EnerQuest Oil & Gas, LLC v. Plains Exploration Production Company et al, 981 F. Supp.2d 575 (USDC WD Texas 2013).

This case was about two issues (1) the determination of whether or not a lease was held by production in paying quantities; and (2) whether shut-in royalties had been timely paid.  The court engaged in a thorough definition of what it takes for a well to be capable of producing in paying quantities.

EnerQuest acquired two leases in Kerns County on July 28, 2008 and August 4, 2008. Neither lease provided for delay rentals and both had the caption “Paid-Up Lease.”  Each contained shut-in royalty clause providing, essentially, if there are wells capable of producing in paying quantities on the leases that are shut-in for 90 consecutive days, the Lessee could maintain the leases by paying $1 per acre on or before the end of the 90-day period.

EnerQuest conducted a production test on one of the wells that had been drilled before it acquired the lease.  The well produced 47,000 cubic feet of gas and the well was shut-in.  No other work was done before the two-year primary term expired.  On September 10, 2010, the Lessors’ lawyer wrote to EnerQuest stating that the leases had expired.  On September 14, 2010, EnerQuest tendered shut-in royalty payments to the Lessors, contending that a well was capable of producing in paying quantities.

The Lessors leased the land to Dan Hughes Company, who assigned the lease to EOG and Plains Exploration.  In April 2011, EnerQuest connected the well to a pipeline and began producing the well.  EnerQuest filed this suit to quiet title.

EOG and Plains contended that the well was not capable of producing in paying quantities when the shut-in royalties were paid and that they were not paid timely.  In determining the first issue, the court determined that shut-in royalty clauses define the circumstances under which a lessee can “bring about constructive or contractual production” sufficient to keep a lease alive.

The court held that “production in paying quantities” sets up a two-prong test.  First the well must be “capable of production” – meaning that if the well is turned on, it would begin flowing without additional equipment or repair.  Second the production must be in “paying quantities.”

EnerQuest argued that the well was capable of production while Plains and EOG argued that since there was no wellhead connection to a pipeline, no separators, no tanks or other surface equipment the well was not capable of production.  The court held that controlling Texas precedent is that the well itself must be capable – not need rods, tubing or pumping equipment – and that the lack of surface equipment was not the criteria.  With that in mind, the court held that a determination of whether or not the production would have been in paying quantities was a fact question that needed to be answered by the trier of fact and that “paying quantities” means capable of generating sufficient revenues to pay operating and marketing costs.  In other words, the revenue must be sufficient to pay taxes, overhead charges, labor, repairs and depreciation on salvable equipment, if any.  Marketing costs would include the cost of connecting the well to a pipeline. However, “one time investment expenses, such as drilling and equipping costs” are treated as capital expenditures and do not count against income.

Also, the determination is to be over “a reasonable period of time under the circumstances.” The burden is on the lessee to prove that there is a reasonable expectation of a profitable market for the gas at the time the shut-in royalties were paid.

With regard to whether the shut-in royalties were timely tendered, the court held that, since there was no delay rental payment that would independently keep the lease alive throughout its primary term, the shut-in payments had to be made within 90 days of when the well was shut in, even though part of this time would have been during the primary term of the leases.  Since the well had been shut in for 103 days when the shut-in royalty payment was tendered, the court held that it was not timely and that the leases had expired.