Common Oil and Gas Lease Conundrums eBook


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An ebook published by the law firm Porter Wright Morris & Arthur LLP. Contains several blog posts they've published on the topic of oil and gas lease issues for landowners. Our favorite article: My Sister is a Fractivist and Won’t Sign an Oil and Gas Lease. What Can We Do?

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Common Oil and Gas Lease Conundrums eBook

  1. 1. Oil & Gas Law ReportBlog series:Common Oil and GasLease ConundrumsA relationship of adifferent stripe.
  2. 2. Page 2 of 20Table of contentsPorter Wright Resources ......................................................................................................................... 3Production in “Paying Quantities”........................................................................................................ 4Lawsuits Over “Fraudulent” Oil & Gas Leases Often Lack Merit...................................................... 7Implied Covenants May Require Mineral Lessees to Develop Deep Rights................................ 10A Bonus Payment Is Not Relevant to the Validity of an Oil and Gas Lease ................................ 12My Sister is a Fractivist and Won’t Sign an Oil & Gas Lease. What Can We Do?........................ 14When Is an Assignment of a Lease not an Assignment of Obligations? ...................................... 18
  3. 3. Page 3 of 20Porter Wright ResourcesPorter Wrights Oil & Gas practice group includes more than 40 attorneys with extensiveexperience in all aspects of doing business in the Marcellus and Utica shale plays. Theseattorneys include:Brett Thornton is chair of the Oil &Gas practice group. He counselsclients on corporate and financingissues related to the operation ofpipeline systems for transportingpetroleum products, and thedevelopment, production andtransport of energy resources.Chris Baronzzi has experience with arange of oil and gas matters,including the Ohio Dormant MineralsAct, lease forfeiture actions, leaseterms, oil and gas well constructionissues, seismic surveys, water testing,division orders, pipeline easements,eminent domain and appropriation.Jeff Fort advises oil and gas clientson operational, governance,environmental, employment andcontracting issues. His practice alsoencompasses permitting, regulatorycompliance, environmental auditsand assessments. and solid andhazardous waste disposal.Eric Gallon counsels on subjectsincluding Clean Air Act complianceand defense, public utilities law,government relations, contractdisputes and damages actions underthe Ohio Consumer Sales PracticesAct and federal TelephoneConsumer Protection Act.Scott North concentrates in theareas of complex civil litigation andregulatory and governmentalaffairs. He presently serves on theOhio Supreme Court Task Force onCommercial Dockets byappointment of the Chief Justice ofthe Supreme Court of OhioRob Schmidt represents clients inenvironmental programs such as theClean Air Act, Clean Water Act,Superfund, solid and hazardouswaste, emergency planning andagricultural issues. He has extensiveexperience negotiating with stateand federal environmental agencies.Chris Schraff practices in the firm’sEnvironmental/Energy/Governmentdepartment, having special interestin the Federal Water PollutionControl Act, CERCLA and RCRAmatters, wetlands regulation,pretreatment requirements, andstate/local environmental statutes.Ryan Sherman concentrates hispractice on complex commercialdisputes, with a particular focus onconstruction matters, IP litigation andsecurities and shareholder disputes.His practice also involvesrepresenting clients in emergencyinjunctive proceedings.Porter Wright Morris & Arthur LLP41 South High St., Suites 2800-3200Columbus, OH
  4. 4. Page 4 of 20Production in “Paying Quantities”August 1, 2012 | Jeff FortThe Point: Oil and gas leases arespecialized instruments of real estate andcontract law. The very existence of thelease can turn on court opinions over 100years old (with little between now andthen) and the court’s interpretation ofsomething as ephemeral as “good faith”can be determinative. Curativedocuments, a royalty check endorsement,division orders and the like may clarifyambiguities when a lot of money is atstake.Discussion: The relationship between theowner of minerals (which may be differentfrom the owner of the surface, the subjectof a future blog) and the oil company istypically defined in and oil and gas leasewhere the Owner, in a contract, grants toLessee defined rights to the property inexchange for promises and money. Thelength of the lease, the term, is addressedin one of the most important provisions thelease — the “habendum” or term clause,which usually appears near the beginningof the lease. The term clause in an oil andgas lease is the product of longdevelopment and experience. It attemptsto reconcile the competing interests of theparties. Owner wants a well and its royaltypayments quickly (a short term) whileLessee wants flexibility and as much timeas possible (a long term). Given the newinterest in oil and gas production in Ohio, itis crucial to understand the term clause forboth old/existing leases and new ones.There are many variations and the additionor deletion of a word or a phrase can havedramatic consequences. An example of atypical provision:“This lease is for a primary term of12 months, and as long thereafter asoil or gas is produced.”As the so-called “thereafter” clause canextend the lease indefinitely, it often is thesource of controversy. It may extend thefixed or primary term so long as oil or gas,“is produced from said land.”Other variations include:• “is or can be produced”• “is or can be produced in Lessee’sjudgment”• “is produced from said land or thepremises are being developed oroperated”• “is produced in paying quantities”• “is produced from said land or landwith which the land is pooledhereunder”• “is produced from said land byLessee, or drilling operations arecontinued, as hereinafter provided.”
