Canada: Habendum Conundrum – Is a Mandatory Well Shut-In By Conservation Laws A "Cause Beyond A Lessee's Control" Sufficient To Extend A Lease Past Its Primary Term?

Introduction

In a recent decision from the Saskatchewan Court of Queen's Bench, Canadian Natural Resources Limited v Rife Resources Ltd., 2017 SKQB 307, the Court considered the interpretation of a common clause in a petroleum and natural gas lease that provides for lease termination after the expiry of the primary term when there is no production unless there is a well on the lands capable of production that is not producing as a result of "any cause whatsoever beyond the Lessee's reasonable control". The issue before the Court was whether a mandatory shut-in of wells pursuant to provincial conservation legislation constituted a "cause beyond the lessee's control" sufficient to continue the lease. The Court concluded that a proper interpretation of the habendum and shut-in provisions necessitated an implied requirement that any shut-in be temporary and not indefinite to trigger a lease extension. As the shut-in order did not have a discernible end date, the Court held that the lease had expired. The case is significant as the implication of such a term in an oil and gas lease is novel and because of the significant financial implications for a lessee faced with a possibe lease expiry arising from the effect of a governmental shut-in order.

Background

Rife Resources Ltd. ("Rife") and Canpar Holdings Ltd. ("Canpar") were lessors and Canadian Natural Resources Limited ("CNRL") was the lessee of lands located in Saskatchewan pursuant to a lease agreement (the "Lease").

The habendum clause of the Lease provided for a 10 year primary term, with the prospect of the Lease continuing in effect after expiry so long as there was continuous production, drilling or working on the lands. Article 11 of the Lease further provided the following with respect to production after the expiry of the primary term: 

If at the end of the aforesaid ten (10) year term leased substances are not being produced from the said lands or lands pooled therewith, or if at any time after the expiration of the aforesaid ten (10) year term leased substances cease to be produced from the said lands or lands pooled therewith, but there is then situated on the said lands or lands pooled therewith, a well or wells capable of production of leased substances and such well or wells are shut-in, suspended or otherwise not producing as the result of a lack of or intermittent or uneconomic market, or any cause whatsoever beyond the Lessee's reasonable control, then, for the purposes of continuing the term of this Lease, each such well shall be deemed to be producing leased substances while shut-in, suspended or otherwise not producing as aforesaid.

The 10 year primary term expired in 2009 but the parties agreed to extend the primary term until 2011. On that date, two horizontal heavy oil wells were in production. CNRL continued with production from those wells after December 31, 2011, and so by operation of the habendum clause the Lease continued in force.

In 2011, CNRL learned that one of those horizontal heavy oil wells was producing natural gas in excess of the gas to oil ratio permitted by provincial conservation legislation. The provincial requirements at the time mandated that where a heavy oil well exceeded the applicable ratio the operator was obligated to:  a) shut-in the well; b) apply for approval of concurrent production of oil and gas from the well; or c) provide the Ministry with a plan that addressed the high gas production.

CNRL applied for approval of concurrent production but the application was denied. As part of the denial, CNRL was ordered to shut-in both of its horizontal heavy oil wells.

CNRL complied with the order to shut-in the wells. However, CNRL also drilled and produced from two other wells on the lands. One of those wells produced until October 2013 and was shut-in, in November 2013. The other well produced until February 2014. After February of 2014, there was no further drilling or re-working on the lands.  Rife and Canpar then applied for a declaration that the Lease had expired when production ceased in February of 2014 and CNRL cross-applied for a declaration that the Lease was continued.  CNRL argued that the mandatory shut-in of the heavy oil wells was "a cause beyond the Lessee's reasonable control" and so, notwithstanding that there was no production on the lands after 2014, article 11 of the Lease operated to continue the Lease.

Decision

The main issues the Court considered in interpreting article 11 of the Lease were:

  1. Whether there was "a well or wells capable of production of leased substances and such well or wells are shut-in, suspended or otherwise not producing"; and
  2. Whether the lack of production was "the result of a lack of or intermittent or uneconomic market, or any cause whatsoever beyond the Lessee's reasonable control".

Purpose of the habendum and shut-in provisions

Prior to considering the application of article 11, the Court reviewed the case law on the interpretation of oil and gas leases and habendum clauses. Its analysis regarding the habendum and the purpose of the Lease was a key factor in the decision.

The Court noted that the habendum clause establishes "the purpose of the lease" which is to "permit the parties to profit from production of the leased substances". The Court cited case law and secondary texts that have interpreted the habendum and suspended well provisions as being "intended to balance the parties' rights by ensuring that the interests of the lessee are protected, while at the same time ensuring that the term of the lease cannot be extended indefinitely when there is no reasonable expectation of a return to profitability in the near future" (at para 20 citing Omers Energy Inc. v Alberta (Energy Resources Conservation Board), 2011 ABCA 251).

In reliance on these comments regarding the purpose of the shut-in provisions, the Court held that the shut-in, suspension or non-production contemplated in article 11 of the Lease must result from a cause that is temporary, as opposed to indefinite or permanent (para 23). The Court further stated "a fundamental premise of article 11 is the expectation that the lessee will resume operations under the terms of the lease after the temporary interruption" (at para 24).

Was there "a well or wells capable of production of leased substances and such well or wells are shut-in, suspended or otherwise not producing"?

In turning to the consideration of the particular facts in this dispute, the Court found that the two heavy oil wells did meet the requirement for there to be wells capable of production.

