Opinion ID: 2512015
Heading Depth: 1
Heading Rank: 11

Heading: definition and application of shut-in royalty clauses

Text: The leases involved in this case contain typical habendum clauses; each clause contained a primary term, which varied by landowner, and a thereafter provision extending the lease as long as gas or its constituent products or other hydrocarbons were being produced. In other words, to continue the leases under the thereafter provisions in the habendum clauses, lessees were required to produce gas in paying quantities during the primary terms. Because they admitted in their answers that they did not actually do so, any extension of the leases therefore became dependent on application of the shut-in royalty clauses to establish constructive production. We disagree with the district judge's harsh assessment that the shut-in royalty clauses before us are at best confusing and ambiguous and at worst nonsensical. We also disagree on the game-changing significance of dewatering operations; it was a possible step but not an indispensable step before the shut-in royalty clauses could come into play. Although the shut-in royalty clauses certainly are more wordy than might be strictly necessary, they nevertheless unambiguously set up three conditions for their application to perpetuate the leases. The first condition is the existence of a gas well or wells on the subject land. The parties do not dispute that this condition is satisfied under the facts before us. The second condition is that the well or wells be shut-in; whether the subject wells qualify as shut-in is a hotly contested question. The third condition may be satisfied by one of two fact patterns: Either the leases must not be continued in force by some other lease provision or the well or wells must be completed and dewatering operations commenced. There is no dispute that dewatering operations have not begun; thus, if the third condition is satisfied, it must be because the first alternative is satisfied, i.e., the term of the leases cannot have been extended by a provision other than the shut-in royalty clauses. There is no dispute between the parties on the satisfaction of this alternative. If, and only if, the three conditions are satisfied, the payment of shut-in royalties, such as those paid or tendered here, must occur to extend the term of the leases. We thus must examine the second condition, i.e., whether the wells qualify as shut-in. Once a legal definition for this term is established, we regard the issue of whether the subject wells satisfied the definition as a fact question. In this appeal, the devil is in the definition. The leases before us do not define shut-in. We therefore turn to case law to fill in what the parties did not tell us. Several previous Kansas Supreme Court cases assist us. In Dewell v. Federal Land Bank, 191 Kan. 258, 380 P.2d 379 (1963), this court ruled on a dispute involving whether the term of a mineral rights reservation in a warranty deed between a seller and a purchaser that required actual production could be extended by payment or tender of shut-in royalties creating constructive production under a subsequent oil and gas lease entered into by the purchaser's successor and a lessee. The answer was no. Dewell, 191 Kan. at 263, 380 P.2d 379; see also Classen v. Federal Land Bank of Wichita, 228 Kan. 426, 432, 617 P.2d 1255 (1980) (restating this as issue of Dewell ); Friesen v. Federal Land Bank of Wichita, 227 Kan. 522, 526-28, 608 P.2d 915 (1980) (Herd, J., dissenting) (recognizing this as true holding of Dewell, in contrast to expanded mischaracterizations in subsequent cases having to do with production from different tracts within pooled or unitized area). In Dewell, the reservation's initial term was 20 yearsfrom May 13, 1939, until May 13, 1959which would be extended `so long thereafter as oil, gas and/or other minerals or any of them are produced therefrom, or the premises are being developed or operated.' Dewell, 191 Kan. at 258-59, 380 P.2d 379. A 10-year oil and gas lease executed in September 1947 by the landowner was extended by operation of the lease's shut-in royalty clause when drilling ended in September 1957, on which date the well was completed as a gas well capable of producing natural gas in paying quantities, and annual royalties were paid by the lessee. (Emphasis added.) Dewell, 191 Kan. at 259, 380 P.2d 379. The gas well completed in September 1957 was  shut-in and not connected to a pipeline until January 1960. (Emphasis added.) Dewell, 191 Kan. at 260, 380 P.2d 379. We stated: The shut-in royalty clause contained in the leases was for the sole benefit of the lessee. It is a privilege granted the lessee in lieu of production. It does not purport to convey