Title: Reese Enterprises, Inc. v. Lawson

State: kansas

Issuer: Kansas Supreme Court

Document:

220 Kan. 300 (1976)
553 P.2d 885
REESE ENTERPRISES, INC., and GLENN F. LAYTON, JR., Appellees,
v.
LAWSON, et al., Appellants.
No. 48,009

Supreme Court of Kansas.
Opinion filed July 23, 1976.
Richard C. Byrd, of Anderson, Byrd & Richeson, of Ottawa, argued the cause, and was on the brief for the appellants.
R. Michael Latimer, of Skoog & Latimer, of Ottawa, argued the cause, and was on the brief for the appellee Reese Enterprises, Inc.
No appearance or brief was filed on behalf of the appellee, Glenn F. Layton, Jr.
*302 The opinion of the court was delivered by
SCHROEDER,, J.:
This is an action for a declaratory judgment brought by the holder of an option to purchase an oil and gas lease to establish the validity of the lease. After hearing the matter the trial court refused to declare the oil and gas lease terminated for failure to produce oil in paying quantities. Appeal has been duly perfected by the defendants below who are the owners of one-half of the mineral rights in the tract of land involved. They also own the surface rights.
The various points asserted involve the provisions in the lease regarding termination set forth in the habendum clause of the lease, where oil was initially found in paying quantities and produced under the "thereafter" clause of the lease, requiring that oil be "found in paying quantities."
Reese Enterprises, Inc., (plaintiff-appellee) is a corporation which owns four leases in Franklin and Miami Counties for investment purposes. It is the holder of an option to purchase an oil and gas lease on the 440-acre tract of land in Franklin County, Kansas, here in question and upon which Glenn F. Layton, Jr., the lessee by assignment, was interpleaded as an involuntary plaintiff (appellee). Roy Lawson and his wife (defendants-appellants) own the surface and one-half of the mineral rights of the 440-acre tract of land in question.
To facilitate an understanding of the case the appellants will sometimes be referred to generally as the lessor; Reese Enterprises, Inc., will be referred to as the optionee or Reese; and Glenn F. Layton, Jr., as the lessee.
The oil and gas lease involved, referred to as the Gingrich lease in the record, was executed on January 18, 1916. It covered the west half of section 28; the north half of the northeast quarter of section 29; and the southeast quarter of the northeast quarter of section 29, all in township 16, range 21, Franklin County, Kansas.
Production of oil in paying quantities occurred during the primary term and thereafter until approximately 1971. Through the years the working interest had been assigned numerous times. The lessee is the last assignee of record, having acquired the working interest on April 21, 1971.
At the time the lessee acquired the lease the method of producing oil from the lease was to pump eight wells by means of electricity. *303 Seventeen other wells were connected to the flow lines which led into the lease tank battery. The lessee was not sure how many wells were located on the property, but he estimated there were between 40 and 50 wells in all. Some of the wells, other than the 25 so-called producing wells, are injection wells which were formerly used by prior lessees to inject salt water into the producing formation in connection with secondary recovery operations. These operations were conducted under a permit from the State Corporation Commission which had expired before the lessee herein acquired the working interest.
At the time water flooding was commenced, the then lessee rented a ten-acre surface tract from the then surface owners of the lease in question upon which was installed a central water treating plant and tank batteries for adjoining leases, which were not unitized with the lease in question. The tank battery for the lease involved here is also on the ten-acre surface lease. An office with a telephone is located on the ten acres. Sometime in 1970 the then lessee failed to pay the rental on the ten-acre surface lease and no rentals have been paid since that time.
After Mr. Layton acquired the working interest on April 21, 1971, as lessee he continued pumping the eight wells until November 1971, at which time he discontinued pumping operations entirely and connected those eight wells to the flow lines leading to the lease tank battery. The lease was then disconnected from its source of electricity in order to avoid electric bills which had been running from $35 to $50 per month.
