What Constitutes Production in “Paying Quantities”?

I am sometimes asked to evaluate whether a lease has terminated for failure to produce in paying quantities. It is not an easy question to answer. So here is a summary of how “paying quantities” are determined.

Basic Rules

When an oil and gas lease provides it will remain in effect after the primary term as long as oil or gas is produced from the leased premises, the law presumes that such production must be in “paying quantities.” The lease is entered into for the parties’ mutual benefit. If the lessee is no longer reaping a benefit because expenses exceed income, “the lessors should not be required to suffer a continuation of the lease after the expiration of the primary period merely for speculation purposes on the part of the lessees.” Garcia v. King, 164 S.W.2d 509 (Tex. 1942)

Production in paying quantities is implied unless the lease provides otherwise. After Garcia v. King, some company lease forms began to provide that the lease would continue after the primary term as long as there was production, “whether or not in paying quantities.” I still sometimes see this language in lease forms.

In Clifton v. Koontz, 325 S.W.2d 684 (Tex. 1959) the court established a two-part test for determining whether a lease has ceased production in paying quantities:

First, did expenses of operating and marketing from a well exceed its income over a “reasonable period of time”?

If so, “under all the relevant circumstances [would] a reasonably prudent operator  … 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 [is being] operated”?

A mineral owner challenging whether a lease has expired for lack of production in paying quantities has the burden of proof on both parts of the test.

How are income and expense determined?

• Severance taxes and the royalty owed to the landowner under its lease are excluded from income.
• If there are overriding royalties carved out of the lessee’s interest, those are not deducted from income.

What expenses may be deducted from income for purposes of the paying quantities test are more difficult to ascertain based on court cases.

• Capital costs, including drilling and completion costs and workover costs, are not included.
• Generally, operating costs are costs incurred on a consistent, repeated basis: labor, minor repairs, pumping costs.
• Overhead charges and depreciation on salvageable equipment may also be included if properly allocated to the well in dispute.
• Administrative and supervisory expenses might be included, but only if those costs would be reduced if the well were not included.

What is a “reasonable period of time” to test production in paying quantities?

No court has established what a reasonable period of time is. It is at least several months.

The Texas Supreme Court has held it is error for the plaintiff to pick the time period to be examined for determining whether costs exceed revenues. In BP American Production Co. v. Laddex, Ltd., 513 S.W.3d 476 (Tex. 2017), BP’s well declined sharply for a period of 15 months, when BP reworked the well and it resumed profitable production. Laddex sued about a year later, claiming that the lease had terminated for failure to produce in paying quantities during the 15-month period. In its instructions to the jury the court asked the jury whether the well failed to produce in paying quantities during that 15-month period, to which the jury answered yes. The jury was then asked whether a prudent operator would have continued to operate the well for the purpose of making a profit and not for speculation, to which the jury answered no. BP appealed, continuing the first jury instruction was erroneous because it limited the jury to a particular time period. The Supreme Court agreed; it reversed and remanded for a new trial.

[C]ertainly the parties were entitled to (and did) attempt to focus the jury in this way through evidence and argument. Laddex had every right to argue to the jury that paying production had ceased because (1) costs exceeded revenue during the fifteen-month period of slowed production and (2) a reasonably prudent operator would not continue to operate the well for profit in light of the slowdown. And BP had every right to contest both of these points by arguing to the jury that the slowdown period did not accurately reflect the lease’s profitability in light of the volume of production before and after this window. But the charge may not ask or instruct the jury about a specific period without unduly influencing the jury and violating Clifton.

Whether a lease has terminated for failure to produce in paying quantities is inherently a question of fact, meaning it always goes to a jury.

Conclusion: It is very difficult to terminate a lease for failure to produce in paying quantities.

Also to be considered: when a mineral owner tells her lessee that its lease has terminated, the lessee has no obligation thereafter to continue producing. The lessor has challenged the lessee’s title, and the lessee cannot be put in the position of having to continue to operate on a lease as long as the lessor is challenging its title. So inquiries about paying quantities have to be carefully worded to avoid repudiation of the lease until the lessor is ready to do so.

