Overview

On September 7, 2011 the Alberta Court of Appeal ("ABCA") upheld the Energy Resources Conservation Board ("ERCB") interpretation of the decisive phrase "capable of producing the leased substances" in the context of the suspended well clause contained in the Canadian Association of Petroleum Landmen ("CAPL") 91 Alta. Petroleum and Natural Gas Lease.  In OMERS Energy Inc. v. Alberta (Energy Resource Conservation Board), 2011 ABCA 251, Justice Conrad affirms the conclusion reached in the ERCB proceedings:

[C]apable of producing the leased substances" is to be interpreted to mean the demonstrated, present ability of a well on the lands to produce the leased substances in a meaningful quantity within the time frames contemplated in the lease.

This decision puts the entire oil and gas industry on notice.  Immediate stakeholder implications include:

  1. Lessees – Lessees will need to undertake an assessment of all suspended wells on lands beyond the primary term and ensure greater communication among team members when shutting in a well;
  2. Freehold Owners – From the perspective of freehold owners, the ABCA decision protects a lessor's leasehold interest and arrives at a sensible interpretation of the suspended wells clause that only permits reasonable extensions of the lease term, without allowing a lessee to effectively sterilize the lands;
  3. Top Lessees – There is a potential opportunity for top lessees to capitalize on freehold leases which were wrongfully or mistakenly continued past the primary term under this form of suspended well clause;
  4. ERCB – An increased adjudicative scope for the ERCB, permitting it to interpret contractual terms for the purposes of ruling on lease validity to a standard of correctness when determining the right to issue a well licence; and
  5. Legal/Industry Associations – This decision sends a clear signal from the courts that lease drafters need to clarify and revise existing lease forms.

Summary

Montane Resources Ltd. (Montane) sought to challenge the interest held by OMERS Energy Inc. (OMERS) in the leased lands.  Montane acquired a subsequent lease from the freehold owner more than a year after the primary term of the initial OMERS lease had expired.  OMERS sought to defend the validity of its interest in the lands to the leased substances in the Court of Queen's Bench after Montane served notice to OMERS to prove its interest in their lease as protected by a caveat.  Notwithstanding such action, OMERS applied to the ERCB for two additional gas well licences:  a re-completion of the existing well in a different formation and a well in a new location.  Montane quickly became aware of the new OMERS wells and upon their application to the ERCB, the ERCB suspended the well licences and production until further review.

At the ERCB, OMERS maintained that its lease was valid and subsisting as it was continued by virtue of the provisions in the suspended well clause.  The ERCB interpreted provisions of the CAPL 91 Alta. Petroleum and Natural Gas Lease to determine whether OMERS was improperly issued gas well licences and, as a result, wrongfully obtaining leased substances from Montane lands.  The CAPL 91 lease form and modified versions thereof are widely regarded among industry participants as the most commonly used petroleum and natural gas lease form on freehold lands in the Western Canadian Sedimentary Basin.

OMERS' initial well continued the lease beyond the five-year primary term, by virtue of continuing "operations" or gas production on the lands.  Approximately one month after the primary term had expired, the well suffered water loading issues, gas production declined and the well was shut-in.  Less than two months later, water clean-out operations were conducted to help reduce water production with minimal success and the well was shut-in for a second time.  Six months later, OMERS again attempted similar water clean-out operations to revive gas production, but once again the initiatives were unsuccessful and the well was shut-in.  It was turned on over a year later and produced a measurable amount of gas.

The ERCB concluded in Board Decision 2009-037 that the underlying OMERS lease had expired after the first round of clean-out operations and, therefore, was not continued by virtue of the suspended well clause.  The ERCB stated that the production volume of the leased substances must be "material" or "meaningful" for a lessee to rely upon a well that is "capable of producing the leased substances" to extend a lease beyond the primary term.  OMERS applied for leave to appeal to the ABCA on several grounds and was granted leave solely on the issue as to "whether the Board erred in its interpretation of the phrase capable of producing the leased substances".

"Capable of Producing the Leased Substances": A Two-Part Test from the ABCA

The ABCA addressed the underlying fundamental bargain negotiated between lessor and lessee and concluded that a freehold lease is a mutually beneficial endeavour between the parties to develop the lands for profit.

What is the impact on the lessor if the phrase was interpreted to include a barely measurable quantity of production of the leased substances?  Conversely, what is the impact on the lessee if production is held to a "paying quantities" standard at issue in American jurisprudence?

