Savings and Pooling Clauses, Royalty Payments, and Implied Covenants Spring2021 Course Notes - GULC
- nisheetdabadge
- May 20, 2023
- 6 min read
Updated: Oct 22, 2023
Savings Clauses as Substitutes for “Production”
Savings clauses, such as the shut-in clause, cessation-of-production clause, dry-hole clause, force-majeue clause, and pooling clauses, exist as a part of an oil and gas lease to allow lessees to extend their leases where they have not obtained or maintained “production” (actual or capability, in paying quantities). They often create a form of “constructive production” that, if satisfied, allows for the continuation of leases through their entire economic life cycles (pooling clauses are more than just savings clauses, making changes to the granting and royalty clauses as well). Shut-in clauses allow for a producing well that hasn’t been connected to actual pipeline (thus, no actual production) to be shut-in and still be treated as constructively producing oil during this shut-in period.
Pooling Clause: Modifying the Granting, Habendum, and Royalty Clauses
Pooling clauses allow lessees to expand a lease from a lessor to include land around the lessor’s leased-in-question estate (i.e. the lessor’s interests); any operations conducted on the pooled land will have the same effect on extended the lease as if those operations were conducted on the originally leased land (i.e. through actual and constructive production on pooled land); and pooled lessors agree to accept royalty payments based on their proportionate acreage of the pooled land (this means that if land is pooled, but oil is only found on the acreage of one of the lessors’ estates, then the other lessors still get some royalties and the lessor whose land actually contained the oil gets a smaller royalty than he would have if there was no pooling). Where no pooling clauses exist in a lease, lessees can still unilaterally seek and obtain compulsory pooling orders where available. Voluntary pooling agreements can also be crafted in non-compulsory jurisdictions, but these are difficult to craft because of strategic negotiation between the multiple to-be-affected lessors. Disputes regarding pooling clauses often require the answering of whether the exercise of pooling was in accord with the terms of the pooling clause, and if so, was that exercise made in “good faith.” Pooling clauses are voluntary and must be exercised by lessees.
Pooling clauses often require lessees to obtain prior approval of a conservation commission or to record a declaration of pooling. Unit production may also be required to be allocated in pooling on an acreage basis; some pooling is allowed for gas and not oil. While courts find that pooling is anticipatory in nature and thus construe lessee pooling authority to be broad, they also tend to interpret pooling language strictly (i.e. if a pooling clause allows for a maximum poolable area, subject to larger potential areas as prescribed by the government, then the area prescribed by the government is the maximum (even if the government also allows for greater areas past the prescription) (Killingsworth)). Lessees generally cannot apply the pooling power (so as to extend a lease) after the original primary lease term has already expired.
Lessees can exercise the pooling power more than once, can create new drilling units if the first drilling unit dissolved, can exercise the pooling power to pool a portion of unpooled land with other lands even if another portion of that land has already been pooled with a different set of lands, and can modify an existing unit through the exercise of the pooling power. Many pooling clauses only allow for pooling to occur as a part of development (not allowing for the pooling of already-producing land). Pooling is only recognized as of the date it is recorded, and cannot be used to pool land retroactively (Tittizer). Field-wide pooling is sometimes disallowed, sometimes allowed for unitizing field-wide development and management, and sometimes even for exploration. If pooling is improper, the lessor’s remedy is often that the pooling is simply deemed ineffective (this often occurs when the lessee exceeds his authority or if the formalities of the pooling clause are not followed). In Luecke, the lessee violated a negotiated pooling provision it had entered into with the lessor by engaging in horizontal drilling which entered parts of the lessor’s lands (which was not poolable under the lease); the court found that society’s interest in efficient production through horizontal drilling allowed for the drilling to be valid, given that the lessor recover royalties based upon the production that could be “attributed to [his] tracts with reasonable probability” (using this instead of the rule of capture (which would have given all the royalties from the drilling to the lessor)). A duty to pool may arise if pooling is required in order to comply with the broad requirements of prudent operation (most pooling clauses, however, obligate nothing of this sort).
The good faith standard for exercise of the pooling power exists in part because of the broad nature of lessee authority under the pooling clause and in part because of the idea that the pooling clause favors the lessee’s interests more so than the lessor’s interests.
Lease Limits on the Pooling Authority
Lessors often dislike and attempt to strike pooling clauses because they can lead to lessees having too much discretion in their abilities to preserve their leases, further diluting royalty payments to lessors. There are three main lease provisions that can be thus used to limit the scope of pooling clauses:
Anti-dilution clause: these clauses allow lessors to limit the extent to which their royalties can be diluted through pooling by limiting a lessee’s ability to pool leased premises unless all of the leased premises is located either within the pooled unit for a well or within a unit for another gas well; they can also limit the acreage of pools (Wingate)
Pugh clause: these clauses restrict lessees from holding onto leases outside of the actual producing unit, which might have been pooled with several different lands / leases (this will still lead to royalty dilution for the lessor who leased out the producing land, but will stop the lessee from extended the leases of surrounding lands via “gerrymandering”); these clauses sometimes don’t apply to pools that flow from compulsory pooling statutes (Tojac Minerals, Inc.) and can be either horizontal or vertical (separating adjoining sub-surfaces, left-right, or levels of surface, up-down); some compulsory pooling statutes also contain Pugh-like provisions
Retained acreage provision: similar to Pugh clauses but don’t apply to pooling; these clauses limit the continuation of a lease based on drilling / prorating units that exist within a lease (meaning that if drilling continues on a portion of a lease past the expiration, only that part of the leased land is extended; the rest of the lease is not extended)
Royalty Payments
A lease royalty can be conveyed through the execution of a lease from a mineral owner, often ranging between 1/8 and 1/3 of the money flowing from production. Overriding royalties can be conveyed by lessees to their assignees or assisting parties for 1/32 to 1/8; nonparticipating royalties can also be reserved by landowners for 1/16, or half of the lease royalty, so that when they sell land, they can still obtain a portion of the proceeds stemming from production. Lease royalties give lessors great revenue if production or mineral prices are high, and less revenue if production or mineral prices are low (royalties are a way of hedging for the probability that minerals will or will not be found and then marketed at a certain rate). Oil royalty clauses often require lessees to deliver produced oil to surface storage sites owned by the lessor, while gas royalty clauses often require lessees to produce and sell the royalty gas and provide the lessor with the final money payments. Royalties benefit lessees because they can pay royalties instead of larger, upfront bonuses, and they benefit lessors because they can lead to large amounts of profit much larger than a smaller upfront bonus. Royalties do create a conflict of interest between lessors and lessees, however, in that the while the percentage might not matter as much to a lessor, it may matter to a lessee, who has spent most of the production revenue on production expenses (thus meaning that a larger revenue royalty might lead to a lease becoming a net cost, after subtracting the operational and royalty costs from the production revenue). Royalty litigation often stems from gas leases, mainly because of the various procedures required to dehydrate, purify, and remove natural gas liquids from produced gas before actually compressing it and selling it via pipeline.
In Vela, the court held that gas prices should be sold at market value, which is necessarily dependent on future long-term contracts for sale of gas (and not set prices at the beginning of the lease for gas contracts).
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