May 12, 2020

Is It Time to Dust Off Your Shut-In Royalty Payment Clause in This Brave New World?

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To successfully avoid a claim of breach, producers will need to carefully consider and implement the terms of their shut-in royalty provisions. Missteps could be costly.

Russia and Saudi Arabia flooded the market just as the coronavirus pandemic brutally suppressed energy demand. Crude storage capacity is filling to the brim. The Oklahoma Corporation Commission (OCC) has issued an emergency order reminding producers that Oklahoma bars production of oil that is “economic waste.”

In Texas, a petition to curtail oil production is pending before the Texas Railroad Commission (RRC). The petition suggests a 10% mandatory reduction in production across the board. The stated hope is that an RRC curtailment order will more evenly distribute the reductions rather than simply allowing prices to spur producers to cut back based on their individualized economic interests. There is also a view that a RRC curtailment order may spur other oil-producing states to do the same. All of this is said to be necessary to buoy prices enough to steel the industry against current conditions and prevent an inordinate number of bankruptcies.

If the RRC were to order curtailment, it would be official action that likely suspends duties, potentially including paying shut-in royalties discussed herein. But the RRC has not acted. Producers, lenders and others are strategizing about what to do if nothing changes in the near or even medium term. Now seems like a good time to give shut-in royalty payment provisions a good hard look.

Why is this important? Cessation of production can cause a lease to terminate automatically if it is past its primary term. Many leases in the key basins in Texas and around the country are beyond the primary term. This would be catastrophic for producers and the broad network of reserve-based lenders who rely on reserves for collateral to secure their loans. Even if not beyond the primary term, producers are under express or implied duties to develop and protect the lease against drainage. Thus, careful examination of leases is crucial right now.

Shut-in royalty provisions may be the most straightforward and best protection in these challenging times. Texas law recognizes contractual and common law temporary cessation of production, but temporary cessation historically has been reserved for mechanical failures that are timely remedied. More recent decisions hold temporary cessation covers a broader array of circumstances, Ridge Oil v. Guinn Investments,148 S.W.3d 143 (Tex. 2004), but none have addressed market conditions.

Other doctrines that might excuse performance are shrouded in uncertainty. For example, unless a force majeure clause expressly provides for it, economic difficulties arising from global oil price decline typically would not constitute a force majeure event excusing performance of lease obligations. See TEC Olmos v. ConocoPhillips, 555 S.W.3d 176, 180-85 (Tex.App—Houston [1st Dist.] 2018, pet. denied); Valero Transmission v. Mitchell Energy, 743 S.W.2d 658, 663-64 (Tex. App.—Houston [1st Dist.] 1987, no writ). Common-law doctrines such as impossibility and frustration are notoriously difficult to sustain, although it may become literally impossible to perform if terminals and pipelines are unable to accept product.

Section 2-615 of the UCC may provide some protection, but is somewhat uncharted territory. Generally, courts have been able to avoid analyzing Section 2.615 because they have been able to point to force majeure provisions that obviate the need to invoke the statute. See PPG Industries v. Shell Oil, 919 F.2d 17, 18-19 (5th Cir. 1990). Texas courts considering Section 2-615 have recognized, however, that due to extraordinary circumstances, performance can become so critically different from what was reasonably to be expected that it alters the essential nature of that performance. See Tejas Power v. Amerada Hess, No. 14-98-00346-CV, 1999 Tex. App. LEXIS 6014, at *5 (Tex. App.—Houston [14th Dist.] Aug. 12, 1999).

Unlike force majeure, impossibility and similar doctrines that excuse a breach; shut-in royalty payments constitute permissible alternative performance. “Shut-in royalties … are periodic payments for the privilege of deferring exploration and production after the primary term.” Amber Oil and Gas v. Bratton, 711 S.W.2d 741, 743 (Tex.App.—Austin 1986, no writ). Historically, shut-in royalty provisions were intended to protect the lessee when there is no market for the product. That may become the situation in light of the extraordinary conditions in the market. But this particular circumstance likely is not a necessary or limiting condition on use of such provisions.

To successfully avoid a claim of breach, producers will need to carefully consider and implement the terms of their shut-in royalty provisions. Missteps could be costly. What follows are four key issues requiring attention.

