United States: Implied Covenants Including the Implied Covenant to Market

This article was written with the assistance of Jamie Lavergne of Hughes & Luce, L.L.P.

One of the most hotly litigated concepts in oil and gas law is that concerning implied covenants in an oil and gas lease. Lessors seem to presume that there are implied covenants that alter the relationship with the Lessee from that established by the written lease. At the same time, Lessees seem to equally misunderstand their obligations. What is becoming clearer is how the Texas Supreme Court views implied covenants. What remains to be seen, though, is how implied covenants will be utilized in the future to the ever-changing oil and gas industry.

In order to adequately represent your client, you have to understand the concept of implied covenants – most don’t. If you think it creates a relationship outside the oil and gas lease and that the written words in the lease are irrelevant, you are wrong. If you think that it requires the producer to put the royalty owner’s interests first, you are wrong. Implied covenants, to the extent they apply, do nothing more than require the producer to act as a reasonably prudent operator would under the same or similar circumstances in the event, and only in the event, the lease is silent on the subject and the covenant is necessary for the fulfillment of the intent of the parties.

To understand why implied covenants are not the "white knight" lessors believe exists, you have to understand the relationship an oil and gas lease creates between a lessor and a lessee under Texas law. An oil and gas lease conveys title to the minerals in fee simple determinable. Jupiter Oil Co. v. Snow, 918 S.W.2d 466, 468 (Tex. 1991). The court, though, interprets the lease using the rules of contractual construction. The relationship under a lease is purely contractual. See Amoco Production Co. v. Alexander, 622 S.W.2d 563, 571 (Tex. 1981); Exxon Corp. v. Middleton, 613 S.W.2d 240, 245 (Tex. 1981). There is no duty of good faith and fair dealing owed by a lessee to a lessor. Hurd Enterprises Ltd. v. Bruni, 828 S.W.2d 101, 109-10 (Tex. App.-San Antonio 1992, writ denied); Cambridge Oil Co. v. Huggins, 765 S.W.2d 540, 544 (Tex. App.-Corpus Christi 1989, writ denied). See also Texas Oil & Gas Corp. v. Hagen, 31 Tex. Sup. Ct. J. 140-42 (1987), judgment and opinion withdrawn, judgment of court of appeals set aside, 760 S.W.2d 960 (Tex. 1988). There is no fiduciary, confidential or trust relationship that requires one party to place the interests of the other before his own. See Crim Truck & Tractor v. Navistar International, 823 S.W.2d 591, 594 (Tex. 1992); Hagen, 31 Tex. Sup. Ct. J. at 142; Atlantic Richfield Co. v. Long Trusts, 860 S.W.2d 439-44 (Tex. App.-Texarkana 1993, writ denied). Moreover, the lessee is not the agent of the lessor for the sale of production. Long Trusts, 860 S.W.2d at 445 (oil and gas lease does not create an agency relationship but merely a contractual obligation to pay a royalty). Simply stated, if there is a breach of the lease, the cause of action against the lessee is for breach of contract and nothing more. Amoco Production Co., 622 S.W.2d at 571 (breach of implied duty states a cause of action for breach of contract and nothing more).

II. Circumstances for Implying a Covenant

Having said the above, courts will, under certain circumstances, imply a covenant into a lease. The concept of implied covenants has existed in Texas oil and gas law since at least 1928. See Freeport Sulphur Co. v. American Sulphur Royalty Co. 117 Tex. 439, 6 S.W.2d 1039 (1928). Covenants are not, however, lightly implied into oil and gas leases since it is not the province of a court to make contracts for the parties. HECI Exploration Co. v. Neel, 982 S.W.2d 881, 888 (Tex. 1998) (citing Gulf Prod. Co. v. Kishi, 129 Tex. 487, 103 S.W.2d 965, 968 {Tex, Comm. App. 1937, opinion adopted}). A covenant is not implied into an oil and gas lease as a matter of law – it is implied, if at all, in fact based on the language, or lack thereof, contained in the lease. Danciger Oil & Refining Co. v. Powell, 137 Tex. 484, 154 S.W.2d 632, 635 (1941). The question that has continuously been asked, consequently, of Texas courts is when should a covenant be implied and, if so, the extent of the implication?

