Lease Cancellation based on “Paying Quantities” Remains A Challenge

Recently, the Texas Supreme Court issued its opinion in BP America Production Company v. Laddex, Ltd., Case No. 15-0248 (Tex. 2017). In the Laddex case two issues were presented to the Court: 1) whether a top lease granted by the lessors had violated the rule against perpetuities, and was therefore void, and 2) whether the underlying lease had expired for failure to produce in paying quantities.

With regard to the Rule Against Perpetuities (RAP) question, the top leasing of existing oil and gas leases appears to be one of the few places in the law where the RAP can still be an issue of real concern. In the present case, the lessee, Laddex, was the party bringing the suit to cancel the underlying BP lease, and if the RAP had been violated, they would not have had standing to bring the case (a lessee of a void lease doesn’t have a dog in the fight, so to speak), so BP’s defense lawyers had to make the argument. In the end, the Court confirmed that the top lease had been properly drafted so as to avoid application of the RAP, so this case adds little to our understanding of the issue. However, it does provide a nice refresher on the RAP and an explanation of how the rule works, so if you are rusty on RAP with regard to top leases, this case provides a great analysis.

With regard to Production in Paying Quantities (PPQ) the case boiled down to how the jury charge at the trial court was structured. The Texas case of Clifton v. Koontz, 325 S.W.2d 684 (Tex 1959) established a two prong analysis for determining if a lease has expired for lack of production in paying quantities. First, an objective prong, measuring whether a well pays a profit over operating expenses. Note that this is only over operating expenses and not a recoupment of the capital investment. Also, the Laddex Court was careful to remind us that in the Clifton profit analysis “there can be no limit as to time, whether it be days, weeks, or months, to be taken into consideration in determining the question of whether paying production from the lease has ceased.” Clifton, 325 S.W.2d at 690. The Second prong of the analysis is whether, under all the relevant circumstances, a reasonably prudent operator would, for the purpose of making a profit and not merely for speculation, continue to operate the well as it had been operated.

The trial court in the Laddex case, while allowing evidence for a larger period of time, restricted the jury’s consideration to a specific 15-month period of production slowdown. BP argued that the months before and after the production slowdown should be included in the time period of consideration to show profitability. The Laddex Court held that any restriction to the period of time to be considered by the jury was impermissible. While this makes the objective prong of the test a little less amenable to an objective measurement, it appears clear that both sides are free to argue what should be considered reasonable, but the actual determination over the time period of profitability is to be left for the jury to decide. This holding continues to show how difficult it is to prosecute a case, and to cancel a lease, over paying quantities. By ruling that the trial court’s jury charge was improper on the objective prong, the Laddex court did not even get to the second prong of the test.

Under the Clifton 2-prong review, even if the jury finds that there was no actual profitable production over a given “reasonable” period of time, the second prong is then considered whether,

in light of all the circumstances, a reasonable and prudent operator would nevertheless continue to operate the well. As the second prong is a subjective measurement, it can arguably have an even wider impact for many cases, and its impact has been expanded in recent years. When the really low oil prices hit during the late 90s, many wells went underwater with regard to profitability. The industry held their leases, and a number of cases were brought seeking to cancel leases based upon PPQ. The subjective standard, and the prudence of the operator who may believe that better days are on the way, is also a question of fact for the jury, making any attempt to cancel a lease under PPQ problematic. The period of very low prices in the late 1990s didn’t last forever, and many wells indeed returned to profitability, and the operators that continued to operate their leases were vindicated (both in practice, and in the courts).

Lets apply the prudent operator subjective prong to the current market. With the fall from $100 oil to the $40-50 bounding range, doubtless there are wells that were once profitable that are now no longer so. All during this period of time we have had the market analysts, the corporate executives, and every manner of expert and pundit forecasting a future rise in the price of oil. The market bounce has thus far eluded us. There are still quite credible market players predicting $75 oil in the not-too-distant future. When the inevitable case arrives in the courts claiming lease failure for failure to produce in paying quantities (and the operator actually needs $60 oil to break even), where is the line of prudence, of reason, for holding out for better days? Clearly the entire industry is hopeful and expecting of higher prices in the not too distant future. At what point does that holding out become unreasonable? What do you think – would prudent operators hold on to wells and leases in the current market that only break even at $60 oil? What do you think a jury will say?

In any event, when these cases do come to trial, the Laddex case reminds us that the “reasonable” time period for determining if the well was producing in paying quantities should be left for the jury to decide.