  5. 5. Page 5 of 20A recent case decided by the SupremeCourt in Pennsylvania illustrates thecontroversy. T.W. Phillips Gas and Oil Co.and PC Exploration, Inc. v. Ann Jedlicka,decided March 26, 2012. The land owner,Jedlicka, sought to have an old leaseterminated for the failure to produce “inpaying quantities.”First, the court reviewed the respectiveinterests of the parties to a lease. Theinterest granted in an oil and gas lease isinchoate. That is, it is an interest that is likelyto vest but has not yet actually done so.Vesting is dependent on the occurrence ofan event. Here, if development during theagreed upon primary term is unsuccessful,no estate vests in the lessee. If, however, oilor gas is produced, an interest in theproperty is created in the lessee, and thelessee’s right to extract the oil or gasbecomes vested.The interest created in the lessee is a “feesimple” meaning that it may last forever inthe lessee and his heirs and assigns, theduration depending upon theconcurrence of an event, here thetermination of production. Since the feecan end, the interest is a “fee simpledeterminable.” It automatically reverts tothe grantor upon the occurrence of theevent. The interest held by the grantor aftersuch a conveyance is termed “a possibilityof reverter.”The lease is also a contract. As the courtpoints out, it must be construed inaccordance with the terms of theagreement as manifestly expressed, andthe accepted and plain meaning of thelanguage used, rather than the silentintentions of the contracting parties,determines the construction to be giventhe agreement. Further, a party seeking toterminate a lease bears the burden ofproof.In short, Jedlicka argued that the leasehad suffered a loss in 1959 and wastherefore terminated and that “lesseesshould not be allowed to hold landindefinitely for purely speculativepurposes.” Lessee argued that the leaseremained valid; that the wells on theproperty have produced gas in payingquantities because they have continuedto pay a profit over operating expenses;and that they have operated the wells ingood faith to make a profit.What’s a “paying quantity?” Jedlickaargued that it is simple math — anobjective test — using a computation ofproduction receipts minus royalty minusexpenses including marketing, labor,trucking, repair, taxes, fees and otherexpenses. Rejecting that approach andreaffirming an 1899 decision, the court heldthat consideration should be given to alessee’s good faith judgment (that is, asubjective test) when determining whetheroil was produced in paying quantities.Jedlicka argued that, “if only a subjectivestandard is used to determine payingquantities, oil and gas companies maychoose to hold onto otherwise unprofitablewells for merely speculative, as opposed toproductive, purposes.”The court disagreed, “a lessor will beprotected from such acts because, if thewell fails to pay a profit over operatingexpenses, and the evidence establishesthat the lessee was not operating the wells
  6. 6. Page 6 of 20for profit in good faith, the lease willterminate. Consideration of the operator’sgood faith judgment in determiningwhether a well has produced in payingquantities, however, also protects a lesseefrom lessors who, by exploiting a briefperiod when a well has not produced aprofit, seek to invalidate a lease with thehope of making a more profitable leasingarrangement.The Ohio Supreme Court considered asimilar case in 1955. Hanna v. Shorts. There,lessee’s argument that “lessee’s good faithjudgment that production is paying mustprevail” in determining whether there isproduction in paying quantities did notsurvive the fact that there had been noproduction at all. (It took the SupremeCourt to figure that out? It just goes toshow that when there is a lot of money atstake, controversy and litigation abound.)Back to top
  7. 7. Page 7 of 20Lawsuits Over “Fraudulent” Oil & Gas Leases OftenLack MeritDecember 13, 2012 | Chris BaronzziThe Ohio shale boom started slowly when afew small companies quietly beganacquiring mineral leases for as little as $25per acre. This soon gave way to a fullblown land rush in the fall of 2010. But aslease prices skyrocketed through the Fall of2011, disillusioned lessors who signedbefore the peak of the market were theones rushing — to the courthouse to filelawsuits to cancel their leases.In order to gain leverage and legitimizetheir lawsuit, lessors frequently allege thattheir lease is “unconscionable” or theywere fraudulently induced to sign it.