any estate or rights to anyone else. Neither does it purport to extend the interest of the holders of the mineral rights. . . . . The provision in the lease executed by [landowner], to which the reversioner was not a party, for payment of shut-in royalty[,] does not constitute an agreement by the reversioner to extend the term of the mineral grant nor make the payment of shut-in royalties the equivalent of production. Dewell, 191 Kan. at 261-62, 380 P.2d 379. Our court agreed with a Texas decision in which the court distinguished between a well capable of producing, i.e., the type of well that activated the shut-in royalty clause in the lease, and a well actually producing, i.e., the type of well necessary to continue the reservation of mineral rights under the warranty deed. Dewell, 191 Kan. at 263, 380 P.2d 379 (quoting Sellers v. Breidenbach, 300 S.W.2d 178, 179 [Tex.Civ.App. (1957)]). Because the well in question was only the former and not the latter before the May 1959 expiration of the 20-year primary term of the reservation, the reservation was not extended. Dewell, 191 Kan. at 263, 380 P.2d 379. Dewell is significant to the question before us because it implicitly defines shut-in. A well is shut-in when it is completed and capable of producing natural gas in paying quantities. The well in Dewell qualified as soon as drilling was completed in September 1957, even though the well was not connected to a pipeline until more than 3 years later. The second of our earlier helpful cases was Martin v. Kostner, 231 Kan. 315, 644 P.2d 430 (1982). In that case, lessees sued to quiet their title to certain oil and gas leasehold estates, and the district judge's ruling in their favor was upheld on appeal. In order to do so, the court examined whether activity on the subject property had been sufficient and timely under an exceptionally straightforward shut-in royalty clause. It read: `[A]t any time, either before or after the expiration of the primary term of this lease, if there is a gas well or wells on the above land ... and such well or wells are shut in before or after production therefrom, lessee or any assignee hereunder may pay or tender annually at the end of each yearly period during which such gas well or gas wells are shut in, as substitute gas royalty, a sum equal to the amount of delay rentals provided for in this lease for the acreage then held under this lease by the party making such payments or tenders, and if such payments or tenders are made it shall be considered under all provisions of this lease that gas is being produced from the leased premises in paying quantities.' Martin, 231 Kan. at 317, 644 P.2d 430. The subject leases were executed on November 6, 1975, for a primary term of 3 years, with conventional habendum clauses allowing continuance of the leases `as long thereafter as oil, liquid hydrocarbons, gas or other respective constituent products, or any of them, is produced from said land or land with which said land is pooled.' Martin, 231 Kan. at 315, 644 P.2d 430. In July 1978, i.e., within the primary term, drilling on one tract began, and, on September 1, 1978, the well was completed and shut in awaiting hookup  with a gas line. (Emphasis added.) Martin, 231 Kan. at 316, 644 P.2d 430. The well was not hooked up to the pipeline until late December 1978 and not turned on until January 3, 1979, i.e., beyond the primary term of the leases. Within a few days, the well began producing. The next month, drilling began on second tract, which is when the parties' dispute arose. Among other arguments, the landowners argued that the lessees' failure to tender or pay shut-in royalties before the expiration of the leases' primary term doomed its continuation. Our court agreed with the district judge that, under the shut-in royalty clause, the 1-year period for remittance of payment did not begin until a well capable of producing gas was completed, which had occurred on September 1, 1978. Martin, 231 Kan. at 317, 644 P.2d 430. Although later language in the opinion also indicates that the fact the well had been placed in production within 1 year of the expiration of the primary lease term was significant to our court's analysis and outcome, see Martin, 231 Kan. at 317, 644 P.2d 430, this language contradicts the shut-in clause at issue, and we hereby disavow it. The clause before us in Martin plainly required only that the shut-in royalty be tendered or paid at the end of the year after the expiration of the primary term and annually thereafter, regardless of whether actual production had ever been begun before the well was shut in during the primary term. The clause said nothing about the significance or lack of significance of production that started after the primary term