Implied Oil & Gas Covenants (Spring 2021 Course Notes - GULC Evenings)

The Implied Covenant to Market

The implied covenant to market oil and gas after it has been drilled for requires a lessee to use the diligence of a reasonable and prudent operator in finding a market and negotiating a sale; this covenant allows lessors to realize royalty payments. The covenant has a “reasonable time” aspect to it which can go up to several years and can be construed to be longer if a shut-in clause exists; in actual production states, shut-in clauses exist to allow lessees to hold onto their leases when marketing is not possible, while in capability of production states, shut-in clauses exist to allow lessors to obtain income while the lessees are diligently looking for a market. Reasonableness of operator action is also based on the facts and circumstances at the time the operating decision was made (i.e. based on industry custom and commonsense relevant at the time) (Robbins). Remedies for a breach of this implied covenant often include either lease cancellation (some states allow for this after notice and a chance to fix the breach are given to the lessee, or if demand would be useless) or forfeiture (some states allow for this if damages would not be a sufficient remedy); damages can be awarded equivalent to the amount of royalty a lessor would have obtained had production been timely marketed. Marketing covenants have historically centered around gas (because oil was sealable in a tank that could be transported to a market elsewhere) due to a scarcity of ubiquitous gas infrastructure (and regulatory issues associated with pipelines), but modern technology has allowed for spot markets and easier transport (i.e. via LNG) of gas. As such, marketing covenant disputes often have more to do with the reasonableness of a lessee’s market-timing decisions, not the availability of a market.

The implied covenant to market at an appropriate price requires lessees to exercise reasonable diligence, as a prudent operator, with due regard for the interest of both lessor and lessee, to obtain a market for the gas produced at a prevailing market price (Champlin Petroleum Co.).

While it is generally understood that royalty payments should be made free of production costs, the implied covenant to market free of “post-production” costs requires lessees to also pay royalties free of some post-production costs. Different states draw different lines for whether gathering and transporting gas should be included or excluded in cost deductions when determining royalty payments. Jurisdictions are also split on whether separation, compression, dehydration, treating, and processing costs should be included or excluded; they are split between the “wellhead” view and the “marketable product” view.

The Implied Covenant to Protect Against Drainage

The implied covenant to protect against drainage requires lessees to stop or offset drainage from tracts they have leased from their lessor going being drained from operations on other tracts. Lessors themselves can’t protect themselves from such drainage because they have leased out the right to develop and produce oil and gas to the lessee.

Implied Covenants to Drill

Implied covenants to explore / develop / test land are different from implied covenants to protect from drainage because royalties aren’t lost due to the loss of oil and gas; the use of money is simply lost (money which could have been obtained from exploration, development, and testing). The implied covenant to test is one covenant which requires lessees to test leased land within a reasonable time, as royalties were the primary consideration for the grant of the lease, and without testing the land, no royalties could be obtainable (this covenant is somewhat outdated due to the fact that modern lease terms are fairly short and clauses such as delay rentals allow for the non-testing of land for periods of time). The implied covenant to develop requires lessees to further develop producing wells if a reasonably prudent operator would drill additional wells to more fully develop the leased premises.

The Implied Covenant to Operate Diligently and Properly

The implied covenant to operate diligently and properly is connected to most of the other implied covenants and is something of a “catch-all” category for lessee duties and responsibilities.

References:

https://www.westacademic.com/Lowe-Anderson-Kulander-Ehrman-and-Griggss-Cases-and-Materials-on-Oil-and-Gas-Law-8th-9781636591698