For the unwary, Pugh clauses (pronounced “Pew”) can sometimes stink. Although it is a fairly common provision in many fee oil and gas leases today, there is no industry standard Pugh clause. As a result, the many variations of the Pugh clause can provide unpleasant surprises to both lessors and lessees who assume that all Pugh clauses operate similarly. From an industry perspective, it is essential for landmen negotiating oil and gas leases to understand how a Pugh clause will operate and potentially affect other provisions in the lease. Additionally, with the sharp decrease in oil prices, many oil and gas companies have pushed drilling schedules into the indefinite future. The delay in drilling necessitates a careful review of the underlying lease portfolios to determine when certain leases will expire. A thorough understanding of the effect of a Pugh clause’s on a lease is vital to this review.
So What Is It?
As a general rule, production, or other operations, on “any part of the land, included in an oil and gas lease will perpetuate the lease beyond the primary term as to all of the land covered by the lease.”Moreover, if lands are pooled or unitized, production or operations on any of the lands within the unit can extend all leases committed in whole, or in part, to the drilling or spacing unit. This means that an oil and gas lease can be held past its primary term by production on only a small portion of the leased lands or on lands outside of the leased lands that are located in a drilling or spacing unit. Understandably, lessors can be less than thrilled to discover that all of their lands are locked-up by a lease when only a small portion of their lands are included within a drilling or spacing unit—preventing them from re-leasing their non-producing lands so that they can receive additional bonus payments, rentals, or production royalties from these lands. Without an “express provision in the lease, the lessor only has recourse to the implied covenant of reasonable development (or further exploration in a state that recognizes such a covenant)” to force additional development on the lessor’s lands or allow them to re-lease the lands altogether.
A Pugh clause can prevent this scenario. Named after a Louisiana lawyer named Lawrence Pugh, the Pugh clause operates to sever the non-producing lands or interval based on some defined criteria, such as acreage or depth. The impact of a Pugh clause “increases the burdens on the lessee who must take additional steps to maintain the lease as to the [non-producing portion]; this may include a return to delay rentals,” (if the lease is not a paid-up lease), “or initiation of drilling operations within a specified period.” In other words, by including a Pugh clause in a lease, any production located on or attributed to leased lands will no longer be sufficient to extend the primary term for the entire leasehold. If the lessee takes no actions to extend the lease excluded by operation of the Pugh clause, the lease will expire as to these excluded lands. This provides an obvious benefit to lessors, who can once again make the forfeited lands available for lease. Since Pugh clauses are decidedly pro-lessor, they are “virtually always inserted into or attached to a lease at the insistence of the lessor’s attorney.”
Horizontal and Vertical Pugh Clauses
It is important to note that Pugh clauses can be horizontal, vertical, or both. A horizontal Pugh clause “has the effect of severing a leasehold as to the pooled and non-pooled portions on the basis of horizontal planes,” while a vertical Pugh clause “has the effect of severing a leasehold on the basis of vertical planes only.” This means a Pugh clause can be structured by depth (e.g., severing all lands below 100 feet of a drilled well or the bottom of the producing zone), or by acreage.
Give Me An Example
Because there is no industry standard Pugh clause, there can be as many different forms of the clause as there are people drafting the clause. The following is an example of a generic Pugh clause:
A producing well, or well capable of producing, will perpetuate this lease beyond its Primary Term ONLY as to those lands as are located within, or committed to, a producing or spacing unit established by Government authority having jurisdiction.
This provision in an oil and gas lease operates to segregate the lease at the end of the primary term according to whether the leased lands were within a drilling or spacing unit established by the appropriate government agency. Any lands not located within a drilling or spacing unit would not be extended by production (keeping in mind, of course, that these lands could be extended by other provisions in the lease, such as those pertaining to drilling operations). As a title examiner, it’s not uncommon to see other triggering criteria in a Pugh Clause—such as one or two years after the end of the primary term, or when drilling operations on any portion of the leased lands cease for a specified amount of time.
It’s crucial to clearly specify how and when the clause will come into play, as illustrated by the following real-life Pugh clause:
Notwithstanding anything to the contrary herein, this lease shall terminate after the primary term as to all the lands not included within a drill site spaced unit as provided by the proper Governmental Authority….
This Pugh clause is poorly drafted because it segregates the leased lands only on the basis of whether they are within a “drill site spaced unit,” without clearly specifying that the spaced units must also be producing in order for the lease to be extended beyond its primary term for those lands. Read literally, the provision raises the question of whether a lease would be extended for lands that are merely subject to a spacing order (and thus presumably within a drill site spaced unit) when there is no production within the drilling or spacing unit, assuming that there is production elsewhere on the lease lands, as was the case in this instance. Although it’s likely that the parties to the lease intended that the clause include a production requirement, it’s uncertain how a court would rule if this clause was litigated, particularly since Pugh clauses tend to be strictly construed.
Problematic Pugh clauses, such as the example above, often arise when the Pugh clause is merely copied and pasted from another oil and gas lease, which can result in omitted words or phrases, or inconsistencies with other provisions of the lease. Problems can also arise when a Pugh clause is drafted by a person who does not fully understand the impact of words or phrases included in, or excluded from, the provision.
As illustrated by the poorly drafted Pugh clause above, not all Pugh clauses are created equal, and it’s important to review and understand the specifics of a Pugh clause when negotiating an oil and gas lease, or when later evaluating how a Pugh clause affects the extension of a lease.