For the last seventy (70) years, the Texas Supreme Court has consistently answered this question by holding that implying a covenant is justified only on the grounds of necessity and nothing more. HECI Exploration Co., 982 S.W.2d at 889; Danciger Oil & Refining Co., 154 S.W.2d at 635; W.T. Waggoner Estate v. Sigler Oil Co., 118 Tex. 509, 19 S.W.2d 27, 31 (1929). The express terms of an oil and gas lease will not be altered by an implied covenant in order to achieve what a court believes is a more balanced or fairer contract. Id. As stated in HECI Exploration Co.:

HECI Exploration Co., 982 S.W.2d at 888 (quoting Danciger Oil & Refining Co., 154 S.W.2d at 635). In other words, a covenant will be implied only if it is necessary to fulfill the intent of the parties as disclosed by the contract as a whole. Danciger Oil & Refining Co., 154 S.W.2d at 635. As further explained in HECI Exploration Co.:

Id. at 889 (emphasis added).

The case of Gulf Production Co. v. Kishi is a perfect example of the analysis a court conducts to determine whether a covenant should be implied into a lease. In Gulf Production Co., the lessor signed two leases that contained provisions stipulating to the number of wells the lessee would bring in after the discovery well was completed. 103 S.W.2d at 966-967. After the lessee completed the number of wells expressly agreed upon in the leases, it discontinued further development. Id. at 968. The lessor filed suit claiming that, though the lessee had drilled the number of wells expressly agreed upon, through the exercise of reasonable diligence more wells should have been drilled. Id. The lessor asserted a cause of action under the implied covenant to reasonably develop and sought damages in the amount of royalties he would have been paid if more wells had been drilled. Id. Essentially, the lessor claimed that an implied covenant altered or amended the express terms of the leases. Nine years prior to the court’s opinion in Gulf Production Co., an implied covenant to reasonably develop was recognized in W.T. Waggoner Estate v. Sigler Oil Co., 118 Tex. 509, 19 S.W.2d 27 (1929) wherein it was held that when a lease failed to define the lessee’s development duties, the court would imply a covenant to develop the lease with reasonable diligence. Id. at 29.

In determining whether to imply the covenant to reasonably develop in spite of the express agreement of the parties, the Gulf Production Co. court stated:

103 S.W.2d at 969. After reviewing the leases, the Court held that the parties had expressly agreed upon the number of wells to be drilled and, thus, had agreed upon the diligence to be exercised by the lessee in developing. Id. Accordingly:

Id. As a result, the lessor could not assert a cause of action for breach of an implied covenant. Id. at 971. Since the lessee had complied with the express terms of the leases, it had no additional drilling obligations based upon an implied covenant.

Based on the overwhelming authority cited or discussed above, inserting implied covenants in oil and gas leases can be summed up very easily. If the parties have a written express agreement concerning an obligation of a lessee that sets forth a standard for compliance, no implied covenant will increase or alter the express agreement. On the other hand, if the parties have not agreed upon an express term that adequately sets forth or describes a standard for compliance, a court will imply a covenant to the extent necessary to fulfill the intentions of the parties, as those intentions have been set forth in the lease agreement. As the San Antonio Court of Appeals simplistically stated:

Magnolia Petroleum Co. v. Page, 141 S.W.2d 691, 693 (Tex. Civ. App. – San Antonio 1940, writ ref’d) (emphasis added).

III. The Categories of Possible Implied Covenants.

There are three recognized broad categories of possible implied covenants. They are:

1. To reasonably develop the premises;
2. To protect the leasehold; and
3. To manage and administer the lease.

Amoco Production Co., 622 S.W.2d at 567. The standard of care in fulfilling one’s duties under an implied covenant is that of a reasonably prudent operator under the same or similar circumstances. Id. The Texas Supreme Court, however, recognizes that the industry evolves and changes. As stated in Amoco Production Co. v. Alexander,

However, because of the complexity of the oil and gas industry and changes in technology, the courts cannot list each obligation of a reasonably prudent operator, which may arise.

