A lot of people subscribe to the myth that an oil and gas lease stays in force as long as the lessee pays the lessor some royalty at least once a year. As a result of this myth, you may see leases going on and on with eighty or so barrels sold off every December. Of course, if the lease itself has a provision that makes this good enough, then so it is. But I’ve never seen such a lease with anything like that as a standard provision, and it’s extremely rare to see it added as a special provision.
In the absence of special provisions, a lease will remain in force so long as it continues to produce in “paying quantities”. There are two facets to this term. The first is the arithmetic of comparing income to expenses to see whether it’s in the red or the black. The second is the time period over which this determination is made. Obviously, a one month period would be too short to get an accurate view, unless it’s otherwise established that it’s a typical month over the long haul. Courts have applied time periods ranging from a few months to a few years. It depends on what’s sufficient to enable the court to say that it would provide a reasonable and prudent operator sufficient data to determine whether the lease should be produced or abandoned.
There’s a standard litany of cases seen in virtually every brief on the issue of whether a lease has terminated for lack of production in paying quantities. The basic brief reads something like this:
“Paying quantities” 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 result in a loss to the lessee. Reese Enterprises, Inc. v. Lawson, 220 Kan. 300, 553 P.2d 885 (1976).
The question of whether the requisite profit has been made is answered by using an objective mathematical test. In order to apply the test an appropriate accounting period must be selected, and the proper income and expense items must be identified. These elements were considered at length in Texaco, Inc. v. Fox, 228 Kan. 589, 618 P.2d 844 (1980).
If there is production in paying quantities, then the lease is valid and continues in force; if production in paying quantities has permanently ceased, then the lease has expired of its own effect under the terms of the habendum clause. Kelwood Farms, Inc. v. Ritchie, 1 Kan. App. 2d 472, 571 P.2d 338 (1977).
An oil and gas lessee, temporarily ceasing production, thereafter has only a reasonable time, under all the circumstances, to return the leasehold to production in paying quantities. Wrestler v. Colt, 7 Kan. App. 2d 553, 644 P.2d 1342 (1982).
A mere temporary cessation of production because of necessary developments or operation does not result in the termination of an oil or gas lease or the extinguishment of rights acquired under its terms. Whether the cessation of production at an oil or gas leasehold is temporary or permanent is a question of fact to be determined by the trial court. Eichman v. Leavell Resources Corp., 19 Kan.App.2d 710, 876 P.2d 171 (1994).
A load of oil a year may or may not amount to paying quantities. The bigger issue is, actually, the subject of a different covenant, one that you generally won’t see actually written in the lease. We’ll talk about this implied covenant in a later article.