September 11, 2018
Author: Michael E. Zimmerman
Organization: Michael E. Zimmerman PC
1) Origin and Basis of Implied Covenants
a) Oil and gas lease forms do not address Lessee’s obligations to conduct operations after the discovery of oil and/or gas.1
b) Williams & Meyer identify the case that truly launched implied covenant law as Brewster v. Lanyon Zinc Co., 140 F. 801 (8th Cir. 1905). In this case, the Appeals Court examined two questions:
Did the lessee expressly or impliedly covenant and agree to continue, with reasonable diligence, the work of exploration, development, and production after the expiration of the five-year period, if oil and gas, one or both, should be found in paying quantities?
Was compliance with this covenant and agreement a condition, the breach of which would entitle the lessor to avoid the lease?2
c) The court reasoned and concluded:
It is conceded, as indeed it must be, that the lease contains no express stipulation as to what, if anything, should be done in the way of searching for and producing oil or gas after the first five years; but it does not follow from this that it is silent on the subject, or that the matter is left absolutely to the will of the lessee. Whatever is implied in a contract is as effectual as what is expressed. Implication is but another name for intention, and if it arises from the language of the contract when considered in its entirety, and is not gathered from the mere expectations of one or both of the parties, it is controlling. Light will be thrown upon the language used, and the intention of the parties will be better reflected, if consideration is given to the peculiar and distinctive features of the mineral deposits which are the subjects of the lease. Oil and gas are usually found in porous rock at considerable depth under the surface of the earth. Unlike coal, iron, and other minerals, they do not have a fixed situs under a particular portion of the surface, but are capable of flowing from place to place and of being drawn off by wells penetrating their natural reservoir at any point. They are a part of the land, and belong to the owner so long as they are in it, or are subject to his control; but when they flow elsewhere, or are brought within the control of another, being drawn off through wells drilled in other land, the title of the former owner is gone. So, also, when one owner of the surface overlying the common reservoir exercises his right to extract them, the supply as to which other owners of the surface must exercise, if at all, is proportionately diminished.
Looking, then, to the present lease, it is seen that the real subject thereof was the oil and gas believed to be in or obtainable through the lessor’s land, and the right to search for them and to reduce them to possession. The terms of the lease, material to the present inquiry, were in effect as follows: The consideration was primarily $1 paid at the time, but secondarily the covenants and agreements of the lessee. The grant was of “all of the oil and gas under the premises described, together with the right to enter “at all times for the purpose of drilling and operating” for “production and transportation” of oil and gas, and to use sufficient water, oil, and gas to run necessary engines for the “prosecution of said business.” The grant was stated to be “on the following terms,” and then followed several stipulations, among which were these express covenants and agreements on the part of the lessee: (1) To drill a well within two years, with a right to enlarge the time frame to five years by the payment of an annual rental of $78 from the end of the second year until a well should be drilled. (2) To drill no well nearer than 300 feet to any building on the premises, and to occupy not exceeding one acre of the surface in connection with any well. (3) “Should oil be found in paying quantities,” to “deliver to the lessor one-tenth of all the oil produced and saved.” (4) “Should gas be found,” to pay to the lessor $50 annually for “every well” from which gas should be used off the premises. The concluding stipulation was that a failure on part of the lessee to comply with “any of the above conditions” should render the lease null and void.
The implication necessarily arising from these provisions – the intention which they obviously reflect – is that if, at the end of the five-year period described for original exploration and development, oil and gas, one or both, had been found to exist in the demised premises in paying quantities, the work of exploration, development, and production should proceed with reasonable diligence for the common benefit of the parties, or the premises be surrendered to the lessor. That this was of the very essence of the contract is shown by the extensive character of the grant, which was without limit as to time and included all the oil and gas in or obtainable through the demised premises; by the provisions for the payment of substantial royalties in kind and in money on the oil produced and saved and the gas used off the premises, which, as contrasted with the consideration paid when the lease was executed, shows that the promise of these royalties was the controlling inducement to the grant; and by the provisions contemplating the drilling and operation of wells, the production and transportation of oil and gas, and the prosecution of that business subject to the restrictions prescribed.