From November 1971, until May 31, 1973, the lessee's method of "production" consisted of what he called "free flow" into the tank battery. During that period of time the property produced 125 barrels of oil. Thus the actual combined total daily production from 25 wells was roughly one-fifth barrel of oil per day over an eighteen month period. During that time, the lessee checked the lease at least once or twice a week and on occasion three or four times a week. That entailed a drive of five miles each way from Wellsville where he lives. He operated other leases in the vicinity of the Lawson property. Checking the lease also involved looking on occasion into the tank battery to see if oil was running into the tank.
In April 1972, the lessee gave KAI Oil Company a nine month option to purchase the lease. From then until the fall of 1972 a Mr. Gillin of KAI operated the lease for the lessee at lessee's responsibility. *304 During the period KAI operated the lease for the lessee, it pulled from one to three wells at a cost of around $30 per well. KAI also re-rocked the entrance road to the office area at an expense of $38 and placed a new cattle guard in the gate at an unknown expense. Mr. Layton, the lessee, thought these were expenses chargeable against the lease.
Although its option to purchase ran through December, KAI decided in the fall of 1972 not to exercise its option. In November 1972, Elmer Sieg, an Eastern Kansas oil operator, inquired about purchasing the lease. From November 1972, through January 1973, he visited the lease approximately ten times. Subsequently, he checked to see if oil was flowing into the tanks. On one occasion it was, and on another it was not. Mr. Sieg decided that he was not interested in the lease if it could not be water flooded.
From the time Producers Pipeline Company ceased buying the oil from the lease in November of 1971, the lessor received only two checks representing royalty payments; one in December of 1972 in the amount of $12.77 and one in November of 1973 in the amount of $9.59. The checks were returned uncashed to Page Oil Company. Those checks represented one-half of the one-seventh royalty payable under the lease.
On February 3, 1973, the lessor demanded in writing of the lessee that he release the lease of record because it had expired by its own terms in that it had ceased to produce oil in paying quantities. The lessee refused to release the lease. On March 21, 1974, the lessee entered into the option agreement with Reese, after Reese had attempted to negotiate a lease with the lessor.
One of Reese's witnesses, Don C. Bloomer, testified that he had pumped this lease in 1967 and 1968, that during that period eight or nine wells were pumped and twelve or fourteen flowing wells were connected to the tank battery. Total lease production was then four or five barrels of oil per day. On the basis of four barrels per day, eighteen months of production by the normal means  that is from November 1971 to May 31, 1973  would equal 2,184 barrels. The same witness testified that the lease in its present condition could not be operated at a profit.
The 125 barrels of oil produced from November 1971 until May 31, 1973, had a gross value of $313.16. Of that amount, the lessee received $268.42 with the overriding royalty owner entitled to $9.79 of that sum.
*305 The lease here in question provides for a one-seventh royalty and contains a term or habendum clause reading as follows:
Reese in its petition for declaratory judgment alleged among other things:
In the prayer Reese asked the court to judicially determine whether "the present lease on which Glenn Layton Jr. is a lessee and defendant is lessor is in full force and effect."
The defendant Lawson answered among other things that the lease was void due to termination as described by its own terms, and that any and all oil produced from the premises after the termination of the oil and gas lease was done in wrongful conversion of the defendants' property.
Upon the defendants' motion Layton was joined as an involuntary plaintiff to the action. Layton answered that as operator of the lease at all pertinent times, since the assignment of the lease to him, it has produced oil in paying quantities as required by the lease instrument. He denied that he was guilty of any wrongful conversion of the defendants' property and further alleged:
*306 The defendants denied the allegations of the involuntary plaintiff, and further counterclaimed against the plaintiffs alleging in part;
The pretrial memorandum of the trial court recited:
The pretrial memorandum further recited the issue as to whether the lease had terminated according to the habendum clause would be tried separately. It recited that, "Layton will contend the oil was flowing all the time and was therefore `found in paying quantities.'"