Solutions for the mineral owner

Define “Paying Quantities” in the lease.

A well shall be deemed to have ceased production in “Paying Quantities” when the gross proceeds of sale of Oil and Gas produced from the well during any consecutive twelve-month period is less than the sum of all costs of operation incurred during said six-month period, including without limitation (i) all landowner royalties, overriding royalties, non-participating royalties, production payments and other burdens payable out of production from such well, (ii) operating costs and expenses (including all costs and expenses charged, assessed or levied under any applicable operating agreement, and including operator’s drilling or producing well overhead rate and any allocable district expenses), (iii) taxes (including severance and ad valorem taxes, but not income taxes), and (iv) any other costs and expenses (other than costs of drilling, completing and equipping the well) attributable to said well.

Upon Lessor’s written request, which request may be made no more often than once in any twelve-month period, Lessee shall furnish Lessor an itemized statement of all revenues and costs for each well which indicate whether or not said well has produced in Paying Quantities during the preceding twelve-month period.  If Lessee does not provide such information within thirty (30) days after Lessor’s written request, the well will be deemed to have ceased producing in Paying Quantities as of the end of such thirty (30) days.  If the costs of operation of a well during any twelve-month period exceed the revenues accrued from production from the well for that same period, the well shall be deemed to have ceased producing in Paying Quantities as of the end of that twelve-month period.

This provision has several advantages for the mineral owner: It defines the “reasonable period of time” as twelve months; it itemizes the costs that must be included; and it eliminates the second prong of the Clifton test, the “prudent operator” test.

Add a minimum royalties clause.

If, during any Lease Year after the end of the Primary Term while this lease is in force, oil or gas has been produced from any well on the Leased Premises, and if there has not been paid to Lessor royalties on production equal to at least ____________________ and No/100 Dollars ($__________) per net mineral acre covered by this lease (after deducting any severance tax) during such Lease Year, Lessee shall, within ninety (90) days after the end of each such Lease Year, pay or tender to Lessor as a minimum royalty the difference between the amount so paid during such Lease Year and said sum of _____________________ and No/100 Dollars ($__________) per net mineral acre as above provided.  The payment of minimum royalty provided for in this paragraph shall not be in lieu of actual production of oil or gas in Paying Quantities.

Assume that a lease covers 100 acres reserving a 1/4 royalty and has two producing oil wells. The lessor owns half of the minerals. In one year the operator produces 5 barrels of oil per month, a total of 60 barrels, sold for $70/bbl. Gross revenue after severance tax is $4000. The lessor’s royalty is ¼, so the lessor was paid ½ of ¼ of $4000, or $500. If the lease has a minimum royalty clause requiring $50 per net mineral acre per year, the minimum royalty payable to the lessor is ½ of 100 acres times $50/acre, or $2500.  The operator would owe the lessor an additional $2000, more than half of its total revenue–an incentive to plug the wells and release the lease. If the minimum royalty is $25/acre/year, the additional royalty due would be $750.

Paying Quantities and Shut-In Royalties

Every oil and gas lease has a shut-in royalty clause allowing the lessee to keep the lease in force when a well has been shut in. Every shut-in clause is different, but all require some kind of payment as “shut-in royalty.” Sometimes the obligation to pay royalties is a covenant; the lease remains in effect after the well is shut in and the lessee has an obligation to pay the shut-in royalty. Sometimes the payment is a condition to continuation of the lease; the lease will remain in effect after the payment only if the payment is made within a specified time after the well is shut in.

The interplay between a shut-in clause and paying quantities sometimes creates confusing cases. One such case is BP America Production Co. v. Red Deer Resources, LLC, 526 S.W.3d 389 (Tex. 2017. The case concerns operation of a shut-in royalty clause in a lease granted in 1962 covering 2,113 acres in Lipscomb and Hemphill Counties.  BP had one gas well on the lease that produced less than 10 mcf per day. In 2011, Red Deer obtained a top lease on the 2,113 acres. BP’s only well stopped producing on June 4, 2012, and BP turned off the valve on the well on June 12 and tendered a shut-in royalty payment to the lessors on June 13. In August 2012 Red Deer sued BP, alleging that the lease had terminated for lack of production in paying quantities prior the date the well was shut in and was not capable of producing when the well was shut in.

