Texas federal district court determines shut- in royalties were not timely paid and production in paying quantities after the primary term did not prevent the leases at issue from expiring. EnerQuest Oil & Gas, LLC v. Plains Exploration & Production Co., 2013 U.S. Dist. LEXIS 159802 (D. Tex. Nov. 7, 2013)

In 2008, EnerQuest Oil & Gas, LLC, and Chieftain Energy, LLC, (EnerQuest) acquired two oil, gas, and mineral leases on lands in Texas. The leases had two-year primary terms and could be maintained "for so long thereafter as a covered mineral [was] produced in paying quantities" or the leases were "otherwise maintained in effect pursuant to [their] provisions." Under certain circumstances, the shut-in well clauses would extend the leases in the absence of actual production.

At the time EnerQuest acquired the leases, none were producing, and EnerQuest made no attempt to produce oil or gas for almost two years. However, in June 2010, EnerQuest ran a diagnostic test on an old oil well that had been shut in by the prior operator and then shut in the well after the test was completed. Based on the results of the test, EnerQuest reclassified the old oil well as a gas well (the "Well") and pooled the leases' acreage into a single gas unit. EnerQuest performed no additional operations on the Well before the leases' primary terms expired.

The lessors notified EnerQuest that the leases had terminated, and EnerQuest attempted to pay shut-in royalties to the mineral owners. Believing the leases had expired, the lessors signed new leases with Dan Hughes Company, which leases were later assigned to defendant EOG Resources ("EOG") or sold to defendant Plains Exploration and Production Company ("PXP"). In July 2011, EnerQuest began producing gas from the Well.

The question before the court was whether EnerQuest successfully maintained the leases beyond their primary terms. The payment of a shut-in royalty can be a substitute for production that keeps the lease in effect. Such a clause allows a lessee to avoid termination of the lease only if: (1) the royalties are timely tendered, and (2) the well was capable of production in paying quantities at the time the royalties were tendered. The District Court for the Western District of Texas found that summary judgment was inappropriate on the issue of whether the Well was capable of producing in paying quantities, but concluded that the shut-in royalties were not timely tendered, such that the leases expired at the end of their primary terms.

On the question of whether the shut-in royalties were timely tendered, neither party disputed that EnerQuest first tendered the royalties on September 14, 2010, and that at that time the leases' two-year primary term had expired. However, the parties disagreed about whether the leases provided that EnerQuest would prepay delay rentals to cover the leases' primary terms. The Court concluded that the lease did not provide for delay rentals, such that the shut-in royalties were due at the end of the leases' primary terms.

Thus, because the Well was not actually producing in paying quantities at the end of the leases' primary terms, to maintain the leases EnerQuest must have satisfied the requirements of the shut-in royalties clauses by paying shut-in royalties within ninety days of the Well being shut in. Because the Well was shut in on June 2, 2010, shut-in royalties were due on August 31, 2010. When the leases' primary terms ended and the shut-in royalties still had not been paid, the leases automatically terminated because EnerQuest had achieved neither actual nor constructive production at that time, and the subsequent production from the Well did not retroactively prevent or preclude the leases from expiring.

This case serves as yet another warning for E&P companies to make sure they are fully compliant with lease terms on the front end in order to protect their producing assets.