The trial court on September 23, 1974, heard the issue as to whether the oil and gas lease had terminated. The findings generally are in accord with the facts heretofore recited. Among the findings are the following:
The trial court then continued with its memorandum and conclusions of law as follows:
*309 CONCLUSIONS OF LAW
The trial court, after hearing the motion for a new trial argued, modified its finding of fact in paragraph 7 by amending it to provide that, "Layton expended the sum of $38.00 for two loads of gravel on said lease and further, that one to three wells were pulled at a cost of $30.00 per well."
The appellants contend the trial court erred in considering this case as one involving forfeiture. It is apparent from the memorandum portion of its opinion and paragraph C of its Conclusions of Law the trial court considered this to be an equitable action in which the defendants were asking the court to declare an existing oil and gas lease forfeited. This was not the issue tendered. The claim was that the lease had expired by its own terms, and that the court should simply declare the legal situation which existed under the facts. (See, Wilson v. Holm, 164 Kan. 229, 188 P.2d 899.)
It has consistently been held in this jurisdiction that a court of equity has no power to extend a lease beyond the term which the parties themselves have fixed by their written contract. This was the situation presented in Kahm v. Arkansas River Gas Co., 122 Kan. 786, 253 Pac. 563, where the court said:
Other Kansas cases have held that where the terms of an oil and gas lease are clear and unambiguous, and there is no showing of mistake on the part of the parties, the court cannot and should not extend the term of the lease beyond the period clearly provided in the lease. (Hanscome v. Coppinger, 183 Kan. 623, 331 P.2d 590; Warner v. Oil & Gas Co., 114 Kan. 118, 217 Pac. 288; Caylor v. Oil Co., 110 Kan. 224, 203 Pac. 735; and Harter v. Edwards, 108 Kan. 346, 195 Pac. 607.)
In Caylor the lease according to its terms was to endure "for one year and as much longer as oil or gas is found in paying quantities." That term expired, the court said, when the production of gas ceased. It further said, "[w]hen the facts did transpire which brought about a forfeiture or termination of the lease, the defendant's duty to clear the record became mature and absolute." The difference between the court's authority in cases involving term clauses on the one hand and implied covenants on the other is further clarified in the Kahm case where the court said:
Under Kansas law a conventional oil and gas lease generally does not create any present vested estate in the nature of title to land which it covers, but merely creates a license to enter on the land and explore for such minerals. (Burden v. Gypsy Oil Co., 141 Kan. 147, 40 P.2d 463; Connell v. Kanwa Oil Inc., 161 Kan. 649, 170 P.2d 631; and Riverview State Bank v. Ernest, 198 F.2d 876, 34 A.L.R.2d 892 [10th Cir.1952], cert. denied, 344 U.S. 892, 97 L. Ed. 690, 73 S. Ct. 212.) Once the lease expires by its terms, *311 the right to enter and explore expires. (38 Am.Jur.2d, Gas & Oil, § 214.)
Reese points to the testimony of Mr. Layton concerning his attempts to further develop the lease. The question here presented does not relate to the steps reasonably necessary to bring the lease into better production for the benefit of both the lessor and the lessee or to further develop the lease. Rather, the question is whether the lease has expired by its own terms. (Baker v. Huffman, 176 Kan. 554, 271 P.2d 276.) This case involves a habendum clause, which expressed a condition of precedent fact upon which the lease may continue.
It is generally accepted that the phrase "in paying quantities" in the "thereafter" provision (extension clause) of an oil and gas lease's habendum clause means production of quantities of oil or gas sufficient to yield a profit to the lessee over operating expenses, even though the drilling costs, or equipping costs, are never recovered, and even though the undertaking as a whole may thus result in a loss to the lessee. In this connection the term "found in paying quantities," as used in the habendum clause of the lease here in question, is uniformly interpreted as requiring "production in paying quantities." (Annot., 43 A.L.R.3d 8 [1972].) In Tedrow v. Shaffer, 23 Ohio App. 343, 5 Ohio L. Abs. 373, 155 N.E. 510 (1926), the court said:
In Smith v. Hickman, 14 Pa. Super. 46 (1900), the court said:
(See also Cassell v. Crothers, 193 Pa. 359, 44 Atl. 446 [1899]; White v. Young, 409 Pa. 562, 186 A.2d 919 [1963]; Union Gas & Oil Co. v. Adkins, 278 F. 854 [6th Cir.1922]; and Wilbur v. United States, 54 F.2d 437 [D.C. Cir.1931].)
