The more things change, the more they remain the same. Tumultuous events are certainly nothing new for the energy sector. But with recent events, including historically low oil prices, the Coronavirus pandemic, and a new administration scrutinizing oil and gas production, questions inevitably arise with respect to royalty leases: What can I do to protect myself? Are there safeguards within my lease? In such times, royalty owners would do well with a refresher.
In typical oil and gas leases, parties contract to certain terms, conditions, and clauses, including the “habendum clause.” The habendum clause normally defines and breaks down the duration of the lease into two terms: a primary term (such as “for five years”) and a secondary term (such as “for so long as oil and gas are produced in paying quantities”). This clause can — and usually will — last as long as the condition in the secondary term is satisfied. The condition associated with the secondary term is referred to as the “production threshold,” which is the negotiated amount the lessee (the oil and gas company) must produce from the well for the lease to remain “active.” When the lessee no longer meets the production threshold, the oil and gas rights conveyed return to the lessor (the landowner), and the lease automatically terminates.
Without more specificity, the secondary term of the habendum clause would likely be a death knell for lessees who failed to meet the production threshold on a property in a given term for reasons other than the property’s depletion of resources. However, certain varying savings clauses can possibly prevent the otherwise automatic termination of the habendum clause. Common examples of these savings clauses include, amongst others: a (1) “shut-in” provision and (2) force majeure provision.
A shut-in provision contained in most oil and gas leases lessens the harsh results of the automatic termination rule. Assuming the condition of the secondary term cannot be satisfied currently, the shut-in provision allows a lessee to provide a “shut-in” payment to the lessor in order to keep a lease in force. Typically, this occurs when there is no market for oil or gas or there is no pipeline ready to receive production.
A lessee also might fall back on a force majeure provision, which provides a lessee relief from the consequences of the failure to comply with the terms of the lease due to an unforeseen event. However, such terms are highly fact-specific and can vary widely under each lease. Recently, however, lessees have increasingly looked to force majeure provisions to prevent an otherwise worthy well from automatically terminating — and which will potentially be discussed in a future article.
Assume you have an existing royalty lease, and given recent volatility, you are rightfully concerned a bankruptcy filing by a producer, or upstream purchaser, is going to impact your investment. You correctly believe in such an event, certain protections will be afforded to you, but without more information, you do not know which actions to take. Two options likely exist for landowners: (1) filing and perfecting any security interest in the oil and gas proceeds and (2) state first-purchaser statutes.
The Uniform Commercial Code generally provides the steps for one who holds an interest in property to “perfect” their interest. By “perfecting” your interest, you essentially gain a priority over any other creditors who have not done so, thus increasing the likelihood for you to receive payment on account of such interest before other creditors. Predictably, perfecting one’s interest requires jumping through a few hoops, including filing a financing statement with the applicable secretary of state.
Certain states — like Texas and Oklahoma — seeking to simplify the process for royalty owners, passed “first-purchaser statutes,” provide that the royalty owners’ interests in the oil and gas proceeds automatically “perfect,” without the need for filing a financing statement. Such an idea has practical roots—within the context of bankruptcy, royalty owners are given a “first-in-line” bite at getting their claims paid before other creditors are paid.
However, a common error is relying too much on the assumption that your state’s first-purchaser statute will apply in the bankruptcy context. Take In re SemCrude, L.P. for example. SemCrude filed for bankruptcy after reporting billions of dollars in losses. Texas producers who sold oil and gas believed under Texas law, their security interests were higher in priority over other creditors and thus first to be paid back in the bankruptcy case. However, because SemCrude was incorporated in a different state and not in Texas, the Court determined that Texas law did not apply. Because the Texas producers had not filed financing statements to perfect their security interests, their interests were subordinate to the banks’ interests, and the Texas producers received less than they would have if their interests were perfected.
Oklahoma, seeking to rectify the effects of the SemCrude decision, amended its statute. And it worked in In re First River. Texas, however, has still not amended their first-purchaser statute.
In light of the ruling in SemCrude, what can Texans do to otherwise protect themselves? By filing a financing statement in the state where the producer is incorporated or reserving a lien, Texan landowners can ensure their interests are secured so that in the event of bankruptcy, they too get a “first-in-line” bite.
1 See Tex. Bus. & Com. Code § 9.343; Okla. Stat. Ann. tit. 52, §§ 548–548.6, repealed by Okla. Stat. Ann. tit. 52, §§ 549.1–549.12. 2 Arrow Oil & Gas, Inc. v. SemCrude, L.P. (In re SemCrude L.P.), 407 B.R. 112 (Bankr. D. Del. 2009); Samson Res. Co. v. SemCrude, L.P. (In re SemCrude, L.P.), 407 B.R. 140 (Bankr. D. Del. 2009). 3 In re First River Energy, LLC, No. 18-50085, 2019 WL 1103294 (Bankr. W.D. Tex. Mar. 7, 2019).
About the authors: Jarrod Martin is a shareholder in Chamberlain Hrdlicka’s Bankruptcy, Restructuring & Creditor Rights practice. He can be reached at [email protected] Tyler Greenwood is an associate in the practice.