1. Fit your circumstances into the language of the shut-in provision.

The right to exercise the shut-in royalty payment right will depend on the particular wording of the shut-in royalty provision. Some clauses only apply to gas. Some clauses are very brief and simply based on the fact of non-production. When the provision is silent as to reasons, the Texas courts will look to whether the cause is reasonable. Other provisions are more specific, permitting shut-in royalty payments only in listed circumstances. These provisions typically include lack of market, lack of pipeline access, governmental restrictions and any other reason beyond the reasonable control of the lessee. When a provision contains a general catch-all after a list of specifics, Texas courts typically apply the ejusdem generis canon of construction and hold that the general only includes causes of the same type as those listed. Barnett v. Aetna Life Insurance, 723 S.W.2d 663, 666 (Tex. 1987). Though the rule has never been specifically adopted for mineral lease construction, Moser v. US Steel, 676 S.W.2d 99, 101 (Tex. 1984) (declining to apply the rule to “oil, gas and other minerals), the rule is routinely applied to similar clauses, such as force majeure clauses.

2. Make the shut-in payment timely to the right party.

As a matter of good practice, the shut-in royalty payment should be made before the well is shut-in to the right party in the correct amount. Historically, failure to pay the right party the correct amount on time results in termination of the lease. Amber Oil & Gas, 711 S.W.2d at 743; In re MSB Energy, 438 B.R. 571, 593 (Bankr. S.D. Tex. 2010). There is, however, a developing line of cases that hold payment of royalties is a covenant, not a condition, and does not result in automatic termination. Rather, failure to timely pay the royalty gives rise to a claim for money damages. See, e.g., Blackmon v. XTO Energy, 276 S.W.3d 600, 607 (Tex. App.–Waco 2008, no pet.).

3. Restart production timely.

It is not uncommon for a shut-in royalty provision to fix time limits for how long the lessee can extend the lease term by paying the shut-in royalty. For example, in the PNP Petroleum case discussed below, the extension was limited to one year. Producers will have to be mindful of these time limits in planning restarts. If there is no stated time limit, courts will look to the lessee’s good faith, diligence and reasonableness. Casey v. Western Oil & Gas, 611 S.W.2d 676, 679 (Tex.App.—Eastland 1980, writ ref’d n.r.e.).

4. Collect data showing you are capable of producing in paying quantities.

The general rule in Texas is that the lessee’s well or wells must be capable of producing in paying quantities. PNP Petroleum I LP v. Taylor, 438 S.W.3d 723, 736-37 (Tex.App.—San Antonio 2014, pet. denied). Again, lease language matters. The San Antonio Court of Appeals paid special attention to the wording and negotiating history in deciding the shut-in royalty provision did not require the shut in wells be capable of producing in paying quantities. Here is the clause in its marked-up form, showing capable of paying quantities had been stricken:

If, at the expiration of the primary term – or at any time thereafter, there is located on the leased premises a well or wells not capable of producing oil/gas in paying quantities or being used as a salt-water injection well(s), and such gas is not otherwise produced and sold in paying quantities for lack of suitable market and this lease is not otherwise being maintained in force and effect, Lessee may pay [to extend the lease term.]

Rejecting the argument that shut-in royalty clauses have a generally accepted industry meaning, the court concluded: “Quite simply, the parties could not have intended for the law to engraft into their agreement the very language they removed.”

Absent a special provision, however, lessees must be able to show the lease well or wells capable of production in paying quantities. Production in paying quantities means the well will generate more revenue than cost when it is turned on.

Michael P. Lennon Jr. is a partner in Mayer Brown’s litigation and dispute resolution and international arbitration practices. He is an experienced arbitration and trial lawyer with an outstanding track record for handling a wide variety of arbitration and litigation matters, particularly in the energy, natural resources and construction sectors. Lennon also has experience handling patent, trademark, copyright and other commercial disputes.

Christopher Watts is a litigation and dispute resolution associate in the firm’s Houston office. His practice focuses on civil litigation in state and federal courts, mediation and arbitration. Watts’ practice also includes a considerable commitment to pro bono matters. Prior to law school, Watts worked as a management consultant for a financial advisory and dispute consulting firm based in Chicago.