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Generally, Texas courts apply a two-pronged test when determining whether an oil and gas lease is producing in paying quantities. First, the court will examine whether the well has operated at a profit over a reasonable period of time after deducting operating and marketing expenses. If so, no further inquiry is necessary. However, if the well is deemed unprofitable, the court will next determine whether a reasonably prudent operator would continue to operate the lease for profit and not for mere speculation. In order for a lease to be terminated, both prongs of the test must be satisfied.[1]

It is important to note that there is no set time period when applying the production in paying quantities doctrine and the doctrine heavily favors the lessee. In such a dispute, all questions are ones of fact and are to be determined by a jury; motions for summary judgment are generally denied.

Profitability

Revenue from oil or gas produced from a lease must be sufficient to provide a lessee with a marginal profit. Operating and marketing expenses (excluding capital costs such as drilling or reworking of the well), and overriding royalty payments are proper factors in determining profitability. The rule behind calculation of profitability is to include all ongoing operating expenses (e.g. cash expenditures related to the daily operation of the well), and to exclude any capital expenditures (e.g. one-time investments such as drilling or reworking).

 Reasonable Period of Time

Two cases most directly on point are Pshigoda, et al. v. Texaco, Inc.[2] (“Pshigoda”) and Peacock v. Schroeder[3] (“Peacock”). The court in Pshigoda[4] deemed a two-year period of unprofitability prior to commencement of litigation and a one-year period of profitability during litigation to constitute a reasonable period of time; the court in Peacock determined a twenty-one month period and an overlapping twelve-month period of profitability to constitute a reasonable period of time. However, an eight-month period of unprofitability, without substantial justification, has been deemed insufficient.[5] Additionally, an isolated fifteen-month period coupled with clear evidence a well produced in paying quantities after such period, has been deemed insufficient.[6] Based on precedent, it is clear that Texas courts rarely consider production of less than one (1) year to be a reasonable period of time in which to consider the doctrine of production in paying quantities.

Reasonably Prudent Operator Standard 

Where a well is shown to be unprofitable over a reasonable period of time, Texas courts next apply the reasonably prudent operator standard: whether an operator would continue to operate the well, as it has been operated, for profit and not for mere speculation. Some factors to consider are the depletion of the reservoir and the price of the commodity produced, relative profitableness of wells in the area, operating and marketing costs of the lease, net profits, the terms of the lease, and the reasonable period discussed above.[7]

There are few Texas cases that apply the reasonably prudent operator standard since most are decided on the resolution of the first prong of the test. The Pshigoda case however, is illustrative. The jury in Pshigoda determined that a reasonably prudent operator would continue to operate the wells in question even though they were unprofitable for a 24 month period leading up to litigation, but profitable for a seventeen (17) month period from file date to trial. The 7th Court of Appeals in Amarillo agreed. Ultimately, it is up to the jury to decide whether or not the lessee’s conduct meets the reasonably prudent operator standard.

For even the most sophisticated lessor, it is difficult to use the production in paying quantities doctrine to terminate a lease since there is no set standard by which to judge a reasonable period of time and a jury could interpret varying kinds of behavior on the part of a lessee as being “reasonably prudent.” The most difficult decision then, is whether to commence litigation where the well has produced unprofitably for a substantial period of time (over one or two years), but the lessee has proposed a workover or reworking of the well. If the workover is successful, it is likely litigation to terminate the lease will be unsuccessful. Ironically however, failure of the workover does not necessarily ensure success of litigation. Rising commodity prices coupled with crafty defense work can potentially extend the life of the lease.

 

Note: The foregoing is a general outline of the production in paying quantities doctrine and should not be considered to be an exhaustive treatment. There are numerous cases that apply the doctrine to shut-in royalty clauses, as well as determine what constitutes an operating expense versus a capital expense, among other issues.

For a very thorough overview of the production in paying quantities doctrine, see Mark C. Rodriguez, Brock Skelley, and Jeremy Tripp’s Production in Paying Quantities in Texas[8] (view HERE) and Charles R. “Skip” Watson’s Production in Paying Quantities in a Low Price Environment[9] (view HERE). Both articles are concise, very well written, and a great primer for understanding the issues.

 

[1] See Clifton v. Koontz, 325 S.W.2d 684 (1959).

[2] Pshigoda v. Texaco, Inc., 703 S.W.2d 416 (Tex.App. – Amarillo, 1986, writ ref’d n.r.e.).

[3] Peacock v. Schroeder, 846 S.W.2d 905 (Tex.App. – San Antonio, 1993)

[4] Pshigoda v. Texaco, Inc., 703 S.W.2d 416 (Tex.App. – Amarillo, 1986, writ ref’d n.r.e.).

[5] Dresher v. Cassidy Ltd. Partnership, 99 S.W.3d 267 (Tex.App. – Eastland, 1993).

[6] BP America Production Company v. Laddex, Ltd., 458 S.W.3d 683 (Tex.App. – Amarillo, 2015, rev. granted 9/2/2016.).

[7] See Clifton

[8] 33rd Annual Advanced Oil, Gas and Energy Resources Law Conference, October 2015.

[9] 34th Annual Advanced Oil, Gas and Energy Resources Law Conference, October 2016.

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