expired. Again, as with Dewell, the significance of Martin to this case is its implicit definition of shut-in. The well was capable of producing gas and completed, i.e., shut-in on September 1, 1978. It was not necessary either that it be hooked up to a pipeline or turned on before it qualified as shut-in and activated the shut-in royalty clause. The third case offering some guidance on the definition of shut-in to be applied in this case was decided in 1983: Pray v. Premier Petroleum, Inc., 233 Kan. 351, 662 P.2d 255 (1983). In that case, a landowner was able to quiet title in the district court for lack of production after a lessee drilled a well on leased acreage. The well was the only one in its area and was 3 miles from the nearest gas pipeline. The lessee invoked the lease's shut-in royalty clause in its effort to extend the term of the lease under the habendum clause. This court first observed that shut-in royalty clauses can provide a remedy for a situation in which no market is available by the end of the primary term of a gas lease. Even though the construction of a shut-in royalty clause depends on the specific terms of the lease in question, certain general characteristics of shut-in royalty clauses should be noted. First, such clauses actually modify the lease's habendum clause to provide for a type of `constructive production.' [Citation omitted.].... Second, [such clauses work for benefit of both parties].... [T]he implied covenant to reasonably develop the leasehold is applicable. [Citation omitted.] Here, however, the complaint against the lessee is not for breach of these provisions. In fact, the evidence indicates the lessee diligently searched for a market. Finally, although the shut-in royalty clause does not normally specify the shut-in gas well must be capable of producing in paying quantities, such a requirement is implied. As noted, the shut-in royalty clause is a savings clause allowing for constructive production. Such clauses provide that upon payment of the shut-in royalty it will be considered gas is being produced within the meaning of the habendum clause. In order to achieve the desired result, namely a profit, production, whether actual or constructive, must be in paying quantities. [Citation omitted.] Pray, 233 Kan. at 353-54, 662 P.2d 255. In Pray, the operative shut-in royalty clause in the lease was simple. It required only (1) that there be a well where only gas was found and (2) that such gas not be sold or used. If these two conditions were met, the lessee would be permitted to extend the lease by paying shut-in royalties. The specific question before this court in Pray was whether the cost of connecting the lonely subject gas well to a pipeline should be part of the calculation to determine whether the implied requirement that any production be in paying quantities. Pray, 233 Kan. at 356, 662 P.2d 255. This court decided that the cost of the pipeline should not be so considered: Involved here is precisely the type of situation contemplated by the clausea well capable of producing a profit is drilled but for the time being no market exists. This is much different from cases ... where no shut-in royalty clause is involved and a determination of production in paying quantities can be made simply by looking at the performance of the well. [Citation omitted.] A case such as the one at bar, on the other hand, necessarily involves some speculation. This speculation should not include the cost of taking the gas to market when the parties have foreseen in the lease the possibility a market might not exist. We hold capital expenditures for building a pipeline are improper considerations for determining whether a gas well will produce in paying quantities under a shut-in royalty clause. Pray, 233 Kan. at 356-57, 662 P.2d 255. Pray, although it focused its attention on the contours of in paying quantities, again implicitly defined a shut-in well as one that had been drilled but not connected to the facilities necessary to market or transport any gas produced. The fourth of our helpful previous cases discussing shut-in royalty clauses was Robbins v. Chevron U.S.A., Inc., 246 Kan. 125, 785 P.2d 1010 (1990). Robbins primarily concerned the proof necessary to avoid summary judgment on an action for breach of an oil and gas lessee's implied covenant to produce and market production reasonably and diligently. It differed from the previous cases because producing wells had been shut in when a dispute about price arose rather than never activated or turned on. Lessee Chevron timely tendered shut-in royalty payments under a clear clause in the lease. The importance of Robbins to this case is the distinction it emphasizes between a claim for violation of the implied