Considering the migratory nature of oil and gas, and the danger of their being drawn off through wells on other lands if the field should become fully developed, all of which must have been in the minds of the parties, it is manifest that the terms of the lease contemplated action and diligence on the part of the lessee. There could not well have been an express stipulation as to the number of wells to be drilled, as to when the wells, other than the first, should be drilled, or as to the rate at which the production therefrom should proceed, because these matters would depend in large measure upon future conditions, which could not be anticipated with certainty, such as the extent to which oil and gas, one or both, could be produced from the premises, as indicated by the first well and any others in the vicinity, the existence of a local market or demand therefor or the means of transporting them to a market, and the presence of wells on adjacent lands capable of diminishing or exhausting the supply in the natural reservoir. The subject was, therefore, rationally left to the implication, necessarily arising in the absence of express stipulation, that the further prosecution of the work should be along such lines as would be reasonably calculated to effectuate the controlling intention of the parties as manifested in the lease, which was to make the extraction of oil and gas from the premises of mutual advantage and profit. Even in respect of the first well, if oil or gas was found in paying quantity there was no express engagement to operate it; but that it was intended to be operated was plainly implied in the engagement to pay royalties to be gauged according to the production of oil and the use of gas. Whatever is necessary to the accomplishment of that which is expressly contracted to be done is part and parcel of the contract though not specified.3
d) Williams & Meyers identify the “broad ground on which implied covenants are properly rested is … the contract principle of cooperation.”4 They wrote:
The bare bones of the leasing transaction are the transfer to the operator of the exclusive privilege of exploring, drilling on, and extracting minerals from the premises. In return for this exclusive privilege, the lessee promises to pay the lessor royalty on minerals produced and saved from the land. Pecuniary return to the landowner depends on diligent operation of the premises by the lessee. If the lessee permits oil and gas to be drained away from the land, the lessor’s return is diminished or destroyed. If the product is not marketed, there is no return. If the lessee fails to develop known, producing formations, return is delayed. In each of these cases, as in others, the principle of cooperation requires that the lessee conduct operations calculated to accomplish the purposes of the lease agreement, namely, the exploitation of the mineral resources of land for the mutual benefit of the parties.
The nature of the leasing transaction indicates the propriety of broad application of the cooperation principle. In most instances, lessor and lessee cannot state specifically how future operations on the land are to be conducted. Too many unknown factors will affect the lessee’s conduct: geology, reservoir mechanics, conservation regulations, economic conditions – all these and others will bear on the lessee’s operations. Neither party wants to bind himself to express, specific contract terms at a time when the relevant facts are unknown. In contrast to other fields of business, the oil industry’s basic procurement contract – the oil and gas lease – is not designed to stabilize expectations in every detail, as, for example, the life insurance contract attempts to do. The parties to an oil and gas lease leave open a number of important matters, because both are better served if events, rather than dim foresight, shape future conduct. In such a case, reliance on cooperation to achieve the fundamental objectives of the agreement is more than justified. It is unavoidable. 5
2) Prudent-Operator Standard
a) The majority view of the standard applicable to performance of implied covenants is the “prudent operator” standard as articulated in the Brewster v. Lanyon Zinc Co.6 case quoted in great detail above. In relevant part, the court wrote:
The object of the operations being to obtain a benefit or profit for both lessor and lessee, it seems obvious, in the absence of some stipulation to that effect, that neither is made the arbiter of the extent to which or the diligence with which the operations shall proceed, and that both are bound by the standard of what is reasonable … Whatever, in the circumstances, would be reasonably expected of operators of ordinary prudence, having regard to the interests of both lessor and lessee is what is required ….7
b) “The prudent operator is a reasonable lessee engaged in oil and gas operations. It is a hypothetical oil operator that does what it ought to do and does not do what it ought not to do with respect to operations on the leasehold.”8
c) The Montana Court adopted this exact language in its articulation of the prudentoperator standard.9
d) Lessor interference with Lessee’s efforts to perform an implied obligation excuse Lessee’s failure to perform. Such actions by Lessor include:
i) Denial of physical access to the leased premises.
ii) Declaration that the lease has terminated, has been forfeited, or cancelled.
iii) Execution of a top lease.
iv) Filing of litigation to cancel, forfeit, or declare the lease terminated.10
3) Covenant to Drill an Initial Exploratory Well
a) This covenant applied prior to development of the modern lease form and imposed on Lessee the obligation to drill an initial well on the leasehold within a reasonable time and to prosecute the drilling operations with due diligence until the well was completed.11
b) The “unless” clause eliminates any implied covenant relating to drilling the initial well.
