This is a familiar but troubling issue for a growing number of landowners throughout the Marcellus Shale fairway. Imagine you own 145 acres in Tioga County, Pennsylvania. You sign a lease with a modest signing bonus in 2007. You soon realize that your signing bonus is considerably less than your neighbor who signed after you. You contact the landman and inquire why. He tells you not to worry because a Marcellus well will soon be drilled on your property and the monthly royalties will be “tens of thousands” of dollars.

1. Shut-in Royalty
Three Gateway Center Can the payment of a shut-in royalty maintain an
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oil/gas lease indefinitely?
Pittsburgh, PA 15222 This is a familiar but troubling issue for a growing number of landowners throughout
www.hh-law.com the Marcellus Shale fairway. Imagine you own 145 acres in Tioga County, Pennsylvania.
You sign a lease with a modest signing bonus in 2007. You soon realize that your
signing bonus is considerably less than your neighbor who signed after you. You
contact the landman and inquire why. He tells you not to worry because a Marcellus
well will soon be drilled on your property and the monthly royalties will be “tens of
thousands” of dollars.
After months of inactivity, operations finally commence in the summer of 2009 and the
vertical well bore is completed that August. Your landman enthusiastically tells you that
the vertical shaft has “bottomed-out” at 8,175 feet and will be “perforated” soon. The
horizontal well bore is then completed and is hydraulically stimulated in September.
You are excited. You anticipate paying off that farm loan and growing your children’s
college fund. And then nothing happens. For months.
You then receive an unusual check in the amount of $1,225.00 the following
September. You now receive that same check every September. There has been no
activity at the well pad site in years. The closest pipeline is several miles away. The
primary term of your modest lease has expired but the gas operator refuses to
surrender the non-producing lease, citing the September “shut-in” royalty payment.
Your excitement has been replaced with frustration and anger. How long can the well
remain shut-in? Does the gas operator have any obligation to actually market “my”
gas? These questions involve two unique oil/gas concepts that are often at odds with
one another: the implied covenant to market and the typical shut-in royalty clause.
Most modern oil/gas leases contain what is commonly known as a shut-in royalty
clause. The clause developed over the years to mitigate the harshness of the automatic
termination rule. Under this rule, an oil/gas lease will generally terminate any time
after expiration of the primary term unless there is a well on the leased premises
producing gas “in paying quantities”. This rule, in a majority of jurisdictions, requires
actual production and marketing of natural gas. Unlike oil, natural gas cannot be
produced and then stored or transported in railroad cars or tank trucks—post-
production facilities such as pipelines, compressors and dehydrators are generally
required to process and deliver the gas to market. In such circumstances where a gas
well has been completed but no market exists for the gas, the shut-in clause enables a
lessee to keep the non-producing lease in force by the payment of the shut-in royalty.

2. Shut-in Royalty
See, Tucker v. Hugoton Energy Corp., 855 P.2d 929, 936 (Kansas 1993)(“...upon payment
of the shut-in royalty it will be considered as if gas is being produced within the meaning
of the habendum clause...”). Such payment serves as “constructive production” and
avoids application of the automatic termination rule.
The ability to declare a well shut-in and simply tender a shut-in royalty in lieu of a
production royalty does not occur automatically. There is no inherent right to shut-in a
completed oil/gas well. Like other lease saving clauses, the shut-in royalty clause must
be specifically negotiated as part of the parties’ lease. If no such clause appears in the
parties’ lease, the lessee runs the risk of forfeiting the lease due to non-production if
the well is taken out of operation.
Unlike the shut-in royalty clause, an implied covenant to market gas exists regardless if
such an express “marketing” clause is set forth in the parties’ lease. What are implied
covenants? Implied covenants in oil and gas leases originated in the 1890’s as a means
of “filling in the gaps” that the express terms of the lease failed to address or even
consider. In Stoddard v. Emery, 18 A. 339 (Pa. 1889), in one of the first implied covenant
cases, the Pennsylvania Supreme Court noted that “[H]ad there been nothing said in the
contract [on the duty to drill additional wells] there would of course have arisen an
implication that the property should be developed reasonably...” Stoddard, 18 A. at 339.
