Shut-in Royalty Clauses Can Pose Challenges for Landowners, Leaseholders and Energy Producers

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.

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 the automatic termination 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.  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 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 a clause is set forth in the parties’ lease.  What are implied covenants?  Implied covenants in oil and gas leases originated in the 1890s as a means of “filling in the gaps” that the express terms of the lease failed to address or even consider.

You have to go back to the 1876 to more fully understand this.  That was when “Stoddard” leased land to “Emory” so that Emory could drill for oil within four months, and if the flow was large enough, Emory was to drill a second well.   The question on which that dispute centered was how much time could elapse between the drilling of the first well and the second one.  It was not specified in the original agreement.

Stoddard contended that it was implied a second well would be drilled within four months of the first one, but the court disagreed.

In Stoddard v. Emery, 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…”

This means that while the court recognized the number of wells to be drilled was specified in the contract, it did not believe an implied covenant existed that obligated the lessee to drill oil wells every four months.

Since the Stoddard ruling, 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 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.  In 1992 in the case Davis v. Cooper in Colorado, the court maintained that 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.”  The covenant implies that if gas is discovered in paying quantities, the well will be operated so as to secure actual production royalties.

In another case, McVicker v. Horn, Robinson & Nathan in Oklahoma in 1958, that court said the lessee must “begin marketing the product within a reasonable time” after completion of the well.  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 a Kansas court noted in Pray v. Premier Petroleum in 1983:

“[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…”

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.

The express terms of the shut-in royalty clause can often create tension with the marketing covenant.  Many shut-in clauses contain no time limitation and arguably allow the lessee to maintain the shut-in status indefinitely.  At some point, after a well has been shut-in for several years, the marketing covenant will be impacted and the lessee will be required to explain and justify the prolonged shut-in status.  While there have been relatively few cases addressing this issue, this is likely to change in the near future.  Throughout the Marcellus fairway many wells have been drilled and hydraulically 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.  Landowners can and will challenge the validity of these leases by asserting a breach of the marketing covenant.