622 S.W.2d at 568. This language suggests that other implied covenants may exist. The absence of any holding or ruling that there are no other implied covenants bolsters the conclusion that an operator’s responsibilities may not be limited to those enumerated in Amoco Production Co. v. Alexander. Further, the analysis in HECI Production Co., supports the idea that other covenants may be necessary, depending upon the circumstances at the time the lease was entered into and the intent of the parties in fulfilling the terms of the lease. 982 S.W.2d at 888.

Professor Hemingway has also outlined the three broad categories of implied covenants as follows:

1. Implied Covenants to develop the lease:
1. To drill an initial well.
2. To reasonably develop the lease after production has started.
2. Implied Covenants of Protection:
1. To protect against substantial drainage.
2. Not to depreciate the lessor’s interest.
3. Implied Covenants to Manage and Administer the Lease:
1. To produce and market.
2. To operate with reasonable care.
3. To use successful modern methods of production and development.
4. To seek favorable administrative rulings.

R. Hemingway, The Law of Oil and Gas Sec. 8.1 (1971); see also Southeastern Pipe Line Co. v. Tichacek, 997 S.W.2d 166, 170 (Tex. 1999). Texas cases have been limited to the covenants to reasonably develop, to protect from drainage and to market. We also know, though, that attempts to create an implied covenant to notify the lessor of a lessee’s suit against an adjoining operator for damages to a reservoir have been rejected. HECI Production Co., 982 S.W.2d at 889. Likewise, a duty to inform the lessor of a classification of a formation as a "tight formation" for tax credits under 26 U.S.C. § 29 has been spurned. Timmins v. Kerr McGee Corp., No. 6:97 CV 86 (E.D. Tex. 1997).

A. The Covenant to Protect Against Substantial Drainage.

As for the covenant to protect against substantial drainage, we know the lessee can fulfill its obligations by:

1. Pooling tracts in good faith (if allowed by the lease);
2. Dropping leases so another operator can develop them;
3. Drilling offset wells;
4. Seeking administrative or regulatory relief;
5. Reworking existing wells; or
6. Drilling replacement wells.

Southeastern Pipe Line Co., 997 S.W.2d at 170; Amoco Production Co., 622 S.W.2d at 568. Please note that the Court has made it very clear that the above list is not the only means to protect from drainage. Others may be required depending upon the facts of each case as it arises. Id.

The Texas cases discussing this implied covenant deal with the marketing of production obligation. The cases tell us that there can be, under certain circumstances, an implied covenant to diligently market and to obtain the best price reasonably available in leases containing certain types of royalty clauses. When the royalty clause directly ties the lessor’s compensation to the performance of the lessee in selling production, the covenant to market is, and should be, implied. Davis v. CIG Exploration, Inc., 789 F.2d 328, 329 (5^th Cir. 1986); Hutchings v. Chevron U.S.A., Inc., 862 S.W.2d 752, 756 (Tex. App.-El Paso 1993, writ denied); Amoco Production Co. v. First Baptist Church of Pyote, 579 S.W.2d 280 (Tex. Civ. App.-El Paso 1979), writ ref’d n.r.e. per curiam, 611 S.W.2d 610 (Tex. 1980). Typical language used in such a clause is the "net proceeds of the sale" or the "amount realized from the sale."

Such an implication is logical because the interests of the lessee and lessor are directly aligned. The parties agreed that the lessee would pay the royalty based solely on the price it received. It is sensible that the lessee should pay royalties based on the highest price reasonably possible since that is the same amount it should be seeking for itself. Accordingly, in reviewing a royalty clause if the amount of the royalty depends upon the price at which the product is marketed, there is an implied covenant to market. El Paso Natural Gas Co. v. American Petrofina Co., 733 S.W.2d 541, 550 (Tex. App.-Houston [1^st Dist.] 1986, writ ref’d n.r.e), cert. dism’d, 485 U.S. 930 (1988).