“Exhibit A” to these lawsuits is often atechnical error in the lease signing or a“fraudulent” statement made by alandman. There are exceptions, but manyof these kinds of lawsuits have no legalbasis.Technical Notary Errors Do NotVoid a LeaseA favorite technical error alleged by lessorsis improper notarization of the lease. ORC§5301.01 does indeed require documentslike mortgages, deeds and leases to besigned and notarized. That statute andrelated case law may lend some supportto an argument to cancel a lease thatcompletely omits a signature, notaryacknowledgment, or name of the lessor.However, Ohio law does not allow a lessorto cancel a lease because of a technicalerror by the notary. “[A] defectivelyexecuted conveyance of an interest inland is valid as between the partiesthereto, in the absence of fraud.” CitizensNat. Bank in Zanesville v. Denison (1956),165 Ohio St. 89, 95. This principle, which isalso reflected in ORC §2719.01, expressesthe law’s refusal to nitpick technical errorsin contracts to undermine the intent ofparties.In Swallie v. Rousenberg,2010-Ohio-4573, ¶35(Seventh Dist.) the courtupheld the validity of adeed as to the parties tothe transaction eventhough the granteeimproperly acted as thenotary. In Logan Gas Co. v.Keith (1927), 117 Ohio St.206, 208 the Court held thateven though one of thelessor’s signatures wasimpermissiblyacknowledged bytelephone, the oil and gas
  8. 8. Page 8 of 20lease remained valid. Finally, ORC §5301.071 provides that even if a notary failsto seal the acknowledgment, the validityof the agreement is unaffected.Calling attention to a notary error may geta notary’s license revoked, or cause aconsternation for a county recorder, but itis not grounds to disregard contractualobligations between parties.Fraud or the Hard Truth?Lessors often complain that a landmantold them to sign immediately or “theywould miss their chance” or “the companywould just take their minerals anyway” orsome similar statement. These kinds ofstatements, even if they were made,probably do not amount to fraud.First, predictions of future events typicallydo not constitute fraud. “It is clear in Ohiothat fraud cannot be predicated uponpromises or representations relating tofuture actions or conduct.” Crase v. ShastaBeverages, Inc., 2012-Ohio-326, ¶42 (TenthDist.). Further, such statements haveproven to be true in many circumstances.Next, Ohio oil and gas law does not requirean operator limit production to within theboundary of a leased parcel. Ohio followsthe doctrine of “correlative rights,” whichpreserves each landowner’s opportunity todraw from a common resource. ORC§1509.01(I). Under this doctrine, so long asthere is no waste or reservoir damage,each landowner has the right to take asmuch oil and gas as his or her wells willproduce, although the minerals may bedrained from the land of others. Williams &Meyers, Abridged Fourth Edition, §203.2.There are a number of scenarios thatwould allow a lessee to drill a well on oneparcel and draw oil and gas out frombeneath adjacent, unleased, parcels inOhio. Drilling a well to intersect largenatural fractures, for example, is onescenario that may allow a lessee toproduce from beneath an adjacent parcelregardless of whether it is leased. In thatscenario, a landman’s statement that alessee could take minerals from beneathan unleased parcel is accurate.Next, statements by landmen thatlandowners should sign a lease quickly,before they “miss their chance” or that theoffer was “for a limited time” seemeddisingenuous in the early months of thelandrush. But when the landrush subsidedin early 2012 some landowners saw leaseoffers of nearly $6,000 per acre withdrawnliterally overnight. This fluctuation in leaseprices was dictated by unpredictablemarket forces, including competitionamong various lessees, the amount of landleft to lease, the price of natural gas, andproduction from exploratory wells.Landmen who urged landowners to seizethe opportunity to lease were notcommitting fraud. In many cases they wereactually giving good advice.Bad Timing Does Not Makea Contract UnconscionableIn order to prove that a lease isunconscionable, a lessor must produceclear and convincing evidence that thelease contains commercially unfair orunreasonable terms, that no voluntarymeeting of the minds was possible, andthere was an absence of meaningfulchoice for the lessors. Featherstone v.Merrill Lynch, Pierce, Fenner & Smith Inc.,2004-Ohio-5953, ¶13 (Ninth Dist.).The legal theory of unconscionability is notyet well developed as it relates to modernleases focused on horizontal drilling. Whatis “commercially reasonable” for thisrelatively new industry will undoubtedlychallenge Ohio courts for years to come.
