Introduction

The habendum clause is a fundamental provision of oil and gas leases. This clause (also called the term clause) sets forth the time period that the rights granted to the lessee under the lease are extended—i.e. how long the lease will be active.1

Basics

An habendum clause in an oil and gas lease typically contains two separate terms, the primary term and the secondary term. The primary term is a fixed period of time during which the lessee has the option, but not the obligation, to pay delay rentals and/or explore for and produce oil and gas. No actual production is necessary to keep the lease active during the primary term. Ten years used to be a common primary term; however, shorter primary terms (e.g. 1 to 5 years) are often seen in areas with proven fields or anticipated drilling.2 As with other lease terms, its length can be negotiated by the lessor and lessee; the relative bargaining power between the parties and the amount of bonus a lessee is willing to pay are important in determining term length.3

At the expiration of the primary term, the lease terminates as a matter of law unless production4 is achieved during the primary term. The time period under the secondary term is indefinite—so long as lease substances are produced, the lease remains in effect. While many leases expire at the end of the primary term without production, if production is achieved, it is not uncommon for oil and gas leases to be held by production for many years.

In having both a primary and secondary term, the interests of both lessors and lessees are represented. The fixed primary term protects lessors from having their mineral interests endlessly tied up without production and encourages development on the land. If production is not achieved by the lessee within the primary term, the lease terminates (unless otherwise extended, such as by other lease terms) and the lessor is free to re-lease his or her mineral interests. Conversely, if production is achieved, the lessee’s risk in expending substantial sums to develop the land is rewarded by extending the lease so long as production continues.5

Formulation

Although there are numerous variations of habendum clauses, a typical habendum clause will read substantially as follows:

[T]his lease shall remain in force for a term of ___ years from this date, and as long thereafter as oil or gas or either of them is produced from said lands.6

Additionally, the phrase “produced in paying quantities” or “produced in commercial quantities” is commonly included in the clause, along with phrases allowing for production to come from lands pooled or unitized with the leased lands.7

Meaning of “Produced”

As noted above, the typical habendum clause requires that oil or gas be “produced” from the leased land to extend the lease beyond its primary term. In most states, “produced” means exactly that—oil or gas must actually be produced from the leased land. A minority of states, including Oklahoma and West Virginia, hold that discovery of oil or gas is sufficient—no production is actually necessary—to extend the lease beyond its primary term, although the well must be completed and capable of production, and the lessee must make diligent efforts to market.8 Another minority of states, including Montana and Wyoming, appear to differentiate between oil and gas, with the discovery of gas being sufficient to extend the lease beyond the primary term, while actual production for oil is necessary to extend.9 The distinction arises because oil can be produced and stored economically while gas generally cannot be stored economically above the ground.10

Some habendum clauses include language that the lease will be extended “so long as oil or gas is capable of being produced in paying quantities.” In such instances, actual production is not necessary to extend the lease beyond its primary term, but may require a well that can be turned “on” to produce in paying quantities without the addition of extra equipment or repair.11

Once the lease is extended into the secondary term, if production ceases the lease automatically terminates (unless otherwise extended by a different provision in the lease).12 However, courts have held that it is not required that production be entirely continuous throughout the extended term to hold the lease. Courts recognize that production may temporarily cease due to repairs, breakdowns, and reworking operations.13 Where the lease is silent, and cessation in production is litigated, the burden of proof rests on the lessee to show that the cessation was for a reasonable reason and for a reasonable amount of time. Courts vary in what constitutes a reasonable amount of time.14 For example, one court held that a four-year cessation in production was “temporary,” while another court held that a six-month cessation was “permanent.” To provide more certainty in the face of inconsistent court rulings, modern oil and gas leases often include a “cessation of production” clause that specifies when production must be continued after cessation for the lease to not terminate.15

Meaning of “Produced in Paying Quantities”

A question that frequently arises when construing an habendum clause is how much production is necessary—i.e. is any amount of production sufficient to hold the lease, or must the production reach a certain level? As noted above, modern oil and gas leases commonly include the qualification that production be in “paying” or “commercial” quantities. For leases that only state “production” is required, courts generally have construed the clause to include this qualification. Thus, regardless of whether the lease includes the qualification “in paying quantities,” the term “produced” typically means “produced in paying quantities.”16

The question then becomes what constitutes “produced in paying quantities.” The Kansas Court of Appeals stated the general rule:

[T]he phrase “in paying quantities” as used in an oil and gas lease habendum clause 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 thus result in a loss to the lessee.17

Put simply, a lease is considered “producing in paying quantities” if production revenue is greater than operating expenses.

In determining production revenue, any royalty paid to the lessor is excluded, although any payment to overriding royalty owners generally are included as revenue.18 For operating expenses, any direct costs to operate, such as labor costs, electricity for pumping units, taxes (but not income taxes) payable by the working interest owner(s), and day-to-day maintenance cost are included.19 There is some dispute among courts whether depreciation and overhead costs should be included as operating expenses.20 Initial expenditures, such as the costs of drilling, equipping, and completing are not included as operating expenses.21 Such analysis makes economic sense—after these initial expenditures, an operator will continue to operate so long as the production on a lease is marginally profitable in order to recover as much of these costs as possible.22

It is important to have a reasonable time period when evaluating production revenues against operating expenses. Leases may operate negatively in the short-term, but profitably in the long-term. One source notes that in almost every instance, a time period of at least a year was used by the courts to evaluate profitability, and frequently a time period of eighteen months to three years was used.23 In times of distressed market conditions, courts have used longer time periods or have assessed whether the lease would have been profitable under normal market conditions.24

Conclusion

An understanding of the habendum clause is crucial when negotiating a lease or when evaluating whether a lease has been held by production past its primary term. As you do so, keep in mind that other lease provisions not discussed in this article may also affect lease duration, such as shut-in royalty, pooling, unitization, Pugh, continuous operations, delay rental, and cessation of production clauses, among others. Additionally, be aware that the law varies from jurisdiction to jurisdiction, and may be different from the general principles discussed in this article.