In the last six years, one of the most extensively litigated issues in oil and gas jurisprudence has been the applicability of an implied covenant to market to an oil and gas lease that based the royalty obligation on the market value of the production. Prior to June of 2001, there was no opinion from the Texas Supreme Court that directly addressed the question. On June 21, 2001, however, the court decided Yzaguirre v. KCS Resources, Inc., 53 S.W.3d 368 (Tex. 2001).

In Yzaguirre, the lease required gas royalties to be based upon the market value of the gas, if it was sold off of the leased premises. Id. at 372. Since the gas was being sold off of the leased premises, KCS paid royalties based upon the spot market price for the area of production. KCS did so despite the fact that the gas was actually being sold pursuant to a long-term maximum lawful rate contract to Tennessee Pipeline Gas Company. Id. at 370. The price received by KCS was substantially higher than the spot market price. Since KCS was paying royalties based on the spot market price, the royalties were substantially less than the amount received by KCS from Tennessee Pipeline Gas Company.

The royalty owners in Yzaguirre contended that royalties should be paid based upon the amount received by KCS and not based upon the lower spot market price. The basis for the royalty owner’s argument was that the implied covenant to market required that royalties be paid upon either the amount realized from the sale of production or the market value in the area of production, whichever was highest. Essentially, the royalty owners contended that the implied covenant to market to obtain the highest price reasonably obtainable "trumped" the market value royalty clause contained in the lease.

The Texas Supreme Court rejected the royalty owner’s argument and conducted a classic implied covenant analysis as discussed above. In doing so, it stated:

Id. at 373 (emphasis added). The court then found that a market value royalty clause is an express covenant. Id. at 374. The court stated that because the lease provided an objective standard for the calculation of royalities that is independent of the price actually received by the lessee, the royalty owner did not need the protection of an implied convenant. Id. at 374. The lessor, said the Supreme Court, had bargained to receive royalties based on the market value of the production and did not bargain for royalties to be based upon the actual price received by the lessee. Id. at 374. The implied covenant to market would not negate or "trump" the express market value clause. Id. Consequently, the Texas Supreme Court would not rewrite the plain terms of the lease to give the royalty owners the benefit of a bargain that they never made. Id.

The Yzaguirre opinion has resolved a significant longstanding dispute between royalty owners and producers. The opinion has also had an affect on the ongoing class action litigation concerning the implied covenant to market. At least two courts have reversed orders certifiying cases as class actions based upon Yzaguirre’s holding that the implied covenant to market does not apply to a market value lease. See Union Pacific Resources Group, Inc. v. Neinast, 2001 WL 1098140 (Tex.App.- Houston [1st Dist.] Sept. 20, 2001); Phillips Petroleum Company v. Bowden, 2001 WL 1249995 (Tex. App. – Houston [14th Dist.] Oct., 2001)(unpublished). Both of these courts opined that since there is not an overriding implied covenant to market that "trumps" the express royalty language in every lease, certification of a case as a class action involving multiple lease forms with varying royalty obligations is inappropriate. Id.

C. The Implied Covenant to Reasonably Develop.

This implied covenant was indeed a hot spot in oil and gas law forty years ago. There are very few reported cases since the 1960’s concerning this covenant. For the time being, one could conclude that the law is well settled. Simply stated, the implied covenant to reasonably develop requires the lessee, after production was originally obtained, to conduct further development with reasonable diligence so that further operations will result in a benefit or profit for both the lessor and the lessee. Clifton v. Koontz, 325 S.W.2d 684, 693 (Tex. 1959). The covenant also includes the reasonable development of the various stratum or horizons under lease. Id. at 695. It is important to note that the further development is tempered by the requirement that the lessee must have a reasonable expectation of making a profit. Id.

As the Amoco Production court observed, the oil and gas industry evolves. The deregulation of the gas industry has opened markets producers could never tap until the last 10 to 20 years. Likewise, improvements in technology, such as horizontal drilling, have allowed lessees to produce from reservoirs that were considered played out and to rework vertical wells to enhance production. Additionally, as prices for oil and gas soar, lessors may wonder why there is not more production from their leases. Innovative lessors may utilize implied covenant law to attempt to reap more benefits from their leases. The following are a few ideas to consider.