  9. 9. Page 9 of 20Likewise, most claims of unconscionabilitywill probably fail because of the voluntarynature of the lease arrangement. If a lessortries to void a lease as unconscionable, thelessor will have to show that they had nochoice but to sign a lease. This will be adifficult task. In most cases, lessors made adeliberate decision to lease with whateverinformation they chose to gather, and theywould have been thrilled if they timed themarket perfectly. But, a lessor’s failure totime the market does not equate to fraudor render a lease unconscionable. Asexplained in my prior blog on the subject,courts do not and should not decide whatprice is “enough” for a particulartransaction.Back to top
  10. 10. Page 10 of 20Implied Covenants May Require Mineral Lesseesto Develop Deep RightsAugust 1, 2012 | Chris BaronzziUntil recently, most lessors and their lawyerswere not educated about technicalnuances of oil and gas law, such asimplied lease covenants. But the recentshale boom and expected productionfrom horizontal wells in the Marcellus, Utica,and Rose Runformations hasrevolutionized therelationship betweenlessors and lessees.The disinterested, ill-informed masses ofOhio lessors thatexisted before 2010are now driven by theprospect of life-changing bonuspayments and fear of environmentalruination. Now lessors read their leases,attend oil and gas seminars, ask questions,and are eager to enforce their rights. Thestakes are high enough that lessors andtheir attorneys are lining up for anyopportunity to forfeit leases.Lessees’ Legal Obligations Are EvolvingThe advent of horizontal drilling in Ohiomay create a trap for unwary lessees.Small lessees may be especially vulnerableif their leases do not contain provisions towaive the implied covenants that Ohiocourts automatically read into oil and gasleases. These implied covenants generallyrequire a lessee to exercise “reasonablediligence” under an oil and gas lease, andspecifically include, among other things, a“covenant of reasonable development.”Moore v. Adams, 2008-Ohio-5953, ¶31-37(Fifth Dist.); citing 5 Williams & Meyers, Oiland Gas Law (1991); Beer v. Griffith (1980),61 Ohio St.2d 119.In recent times implied covenants havenot been terribly burdensome to Ohiolessees because theopportunity for oil andgas production in Ohiowas well known andcould be exploitedwith conventional andaffordable drillingtechniques. However,as horizontal shaledrilling and otheremerging technologiesgain acceptance, theconcept of“reasonable development” will changeand burdens on lessees will increase.Just as hand-dug wells would no longersatisfy a lessee’s implied covenants, lesseesmay soon have an obligation to developshale resources through horizontal wellsand other such technology.Ignoring implied covenants to speculateon increasing oil and gas prices orbecause of an inability to financehorizontal drilling operations is risky forlessees. There is legal precedent forawarding damages or forfeiting leasesbecause of a lessee’s failure to meetimplied covenants. Implied covenantshave even been used to break leaseswhen the explicit terms of the lease werenot violated and the leasehold wasostensibly held by production.
  11. 11. Page 11 of 20In Beer v. Griffith (1980), 61 Ohio St.2d 119,a lessor asked the court to forfeit a leaseheld by a financially troubled lessee thatwas only operating one well on a 150 acreleasehold. The Ohio Supreme Court found,“while lessee did not violate any expressprovision of the lease, lessee did breach animplied covenant to reasonably developthe lands.” Id. at 121. The Court ultimatelyforfeited the lease on all but the 40-acreunit that contained a productive well. TheCourt held, “with respect to the wells whichwill require further efforts to be productive,and also with respect to all unexploitedacreage, forfeiture of lessee’s interest iswarranted in order to assure thedevelopment of the land and theprotection of lessor’s interests.” Id. at 122.In Sauder v. Mid-Continent PetroleumCorp. (1934), 292 U.S. 272, the United StatesSupreme Court reached a similarconclusion on similar facts. In its decision toforfeit a lease on a 320 acre tract, theCourt held, “production of oil on a smallportion of the leased tract cannot justifythe lessee’s holding the balanceindefinitely and depriving the lessor, notonly of the expected royalty fromproduction pursuant to the lease, but ofthe privilege of making some otherarrangement for availing himself of themineral content of the land.” Id. at 281.The rationale for a court to forfeit a leasewhen a leasehold is not being fullydeveloped is that the “real considerationfor the lease” is the lessor’s “expectedreturn derived from the actual mining ofthe land.” Ionno v. Glen-Gery Corp., 2 OhioSt.3d 131, 133 (1983). ”The law of Ohiorequires that potential production betranslated into actual production.”American Energy Services v. Lekan (1992),75 Ohio App.3d 205, 213 (Fifth Dist.).What Does This Mean for Ohio Lessees?As demonstrated by the Beer and Sauderdecisions, implied covenants havesometimes been applied very much like acontractual Pugh clause. Under the rightcircumstances, implied covenants couldbe used against a lessee to seek damagesor to strip a lessee of virtually all of itsvaluable lease rights.But, until