Mineral rights leases ‘held by production’ will be a bone of contention
Yesterday, at the Crain’s 2014 Shale Summit, I was on a panel that discussed the topic of “held by production” acreage — what does it mean, and what are its implications for landowners? Two other local lawyers, Don Fischbach and Chip Collier from the Calfee and Benesch law firms, respectively, joined me on the panel.
The sudden appearance of the shale gale has been a welcome surprise to many landowners in Ohio, but a number of landowners have been cut out of the lease-bonus windfall. This is because their mineral rights already were controlled by small producing companies through old leases held through an oil and gas industry custom called “held by production,” or “HBP.”
Historically, under American leases, oil and gas companies can control the entire leasehold for the life of production, as long as one well on that property is producing in “paying quantities.” So a small well producing in the shallow Clinton formation could conceivably hold an entire lease for 50 years, as long as the value of production exceeds operating costs.
Many Ohio leases were granted at a time when bonus payments were trivial — often less than $50 per acre. What’s more, royalties were relatively small — usually 1/8 of the production. Now, when producers are offering bonuses of $5,000 per acre and royalties approaching 20%, those whose mineral rights may be held by shallow Clinton production are missing out on the shale gas windfall.
So, what recourse do the landowners have, if any? That was the primary discussion among the panelists at the Shale Summit.
To be clear, the landowners are not completely left out in the cold; they still have their 1/8 royalty interest and they will get that from shale drilling if their current leaseholder sells its lease to a shale driller. And if they are entering into a new lease, they now know to include a “Pugh Clause” — a provision that requires the release of acreage not developed within a period of time.
But we can appreciate the frustration of the landowner who has endured years of marginal operations only to see the operator pocket his bonus through subleasing the deep rights to drill in the Utica.
So does the landowner have any recourse when this happens? The answer is that, absent a Pugh Clause, if the operator has been producing natural gas in good faith and in “paying quantities” over the years, probably not. Most of the small operators have operated in good faith. These operators just got lucky.
But lawyers have a saying: bad facts make for bad law. Sometimes, operators do not operate in good faith. Leases are valuable commodities, even when they are not producing. So they lie about production, obfuscate records, and otherwise do whatever it takes to hang onto their leases. That’s an invitation for the courts to fashion new law to ensure justice.
The HBP doctrine led to just that phenomenon. Operators in Louisiana and Texas held huge swaths of acreage with just a handful of wells, keeping landowners from seeing the development of their properties for decades. Producers sat on properties indefinitely and with impunity, sometimes operating under the theory that nothing ruins a good oil and gas prospect like drilling it.
As a result, courts in those states (and later elsewhere) began to read into leases “implied covenants” — duties that operators had to lessors that were not expressly stated in the leases. While the courts conceded that there was no fiduciary obligation owed by the operator to the landowner, they found that there was a fundamental duty of good faith and fair dealing. Producers had to make at least a token effort to protect the interests of the landowners.
Most of the debate initially related to the duty to market the production at a fair price, since in the early days of the industry, producers sold the royalty share of production to themselves. But one of the implied covenants that developed was directly in response to the HBP doctrine — operators in some states were held to an implied duty to “prudently develop” the property.
Armed with this new duty and the threat of lease cancellation, landowners began to successfully force operators either to develop their property or to release it. Ohio was one of the states that found that its leases contained an implied covenant to prudently develop minerals.
Operators were quick to respond. They started placing “waivers of implied covenants” into their leases.
Under most states, when it comes to waivers of legal rights, the waiver has to be clear, unequivocal and brought to the attention of the party who is waiving his rights. You can’t, for instance, bury a waiver of rights to seek consequential damages for breach of contract on the back of a purchase order, or in the fine print on a 60-page contract. Waivers of this nature usually require such things as “magic words” — boldface letters, all capitals, or some other way of putting the party on notice that rights were being waived.
So how does this waiver work in Ohio? The rule here is that a waiver of implied rights must be “express” before it can be enforceable. But “express,” it turns out, is apparently in the eye of the beholder. In one recent Ohio case, the court found a general waiver to be sufficient to deprive the lessor of the expectation that the operator must act prudently in developing his property.
To me, this is an invitation for another court somewhere, facing some egregious imbalance in justice, to craft new law. Operators can and should be given great leeway in deciding how to develop a property. And lessors can protect themselves through a Pugh Clause and other lease language. But to think that landowners understand what rights they are giving up with a general waiver is simply not believable.
Shale development is changing much about the oil and gas industry. The custom of HBP may eventually be one of them. It is not accepted by mineral rights owners outside of the United States and Canada. In Nigeria, for instance, granting instruments are for a certain term, and if production is still there at the end of the term, you turn it over to the sovereign.
But in Ohio, for the near term, the concept of HBP will be a major part of the oil and gas landscape. For most landowners, this is fine; they are happy for their operator partner to continue producing and paying royalties. But inevitably, HBP can lead to conflicts of interest between the landowner and the operator.
Landowners are well served to watch for them, because they may not be able to count on the duties of good faith and fair dealing to protect them.
Andrew Thomas is Executive in Residence at the Energy Policy Center of the Levin College of Urban Affairs at Cleveland State University and also of counsel to the law firm Meyers, Roman, Friedberg & Lewis.Click here to return to our blog