Rife and Canpar argued that the wells were not capable of production of leased substances because, even if the intervening event of the Ministry's order to shut-in the wells were removed, CNRL still would not be able to operate the wells for extraction of either gas or oil because of the provincial conservation requirements. Rife and Canpar took the position that the wells could not be produced because they continued to produce gas in excess of the requirements and because the infrastructure was not in place to capture the gas.

The Court rejected this argument holding that for the purposes of the interpretation of article 11, the provincial regulations were not to be considered and the only issue was whether the wells were physically capable of producing oil. The Court stated, at para 35:

The requirement that a well be 'capable of production of leased substances' relates to the physical capability of the well, as opposed to an intervening cause. The intervention of provincial regulation relates not to this first requirement, which is concerned with physical capability, but to the next requirement of article 11 – whether the production has been interfered with by an event that is beyond Canadian Natural's reasonable control.

Was the lack of production "the result of a lack of or intermittent or uneconomic market, or any cause whatsoever beyond the Lessee's reasonable control"?

On the second issue, the Court found that the shut-in orders were not a "cause beyond [CNRL's] reasonable control".

The Court came to this conclusion based on the fact that the Ministry's order was not temporary but rather permanent. Due to his comments on the purpose of article 11 being to address temporary lapses in production, the Court held that this was not the type of scenario covered by article 11.

The Court concluded that the Lease expired once it was clear that the Minister's shut-in order was permanent, in February of 2014. The Court stated at para 24:

The effect of the intervening event must be temporary because requiring the lessor to wait indefinitely for an eventual resumption of operations would be contrary to the profit-making purpose of the lease. The specific purpose of article 11 is to protect the lessee in the event of an event beyond its control such as a natural catastrophe (e.g. Hurricane Katrina) or such as a regulatory decision (e.g. such as the imposition of road restrictions). When such an event intervenes, the lessee is entitled to the time necessary to get past that event and resume operations under the lease. Flowing from the overall purpose of the lease, a fundamental premise of article 11 is the expectation that the lessee will resume operations under the terms of the lease after the temporary interruption.

Estoppel

CNRL also argued that Rife and Canpar were estopped from asserting that the Lease terminated because CNRL continued to pay rent and Rife and Canpar did not advise CNRL that the Lease had terminated. The Court held that estoppel did not apply because the case was about automatic termination of the Lease and not by termination by notice. The Court further noted that there was no evidence that CNRL, Rife or Canpar were aware of CNRL's mistaken belief that the Lease was still in force.

Implications

While there are a myriad of different forms of freehold leases, and lease disputes are to be resolved in accordance with an interpretation of the particular lease in question, the Court's reasoning in this decision has potentially broad implications for the interpretation of oil and gas leases generally.

The requirement that a shut-in be temporary rather than permanent was not express in the Lease and required the implication of a term. Generally courts are hesitant to imply terms into agreements. Pursuant to the well-established rules of contractual interpretation, terms are to be given their plain and ordinary meaning unless to do so would result in an absurdity.

In previous decisions interpreting habendum clauses, the Alberta Court of Appeal has declined to imply terms. For example, in Freyberg v. Fletcher Challenge Oil and Gas Inc., 2005 ABCA 46 ("Freyberg") the Court reversed the trial judge's implication of a term on the basis that the implication defeated the policy objectives supporting a strict construction of habendum clauses in oil and gas leases. The Court in that decision stated at para 57:

Second, the terms of gas contracts are to be given effect according to their plain and ordinary meaning unless to do so would result in an absurdity: Suncor Inc. v. Norcen International Ltd. (1988), 1988 CanLII 3918 (AB QB), 89 A.R. 200 at 224‑226 (Q.B.). As stated by Martland, J. in Canada-Cities Service Petroleum Corporation v. Kininmonth et al., 1964 CanLII 81 (SCC), [1964] S.C.R. 439 at 448, "the essential task... is to construe the terms of the lease which is in question." In my view, the purported implied term does not give effect to the plain and ordinary meaning of the contract.

Similarly, in Bearspaw Petroleum Ltd. v Encana Corporation, 2011 ABCA 7 ("Bearspaw") the Court rejected the implication of a term that was inconsistent with an express term in the lease. As such, this case arguably provides a more relaxed approach to the implication of terms into oil and gas leases.

One practical difficulty with this decision is determining what time period results in a shut-in being temporary versus permanent. On review of previous shut-in cases, it is clear that there is no consistent time frame that parties can look to when assessing their own leases. In this case, the two wells had been shut-in for 5 years. In the Bearspaw decision, the wells in question were also shut in for approximately 5 years however, the Court in that case found the lease continued. In Kensington Energy Ltd. v B & G Energy Ltd., 2008 ABCA 151 the well in question was shut-in for approximately 2.5 years. In Freyberg, the well in question was shut in for approximately 21 years. The result of this case is that lessees will have to make an assessment of whether a shut-in is temporary or permanent with little judicial guidance for what that means.

In addition to these practical considerations, we wonder about whether the expiry of the Lease in these circumstances would be in the reasonable contemplation of the parties at the time of the Lease.  In these circumstances, it is highly unlikely that another lessee would invest the funds to drill a new well, which would likely also be subject to the same problems regarding the conservation legislation if produced from the same reservoir. Therefore, the practical outcome of this decision likely will not address the Court's concern about protecting the "profit-making purpose of the lease". And, from a policy perspective, if another well were to be drilled, it would ironically potentially lead to a proliferation of infrastructure contrary to the usual goal of conservation legislation.

In sum, this decision results in increased risk to lessees as it adds uncertainty to interpreting shut-in clauses and implies a term that is difficult to apply in practice. An unexpected lease termination can have significant financial implications for a lessee so oil and gas companies should be aware of the shut-in obligations relevant to their particular leases to assess their risk of a similar result to this case.

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