Words of a contract must be interpreted in consideration of the intention of the parties within the plain and ordinary meaning consistent with the whole agreement, provided that any such interpretation should not produce an impractical result not contemplated by the lessor and lessee.  When addressing continuation of a lease past the primary term under the suspended well clause, the ABCA stated that the parties should consider two factors:

  1. Time Element: "Capable" – the ABCA stated that "the well must be ready and able to produce gas (in the required quantity) when the tap is turned on".  This temporal component suggests that the well must be in working condition and that no further activities or operations are needed to produce.  During the critical time period, the OMERS well required clean-out work to reduce water production and the ERCB concluded that the "well could produce in its existing state and configuration, without requiring further operations to produce and, in particular, of the kind listed in Clause 1(g)"; and
  2. Volumetric Threshold: "Producing the Resource in a Meaningful Quantity" - based on the facts, the ABCA was not satisfied that the OMERS well after successive operations was "capable of producing a volumetric quantity that would encourage both production and operations to maximize that production".  Similarly, the ERCB concluded that "there must be at least some material, as in a meaningful, volume of production possible for the lessee to rely on the suspended well clause to extend the lease".  Both the ABCA and the ERCB agreed that the rationale behind a threshold above a miniscule amount of production recognizes the parties' intention to develop the lands with a common view to profit.

Business As Usual?  It Depends.

As noted by the ABCA, what is "material" or "meaningful" depends on the relevant factors of each case.  The court suggests that defining the volumetric quantity of "material" and "meaningful" will be revealed in future litigation.  Stay tuned.  In this case, the litigants engaged multiple experts to analyze and break down gas production into scientific minutia, certainly beyond what could be expected of a reasonably prudent operator.

Until this issue is resolved, oil and gas industry participants are left unsatisfied, with more questions than answers, especially lessees as they scramble to assess the number of potentially dead leases in fear of receiving notices from top lessors to prove their caveated interest.

Moving forward, the court does provide some useful criteria when considering whether a well is "producing the resource in a meaningful quantity" and establishing a volumetric continuum:

  1. A puff is not enough - production volumes must be more than a miniscule amount, mere pressure at the wellhead is insufficient;
  2. "In cases where the production is clearly profitable, quantification, and how it is arrived at, will not be an issue";
  3. "Capable of producing the leased substances" is not the same standard as "paying quantities" in American jurisprudence;
  4. The "well must be capable of producing a volumetric quantity that would encourage both production and operations to maximize that production";
  5. "There must be some commercial viability to the well"; and
  6. Is there a reasonable expectation of profitable returns from the well?

Shut-In or Shut-Out?

A decision to shut-in a well is a triggering event for the suspended well clause.  The ABCA carefully remained focused on the "capable of producing the leased substances" interpretation and did not discuss whether OMERS had a valid reason to shut-in the well.  Prior freehold lease forms enumerated reasons for when a well could be shut-in which could include a lack of market or an intermittent market.

The CAPL 91 Alta. lease form does not specify instances where the lessor has a right to shut-in a well, as enumerated reasons in previous versions of the lease were replaced with the phrase "capable of producing the leased substances".  In what could be viewed as foreshadowing future litigation, Justice Conrad commented that "I leave to another day the question of whether the language of this lease, viewed objectively, demonstrates a common intention that a well, even one "capable of producing" can only be shut-in for prudent reasons".

Noticeably absent from the decision was the court's analysis of the ERCB findings.  In particular, a review of the determination that the OMERS lease had expired on May 10, 2006, the day after the first failed clean-out attempt.  Based on an application of the facts to the lease and ABCA decision, this result is potentially misleading to industry stakeholders.  Continuation of the lease was likely governed by the habendum clause, thus giving reason for a date subsequent to May 10, 2006 on which the OMERS lease had actually expired.

Practical Implications for the Canadian Oil and Gas Industry

As a result of the highly anticipated ABCA judgment, decisions regarding continuation beyond the primary term under the suspended well clause should not be taken lightly.  The ABCA has effectively served notice on industry stakeholders who rely on the development and exploitation of freehold lands for profit.  Going forward, there is significant precedential value in the two part test and supplementary guidance from the ABCA to determine what the relevant time period and volume thresholds are necessary for a well to be "capable of producing the leased substances".

Lessors have been assured that the suspended well clause, with wording similar to the CAPL 91 Alta. lease form, should not be used by the lessee for speculative purposes or to tie up lands indefinitely. Also, engineers, geologists, landmen, administrators and legal counsel on lessee management teams need to be constantly communicating about any decision to shut-in a well and how it might affect other business decisions such as divesting leased lands sooner, perhaps even top leasing their own leasehold interest after the primary term.  Lastly, the ABCA is alerted to the ERCB's expanding adjudicative scope and will maintain a careful watch on the exercise of their jurisdiction with the many cases likely to come.