4) Implied Drilling Covenants
There are three drilling covenants implied in oil and gas law. To date, the Montana Court recognizes only the first two.
a) The implied covenant to protect from drainage.
b) The implied covenant of reasonable development.
c) The implied covenant of further exploration.
5) The Implied Covenant to Protect from Drainage
a) This covenant addresses potential permanent loss of otherwise recoverable oil and gas due to migration of the oil and/or gas from the leasehold to neighboring land.
As reasonable parties, Lessor and Lessee could not have intended for this loss to occur.
b) Two elements of proof comprise the cause of action:
i) Substantial drainage has occurred on the leasehold.
(1) The measure of “substantial” is not determined in case law.
(2) Williams & Meyer, first, questioned whether the independent requirement for drainage to be substantial is justified, then, conclude that it is a sound requirement.
(a) Obtaining exact knowledge of the reservoir is impossible; therefore drainage must be substantial, because the evidence may be speculative.
(b) But the penalty of forfeiture is stiff; the proof should show more than minimal drainage.12
ii) Offset well would produce oil or gas in sufficient quantities for the Lessee to recover capital expended to drill, equip, and operate the well and to earn a return on the capital.13
(1) How much profit is “reasonable profit” necessary to trigger the obligation to drill the offset well?
(2) Williams & Meyer report that cases do not touch the problem.
(3) Cases do indicate that the market determines the reasonableness of the profit. If the cost of the well is greater than the market value, the profit, if any, is unreasonably small.
(4) Another means of addressing the problem is to consider the time necessary for well to return the invested capital. If a well will return the investment in a matter of years, it is a good investment. If a well will not return the investment for 10 years or more, the investment is probably not a good investment. The measure of a “reasonable profit” is likely somewhere between the extremes. 14
iii) Remedies:
(1) Cancellation/forfeiture; probably not valid today. Instead, courts require drilling of the protection well within a stated period of time or forfeit.
(2) Damages.
(a) Difficulty in measuring the damages is not a bar to recovery.
(b) One measure of damages is the Lessor’s royalty on oil and/or gas drained away from the leasehold.
(c) Another measure of damages is the Lessor’s royalty on the amount of oil and/or gas the offset well would have produced from the time it ought to have been drilled.15
c) In Berthelote v. Loy Oil Co.16, the Montana Court, in dictum, classified the implied covenant to protect from drainage as a “usual implied covenant.” Importantly, it said:
i) The necessity of drilling offset wells is brought about by third-parties, not by acts of the Lessee, unless the Lessee owns adjoining acreage.
ii) Unless the Lessee owns adjoining acreage, the Lessor must give Lessee reasonable notice or demand Lessee drill a protection well.
d) In Severson v. Barstow, the Montana Court discussed the implied covenant to protect from drainage, even though it was not invoked by the facts. The court said that because there was “no possible market for the gas when produced, the drilling of a number of additional wells would not protect this land in this respect, for each well, when drilled, would have to be capped and the drainage would continue as theretofore … The failure of the lessees to drill offset wells cannot be deemed a breach of this implied covenant, unless or until it is shown there would be a market for the gas produced from such wells. 17
e) In U.V. Industries, Inc. v. Danielson,18 the Montana Court examined the relationship between the 1953 Montana Oil and Gas Conservation Act and “the common law ‘offset drilling rule.’” It said, “The common law theory applies in every oil and gas lease a covenant on the part of the lessee to protect the premises of his lessor from drainage of an adjacent producing well by drilling an offset well.”19 The obligation to drill an offset well is not excused by the Conservation Act.
6) The Implied Covenant of Reasonable Development.
a) The covenant of reasonable development concerns further drilling in known producing formations. A duty to drill development wells does not arise until initial production is obtained on the leasehold.20
b) The covenant of reasonable drilling addresses two types of harm.
i) Permanent loss of recoverable oil and/or gas.