covenant, which entitles a lessor to damages, and a claim for violation of a shut-in royalty clause, which entitles a lessor to cancellation of the lease. As Pray had observed, `[t]he fact a lease is held by payment of shut-in royalties does not excuse the lessee from his duty to diligently search for a market and reasonably develop the leasehold.' Robbins, 246 Kan. at 135, 785 P.2d 1010 (quoting Pray, 233 Kan. 351, Syl. ¶ 3, 662 P.2d 255). The distinction on which Robbins focuses also bears emphasis here. To the extent the landowners in this case argue with Maw and Clary because of a failure to develop and maximize any market advantage or position, and to the extent Land's affidavit contests landowners' view on that subject, this case involves the covenant to produce and market reasonably and diligently. Any alleged or actual breach of that covenant should not be confused with a claim that the shut-in royalty clause did not apply or, if it applied, was not met. The last potentially relevant shut-in royalty case from our court was decided in 1993. Tucker v. Hugoton Energy Corp., 253 Kan. 373, 855 P.2d 929 (1993). Tucker involved certain landowners' efforts to terminate leases whose wells required particularly challenging maintenance. As in Robbins, the wells had been producing, but the lessees allowed them to be shut down for several years while the cost of their maintenance was not, at least in their view, justified by the revenue stream the wells generated. Meanwhile, the lessees paid shut-in royalties to the landowners. As in Pray, the language of the shut-in royalty clauses at issue was relatively simple. It required (a) that the well or wells be capable of producing gas only and (2) that the gas not be sold or used for a period of 1 year. If shut-in royalties were paid or tendered, the leases would be regarded as producing under the leases' habendum clauses. This court held that the shut-in royalty clauses and payments did not save the leases, when the district court found that there was a limited market for the gas from the wells and the lessees chose to stop producing because the wells required constant work. The court's discussion appears to focus alternately on both the shut-in royalty clauses and the covenant to produce and market. Tucker, 253 Kan. at 378-82, 855 P.2d 929. Although Tucker asserts that the total absence of a market for natural gas is a prerequisite to classify a well as shut-in and thus bring into play a shut-in royalty clause, this assertion appears to arise out of an overinterpretation of Pray and insufficient attention to the subject leases' language. The presence or absence of a market and its prospects for a lessee's ability to turn a profit may be made pertinent to interpretation and application of a shut-in royalty clause because of the lease's language, but it is not inevitably relevant as a matter of law. In other words, Pray did not make the absence of a market a part of Kansas' definition of shut-in. Such a consideration is, on the other hand, indispensable to analysis of whether a lessee has discharged its duty under the covenant to produce and market. That covenant is not before us here. We see more useful guidance in the Court of Appeals' December 2009 decision in Welsch v. Trivestco Energy Co., 43 Kan. App.2d 16, 221 P.3d 609 (2009). In Welsch, the lessee's successor, Trivestco, had failed to pay or tender any shut-in royalties during the 2 1/2 years that actual production from the lease's well was stopped because of the gas purchaser's financial problems. Trivestco also did not attempt to restart production from the well or to drill elsewhere on the lease after the 2 1/2 years passed. The district judge refused to grant summary judgment cancelling the subject lease, ruling that the lease's shut-in royalty clause created a covenant entitling the lessor and any successor to money damages rather than a condition entitling the lessor and any successor to termination. The Court of Appeals panel disagreed, reversing and remanding with directions to cancel the lease. Welsch, 43 Kan. App.2d at 18, 29, 221 P.3d 609. The panel observed the critical importance of lease language: First, we note that the [shut-in royalty provisions of the subject lease] are not a part of the habendum clause but rather are contained within the royalty clause. Second, we note that the provisions are stated in language indicating that such payments are optional; that is, the lease provides that the lessee `may' pay or tender such royalties rather than employing language of obligation. Third, we note that the provisions contain the saving clause that if such royalties are paid, `it shall be considered under all provisions of this lease that gas is being produced from the leased premises