Ohio shale resources are provenand horizontal drilling or other advancedtechnologies are widely accepted in Ohio,the standard for what constitutes“reasonable development” and“reasonable diligence” under a minerallease will not change. Lessees still havetime to protect themselves by eitherexploring and developing deep rights ontheir own or by entering into farm-outagreements or similar arrangements withother operators to share the cost of thoseactivities.Fortunately, despite the existence of sometroubling legal precedent, forfeiting oil andgas leases remains difficult for lessors, andsuch lawsuits can often be successfullydefended by legal counsel who knows thenuances of oil and gas law.The shale resources many oil and gasoperators currently have under lease inEastern Ohio may be worth untold millionsof dollars. By any measure they are far toovaluable to risk losing. Lessees should takesteps to preserve their lease rights andidentify legal counsel who can assist themwith those arrangements and with thedefense of any lease forfeiture lawsuitsthey may encounter.Back to top
  12. 12. Page 12 of 20A Bonus Payment Is Not Relevant to the Validityof an Oil and Gas Lease LawAugust 1, 2012 | Chris BaronzziIn Eastern Ohio before 2010, a customarysigning bonus for an oil and gas lease wasusually less than $25 per acre, as it hadbeen for years. By the fall of 2011, after theshale boom hit, lease bonus prices hadrisen in leaps and bounds to their peak (sofar) of about $6,000 per acre before pullingback significantly in the spring of 2012.Naturally, everyone who did not have theforesight or nerve to hold out for $6,000 peracre was left feeling more than a littlemiffed. After all, a typical bonus check ona 100 acre parcel in 2009 or early 2010would have been $2,500 but that bonusmay have swelled to $600,000 in less thantwo years!Courts Do Not Decide What is “Enough”Fortunately for our economy and legalsystem, a party to a contract cannot lateradjust the contract price when they finallyrealize the value of a transaction. In fact, itis the imbalance of information, risktolerance, and vision among differentpeople that is the driving force of businessin the United States.But even reasonable lessors wereoverwhelmed by the incredible disparitybetween lease bonuses paid during theshale boom. That disparity, combined withthe belief that the oil and gas companieshave bottomless bank accounts, spawnedlawsuits by lessors to try to break leases withthe hope of signing for more.Of course, breaking contracts requiresmore than just a lot of hard feelings aboutnot getting paid enough. “It is axiomaticthat courts, as a general rule, will notinquire into the adequacy of considerationonce consideration is said to exist.” Rogersv. Runfola & Assoc. Inc. (1991), 57 OhioSt.3d 5, 7. In other words, as long as somevaluable consideration was paid for alease, the amount of that consideration isnot relevant to the validity of the lease.Oil and Gas Leases Are DifferentCourts should be even more reluctant topass judgment about the initialconsideration given for oil and gas leasesthan the consideration given forconventional contracts.
  13. 13. Page 13 of 20Unlike conventional contracts for sale of anasset at a determinable price, animportant part of the consideration givenfor an oil and gas lease is the lessee’spromise to pay future royalties onproduction. The bonus payment is only part— and possibly a small part — of the totalconsideration that will be realized from anoil and gas lease.If the total consideration (including bonusand royalties) for an oil and gas lease iscalculated, the average difference invalue realized by different lessors over thelife of their leases will be much less distinctthan the disparity in bonus payments theymay have received.For example, our hypothetical landownerwith a 100 acre parcel who signed a leasefor $2,500 may have only received .42% ofthe maximum bonus that would have paidat the peak of the market. But takingroyalties into account, the total value ofthat same lease is discounted merely11.94%, assuming royalty income of$5 million over the life of the lease.Furthermore, even with a narrow focus ononly the bonus payment, it is incredible fora lessor to allege that he or she wouldhave received a much larger bonus if alandman or lessee had been moreforthcoming. Market forces caused bonuspayments to fluctuate wildly during theshale boom and no one could predictwhen the market would peak or when itwould collapse.Consequently, landowners and courtsshould not be tempted to judge oil andgas leases from a narrow and short sightedanalysis of only the disparity in bonuspayments. Likewise, no one should beconvinced by the perfect perspective ofhindsight that a landowner would havetimed the market better if furtherinformation was known.Back to top
