Like virtually all modern oil and gas leases, federal leases have a fixed primary term (typically 10 years) and a habendum (i.e., “so long thereafter”) clause. But understanding the provisions of the Mineral Lands Leasing Act of 1920 (“MLA”) and BLM regulations governing extension of federal oil and gas leases can be tricky.
Production in paying quantities. Obtaining production is the most obvious means of lease extension – if there is a producing oil or gas well on the leased premises when the primary term expires, the lease is extended for so long as oil or gas is produced in paying quantities. The term “paying quantities” means production “sufficient to yield a reasonable profit after payment of all the day-to-day costs incurred after the initial drilling and equipping of the well, that is, the costs of operating the well, including workovers and maintenance, rendering the oil or gas marketable, and transporting and marketing that product.”
However, it isn’t necessary for there to be actual production from a federal lease for it to be extended beyond the primary term; rather, the lease will be extended indefinitely if there is a well “capable of producing oil or gas in paying quantities” on the leased premises. BLM determines whether a well meets this requirement. The well must be physically in a condition to produce by “flipping a switch” with little or no additional work. For example, a shut-in well qualifies as capable of producing in paying quantities, but a well in which the casing has been set and cemented but not perforated does not qualify. The IBLA also has upheld lease termination when equipment required for production was not on site.
This extension has its limitations, since the MLA grants BLM the authority to order the lessee to begin production within a period of not less than 60 days from receipt of notice from that agency. Failure to commence actual production within the time allowed by BLM results in termination of the lease. And because federal leases are not paid-up leases, the lessee also must pay annual rentals on or before each anniversary date of the lease until oil or gas in paying quantities actually is produced from the lease.
Drilling over primary term. If the lessee is engaged in drilling operations at the expiration of the primary term of the lease, the lease term will be extended for an additional two years if certain requirements are met. Actual drilling operations that penetrate the earth are required. Mere site preparation, or even moving a rig on site, is not enough to obtain extension of a federal lease by drilling. The operations must be conducted under an approved application for permit to drill (“APD”). Also, to get the drilling over extension, the lessee must have paid rentals on or before the lease anniversary date.
After commencing drilling operations, the lessee must diligently conduct such operations in a bona fide effort to drill and complete the well as a producer. The standard is that of a reasonably prudent operator, and drilling operations must be conducted in a manner that “anyone seriously looking for oil or gas can be expected to make in that particular area, given the existing knowledge of geologic and other pertinent facts.” Notably, the drilling over extension relates only to the primary term, and it is not available if the lease was previously extended for another reason. Nonetheless, the drilling over extension can apply if the lease was suspended (see below), since that results in tolling the lease term.
Commencement of additional drilling operations. If production in paying quantities ceases on a federal lease in its extended term, the lessee must commence reworking operations or drilling operations for a new well within 60 days or the lease will terminate. Because the MLA itself provides that the 60-day period to commence drilling or reworking operations begins running “after cessation of production,” the safest course is to commence operations within that period. BLM regulations, on the other hand, provide that the 60-day period does not begin until receipt of notice from BLM that the lease is not capable of production in paying quantities. As with drilling over the primary term, once commenced, continuous operations in the extended term also must be conducted with reasonable diligence.
Assign part of the lease. If the lessee assigns 100% record title (and operating rights) in a portion of a federal lease, such assignment will cause a segregation of the assigned lands into a separate lease. Such segregation potentially can extend a federal lease in different ways. First, if a discovery of oil or gas in paying quantities later is made on any portion of the original leased lands, both the base lease and the segregated lease will continue for the longer of the primary term of the base lease or for two years after the date of discovery. Interestingly, there is no requirement to complete a well – a discovery can be proved by other evidence. However, a well eventually must be completed as capable of producing in paying quantities in order to qualify. As with other extensions, rental payments are still required until there is a discovery. Second, if the base lease is in an extended term due to production (actual or allocated) or by payment of compensatory royalties, the undeveloped portion will continue for two years from the effective date of the assignment and so long thereafter as oil or gas are produced in paying quantities.
Pay compensatory royalty. If the leased premises are determined by BLM to be subject to significant drainage from a well on neighboring lands and the lessee enters into a compensatory royalty agreement with BLM and pays a compensatory royalty for the drainage, such payment will extend the lease for the period in which the compensatory royalties are paid plus one year thereafter. As a practical matter, BLM typically will not enter into a compensatory royalty agreement if it believes the lessee can drill an offset well. The lessee also must pay rentals.