(1) Williams & Meyer conclude this case is relatively rare.
(2) Examples of such loss =
(a) Gas cap field.
(i) Gas is compressed on top of the oil reservoir. As the oil is produced the gas cap expands, pushing down on the oil with greater pressure, pushing it to the well bore.
(ii) Producing a gas cap reservoir too fast causes the gas to move down into the oil and some of the oil will not be recovered.
(iii) Prompt drilling into the oil zone will result in recovery of oil that would otherwise be lost for want of gas pressure in the cap.
(b) Water drive field.
(i) Water drive fields drain “up structure.”
(ii) Wells on the extreme up-dip side of the field will produce as long as the field produces (produced oil is replaced by oil migrating from the down-dip side of the field).
(iii) Failure to drill wells on the up-dip side of the field results in less ultimate recovery.
ii) Delay in recovering the hydrocarbons in place.
(1) Existing wells may be inadequate to drain the oil and/or gas in place.
(a) Lessee may drill wells on an 80-acre offset pattern.
(b) Lessor may prove that one well will drain no more than 60 acres.
(c) Lessor is denied more immediate use of capital represented by the oil and/or gas left in the ground.
(d) Further Lessor has the risk that Lessee may not economically drill additional wells at a later time to recover the bypassed oil and/or gas.21
(2) Field drilled on a 40-acre basis may produce an oil reservoir twice as fast as drilling the field on an 80-acre basis.
(a) But, doubled drilling and operating costs may reduce Lessee’s profit below that to be made on the 80-acre drilling pattern.
(b) Balance between Lessor’s desire for speedy production and Lessee’s desire for reduced drilling and operating costs.22
c) Elements of a cause of action for breach of the development covenant.
i) Development well must produce in paying quantities, which means Lessee must recover drilling and operating capital and a reasonable return.
ii) The prudent operator would drill the additional well or wells.
(1) Market demand. No market demand, no duty.
(2) Production rates allowed by conservation regulation. Low allowable, no duty.
(3) Elapsed time since the last well was drilled. Gist of the cause of action is delay; the greater the delay the greater the harm. 14-year delay suggests a different result than a 6-month delay.
d) Remedies:
i) Cancellation/forfeiture of the lease (minus the area around producing wells).
ii) Conditional decree of cancellation/forfeiture.
iii) Damages.23
e) In Berthelote v. Loy Oil Co., the Montana Court recognized the implied covenant of reasonable development with these words: “If the well was producing gas in paying quantities, then there was an implied obligation, under the terms of the lease, to use reasonable diligence to
7) The Implied Covenant for Further Exploration.
a) This covenant relates to loss caused by Lessee’s refusal to test the land for productivity or to surrender the acreage so that others may do so. Williams & Meyer explain this covenant by observing, “The gravamen of the lessor’s complaint is that the lease has been held for an undue length of time without a test of formations favorable to the accumulation of oil and gas, that so long as lessee holds the lease and refuses to explore there can be no test, and that lessor is therefore being deprived of such exploration as may lead to discovery of new production and consequent increase in royalties.”25
b) To establish breach of the implied covenant of further exploration, the Lessor must show that under the circumstances failure to drill exploratory wells in search of new producing formations is unreasonable.26
c) The remedy for the breach of the implied covenant of reasonable development is a claim for damages; whereas, the remedy for the breach of the implied covenant of further exploration is an order to drill one or more exploratory wells within a specified time or suffer cancellation of the lease as to unexplored and unproductive portions of the leased premises.27
d) If Lessee claims breach of the implied covenant of further exploration, the Lessee must prove that a reasonable operator would explore further or surrender the premises.28
e) Factors relevant to showing a reasonable operator would explore or surrender include:
i) The elapsed time since the last well was drilled.
ii) The size of the tract and the number of existing wells in relation to the tract.
iii) The existence on the land of untested geological formations favorable to the accumulation of oil and gas.
iv) Lessee’s attitude toward further testing of the land, and Lessee’s operations on the land and elsewhere in the vicinity of the leasehold.
v) The feasibility of further exploratory drilling, including the cost of drilling, the market for the product, and the size of the block needed to justify the well.
vi) Whether part of the leasehold is excluded from a production unit, so that the lease is being preserved without the payment of royalty for such acreage or the conducting of operations on the leasehold.