Since Stoddard, courts have “implied” certain additional duties and obligations on every
lessee, regardless of the express terms of the lease. Most jurisdictions recognize at least
three (3) implied covenants in every oil/gas lease: the implied covenant of reasonable
development, the implied covenant to prevent drainage and the implied covenant to
market gas.
The marketing covenant requires a lessee to use due diligence to market the gas and to
obtain the best possible price. The implied duty to market is an obligation imposed upon
a lessee to make a “diligent effort to market the gas in order that the lessor may realize a
return on his royalty interest.” See, Davis v. Cooper, 837 P.2d 218 222 (Colo. App. 1992).
The covenant implies that if gas is discovered in paying quantities, the well will be
operated so as to secure actual production royalties. The covenant requires the lessee to
“begin marketing the product within a reasonable time” after completion of the well. See,
McVicker v. Horn, Robinson & Nathan, 322 P.2d 410 (Okla. 1958). Failure to diligently
market the gas will result in the breach of the marketing covenant and possible forfeiture
of the lease itself.
The lessee’s obligation to market the gas is not relieved or suspended by the decision to
shut-in a well. The lessee must still act as a reasonably prudent operator in attempting to
market the gas. This includes completing the necessary down-stream facilities such as
pipelines and compressors. As one court noted:
“[T]he fact that the lease is held by payment of shut-in gas royalties does
not excuse the lessee from his duty to diligently search for a market...”
See, Pray v. Premier Petroleum, 662 P.2d 755, 758 (Kan. 1983). Thus, even if the lessee’s
initial shut-in of a well was valid and legitimate, the lessee cannot ignore or neglect its
duty to market the gas. It must make some effort to market the gas after completing the
well. Mere payment of the shut-in royalty will not negate this duty.
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The express terms of the shut-in royalty clause can often create tension with the 401 Liberty Ave
marketing covenant. Many shut-in clauses contain no time limitation and arguably allow 22nd floor
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the lessee to maintain the shut-in status indefinitely. At some point, after a well has been
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3. Shut-in Royalty
shut-in for several years, the marketing covenant will be impacted and the lessee will For more information, contact:
be required to explain and justify the prolonged shut-in status. While there have been Robert J. Burnett, Esq.
relatively few cases addressing this issue, this is likely to change in the near future. 412.288.2221
Throughout the Marcellus fairway many wells have been drilled and hydraulically rburnett@hh-law.com
stimulated but remain shut-in due to the lack of pipelines. These leases cannot be
maintained forever by the simple payment of the shut-in royalty. Litigation is inevitable.
In order to mitigate this tension in the future and avoid litigation, landowners and gas
operators alike should consider revising the shut-in royalty clauses in their leases. The
clauses should clearly define the permissible reasons for shutting-in a well and, more
importantly, they should place a reasonable limit on how long the shut-in period can last.
For example, a clause that reads as follows balances the need for shut-in capability with
the obligations mandated by the marketing covenant:
“It is understood and agreed that this Lease as to its entirety cannot be
maintained in force solely by the payment of the shut-in royalty for a period
in excess of two (2) years...”
Alternatively, a landowner that is concerned with an unduly long shut-in can request and
negotiate a “stepped-up” royalty, which increases the royalty as the marketing delay
continues. These clauses often provide for a significantly higher annual shut-in royalty in
years two (2) and three (3) of the shut-in period. Such clauses serve as a disincentive to Robert J. Burnett is a Director at the
prolong the shut-in period and encourage compliance with the marketing covenant. A downtown law firm Houston Harbaugh, P.C.
third, albeit more dramatic, shut-in limitation mechanism is the acreage severance His practice is concentrated in business and
clause. These clauses obligate the lessee to release and sever the undeveloped lease commercial litigation. Robert is a member
acreage if the shut-in period exceeds a fixed time period, usually three (3) to four (4) of the Environment, Energy and Resources
years. Again, such clauses encourage the lessee to actively find a market for the gas or section of the American Bar Association as
well as the Pennsylvania Independent Oil
face possible severance of undeveloped acreage.
and Gas Association.
The shut-in royalty clause is a necessary and integral component of any oil/gas lease.
The ability to shut-in a well, however, must be balanced with the obligation to diligently
market the gas and generate production royalties. Both concepts can and should be
harmonized to mutually benefit both the landowner and the gas operator.
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