The Supreme Court of Kansas in Tate v. Stanolind Oil & Gas *312 Co., 172 Kan. 351, 240 P.2d 465, was confronted with a drilling clause in an oil and gas lease using the expression "found in paying quantities" and a habendum clause designed to continue the lease beyond the primary term, where oil or gas was found in paying quantities, for a secondary term "as long thereafter as oil or gas, or either of them is produced from said land." The court there found it necessary to construe the ambiguity between the habendum (the term clause) and the drilling clause of the oil and gas lease in question. It held the conflict was not irreconcilable and the lease was given a practical construction which most reasonably effectuated the intention of the parties and permitted both provisions to be operative. A court of equity was there confronted with an action designed to have the oil and gas lease forfeited where production was not immediately undertaken upon discovery of oil in paying quantities. That is not the situation confronting the court in the instant case.
The production of oil or gas "in paying quantities" as used in oil and gas leases was said in Wolf Creek Oil Co. v. Turman Oil Co., 148 Kan. 414, 83 P.2d 136, to have two entirely distinct and separate uses in the law of oil and gas, with different meanings, which were not to be confused, attributable to the term as it was employed in different portions of the lease. The first instance was said to be in connection with express or implied covenants of the lease to continue drilling operations upon the contingency that tests, or previously drilled wells, had resulted in finding oil or gas in paying quantities. As used in that connection the term "paying quantities" meant that oil or gas had to be found in such quantities that an ordinarily prudent person, experienced in the business of oil or gas production, would, taking into consideration the surrounding conditions, expect a reasonable profit over and above the entire cost of drilling, equipping, and operating the well or wells drilled. On the other hand, where the term "paying quantities" was used in the habendum clause to express a condition of precedent fact upon which the lease might continue, it was said to be uniformly interpreted as requiring production in such quantities as would pay a small profit over the cost of operating the well, although the cost of the drilling and equipping the well might never be paid, and the operation as a whole might result in a loss to the lessee.
As used in the habendum clause, the phrase "paying quantities" refers to operations of the lease after drilling has been accomplished during the primary term and production has been established. *313 From the standpoint of grammatical construction of the lease and from the standpoint of the purpose of the habendum clause, the cost of drilling and preparing a well for production, and the ultimate profit to be expected from any particular well, are not taken into account in determining whether or not the lease is producing in paying quantities.
Authorities differ as to whether the phrase "paying quantities" is used to describe an objective standard or a subjective standard. Where the subjective standard is used the determination is based upon the reasonableness or the good faith of the lessee's judgment.
Where the subjective approach is taken the question might well be asked why the matter should be left to the sole judgment of the lessee. At first glance, it would appear that the self-interest of the lessee would provide protection for the lessor. If the lease ceased to be a profitable operation it would appear to be to the interest of the lessee to abandon the project, and it would appear to be unlikely that the lessee would have any interest in continuing to operate at a loss. This conclusion, however, does not take into account the very real factor that the lessee may be interested in preserving his interest for speculative purposes. He may consider it to be to his economic advantage to continue a marginal or losing operation in order to take advantage of possible discoveries in formations other than the formation from which he is producing. He may also anticipate a change in marketing conditions or market prices of oil or gas. There may also be other circumstances which indicate to him that a current operating loss may eventually be turned into a profit in the long run. (2 Kuntz, A Treatise on the Law of Oil and Gas, § 26.7 [e], [f] and [g] [1964].)
