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Oil and gas production leases usually provide compensation for the landowner in the form of a specified royalty payment based on the value of oil and gas production. However, such leases often include a provision which allows for the lease to continue during periods of non-production simply upon payment by the lessee of a minimal annual “delay rental”. However, such provisions which preclude landowners from terminating the lease for non-production may be time limited or conditional upon there being no profitable market. Where production has been suspended improperly limiting the landowner’s income to the “delay rental”, even though production is thereafter resumed, is the landowner entitled to termination of the lease? Is the landowner entitled to more than the lease royalty payment for the subsequent production?
In a case currently pending in Alberta, the Alberta Court of Appeal has considered lease provisions which purport to permit indefinite lease extensions upon payment of a “delay rental” despite cessation of production for reasons beyond the lessee’s control or because of “a lack or an intermittent or uneconomical or unprofitable market”. The Court of Appeal determined that “failure to produce, when economical and profitable to do so, results in termination of the lease.” The court stated:
“… When a lessee does not perform – in the sense of drilling, paying or producing – and any term is dependant on such performance, the lease terminates … It follows that if there was an economic and profitable market, on the anniversary date of the lease, there is no deemed production and the lease terminates … The respondents (lessees) should bear the burden of proving the lack of an economical and profitable market”.
In this case, having determined that the lease terminated because of improper cessation of production when there was in fact an economical and profitable market, the Court of Appeal directed an assessment of damages to determine the compensation to which the landowner was entitled for production following the lease termination. In a recent judgment with respect to this damage assessment, the court assessing damages has determined that compensation to the landowner should not be limited to the royalty payment provided in the lease. Instead, the court has determined that the landowner is entitled to compensation both for the period of non-production following termination of the lease and during the period of subsequent production in an amount equivalent to the value which she could have realized from this production.
In considering the proper measure of compensation, the court stated:
“Courts awarding a remedy based in restitution would often draw a distinction between the “mild” and “harsh” forms rules of damage. In instances where a defendant knowingly commits a trespass or otherwise acts with mala fides, the harsh rule may be applied. Under this rule, the courts will award a remedy based on the value of the material (here, gas) with the only allowable deduction being that expended to transport the materials to market. Alternatively, where the trespass in question is an innocent one and there are no other indicia of poor conduct or mala fides, then the “mild” rule will apply, meaning that the remedy will be based upon the value of the material taken, less any costs incurred by the trespasser for severance, production and marketing.
The second approach awards damages on a compensatory basis. It does not focus on stripping the benefit of a trespass away from a wrongdoer, but rather on placing the plaintiff back into the position he or she would have been in but for the commission of the tort. Under this approach, in a case such as this, it may be that the plaintiff receives damages equivalent to the substance converted less the costs of production (the mild rule in the restitutionary approach) or something less. It depends upon the facts.”
While concluding that the appropriate approach in the case under consideration was compensatory damages, the court held that the landowner would not have produced this well on their own and accordingly was not entitled to the value of production less cost of removal. Rather, the court stated that the appropriate measure of damages must be based upon the new lease royalty which would have been negotiated between the parties considering their respective bargaining positions following termination of the lease. The court held:
“In my view the appropriate question to ask is had both sides known conclusively in December, 1999 that the lease was not valid, as reasonable parties and in the case of the (operators) who are public companies, under a duty to maximize value for the shareholders, knowing that it was economic to produce the well at that time, what agreement would they reach? (The landowner) would not have accepted a 15% royalty and a bonus. Neither would she have accepted a slightly increased royalty and bonus … She had significant bargaining power.
… The (operators) could not argue that (the landowner) would be only entitled to the industry standard royalty amount because that amount takes into account the risk in oil exploration and recovery. The reason that lessors usually receive a royalty of 15% is that the oil companies must be able to account for its risk over all when it drills each well. Thus a good profit on a highly productive well will offset the losses of drilling dry wells. In 1999 in negotiating with (the landowner), the (producers) could not make that argument because (the well) was a good well.
… While (the landowner) is entitled to a significant amount of the production, she would not have left the notional negotiating table with everything less expenses. For me to make that determination, I require a calculation of what the value would be to both sides at a series of royalty percentages. From that I can assess the damages.”
With increasing oil and gas prices, landowners who have or are currently receiving “delay rental” payments under oil and gas production leases, should review these leases and the conditions which may attach to production cessation. If production has been improperly suspended, such leases may have terminated and landowners may be entitled to compensation for lost production and compensation in excess of lease royalties once production has resumed.
Paul practices mainly in the areas of environmental law, energy law, and commercial litigation. He is author of "Civil Procedure in Practice" and a regular contributor of articles to various journals. Paul is certified by the Law Society as a Specialist in Civil Litigation.