Unit-related extensions. If consent of the necessary parties is obtained and approval is obtained from BLM (which includes a public interest determination), the lessee may commit a federal lease to a federal exploratory unit, which can affect lease extension. A federal lease is not extended automatically through commitment to a unit agreement alone. However, production of oil or gas in paying quantities anywhere in the unit area will maintain a committed federal lease so long as the lease remains committed to the unit. Production from a well that meets the paying quantities test on a lease basis but which is not sufficient to establish a unit well and form a participating area (often called a “Yates well”) nonetheless will extend the leases committed to the unit. Also, the drilling over extension discussed above will extend a federal lease when actual drilling over the end of the primary term occurs on any lease committed to the unit. Until a well capable of production in paying quantities is drilled on the lease or a participating area is established and production is allocated to the lease, the lessee must continue paying rentals.
Commitment of a federal lease to a unit with lands both inside and outside of the unit area will cause the lands outside of the unit area to be segregated into a separate lease. The uncommitted lands will be extended for the term of the original lease, but for not less than two years from the effective date of the commitment to the unit. Similarly, when all of the leased lands in a federal lease committed to a unit are eliminated from the unit by termination or contraction of the unit, the lease will be extended for the term of the original lease, but for not less than two years from the effective date of the elimination. However, in both cases, there is no extension if the public interest requirement is not met. The public interest requirement is met “if the unit operator commences actual drilling operations and thereafter diligently prosecutes such operations in accordance with the terms of said [unit] agreement.”
Partial commitment and elimination from a unit can result in some lease extension complexities. In particular, if a federal lease is producing beyond its primary term when it is partially committed to a unit (and thus the non-committed land is segregated), the segregated portion that does not have a producing well will remain in effect for so long as production in paying quantities continues from the existing well(s) on the other portion, regardless of which portion is committed to the unit. This typically is referred to as “associated production.” But if the lease is still in its primary term (even if the lease is producing), the non-producing portion will not receive the benefit of the existing production after segregation. Instead, it will remain in effect for the rest of its fixed term or two years, whichever is longer.
Additionally, a producing lease fully eliminated from a unit will receive a fixed term equal to the later of two years from the effective date of elimination or its original primary term, even though the lease is producing in an extended term at the time of elimination. This means that if the lease subsequently is partially committed another federal unit it would not receive any “associated production” as discussed above. There are many nuances and interesting results when a federal lease has been committed to and eliminated from multiple units. Thus, the facts and relevant law should be reviewed carefully to determine whether a lease in this situation has been properly extended.
Communitization agreement related extensions. Commitment of lands in a federal lease to a communitization agreement is the federal equivalent of pooling. A communitization agreement generally must conform to an existing state spacing pattern or commission order and it must be approved by BLM. Unlike unitization, commitment of part of the lands in a federal lease to a communitization agreement does not result in segregation, and thus the segregation extension mentioned above does not apply.
Similar to federal units, if any portion of a federal lease is committed to a communitization agreement, the entire lease will be extended by production in paying quantities or by the completion of a well capable of producing in paying quantities on any communitized land. In addition, actual drilling operations over the primary term of a federal lease anywhere on the communitized lands will extend the lease for two years. BLM’s approval of the communitization agreement need not be obtained prior to the end of the primary term in order to obtain the lease extension benefits, but the agreement must be signed by all necessary parties and filed with BLM prior to lease expiration. Finally, if a communitization agreement is terminated, so long as the public interest requirement was met, the eliminated federal lease will receive an extension of the remainder of its primary term or two years, whichever is longer.
Suspensions. The MLA also provides for another means of keeping a federal lease alive that technically results in tolling of the lease term and adding the period of suspension to it. The MLA gives BLM the authority to grant two types of suspension of an entire federal oil and gas lease following receipt of a timely application from all record title holders (or the unit operator with respect to all leases committed to a federal unit) showing why such relief is necessary. First, BLM may grant suspensions of both operations and production “in the interest of conservation” (known as a Section 39 suspension). Section 39 suspensions are intended to provide extraordinary relief when a lessee is denied beneficial use of its lease. For example, BLM might grant a Section 39 suspension to allow time for the reviews required by environmental statutes such as NEPA and the Endangered Species Act. BLM also has identified many situations in which a Section 39 suspension is not warranted – a significant one being when an APD is submitted incomplete or untimely. A Section 39 suspension terminates if the lessee undertakes activity such as road construction, site preparation or drilling. Rentals and minimum royalty payments are suspended under a Section 39 suspension.
Second, BLM may grant suspension of operations only or a suspension of production only when the lessee is prevented from operating on or producing from the lease, despite the exercise of due care and diligence, by reason of force majeure (known as a Section 17 suspension). BLM may only grant Section 17 suspension after operations on the lease have commenced and production has been obtained.