8) The Implied Marketing Covenant
a) Most cases regarding this implied covenant concern gas production.
i) Oil may be stored readily.
ii) Oil may be transported readily.
iii) Natural gas requires treatment, gathering and, most likely, compression; all of these require major capital investment.29
b) Elements of a cause of action for breach of the marketing covenant.
i) Discovery of oil and/or gas on the leasehold.
ii) Failure to sell the discovered product.
iii) Ability of the prudent operator to sell the product through the exercise of reasonable diligence.30
iv) Damage to Lessor as a result of the failure to obtain a market.
c) Absence of a market bars liability on the implied covenant to market. A Lessee that simply neglects to seek a market, however, may lose the lease under the habendum clause. Lack of market may follow from:
i) Distance of the well from a pipeline.
ii) Insufficient pressure to force the gas into the pipeline.
iii) Impurities in the product that causes would-be purchasers to decline the offer.
iv) A lack of demand.
d) Remedies:
i) Cancellation/forfeiture.
ii) Damages.
e) The Montana Court requires diligence in marketing production.
i) In Fey v. A.A. Oil Corp.31, the court addressed a situation where a natural gas well was completed in July of 1942, but the natural gas was not sold until October of 1950, when the Lessee entered a contract with Montana Dakota Utilities. The court noted the record established Lessee’s efforts to “interest a pipe line company to build into the structure and buy the gas.”32 Quoting from Vol. II, Summers, Oil & Gas §415, the court addressed the implied covenant to market in Summers’ words: “whether this duty to market be expressed in general terms or implied, the performance thereof must be tested by what amounts to reasonable diligence under all of the facts and circumstances of the particular situation. In some of the decisions it is said that the diligence of the lessee is to be measured by what a reasonably prudent operator would have done under the circumstances, having in mind his own interest as well as that of the lessor.”33
ii) In Christian v. A.A. Oil Corp.34, the court said, “the mere discovery of oil and gas is not sufficient under a lease continuing, as in the present case, for ‘as long thereafter as oil or gas is produced.’ The oil or gas must be withdrawn from the land and reduced to possession for use in commerce … After the mineral is discovered the lessee is required to use reasonable diligence in operating the well and marketing the product within a reasonable time.”35
iii) In Somont Oil Co., Inc. v. A&G Drilling, Inc.36, the court cited and quoted from Christian v. A.A. Oil Corp. saying, “The test for determining whether … the lessee was acting with reasonable diligence in producing and marketing the gas from the leased lands is the diligence which would be exercised by the ordinary prudent operator, having regard to the interests of both lessor and lessee. This is a question of fact that will depend upon the facts and circumstances of each case.”37
9) The Implied Covenant to Conduct Operations with Reasonable Care and Due Diligence
a) Williams & Meyer characterize this implied covenant as a “catchall obligation” to cover situations not addressed by the more specific implied covenants.38
b) The covenant may cover five situations:
i) Negligent operations.
(1) Producing jurisdictions generally agree Lessee must conduct operations on the leasehold with due care.
(2) The standard of care is that of the prudent-operator standard.39
ii) Premature abandonment of the lease.
(1) The implied covenant of reasonable care and diligence is applied when the
Lessee ceases production and abandons and plugs the well.
(2) Lessee is bound to operate the well so long as the operation remains
profitable.40
iii) Failure to use modern production techniques.
(1) This addresses Lessee’s duty to employ new production techniques to increase production.
(2) Lessee may be subject to a duty to institute a secondary recovery operation.
iv) Failure to seek favorable administrative action.
(1) Thesis =
(a) Lessee must operate the leasehold in the manner of an ordinary prudent operator.
(b) Operations that the prudent operator would undertake may be forbidden by conservation laws or regulation.
(c) The seeming prohibition may not be binding on Lessee, because …
(i) Properly construed the statute or regulation or order does not bar the action;
(ii) Lessee could obtain an exception; or
(iii) The statute, regulation or order is invalid.
