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Pump jack

By Hayley S. Murray and Megan R. Knell

A shut-in clause (or shut-in royalty clause) typically allows for shut-in royalty payments as a substitute for actual production.  However, payment of shut-in royalties does not necessarily relieve a producer of its duties under the implied covenant to manage and administer the lease.  

The court in Amoco Prod. Co. v. Alexander recognized three implied covenants that lessees are bound by: (1) the implied covenant to develop the premises, (2) the implied covenant to protect the leasehold, and (3) the implied covenant to manage and administer the lease. 622 S.W.2d 563, 567 (Tex. 1981).  With respect to all implied covenants, lessees must act as reasonably prudent operators, considering both the interests of the lessor as well as their own interests, unless a lease expressly provides otherwise (i.e. providing that the lessee has a fiduciary duty to the lessor).  Included within the broad covenant to manage and administer the lease is the duty to market. See Cabot Corp. v. Brown, 754 S.W.2d 104, 106 (Tex.1987). The duty to market requires that a lessee (1) market production with due diligence, and (2) obtain the best price reasonably available. However, the implied covenant to market will not be enforced where such covenant is negated or limited by an express clause in a lease. See Yzaguirre v. KCS Res., Inc., 53 S.W.3d 368, 373 (Tex. 2001). For example, the lease clauses in Yzaguirre expressly provided that the royalty for gas sold off the premises would be paid based on “market value.” Despite the “market value” provision in the leases, the lessors argued that the lessee had to obtain the best price available pursuant to the implied covenant to market. The lessors asserted that the lessee had breached the implied covenant to market by paying royalty based on the market value of the production rather than the higher price received by lessee under the terms of its long-term sales contract. The court rejected the lessors’ argument and refused to recognize an implied covenant to reasonably market in “market value” leases “[b]ecause the lease provides an objective basis for calculating royalties that is independent of the price the lessee actually obtains. . . .” Id. at 374.  As a result, “the lessor [did] not need the protection of an implied covenant,” and the court held lessee had correctly paid royalties based on the express market value provision in the lease. Id.

Determining whether a lessee has met its duty to market is typically determined on a case-by-case basis.  Courts have often considered a variety of factors in determining whether a lessee has complied with this duty, including: (i) the location of the leases or wells involved, (ii) quality and volume of production, (iii) the failure to sell at market value, and (iv) the absence of a market. 

Although a lessee may be authorized to shut-in a well pursuant to the terms of a lease, this does not relieve the lessee of its duty to market production indefinitely. Instead, a lessee must continue to operate the well as a reasonably prudent operator, meaning it must continuously evaluate its operation (or, alternatively, shutting-in) of the well.  If a lessee shuts-in a well while oil and/or gas prices are depressed, and it continues to shut-in the well once prices rebound, a lessee may be in breach of the implied covenant to market.  Similarly, if a lessee fails to shut-in a well because of market conditions, a lessee may have failed to act as a reasonably prudent operator, which could subject the lessee to a claim for breaching its duty to market.  

While producers may have express authority to shut-in wells pursuant to the terms of their leases, they should be mindful that such right cannot be exercised indefinitely. Instead, the implied duty to market requires a lessee to continuously evaluate its decision to shut-in a well in order to ensure that it is acting as a reasonably prudent operator. Failure to do so could expose the lessee to a variety of claims by a lessor, including lease termination.