Canada: Limiting Deemed Production: How Long Can A Shut-In Well Sustain A Valid Lease?

Last Updated: December 20 2017
Article by Deirdre Fleming

Introduction

In Canadian Natural Resources Limited v Rife Resources Ltd.1 (Canadian Natural), the Saskatchewan Court of Queens' Bench (the Court) set a new limit on how long a party can rely on deemed production to sustain a valid oil and natural gas lease. Shut-in well clauses typically permit a lease to continue by way of deemed production—where a well is capable of production, but is shut-in for reasons beyond the lessee's reasonable control. In Canadian Natural, the Court found that a party relying on such a provision must take steps to remedy the reason for the non-production, otherwise, a temporary shut-in would effectively become indefinite. It is contrary to the fundamental profit-making purpose of an oil and gas lease for deemed production to continue indefinitely, and when this occurs, the lease will terminate.

Background

In 1999, Canadian Natural Resources Limited (CNRL) entered into an oil and natural gas lease with Rife Resources Ltd. (Rife) and Canpar Holdings Ltd. (Canpar). The habendum clause provided a 10-year primary term, with the prospect of continuing the lease after the primary term, if there was continuous or deemed production. The shut-in clause outlined what constituted deemed production. A well "capable of production" but shut-in as a result of "any cause whatsoever beyond the Lessee's reasonable control" would be deemed to be producing leased substances.

The parties agreed to extend the lease's primary term from 2009 to 2011. At the end of the primary term, CNRL had two producing wells, though both were producing in excess of the provincial regulation's prescribed gas to oil ratio (GOR). Wells exceeding this GOR must be shut-in unless the lessee obtains approval for concurrent production of oil and gas from the Ministry.

In January 2012, CNRL applied to the Ministry for concurrent production approval. Waseca Energy Inc. (later, Husky Oil Operations Ltd.) (Husky) objected on the basis that the wells interfered with its planned steam assisted gravity drainage scheme. The Ministry agreed with the objection and denied CNRL's application. The Ministry ordered (the Order) that the wells be shut-in "pending further review." CNRL shut-in the wells some time after April 3, 2012, but other wells on the land continued until February 2014.

CNRL made unsuccessful efforts to negotiate with Husky in 2012, but after failing to resolve the conflict, CNRL made no further efforts and planned to wait until Husky completed the project before resuming operations. Five years elapsed without any change, and there was no way of knowing when Husky would complete its project.

In May 2015, Rife and Canpar notified CNRL that the lease terminated in 2014. Canpar and Rife continued to accept lease payments as part of CNRL's annual payments in 2015 and 2016.

Rife and Canpar sought a declaration that the lease expired in February 2014, while CNRL sought a declaration that the lease was continued by deemed production. To fall within the lease's definition of deemed production, CNRL needed to establish two key elements:

  1. the wells were physically capable of production; and
  2. the shut-in was the result of a cause beyond the Lessee's reasonable control.

The First Requirement: That the Wells Were Physically Capable of Production

On the first element, CNRL argued that the two wells were physically capable of production. If Husky withdrew its objection and the Ministry lifted the order, CNRL could easily construct the required infrastructure to concurrently produce leased substances, namely gas and oil. Rife and Canpar argued that the wells are not capable of production on the basis that even if Husky withdrew its objection and the Ministry lifted the shut-in order, the GOR regulation would still bar production.

The Court found that at this stage of the analysis, courts must only look to whether a well is physically capable of producing leased substances. The wells were capable of producing at least one of the leased substances and thus CNRL met the first requirement of deemed production.

The Second Requirement: That the Wells Were Shut-in for a Reason Beyond its Control

On second requirement, CNRL had to establish that the reason for the shut-in was beyond its reasonable control. CNRL argued that the Ministry's Order was a temporary cause beyond its reasonable control and CNRL had every intention of resuming production once Husky's thermal project ceased operations.

The Court rejected CNRL's argument and found that, by 2014, the Order no longer constituted a reason beyond its control.

The Purpose of an Oil and Gas Lease

In making its finding, the Court relied on the fundamental purpose of an oil and gas lease. In the typical case, the purpose of an oil and gas lease is "to permit the parties to profit from production of the leased substances."3 The reason a lessee has the prospect of continuing the lease in force after the primary term expires is to facilitate this continued profit making.

Shut-in well clauses protect the lessee when there is 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)."4 Lessees should receive some flexibility when such uncontrollable events interfere with production.5 The lessee needs time to recover from the event and resume operations to facilitate the lease's profit making aim. A fundamental premise of this provision is that the disrupting event will be temporary and the lessee will make efforts to resume production after the temporary interruption.6

The Court determined that CNRL had not taken reasonable steps to recover from the Order, and could not rely on it. The Order was not a temporary cause beyond CNRL's control and a "lease cannot be extended indefinitely when there is no reasonable expectation of a return to profitability in the near future."7

CNRL's Estoppel Case Fails

CNRL also argued that Rife and Canpar were estopped from asserting that the lease had terminated as they had accepted CNRL's annual payments—which included the lease's rent payments. CNRL claimed that this acceptance led it to mistakenly believe that the lease remained in force.

The Court dismissed this argument, looking to the practical realities of the industry. The "continued payment and acceptance of rent after May 2015 was merely clerical— without any conscious statement, assertion or acquiescence."8 In CNRL's case, the rent payments were made and received simply as part of an administrative function on both sides. This finding provides some reassurance to lessors accepting lump payments from a number of assets. Mistakenly accepting a rent payment on a terminated lease as part of a larger payment will not likely prevent a lessor from asserting that a lease has terminated.

Conclusion

This decision is an important reminder for lessees and lessors to be vigilant about leases continuing in force through deemed production due to reasons beyond the lessee's control. Lessees relying on this type of provision need be mindful that while courts will allow them some flexibility in recovering from a damaging event, the lessees also have a time sensitive obligation to pursue recovery. The Court did not define how long a party could rely on such a provision, simply finding that there must be a reasonable expectation of a return to profitability in the near future. Given a court's discretion on this period of time, it is essential that lessees make efforts to remedy the issue and consider the reasonability of their timeline to resume production.

Regulatory orders to shut-in wells can still be a valid reason for continuing a lease by way of deemed production, but the timeline for resuming production cannot, according to the Saskatchewan court, be indefinite; otherwise, the term would undermine the fundamental profit making purpose of an oil and gas lease.

Footnotes

1. Canadian Natural Resources Limited v Rife Resources Ltd.,2017 SKQB 307.[Canadian Natural]

2. Canadian Natural, at para 5.

3. Ibid, at para 24.

4. Ibid, at para 20.

5. Ibid, at para 19.

6. Ibid, at para 24.

7. Ibid, at para 44.

8. Ibid, at para 20.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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