A. Marketing. Over the last few years, innovative lessors have alleged various theories to try to expand the implied covenant to market and to try to circumvent the argument concerning no implied covenant in a market value lease. As many lessors have observed, gas is sold in large volumes at major sales points, such as the Houston Ship Channel, Waha, and various municipal city gates. Large producers routinely transport the gas to these locations for sale, or have sold the gas to an affiliated company in the field, with the gas being resold at the major sales points. Smaller producers sell gas to marketing, or paper, companies that, through various paper transactions, sell the volumes at the major trading centers. Still, there are other situations where the producer uses exchange agreements to sell its volumes at the major centers. Lessors want their royalties based on the higher downstream market price.

In many of these situations, lessors argue that their 1/8th share of the gas should be given the same marketing treatment as the producer’s 7/8th share. Additionally, lessors claim that a reasonably prudent operator would market its gas at the major centers and a failure to do so is a breach of the implied covenant. Some lessors even argue that, because of interconnecting pipelines and exchange agreements, producers should pay royalties based upon the highest market center price that is reasonably available, even though the gas was not sold there. As to market value leases, lessors argue that the real market is at the major hubs so; consequently, royalties should be based on the market price at the major sales points and then netted back to the wellhead, after deducting transportation costs.

The problem with these theories is that in many instances the industry is not that simple. One reality is that the molecules of gas have to be moved somewhere for sale. Not all transactions, and in reality a small percentage of them, are paper transactions. These arguments also ignore the problems of pipeline capacity, the capital recoupment from pipeline construction, the delay caused by processing, a fluctuating market between the day of production and the day of sale, the fact that gas has to be stored; and the fact that the molecules sold may not be, and many times are not, the molecules produced from the subject lease. While these arguments simplify the industry for a jury, they fail to express the true condition of the market and the realities of selling natural gas. If the industry was as simple as lessors assert, everyone would be in the gas marketing industry.

B. Production. Improvements in drilling techniques, not to mention the use of 3-D seismic for discovery purposes, could cause the reasonable development covenant to rise from the dead. Furthermore, lessors could assert a section of the implied covenant to manage and administer the lease that, to my knowledge, has not previously been urged in Texas, i.e. to use successful modern methods of production and development. R. Hemingway, The Law of Oil and Gas Sec. 8.1 (1971). No matter which theory, the standard for determining whether the covenant was breached is whether a reasonably prudent operator has a reasonable expectation of making a profit. It does not appear that the producer being cash poor is an option. If such is the case, the producer could be facing an argument that he should have entered into a Farmout Agreement with another producer.

It has been shown that older wells and older fields have resurged as a result of reworking vertical wells with horizontal drilling. Also, it has been shown that horizontal drilling has successfully resulted in production from previously difficult formations such as in the Pinnacle Reef, the Austin Chalk and various tight sands areas. 3-D seismic has also resulted in the location of formations that were previously difficult to find. These advances may raise questions with royalty owners. Those questions could include:

These are all issues to keep in mind. One should also think about how pooling can avoid individual lease claims. In any event, lawsuits on these issues will require extensive expert testimony and will be expensive to prosecute and defend.

The oil and gas bar continues to struggle with implied covenants. This is partially because of the attempt to alter existing law to match what are perceived changes in the industry. The Texas Supreme Court has shown reluctance in modifying the relationship between lessor and lessee, which results in a hesitancy in changing implied covenant law. Royalty owners argue that implied covenant law somehow balances the playing field. That essentially means that the covenant should change the lease. The law does not support that position. At the same time, producers and lessees need to be wary of conflicts of interest between leases and in the use of affiliated companies. First, as the Court held in Amoco Production, a reasonably prudent producer may drill a field in such a way as to maximize production at the cheapest cost. That producer cannot, however, do so at the expense of one lease for the benefit of another. Second, using affiliate companies may be entirely appropriate, and are in many instances. The use of one, though, raises the issue of self dealing which will always result in an implied covenant argument whether the argument is justified or not.