  14. 14. Page 14 of 20My Sister is a Fractivist and Won’t Sign anOil and Gas Lease. What Can We Do?August 17, 2012 | Christen Blend and Jeff FortWhen something is owned by more thanone person at the same time, there can beproblems.Background (and we mean far back!)Since the Statute of Westminster II, c. 22(1285), a co-tenant has been subject tothe law of waste. This rule of liability is foundin the law of all states in one form oranother. Therefore, as a generalproposition, a cotenant may not removeminerals from concurrently owned landwithout the consent of the othercotenants. Williams and Meyers, Oil andGas Law, § 502.But waste goes both ways. Given thefugitive nature of oil, which may bedrained from the land by a well onadjoining property, if the cotenant owninga small interest in the land was required togive his consent before the others couldproduce the oil, he could arbitrarily destroythe valuable quality of the land.Most states, therefore, strike a balanceand allow “unilateral” production by acotenant subject to an accounting to theother cotenant, i.e., a sharing of netproceeds.HypotheticalAssume that three siblings, A, B, and C,inherited the minerals on a 160-acre parcelof land. Oil Company proposes to drill a 40-acre well on the property and all threesiblings sign a lease providing for a 1/8royalty in exchange for Oil Company’spaying the expenses. If production isrealized, the proceeds will be divided asfollows:Owner Fraction DecimalA 1/3 x 1/8 0.0416666 RIB 1/3 x 1/8 0.0416667 RIC 1/3 x 1/8 0.0416667 RILessee 7/8 0.8750000 WITotal 8/8 1.0000000Now assume C won’t sign a lease.Ohio LawUnder Ohio law, a tenant-in-commongenerally may transfer, devise, orencumber his interest in the propertywithout the consent of his co-tenant. Kosterv. Bodreaux, 11 Ohio App.3d 1, 5 (1982),citing 4 Thompson on Real Property,
  15. 15. Page 15 of 20Separate and Concurrent Ownership,Section 1793, at 136-137 (1979).Ohio courts have not decided the morespecific issue of whether one tenant-in-common may make a valid lease of hismineral rights without the consent of hiscotenant, and courts in other states thathave considered this issue have not ruledconsistently. While some courts have heldthat one tenant-in-common may lease hisoil rights without the consent of hiscotenant, others have held to the contrary.Still other courts permit a tenant-in-common to exploit underground deposits,but require him to account to a cotenantfor any profit that is realized.Ohio law states generally that “[o]netenant-in-common … may recover fromanother tenant-in-common … his share ofrents and profits received by such tenant-in-common … from the estate, accordingto the justice and equity of the case.” OhioRevised Code 5307.21. Ohio courts havenot considered this requirement in thecontext of underground mineral rights. But,given this statute and since oil and gasresources are finite and transitory, Ohiocourts may be receptive to the argumentthat one cotenant should be allowed toproduce minerals from the propertywithout the other cotenant’s consent.With that background, A, B, and OilCompany may elect to proceed withoutC, but such unilateral development is riskyfor Oil Company. In such a case, OilCompany becomes a tenant-in-commonwith C as to the rights granted by thelease, i.e., the right to explore for andproduce the minerals. How are theproceeds divided? As there is no leaseproviding for a 1/8 royalty and anallocation of expenses for C, a possibleoutcome is:Owner Fraction DecimalA 1/3 x 1/8 0.0416667 RIB 1/3 x 1/8 0.0416667 RIC 1/3 0.3333333 MILessee 2/3 x 7/8 0.5833333 WITotal 8/8 1.0000000Since C has benefitted from OilCompany’s work and they are cotenants,absent any agreement, Oil Company maybe able to deduct from C’s share of theproduction C’s share of the expenses. So,even though A and B may be able tolease and Oil Company can produce, OilCompany’s interest in production from thewell is merely 58.3% (as opposed to 87.5% ifall three siblings agreed to lease).AlternativesAlthough Ohio case law offers no clearanswers when one or more cotenants areholdouts, the Ohio Revised Code givesoperators options.I. Mandatory PoolingIf the minimum acreage needed to drill awell cannot be obtained voluntarily, theOhio Revised Code provides for“mandatory pooling” — a procedure toforce an uncooperative owner toparticipate in a drilling unit in certainsituations. ORC § 1509.27. Mandatorypooling is process designed to protectcorrelative rights and to effectivelydevelop the mineral resources.The procedure also anticipates thesituation where the recalcitrant cotenantof a mineral estate will not sign a lease. Insuch a case, the Mandatory Pooling Order
  16. 16. Page 16 of 20from ODNR would likely provide thatmandatorily pooled parties are granted apro rata share of production from the welland the standard 1/8th royalty interestupon production of the well. However,such an Order would also require theparties to share all reasonable costs andexpenses of drilling and operating the wellas follows:• If the owner elects to participate(working interest owner), then theMandatory Pooling Order mustspecify the basis upon which eachowner of a tract pooled by the ordershall share in these expenses.