Face Challenges Confidently

278 Blackmon v. XTO Energy

Wednesday, September 2nd, 2015

Richard F. Brown

The following is not a legal opinion. You should consult your attorney if the case may be of significance to you.
Blackmon v. XTO Energy, Inc., 276 S.W.3d 600 (Tex. App.—Waco 2008, no pet.) examines the definition of “production in paying quantities” (“PPQ”) and determines the appropriate remedy for a lessee’s failure to pay shut-in royalties. The third party who had been purchasing the gas produced from the well in issue refused to continue because the carbon dioxide content was greater than three percent. No gas was produced during the time required for lessee to install an amine processing unit to make the gas marketable by removing the excess carbon dioxide. Lessors first alleged that the oil and gas lease had terminated because lessee could not sell the gas without first processing it. Lessors argued that the well was not capable of PPQ because it needed additional equipment or repairs in order to produce marketable gas.
The court, however, focused on whether the well was capable of producing gas in marketable quantity, not marketable quality. The court stated that the well was connected to pipeline facilities and was capable of producing a high volume of raw gas at the wellhead. Therefore, the processing unit was not the type of additional equipment necessary to enable gas to flow from the wellhead in a producing quantity. Rather, the processing unit was installed to render the gas of marketable quality. The court concluded that the well was capable of flowing from the wellhead in a marketable quantity regardless of whether the processing unit was installed; thus, the well was capable of PPQ when it was shut in. The court further noted that the processing unit required to process the carbon dioxide out of the gas produced was installed downstream of the wellhead. The court reasoned that those cases holding that this type of equipment is a post-production cost further supported its conclusion that the equipment was not necessary to produce the gas.
Lessors next alleged that lessee’s failure to pay shut-in royalties resulted in the automatic termination of the lease. The court focused on whether this particular shut-in royalty provision created a special limitation, a condition subsequent, or a covenant. The court noted that in case of doubt as to the true construction of a clause in a lease, it should be held to be a covenant and not a condition or limitation, as the law does not favor forfeitures. Leases utilizing an “unless” form and providing that the payment of shut-in royalties is a form of constructive production have routinely been held to create a special limitation, and that form of lease will terminate if the shut-in royalty is not paid. However, the lease in this case provided that if a well was shut-in, the lease would continue, but if the shut-in continued for ninety days, lessee “shall pay” shut-in royalties. For a breach of a mere covenant, the lessor has no right of reentry, unless there is an express clause in the agreement to this effect, but has the right to sue for damages only. Because the lease in this case was a covenant and because there was no express clause divesting the estate of the lessee, the court held that the provision for payment of shut-in royalties could only be enforced by a suit for money damages.
The significance of this case is that it sharpens and narrows the analysis required to determine whether a well is capable of PPQ.   This court drew a line between the equipment necessary to produce and the equipment required to make the gas marketable (the equipment which is normally included in post-production costs). That is, the equipment necessary for the gas to flow when the well is turned “on” does not include all of the equipment necessary to make the gas marketable. This court cited with approval the Texas Supreme Court’s opinion holding that in order for a well to be capable of PPQ, “there must be facilities located near enough to the well that it would be economically feasible to establish a connection so that production could be marketed at a profit.” Apparently, connected to a pipeline is “near enough,” but there is nothing in this opinion as to whether the production could be marketed “at a profit.” Presumably, profitability was uncontested.
The case also holds that when a shut-in royalty provision is determined to be a covenant by the court, that covenant may be enforced only by a suit for money damages and not by a suit for lease termination. Or stated more generally, under a “shall pay” shut-in royalty clause, coupled with a provision that the mere existence of a shut-in well capable of producing in paying quantities is constructive production, the failure to pay shut-in royalties will not result in lease termination.