Many of the early cases, which have taken the position that the requirement of production in paying quantities is actually for the benefit of the lessee, hold that the determination of whether or not the lease is producing in paying quantities should be left to the judgment of the lessee when that judgment is exercised in good faith. (See cases accumulated in 2 Kuntz, A Treatise on the Law of Oil and Gas, § 26.7 [e] [1964].) Under those cases, the test to be applied is theoretically subjective in nature, with the determination turning upon the presence or absence of good faith on the part of the lessee. There the test actually becomes one of determining what a reasonably prudent operator would do for the purpose of making a profit and not for purposes of speculation.
In our opinion the better approach is to follow the innumerable *314 cases which apply an objective test, where the determination of "paying quantities" turns upon a mathematical computation. (See cases accumulated in Annot., 43 A.L.R. 3rd 8 [1972]; 21 J.B.A.K. 320 [1953]; and 2 Kuntz, A Treatise on the Law of Oil and Gas, § 26.7 [1964].) This approach recognizes the interest of both the lessor and the lessee, and it gives the lessor some protection when the burdens of the lease far exceed the meager royalty payments, when they fall below the customary delay rental.
An application of the objective standard to a determination of whether an oil and gas lease is producing oil in "paying quantities" under the "thereafter" clause of the lease is not free from difficulties. To avoid termination of the lease we start with the proposition that the lessee must operate the lease to produce those quantities of oil or gas which will produce a profit, however small, over operating expenses, after eliminating the initial cost of drilling and equipping the well or wells on the lease which are required to prepare the lease for production.
In arriving at the amount of income which has been realized, the lessee's share of production or his share of receipts from the sale of oil or gas is taken into account. More specifically, the income attributable to the working interest as it was originally created is taken into account, and only the lessor's royalty or other share of production is excluded. Thus, the share of production attributable to an outstanding overriding royalty interest will not be excluded but will be taken into account in determining income. (Clifton v. Koontz, 160 Tex. 82, 325 S.W.2d 684, 79 A.L.R.2d 774 [1959]; and Transport Oil Co. v. Exeter Oil Co., 84 Cal. App. 2d 616, 191 P.2d 129 [1948].)
Expenses which are taken into account in determining "paying quantities" include current costs of operations in producing and marketing the oil or gas. Most of the costs so incurred are easily identified as being direct costs, and present no difficulty. In this connection the lessee is held accountable for the production of the lease as a prudent operator working for the common advantage of both the lessor and the lessee. All direct costs encountered, whether paid or accrued, in operating the lease as a prudent operator are taken into account. These direct costs include labor, trucking, transportation expense, replacement and repair of equipment, taxes, license and permit fees, operator's time on the lease, maintenance and repair of roads, entrances and gates, and expenses encountered *315 in complying with state laws which require the plugging of abandoned wells and prevention of pollution.
Turning now to the record of the trial in the instant case, from November 1971, when Layton ceased pumping operations on the lease until May 31, 1973, when all operations ceased, the gross value of the 125 barrels of oil produced was $313.16. Deducting the royalty payments from the gross proceeds for this eighteen month period of time leaves a balance of $268.42 as the gross receipts from the sale of oil produced during the period involved. It should be noted this includes an overriding royalty of .03125 per cent in favor of Bert Hemminger which amounted to $9.79.
From the lessee's gross receipts of $268.42 must be deducted the direct expenses attributable to the operation of the lease. On the evidence presented these may be itemized as follows:
An examination of the lessee's testimony shows that he came to the trial prepared to testify about everything except operating expenses. In this connection his testimony was evasive. Regarding the out-of-pocket expenses in 1972 he testified, "[t]o my knowledge there would have been none." Regarding operating expenses in 1973 he said, "[n]one to my knowledge." Regarding the number of wells pulled he said, "I do not have the record before me." He admitted, however, on cross-examination there were from one to three wells pulled at an operating cost of around $30 each. This we construe as an admission of three wells pulled at a cost of $30 each.