The shut-in royalty clause reads:

Where gas from any well or wells capable of producing gas … is not sold or used during or after the primary term and this lease is not otherwise maintained in effect, lessee may pay or tender as shut-in royalty …, payable annually on or before the end of each twelve month period during which such gas is not sold or used and this lease is not otherwise maintained in force, and if such shut-in royalty is so paid or tendered and while lessee’s right to pay or tender same is accruing, it shall be considered that gas is being produced in paying quantities, and this lease shall remain in force during each twelve-month period for which shut-in royalty is so paid or tendered ….

The jury was asked four questions. The Court considered the jury’s answer to two of those questions:

Question 1: from April 27, 2009 to June 12, 2012, did the Vera Murray lease fail to produce oil and gas in paying quantities?

Answer: No, the Vera Murray lease did not fail to produce in paying quantities.

Question 3: Was the Vera Murray #11 well incapable of producing in paying quantities when it was shut-in on June 13, 2012?

Answer: Yes, the Vera Murray #11 well was incapable of producing in paying quantities when it was shut-in on June 13, 2012.

Based on the jury’s answer to Question 3, the trial court held that the lease had terminated. The court of appeals affirmed. 466 S.W.3d 335 (Tex.App.-Amarillo 2015).

The Supreme Court reversed and rendered. It held that Question 3 asked the wrong question. The correct question would have been: Was the Vera Murray #11 well incapable of producing in paying quantities “on the last day gas was sold or used–June 4, 2012.” The Court also held that BP had preserved the error in Red Deer’s jury question and that it would not remand for a new trial because Red Deer “submitted a theory upon which it could not recover.”

I find the court’s opinion very confusing. It is true that the shut-in clause provides that the date the well last produced is the date when the well must have been capable of producing in order to preserve the lease by paying shut-in royalty. But the question to the jury, which picked June 13 as the relevant date, seems a harmless difference – if the well was not capable of producing on June 4, how could it have been capable of producing on Jun 13?

Other language in the opinion is confusing. For example, the Court says that the tender of the shut-in payment would keep the lease in force “so long as the well was capable of production in paying quantities over a reasonable period of time on the date that gas was last sold or used.”  Suppose the well had been producing in paying quantities (as the jury found), but it was shut in because the casing collapsed and it would have to be reworked before returning to production. The fact that the well had produced in paying quantities over a reasonable time prior to being shut in would not, in my view, mean that a shut-in payment would preserve the lease. A well not capable of producing at all is certainly not capable of producing in paying quantities.

It seems to me that this case and several of the Court’s statements suffer from failing to distinguish between two circumstances: in the first, a well ceases to produce and cannot return to production without additional work on the well. In the second, a well’s production is not in paying quantities. In both cases, courts have held that the lessee may not rely on a shut-in royalty clause to extend the term of the lease. In the first instance, courts have held that a shut-in royalty payment cannot extend the term of the lease if the well was not capable of producing gas at the time it was shut in without additional work on the well. In the second instance, courts have held that a shut-in clause cannot save a lease if it has already terminated because the well shut in had already ceased to produce in paying quantities — it might still be capable of producing some gas, but the lease has terminated before the well was shut in because of lack of production in paying quantities. The Court does not distinguish between these two circumstances: “to negate BP’s invocation of its shut-in royalty rights Red Deer bore the burden of proving that the #11 well was incapable of production in paying quantities over a reasonable period of time as of June 4, 2012.”

Red Deer did not convince the jury that the lease had terminated for failure to produce in paying quantities before the well was shut in. Its second question should have been: Was the Vera Murray #11 well incapable of producing after June 4, 2012? If the well was incapable of producing at all after June 4 without first being worked over, then BP’s tender of shut-in royalty would not be able to sustain the lease past that date.