in paying quantities'; that is, payment of such royaltiesif elected by the lesseeis obviously intended to relate to the habendum clause that preserves the lease in effect `as long thereafter as' production is achieved. Finally, we note that production from the lease was achieved during the primary term, and its cessation occurred well into the secondary term of the lease, where the habendum clause required production for the term of the lease to continue. These unique features of the shut-in royalty provisions are paramount to our construction and application of those provisions to the factual circumstances here. Generally, reliable authorities recognize that an option to pay shut-in gas royaltiesin contrast to an obligation to do socan support cancellation where the optional royalties are not paid. Generally, such an option is considered to create a special limitation on the lease, and the failure to pay the shut-in royalties will terminate the lease. [Citation omitted.]... . . . . ... [H]ere the lease does provide `by implication' that it will expire absent such payment. In stating that `if such payments or tenders are made it shall be considered under all provisions of this lease that gas is being produced,' the lease implies that if such payments are not made, the production requirement of the habendum clause is not satisfied by reason of the shut-in well. In the absence of production in paying quantities, the lease expires by its own terms. Welsch, 43 Kan.App.2d at 22-23, 221 P.3d 609. Compare Daniels v. Quest Cherokee, 2009 WL 5062371 (Kan.App.2009) (unpublished opinion) (decided same day by same panel as Welsch; interpreting stand-alone mandatory shut-in royalties clause with no reference to habendum clause to be covenant rather than condition). A synthesis of these earlier cases from our court and the Court of Appeals makes it evident that a well generally qualifies as shut-in under Kansas law when it is physically complete and capable of producing in paying quantities, even if it has not actually produced in paying quantities in the past. The fact that it has not yet been connected to a pipeline does not necessarily make it incomplete or prevent it from being accurately described as shut-in. The setup and performance of dewatering operations may affect a well's completeness, but we decline the lessors' invitation to adopt a rigid legal definition of shut-in entirely dependent upon whether dewatering has begun or upon whether equipment or repairs are still needed. See Anadarko Petroleum Corp. v. Thompson, 94 S.W.3d 550, 557-58 (Tex.2002); Hydrocarbon Mgt. v. Tracker Exploration, 861 S.W.2d 427, 433 (Tex.App.1993). Under Kansas case law and in the absence of a lease provision to the contrary, the factors to be considered by the factfinder in determining whether a well is physically complete and capable of producing in paying quantities, i.e., shut-in, are those that affect the properties and potential of the well itself, rather than the likely success of any processing or transport of product that remains to be attempted or accomplished. Other factors, such as comparisons to marketing efforts pursued for minerals produced on neighboring leases, on the other hand, are not relevant. They go to the entirely different legal theorywhether damages are due for breach of the covenant to produce and market production reasonably and diligentlythat is not before us here. Today we look only at a claim that the subject oil and gas leases should be cancelled for failure to extend their terms through compliance with their shut-in royalty clauses. As we have stated, the question of whether the wells at issue in this consolidated case qualified as shut-in, defined as it must be when the leases are silent purely by our synthesis from case law, is one of fact. Although a future case may arise on a record in which the uncontroverted evidence makes the correct finding of fact inescapable, this is not such a case. This case must therefore be reversed and remanded with directions to vacate the summary judgment in favor of landowners and to permit further proceedings, including, as the parties and the district judge deem necessary, discovery and the development of expert testimony. The question to be answered by the trier of fact is whether the subject wells were physically complete and capable of producing in paying quantities. Because the analysis and discussion above are dispositive, we do not reach lessees' other arguments in favor of reversal of the district court's decision. Reversed and remanded to district court with directions to vacate the summary judgment in favor of the landowners and conduct further proceedings. McFARLAND, C.J., not participating. DANIEL L. LOVE, District Judge, assigned. [1]