Operator (RPO) Test - Would aReasonably Prudent Operator, for purposes of making a profitand not for mere speculation, continue to operate the well in thesame manner under the same circumstances?

• Part 2 is a forward looking question of fact for the jury• Fact intensive look at the specific circumstances involved

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PPQ Test – Part 2: Reasonably Prudent Operator Standard

• Part 2: Reasonably Prudent Operator (RPO) Test - 3Elements

Element 1: Does it appear that the objective is to make a profitand not for mere speculation?Element 2: Would a RPO continue to operate the well?Element 3: If yes, then would RPO do so in the same mannerand under the same circumstances?

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PPQ Test – Part 2: Reasonably Prudent Operator Standard

• RPO Test assumes some actual physical production• Not applicable where there is a total lack of production• For total lack/lapse in production, operator must look to OGL for

an adequate savings clause• E.g. Shut-In Royalty, Temporary Cessation Clause, Re-working

provisions, etc.• Essentially we’re asking – Is continuing to operate this well at a

lease reasonable? (i.e. is what is happening reasonable)

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PPQ Test – Part 2: Reasonably Prudent Operator Standard

• RPO Factors to Consider1. Reservoir depletion2. Price obtained for product3. Relative profitableness of wells in the area4. Operating and marketing cost trends5. Reasonable considerations about commodity price environment and

future expectations

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Timeline for Determining Production in Paying Quantities

• MAJOR ISSUE: Over what period of time is PPQ determined?• Answer = It depends. NO BRIGHT-LINE RULE• TX Supreme Court has made clear that unless specifically

determined by the OGL, a well’s profitability is not determinedby looking at a specific accounting period

• Determination will be fact-specific to the particular case

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Timeline for Determining Production in Paying Quantities – BP America Production Company

v. Laddex, 513 S.W.3d 476 (Tex.2017)• FACTS:

• BP has a well that produced for years.• Production sharply declined for 15 months, after which well was re-worked and

resumed constant production.• 1 year later, mineral owner top-leases.• Top-lessee files suit, alleging BP lease expired for lack of PPQ during 15 mo. period.• Jury is instructed to consider PPQ only as to 15mo of low production.

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Timeline for Determining Production in Paying Quantities – BP America Production Company

v. Laddex, 513 S.W.3d 476 (Tex.2017)• District Court: Judgment for Top Lessee. Lease expired for failure to PPQ

during 15 month period.

• Court of Appeals: Reversed judgment; trial court erred in limiting jury’sprofitability consideration to a specific time period (the 15 mos.)

• Texas Supreme Court: Upholds Court of Appeals.

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Timeline for Determining Production in Paying Quantities

KEY RULING: No specific timeline is to be considered by jury inPPQ analysis

1. “There can be no limit as to time, whether it be days, weeks, ormonths, to be taken into consideration in determining the question ofwhether paying production from the lease has ceased.” Clifton v.Koontz, 325 S.W.2d at 690.

2. BP v. Laddex Jury instruction was in error because it limited PPQconsideration only to a specific period.

3. Parties are allowed to influence the jury’s focus to a specific timelinethrough arguments, but jury may not be instructed to consider aspecific time-period

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Timeline for Determining Production in Paying Quantities

• Dreher v. Cassidy Ltd. Partnership, 99 S.W.3d 267 (Tex. App. –Eastland 2003, no pet.)

• Lessor produced evidence that lease failed to PPQ for eight (8)month period, but produced no evidence as to why the eightmonth period was unreasonable.

• Holding for Lessor – 2nd prong of Clifton test not met.• Evidence of an 8-month period where Op.Exp.>Op.Rev. alone

not conclusive – must also show why it was unreasonable

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Timeline for Determining Production in Paying Quantities

• Test is whether a reasonably prudent operator have continuedto produce the well for same time period in the same way withan expectation of a profit

• IMPORTANT: A reasonably prudent operator does not mean theparty alleging lease termination

• Party alleging lease termination must demonstrate that the manner andtime period were unreasonable in terms of seeking profit, and insteadshowed the operations were geared toward mere speculation of futureprofits

• This means – “What can you convince a jury of?”