When the lessee was asked about the amount spent on the lease he said, "I do not have the invoices." Regarding the cost of the new cattle guard he said, "I don't have that record." He also testified, "[a]ctually, I don't know" how much money KAI Oil Company spent on the lease. As to the taxes paid on the lease he assumed he paid them in 1972 and said, "I don't have that information before me" and "I am sure that they were paid, yes." He also testified that he did not take taxes into consideration in his testimony when he said that this lease produced at a profit.
*316 During the winter of 1971-1972 the lessee checked the lease here in question at least once or twice a week and on occasion three or four times a week. The trial court found no cost attributable to this item yet the lessee admitted his time involvement was an expense. In addition to the foregoing the lessee checked the lease during November 1972, through February 1973. The record discloses the lessee lives five miles from the lease. The cost of ten cents per mile to operate a truck or automobile are attributable to the expense in operating this lease and thus makes a round trip cost $1. Carrying the calculation to its logical conclusion the lessee spent at least $60 "checking" the lease during the period involved. When the lessee was asked how he could determine that he had a profit from operating the lease, if he did not know how much money he spent on the lease, he answered, "The expense to pay that indebtedness was furnished by KAI Oil Company during this operation." On the record here presented the expenses encountered by KAI Oil Company are all direct costs in operating the lease attributable to the period here in question.
The lessee according to his own testimony said the lease had 40 to 50 unplugged wells. Of these wells only 25 were "producing." Of necessity, the state law required the lessee to plug at least fifteen abandoned wells.
K.S.A. 55-128 provides that it is the duty of the lessee to plug the hole of any well drilled before it is abandoned. Here the lessee did not plug a single well. This court takes judicial notice (K.S.A. 60-409) of the rules and regulations of the State Corporation Commission pertaining to the plugging of wells, and also the fact that the fee for a plugging permit is $20 per well. (K.A.R. 82-2-301 to 82-2-311 inclusive.)
Certainly fifteen unplugged wells have been abandoned for all intents and purposes on the lease here in question. The cost of $20 per well for a plugging permit totals $300. This is an expense attributable to the operation of the lease for the period here involved because the lessee was obligated by statute to incur that expense. The lessee cannot take advantage of a breach of his statutory duty by failing to plug abandoned wells and assert he had no expense.
Furthermore, K.S.A. 55-132a requires the lessee to restore the surface around abandoned wells within six months. No expense need be attributed to this item, but had the lessee done what he *317 was required by statute to do, the expense would obviously have been considerable.
On the basis of the foregoing it is obvious the expenses of the lessee in operating the lease, or attributable to the operation, for the period here in question far exceeds the gross income to the lessee from the sale of oil produced.
For the reasons heretofore stated the lease in question expired by its own terms prior to May 31, 1973.
We hasten to add our opinion should not be construed as requiring an eighteen month period of unprofitable operation to terminate an oil and gas lease under the "thereafter" clause of the lease, which provides that the continuation of the lease be dependent upon the production of oil in paying quantities. The time factor in the formula heretofore discussed is a question we leave open.
The appellant contends the lessee's act of disconnecting pumping wells from their source of electricity was tantamount to the abandonment of production. (Citing Collins v. Oil & Gas Co., 85 Kan. 483, 118 Pac. 54.) The appellee by motion has called our attention to the fact that this point was not assigned as error pursuant to the requirement of K.S.A. 1975 Supp. 60-2701 (Rule No. 6 [d]). This point, having been asserted for the first time in the appellant's brief, must be stricken. Under the circumstances we shall decline to consider this point and leave the question open.
For the reasons heretofore stated the trial court erred in the theory upon which it determined the case. On the record presented the judgment should be reversed, the lease having expired by its own terms for failure to produce oil in paying quantities as required by the term clause of the lease. (K.S.A. 60-2105.)
The judgment of the lower court is reversed with directions to try the remaining issues in the case.