(2) If Lessor can show the above elements, the Lessee has a duty to pursue the administrative action.
v) Failure to produce fair share from leasehold. [i.e., Lessee holding more than one lease must produce each so that each Lessor obtains a fair share]
vi) In Fey v. A.A. Oil Corp.41, the Montana Court said, “Whether due diligence has been exercised depends upon the facts and circumstances of each case. The question here is whether or not the lessees under the facts and circumstances exercised due diligence to operate the lease.”42 Relevant facts and factors in this case included:
(1) This was a wholly wildcat field;
(2) War conditions prevailed and casing and materials were under government control;
(3) Labor was almost impossible to obtain;
(4) Lessors had much to gain and little to lose;
(5) Lessees’ venture was speculative and expensive;
(6) A gas well was completed timely.
(7) Other wells were drilled on the structure, sufficient in number to attract a pipe line and market.
1 Williams& Meyers, Oil and Gas Law – Abridged Second Edition §801 (2004).
2 Brewster v. Lanyon Zinc Co. 140 F. 801, 806 (8th Cir. 1905)
3 Ibid. at pp. 809 and 810. Brewster v. Lanyon Zinc Co. is the first statement of the prudentoperator
standard.
4 Williams & Meyers, Oil and Gas Law – Abridged Second Edition §802.
5 Ibid. at §802.1. See also Sundheim v. Reef Oil Corp., 247 Mont. 244, 249 (1991). Here the
Montana Court said, “The purpose of the implied covenants is to fully effectuate the intentions of
the parties to a lease. Obviously, the primary intention is to produce oil and gas for a profit and to
obtain royalties for the lessor. [citations omitted] To insure this result is obtained the courts have
implied, through the express terms of oil and gas leases, certain duties which must be performed
by the lessee.”
6 Brewster v. Lanyon Zinc Co., 140 F. 801 (8th Cir. 1905).
7 Ibid. at 814 (emphasis added). See also Williams & Meyers, Oil and Gas Law – Abridged
Second Edition §806.3.
8 Williams & Meyers, Oil and Gas Law – Abridged Second Edition §806.3.
9 See Sundheim v. Reef Oil Corp., 247 Mont. 244, 255 (1991), Christian v. A.A. Oil Corp.,
161 Mont. 420, 427 (1973), and Fey v. A.A. Oil Corp., 129 Mont. 300 (1955).
10 Williams & Meyers, Oil and Gas Law – Abridged Second Edition §808.
11 Ibid. at §811.
12 Ibid. at §822.1.
1313 Ibid. at §822. Note the definition of paying quantities for application of the implied covenant
is different from the definition of paying quantities for extending the lease into the secondary
term.
14 Ibid. at §822.2.
15 Ibid. at §§825m 825.1 and 825.2.
16 Berthelote v. Loy Oil Co., 95 Mont. 434 (1933).
17 Severson v. Barstow, 103 Mont. 526 (1936).
18 U.V. Industries, Inc. v. Danielson, 184 Mont. 203 (1979).
19 Ibid. at 208.
20 Williams & Meyers, Oil and Gas Law – Abridged Second Edition §832.
develop the demised premises, so long as the enterprise could be carried on profitably.” 24
21 Ibid.
22 Ibid.
23 Ibid. at §834.
24 Berthelote v. Loy Oil Co., 95 Mont. 434 (1933).
25 Williams & Meyers, Oil and Gas Law – Abridged Second Edition §815
26 Ibid. at §841.
27 Ibid. at §815.
28 Ibid.
29 Ibid. at §853.
30 Ibid. at §§855 and 856.
31 Fey v. A.A. Oil Corp., 129 MNont. 300 (1955).
32 Ibid. at p. 316.
33 Ibid. at 318.
34 Christian v. A.A. Oil Corp., 161 Mont. 420 (1973).
35 Ibid. at 429.
36 Somont Oil Co., Inc. v. A&G Drilling, Inc. 310 Mont. 221 (2002).
37 Ibid. at 231.
38 Williams & Meyers, Oil and Gas Law – Abridged Second Edition §861.
39 Ibid. at §861.1.
40 Ibid. at § 961.2.
41 Fey v. A.A. Oil Corp., 129 Mont. 300 (1955).
42 Ibid. at 319.