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Timeline for Determining Production in Paying Quantities

• No clear point at when lease terminates for lack of PPQ• Operator is continuing to produce something, unlike in temporary

cessation of production issue• Fact issue for jury to decide if that production is enough based on

reasonableness inquiry

• POTENTIAL ISSUE: Adverse Possession of Leasehold Estate• Natural Gas Pipeline Co. v. Pool, 124 S.W.3d 188 (Tex.2003)• Lays out arguments for acquiring leasehold estate by adverse

possession after a lease has ‘terminated’ despite ongoing production• Applicable to claims of termination due to lack of PPQ 3+years prior

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PPQ Test – Burden of Proof is on Party Alleging Lease Termination

TX SCT in Clifton v. Koontz makes clear that the party alleginglease termination for lack of PPQ (plaintiff) has the Burden ofProof on both prongs of Koontz Test

“Whether a well is producing in paying quantities is a question offact for the jury, and the burden is on the lessor to prove a lack ofsuch production in order to terminate the lease.” BP AmericaProduction Company v. Laddex, 513 S.W.3d 476 (Tex.2017)

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PPQ Test – Burden of Proof is on Party Alleging Lease Termination

• Plaintiff must plead and prove…• Well costs more to operate than it makes

• If well is profitable (excluding initial capital investment, such as acquisition,drilling, completion), plaintiff cannot prevail

AND• RPO under all relevant circumstances would have P&A’d the well, i.e.

not continued to operate the well for purposes of a profit

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Summary – Production in Paying Quantities Considerations in Texas

• Production means that oil/gas is actually being produced and marketed• Production means “production in paying quantities” whether lease says so or not

• Lease can expressly provide otherwise

• PPQ is a Question of Fact for the Jury• Two Part PPQ Test

• Part 1 – Accounting Test = Is Operating Revenue > Operating Expense?• IF YES – Inquiry over• IF NO – Proceed to Part 2• Operating Costs = Taxes, Overhead, Labor, Repairs, Actual Depreciation on Salvageable Equipment, ORRIs

• Periodic cash payments incurred in the daily operation of a well• Not Operating Costs = Drilling, Completion, District Wide Overhead, Reworking, Depreciation on Original Investment Costs

• One-time investment expenditures; capital expenditures

• Part 2 – Reasonably Prudent Operator Test = Would a RPO for purposes of profit and not speculationcontinue to operate the well in the same manner under the same circumstances?

• Question of Fact for Jury

• Party alleging lease termination has Burden of Proof

• No specific timeline for determining PPQ

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Summary – Production in Paying Quantities Considerations in Texas

• Production means that oil/gas is actually being produced and marketed• Production means “production in paying quantities” whether lease says so or not

• Lease can expressly provide otherwise

• PPQ is a Question of Fact for the Jury• Two Part PPQ Test

• Part 1 – Accounting Test = Is Operating Revenue > Operating Expense?• IF YES – Inquiry over• IF NO – Proceed to Part 2• Operating Costs = Taxes, Overhead, Labor, Repairs, Actual Depreciation on Salvageable Equipment, ORRIs

• Periodic cash payments incurred in the daily operation of a well

• Not Operating Costs = Drilling, Completion, District Wide Overhead, Reworking, Depreciation on Original Investment Costs• One-time investment expenditures; capital expenditures

• Part 2 – Reasonably Prudent Operator Test = Would a RPO for purposes of profit and not speculationcontinue to operate the well in the same manner under the same circumstances?

• Question of Fact for Jury

• Party alleging lease termination has Burden of Proof

• No specific timeline for determining PPQ

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Which Theory Does Colorado Follow?