• A non-participating owner will notreceive any share of production,exclusive of his/her share of theroyalty interest, until their share ofsuch costs are recovered by the OilCompany, plus an additional riskpenalty. The costs and penaltycannot exceed 200% of the non-participating owner’s proportionatecosts of the well for high financial riskand horizontal wells, or 150% forother wells. ORC § 1509.27.Thus, continuing the hypothetical, if Cbecomes a non-participating owner, theallocation is:Until costs and penalties are paid:Owner Fraction DecimalA 1/3 x 1/8 0.0416667 RIB 1/3 x 1/8 0.0416667 RIC 1/3 x 1/8 0.0416667 RIC 1/3 x 7/8 0.2916666 WI*Lessee 2/3 x 7/8 0.5833333 WITotal 8/8 1.0000000*Paid to working interest to recover costs andpenalties.After costs and penalties are paid:Owner Fraction DecimalA 1/3 x 1/8 0.0416667 RIB 1/3 x 1/8 0.0416667 RIC 1/3 0.3333333 MILessee 2/3 x 7/8 0.5833333 WITotal 8/8 1.0000000In this scenario, the Oil Company (and allother working interests) benefit from thepenalty imposed upon the recalcitrantcotenant until the well has paid out but theOil Company’s interest in the production isstill merely 58.3%.The scenarios above assume that theentire unit is located on ABC property.However, if ABC property comprises only asmall portion of the drilling unit, say 2 acresout of a 640 unit, the economics are farmore favorable. In that situation, C’sinterest, even after cost and penalties arededucted, is 1/3 x 2/640 or 0.0010417(0.104%). Even if it were 2 acres out of a 40-acre drilling unit, it would be 1.67%.These figures illustrate the importance ofstrategizing to determine where to locatethe well so as to minimize the recalcitrant’sshare or, the importance of striking a deal.II. PartitionThe age-old method of ending acotenancy is partition, and in Ohio thisremedy is provided for by statute. OhioRevised Code section 5707.01 states:Tenants in common, survivorship tenants,and coparceners, of any estate in lands,tenements, or hereditaments within thestate, may be compelled to make or sufferpartition thereof as provided in sections5307.01 to 5307.25 of the Revised Code.
  17. 17. Page 17 of 20The code sections that follow outline aprocedure for filing a petition, obtaining anorder of partition from the court ofcommon pleas, the appointment of one tothree commissioner(s) to make thepartition, etc. If it cannot be partitioned“without loss of value,” the commissionerestablishes a value and one cotenant paysthe other or there is a sale by the sheriff orat public auction.In the context of Ohio shale resources, aCourt would likely struggle with thespeculative nature of the value of themineral interests and whether physicallydividing the property would devalue theproperty, especially when a recalcitrantowner would own one of the contiguousparcels. Given these problems, a courtmay very well order a sale of the property,which amounts to a roll of the dice for allowners. Instead of assuming this risk, allcotenants would probably be better off tonegotiate a price and find a way to settlethe dispute without a sale. Recognize,however, that emotions, distrust, andspeculation about a possible bonanzaalways make settling partition actionsdifficult.Back to top
  18. 18. Page 18 of 20When Is an Assignment of a Lease not an Assignmentof Obligations?February 26, 2013 | Jeff FortWhen oil companies transfer oil propertyamong themselves, they frequently do soby an assignment of lease rights.Sometimes they assign all their interestunder a lease, but they often assign just aportion of the lease, or reserve someinterest in the property. In the event ofmultiple assignments — such as when partyA assigns to party B, who assigns to party C,and so on — there can be confusion aboutwhat was assigned, and who is obligatedto do what.This kind of controversy set the stage forthe recent decision by the North DakotaSupreme Court captioned Golden v. SMEnergy Co., 2013 ND 17, Feb. 1, 2013. TheGolden decision presents an interestingdiscussion about royalty payments, divisionorders and assigned obligations. Does thiscase portend what can happen in Ohio?Only for companies that do not learn frommistakes made in other states.The FactsGolden owned oil and gas leases coveringproperty in McKenzie County, N.D. In 1970,Golden sold his “entire interest in theleases” to “B” “subject to my retention offour percent (4%) overriding royalty.”Golden also designated a “joint area ofinterest” (“JAI”) in which the parties hadfurther rights and obligations. Specifically,the parties agreed that if Goldenpurchased additional property in the JAI,he would sell it to B at cost, subject to a 4%overriding royalty. On the other hand, if Bacquired additional property in the JAI, itwould assign a4% overridingroyalty to Goldenat no cost. Finally,the agreementbetween Goldenand B providedthat, “anyassignment of thisAgreementmade by [B] shallrecite that sameis made pursuantand subject tothe terms and conditions of thisAgreement.”B did, in fact, acquire new leases in the JAIand assigned the override to Golden. Thenin 1993, B assigned its interest in the leasesand lands covered by the 1970 agreementto C. The assignment included a provisionthat B was assigning “all right, title andinterest of Assignor in and to … alloperating agreements, joint ventureagreements, partnership agreements, andother contracts, to the extent that theyrelate to any of the Assets.” (emphasisadded)C also subsequently acquired additionalleases in the JAI before assigningeverything to D. The assignment from C toD provided that D “assumes all ofAssignor’s duties, liabilities and obligationsrelating to the Assets to which Assignor wasa party or by which it was bound on andafter the date hereof.” D ultimatelymerged into Defendant, SM Energy (“SM”).
