As oil and gas companies shut in wells to cope with the supply-demand imbalance, a law firm has some advice for producers: know what is holding the lease and review common lease-saving provisions.

Failing to do so could be a risky move with unfavorable consequences.

“Regardless of the reason for a producer wanting or needing to take production offline, that producer must first comply with the terms of each applicable oil and gas lease,” Michael P. Darden, partner with Gibson, Dunn & Crutcher LLP, said on a recent webinar.

If the producer does not comply with terms needed to maintain the lease, the lease could be terminated or the lessor—whoever has transferred the property—could claim the lease is terminated, dashing hopes of bringing such wells back online when market conditions improve.

The warning come as the industry continues to endure the economic side effect of an oil price war between Saudi Arabia and Russia coupled with a global oversupply of hydrocarbons and slowed demand largely due to the COVID-19 pandemic. Stay-at-home orders related to COVID-19 have resulted in people traveling less, decreasing the demand for fuel. Oil- and gas-producing countries from across the world have pledged to cut production in an effort to restore the supply-demand balance as oil prices remain low.

About 616,000 bbl/d of U.S. oil production is expected to be shut in during May with another 655,000 bbl/d in June, according to analysts at Rystad Energy. That’s up from about 187,000 bbl/d shut in during April. The latest estimates are based on plans released by 19 producers, the firm said, noting the numbers do not represent the total U.S. production curtailment.

“The cuts will be achieved through a combination of measures including deferral of POP wells, shut-ins of higher-cost wells, and partial reduction of output from other selected wells,” Rystad Energy’s Vice President North American Shale and Upstream Veronika Akulinitseva said in a news release. “The Bakken and Permian volumes are so far estimated to be affected the most, as most of the companies that have reported cuts are largely present in these basins.”

Besides economic and technical factors in determining which wells to shut in, leasehold obligations are part of the process.

Oil and gas leases are typically broken into two distinct terms: one is the primary term for a set period and the other is the secondary term involving oil or gas being produced in paying quantities, Darden explained. An oil and gas lease typically terminates at the end of the primary term, if there is no production in paying quantity. If that’s the time, there is no secondary term.

Or assuming there is production in paying quantities at the end of the primary term, the lease terminates during the secondary term when there is no longer production in paying quantity.

Either the end of the primary term or failure to produce the paying quantity determines whether a lease is terminated, Darden said, noting the concept of production in paying quantity is an integral part of the lease maintenance discussion.

“The test for determining whether there is production in paying quantity may sound simple, but it requires a fact-intensive examination and is actually somewhat complex, involves many factors and imposes a fairly high burden on a party claiming a lack of production in paying quantity,” he said. “Generally speaking, the test looks to whether there is profit from production from a well—that’s revenues over operating expenses—no matter how small the profit is and to whether a reasonably prudent operator would continue to operate the well with expectations of making a profit. Again, no matter how small, and not merely for speculation.”

To maintain a lease past its primary term, Darden said there must either be production in paying quantities or the lease must comply with a term that provides for maintenance of the lease without such production in paying quantity. These are known as lease-saving provisions.

“One must tread very carefully here,” he warned. “If the lease is past its primary term and is not producing in paying quantity, the lessee must ask itself and answer definitively and satisfactorily this fundamental question: what’s holding the lease?”

He also pointed out that the lessee must make sure there is no lapse between the effect of the lease-saving provision and the restart of production in paying quantity.

Common lease-saving provisions, as outlined by Darden, include shut-ins, continuous operations, governmental regulations and force majeure.

Shut-in provisions may be drafted narrowly, he said, advising producers to review provisions carefully. Some, for example, may allow shut-ins for only gas production, while others may require a lack of market or pipeline connection, or limit the amount a time a well may be shut in.

Continuous operations provision allows the producer to maintain a lease if there is no production in paying quantity. Operations must be conducted on the site without a lapse of a specified number of days between the completion of one operation and the start of the next. Such provisions may limit the lease saving operations to drilling.

Governmental regulations provision allows a producer to suspend operations to comply with governmental rules. “The producer must confirm compliance with the governmental regulation does, in fact, prevent production of hydrocarbons or conduct of operation and the provision results in the absence of production in paying quantities through the period of which performance is prevented by compliance.”

Force majeure provisions allow a producer to stop operations after certain events. This provision may be used “typically only to the extent that the performance is actually prevented by the force majeure event,” Darden said, noting some force majeure provisions are written tighter than others. In some instances, the force majeure event may be all that is needed to stop production, while others may require the event to be out of the producer’s control and was unforeseeable and unavoidable within reason.

Of the provisions, force majeure has generated the most questions, Darden said.

However, “it appears that the mere existence of the COVID-19 pandemic in and of itself is a hard sell as a force majeure event,” he added. Some provisions may require specific performances to be excused by the event or additional requirements may need to be met.

Some questions he suggests asking: Does the event trigger the force majeure provision? Does the event prevent performing? If there are additional requirements for the provision, have the requirements been met? What specific performance is excused by the terms of the provision? Have contractual notice requirements, if needed, been met?

“Producers must remember to comply with implied covenants as well as with the expressed terms of their leases,” Darden said. “Producers must be mindful of the issues that arise out of various contracts and other relationships when production is reduced or shut in. And above all the first step is the answer to the crucial question what’s holding the lease?”

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