• Sort of a hybrid of Texas and Oklahoma law

• Follows the Texas requirement to be capable of producing in paying quantities

• However, lease can extend into ST without being marketed yet, similar to Oklahoma requirement

• Both Texas and Oklahoma cases cited in Colorado case law

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Colorado Test, Part 1 – Is the well capable of Production in Paying Quantities

• A finding that the well is producing in paying/commercialquantities within the PT is sufficient to satisfy the habendum clause

• Davis v. Cramer, 837 P.2d 218, 222 (Colo. App. 1992)

• The applicable standard for determining whether a well iscommercial would be whether it will return a profit over operatingexpenses and not whether it will return a profit after recovery of alldrilling expenses

• Landauer v. Huey, 143 Colo. 76, 85, 352 P.2d 302, 308 (1960)• Cites Texas cases: Mercantile Nat. Bank at Dallas v. McCullough Tool Co., Tex.Civ.App., 250 S.W.2d 870; reversed

on other grounds 152 Tex. 471, 259 S.W.2d 724; and Nystel v. Thomas, Tex.Civ.App., 42 S.W.2d 168

• Cites Texas cases

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Colorado Test, Part 2 – Is Marketing Required to Extend into ST?

• Marketing is not an essential part of production, and thehabendum clause is satisfied by discovery in commercialquantities

• Davis v. Cramer, 837 P.2d 218, 222 (Colo. App. 1992)• See also Hoff v. Girdler Corp., 8 P.2d 100 (Colo. 1939) (production without marketing during the

primary term is not alone sufficient to declare abandonment of the lease absent breach of the implied covenant to market)

• This is similar to the Oklahoma standard

• However, this is an implied covenant to market

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Implied Duty to Market

• The operator has a duty to meet the implied covenant of diligent and prudent operation, which includes the duty to market the product

• Mountain States Oil v. Sandoval, 125 P.2d 964, 967 (Colo. 1942)

• Performance required to comply is that of a prudent operator• Davis v. Cramer, 837 P.2d 218, 222 (Colo. App. 1992); Davis v. Cramer, 808 P.2d 358, 362

(Colo. 1991)

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Prudent Operator Standard

• Whether lessee exercised proper diligence is determined bywhatever would be reasonably expected of all operators of ordinaryprudence in the circumstances

• Davis v. Cramer, 837 P.2d 218, 222 (Colo. App. 1992), citing Davis v. Cramer, 808 P.2d 358,362 (Colo. 1991) and Strange v. Hicks, 188 P. 347 (Okla. 1920).

• Lessee has a reasonable time after competition of the well to complywith an implied covenant to market

• Davis v. Cramer, 808 P.2d 358, 362 (Colo. 1991)• Cites Oklahoma cases: Gazin v. Pan American Petroleum Corp., 367 P.2d 1010 (Okla. 1961); McVicker v. Horn,

Robinson and Nathan, 322 P.2d 410, 411 (Okla. 1958)

• Have to ask: Would Prudent Operator be marketing product?

• Cites Oklahoma cases

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Implied Duty to Market during the PT

• This duty to market arises when production in paying quantities, even ifduring the PT

• Davis v. Cramer, 837 P.2d 218, 222 (Colo. App. 1992); Davis v. Cramer, 808 P.2d 358, 362(Colo. 1991)

• Even though being capable of producing in paying quantities is enough tomeet the habendum clause, if the operator is not diligent at marketing theproduct, the lease may not extend into the ST

• Well capable of producing in paying quantities, production not yet marketed butoperator is being diligent at marketing as a “prudent operator” à extend into ST

• Well capable of producing but the operator is not being diligent about marketing as a“prudent operator” à lease will not extend into the ST

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Summary

• 1st – Must meet Habendum Clause• Production in Paying Quantities

• Profit > Operating Costs

• 2nd – Must meet Implied Duty to Market• Prudent Operator Standard

• Must act how a prudent operator would act• Lease could extend into ST without marketing if prudent operator

wouldn’t market

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QUESTIONS?Benjamin Holliday

ben@theenergylawgroup.com(210) 767-3355