Given the recent historic developments of the global pandemic and the dramatic drop in oil prices, the oil and gas industry is facing new issues never before encountered at this magnitude. For instance, storage of oil and gas is expected to reach full capacity. Pipeline companies are refusing to accept production in their pipelines. Global demand has come to a dead halt. The Railroad Commission has been asked to consider implementing statewide proration. In many cases, producers are facing the dilemma of involuntarily shutting in wells at the risk of possibly losing valuable leases. How long these events will last is currently unknown but many in the industry expect the industry fallout will stretch out over the next 12-18 months, if not longer.
It is inevitable that the law governing oil and gas will once again take on new developments. Undoubtedly, over the ensuing months many in the industry will be faced with challenges which will, by necessity, invoke the reasonably prudent operator standard in the context of the lessor/lessee relationship. This article provides a reminder of those duties and the interplay of the standard in the relationship between the lessor/lessee.
The Reasonably Prudent Operator Standard in the Context of the Implied Obligations that Exist Between the Lessor and Lessee
At the outset, the most important thing a producer should do is look at the actual language of the lease. The reasonably prudent operator standard normally arises under implied obligations that are created as a creature of the law. However, it is important to keep in mind that where an express clause in an oil and gas lease addresses matters typically considered part of an implied covenant, the express provision will control. Therefore, the language of the lease is paramount as the language of the lease can actually preempt any implied covenants and possibly expand or contract those obligations.
Implied covenants are implied obligations or duties that an oil and gas lessee owes a lessor to reasonably develop, produce, operate, and market the leased oil and gas interest for the benefit of both the lessor and the lessee. Although implied covenants are not expressed in the lease, they are the embodiment of the ongoing relationship between lessor and lessee established and memorialized by the oil and gas lease. Implied covenants function in two ways: (1) by providing what a reasonable lessee must do, the duty itself, and (2) by providing how a reasonable operator must carry out his duties, the standard of performance of the duty. The reasonably prudent operator standard primarily defines the standard of conduct required by the lessee to comply with the implied covenants and attempts to strike an appropriate balance between the conflict or imbalanced positions of the lessor and lessee.
The “Reasonably Prudent Operator Standard”
In evaluating whether a lessee complied with the reasonably prudent operator standard, each determination will be factually specific to the oil and gas lease in issue, in the particular locality at issue. However, based on existing case law, the subjective position of the lessee will normally not be considered: “[i]t is irrelevant that the lessee is in financial trouble and cannot afford to drill additional wells or that the lessee has more attractive investment opportunities in his portfolio of leases. If a reasonably prudent operator would have performed differently, the lessee has breached its obligations to the lessor.” In most cases, the key factor in determining whether a particular lessee complied with the reasonably prudent operator standard is whether the action taken or not taken by the lessee was reasonable under the circumstances.
Use of the Prudent Operator Standard in Evaluating Whether the Lessee has Complied with Particular Implied Covenants
Duty to Develop
The implied covenant to develop, likely the most commonly litigated implied covenant, provides that the lessee must act reasonably and prudently to develop the premises. Under the reasonably prudent operator standard, “the lessee is obligated to continue to make reasonable efforts to develop the leased premises for the common advantage of both the lessor and the lessee.” However, courts have recognized that a lessee’s obligations to develop are not unlimited in the sense that the lessee is obligated to undertake development operations which are unprofitable. Instead, a lessee only has a duty to drill an additional well “if, considering the cost of the same and the probable profit therefrom, he would have been doing what an ordinarily prudent person would have done in the same or similar circumstances.” Courts have considered several factors when determining if a lessee has met his development duty, such as the geological data, the number and location of wells drilled on or near the leased property, productive capacity of existing wells, the cost of drilling compared with the profit reasonably expected, the time interval between completion of the last well and the demand for additional operation, and the acreage involved.
Duty to Protect Against Drainage
The implied covenant to protect against drainage implies a duty on the lessee to take action to prevent drainage, including both local radial damage as well as field wide drainage. This may include the obligation to drill wells offsetting those on adjoining tracts or pool with adjoining tracts. The prudent operator rule can require a lessee to drill a protection well on a lessor’s acreage where a nearby tract is draining the lessor’s tract, and a protection well would be profitable. However, Texas courts will not require protective action by a reasonably prudent operator until “substantial drainage” has occurred.
Duty to Market
As part of a lessee’s duty to manage and administer the lease, the lessee has a duty to reasonably market the oil and gas produced. Once again, the standard to be applied is that of a reasonably prudent operator under the same or similar circumstances. This duty ordinarily only applies under a “proceeds” royalty provision, and not under a “market value” royalty provision. The lessee’s duty contains two elements: (1) to market production with due care, and (2) to obtain the best price reasonably possible. “The focus in an action for breach of the duty to reasonably market is on the conduct of the lessee and not other sales.” Courts may look at factors such as “the availability of a market, means of transportation, the availability of pipe lines, the cost involved in transporting the product to the nearest available market.”
Duty to Conduct Operations with Reasonable Care and Due Diligence
The broadest, and most circular, of the commonly applied covenants is the duty to operate with reasonable care and due diligence. The duty, also called the duty of diligent and proper operations, “is a duty to perform operations such as testing, completing, operating, reconditioning, and plugging of wells. It is also a broad duty to perform those operations and all others in a diligent manner.” The provision acts as a “catchall obligation covering those acts or omissions not comprehended by the more specific implied covenants.” It may also be interpreted to include a duty to not prematurely abandon the lease or a producing well, a duty to use modern production techniques, a duty to seek favorable administrative action, and a duty to produce fair share from the leasehold. This aspect of the reasonably prudent standard is likely to see creative use by lessors and lessees under current circumstances.
The Reasonably Prudent Operator Standard in the Context of “Production in Paying Quantities”
The reasonably prudent operator standard also comes up in the context of evaluating whether a lease while in its secondary term is “producing in paying quantities.” Texas courts apply a two-prong test. The first prong involves determining whether the well is making any profit. The second prong of the test applies the reasonably prudent operator standard. Under the second prong test, even if a well is not generating a profit, it may nevertheless be deemed as producing in paying quantities if “a reasonably prudent operator would, for the purposes of making a profit and not merely for speculation, continue to operate a well in the manner in which the well in question was operated.”16 Given the dramatic drop in prices and the inability of producers being able to store oil and gas in the near future, the contours of these tests will surely arise.
While the industry is in uncertain times, it is important to keep in mind that the reasonably prudent standard will likely come into play in numerous contexts. This article briefly covered from a high level the standard in the context of implied lease covenants. The standard also comes up in the context of the operator/non-operator relationship and joint operating agreements which was not covered in this article. Regardless, the importance of the terms of the lease cannot be overstated when evaluating the duty and obligations of the producer in fulfilling its obligation under the lease.