  19. 19. Page 19 of 20All relevant documents in this case wereduly recorded.The dispute arose when, beginning in 2009,SM recognized and paid Golden’s 4%overriding royalty on production from awell located in the JAI, but refused to paythe 4% overriding royalty for earlier periods.The overriding royalty was apparentlyerroneously overlooked by the partiesbefore 2009. Making matters difficult forGolden, the royalty payments made by SMbefore 2009 were in conformance withdivision orders executed by Golden.The Court’s Analysis of the AssignmentsGolden filed a declaratory judgmentaction to determine the parties’ rights, toquiet title to interests in the land, and for anaccounting.SM argued the lower court erred ingranting summary judgment in favor ofGolden because, as a matter of law,neither SM nor its predecessors in interestassumed the JAI clause in the 1970agreement. Specifically, SM argued thatthe AMI clause did not relate to propertiesB had previously acquired and assigned toC, but only to properties B might acquire inthe future. On the other hand, Goldenargued that the assignments leading to SMunambiguously established that SMassumed the AMI clause because theassignments were subject to the terms of“other contracts” that related to theconveyed leases.The North Dakota Supreme Court began itsanalysis of the agreement by observing:The “joint area of interest” clause inthe 1970 letter agreement iscommonly referred to in the oil andgas industry as an area of mutualinterest (AMI) agreement, which hasbeen defined as an “agreement bywhich the parties attempt todescribe a geographical area withinwhich they agree to share certainadditional leases or other interestsacquired by any of them in thefuture.” [Citation omitted] The partiesin this case agree that the AMIclause is not a covenant that runswith the land, but is a personalcovenant that is enforceable onlybetween the original parties to theagreement.After analyzing general hornbook law onassignments of contracts, the court notedthat the same principles apply to AMIclauses:If an assignee takes an interest in oiland gas leases and the documentof conveyance states that it isspecifically subject to the terms of acontract wherein the area of mutualinterest was created, and theassignee operates under theagreement or attempts to use orenforce the terms of that contract, itis submitted that the assignee hasassumed the obligations of the areaof mutual interest and it isenforceable against him. Whether ornot these obligations were assumedby a party acquiring oil and gasleases subject to an area of mutualinterest clause is a question of intent,and all the surroundingcircumstances must be evaluated todetermine that intent. [Citationomitted]The Supreme Court concluded that thecontested provisions of the 1993assignment were ambiguous and that atrial would be necessary to discern theintent of the parties. In support of thisholding, the court observed that one of
  20. 20. Page 20 of 20the hallmarks of an ambiguous contractualprovision is that, as was the case in Golden,each opposing party was able toarticulate a rational argument to supportits position.The court also held that even though theagreement between Golden and B wasduly recorded and, therefore, gave Cconstructive notice of its terms, notice to Bwas not equivalent to an agreement by Bto be bound by the terms of theagreement. Of course, if the agreementwas deemed to run with the land, thecourt may have reached a differentconclusion.The Court’s Analysis of theOverriding RoyaltyWith regard to the override, SM did notcontest its obligation to pay Goldenroyalties on the disputed well, nor did SMdeny that Golden was previouslyunderpaid. Rather, SM argued, citing NorthDakota precedent, that a well operator isnot required to compensate a royaltyowner for underpayments if the paymentswere based on division orders executed bythe royalty owner.The court disagreed and distinguished priorcase law by noting that in previous casesthe well operator paid out 100% of theproceeds from the well. In prior cases somepayees were overpaid and others wereunderpaid but the well operator realizedno benefit from the mistake and was notunjustly enriched, which is different thanthe present case wherein the operatorwould benefit from the error. The courtinstructed:“Generally, the underpaid royaltyowners, however, have a remedy:they can recover from the overpaidroyalty owners. … The basis forrecovery is unjust enrichment. …[Prior case law] does not hold that awell operator is automaticallyinsulated from liability forunderpayment of royalties simplybecause the incorrect paymentswere made in accordance with anexecuted division order. * * * Here, itis undisputed that SM is the welloperator that prepared the divisionorder and SM is also the overpaidworking interest owner. BecauseGolden was underpaid during therelevant time period and SM wasoverpaid, Golden has suffered harmand SM has been unjustly enrichedby retaining the benefits of theerroneous division order andreceiving the payments to whichGolden was entitled.”The Supreme Court concluded that SMwas unjustly enriched and owed Goldenretroactive overriding royalty paymentsregardless of whether the erroneouspayments were based on a division ordersigned by Golden.Lessons Learned1. Consider whether an obligation in acontract can be made to “run withthe land” so as to obligate futureowners who acquire an interest inthe land.2. Take care to make your contractualobligations and assignmentprovisions clear. A carefully draftedcontract is still priceless.3. Don’t count on division orders tocure all payment errors.Back to top