What Does A “Shut-In Royalty” Have To Do With Retail Real Estate [And (Maybe) Save Those Drafts]?

Print
Print Friendly

With apologies to attorneys and others who understand “Oil and Gas Leases,” Ruminations will try to draw some lessons from a case decided by the Court of Appeals of Texas on May 21 of last year. It is called PNP Petroleum LP v. Taylor and the decision can be found by clicking: HERE.

Whatever similarities or differences there may be between an “Oil and Gas” lease and the ones we usually drone on about, the relevant commonality for today’s purposes is that an “Oil and Gas” lease has a “term,” and thus an “expiration date.” The one in the PNP lease was for a single year, its “primary term,” and there were two ways by which the term could be extended. The first, and not implicated in the dispute, was that the term would extend for “as long thereafter as oil / or gas in paying quantities is produced from and sold from the land subject to this lease.” That didn’t apply because the thirteen wells on the land were “non-producing” at all relevant times.

What the dispute was about was the second way the lease’s term could be extended. Here’s that lease provision:

SHUT-IN ROYALTY (Saving) If, at the expiration of the primary term there is located on the leased premises a well or wells not producing oil/gas in paying quantities, Lessee may pay as royalty a sum of money equal to Twenty ($20) dollars per proration acre associated with each well not producing. The shut-in well royalty payment will extend the term of this lease for a period of one (1) year. Lessee may extend this lease for one (1) additional year by the payment of a like sum of money. MAXIMUM SHUT-IN It is agreed that this lease cannot be maintained by the payment of shut-in royalty for a period of more than two (2) years beyond the expiration date of the primary term.

In sufficient time before the one-year primary term was to expire, the tenant gave proper notice of its exercise of the extension right under the “second way,” the one that involved the “Shut-In Royalty.” Its landlord rejected the exercise and returned the payment. That bothered the tenant enough that it sued for a declaration (from a Texas lower court) that the extension exercise was valid. For legal aficionados, it sought a “declaratory judgment” that the lease’s term had been properly extended.

To those of us who wouldn’t know an oil well from a gas well [but do know that olive oil (not the sailor’s friend) comes from olives], this dispute doesn’t sound very complicated. The wells on the land were not “producing oil / gas in paying quantities.” That was undisputed. So, why did the tenant lose at the lower court level?

Please accept that this case is about contract interpretation, a topic Ruminations has milked many times in the past. Texas case law teaches that “[i]f a lease term has a generally accepted meaning in the oil and gas industry, we use its generally accepted meaning.”

We’re going to call this the “dictionary rule” and to further expound on that rule, we’re going to reach into the text of an August, 2014 “Report and Recommendation” of a United States Magistrate Judge in Texas where he pieced together parts of a number of earlier court decisions. We’re telling you that so you don’t think we could express this as well on our own.

“When a term is not specifically defined by a contract a court must give the term its ‘plain, ordinary and generally accepted meaning,’ unless the contract itself shows it to have been used in a different sense.” … “On the other hand, when the contract defines a term, a court may not ‘disregard those definitions and substitute other meanings.’” … Even when a term is not defined, ‘courts may refer to extrinsic evidence such as industry dictionaries or statutory definitions to determine the commonly understood meaning’ of the term.” … “Numerous courts have appealed to ‘outside’ definitions to interpret a contract term.

There’s nothing amazing about such an “interpretation” rule. Various industries have adopted certain words or phrases and when people in the industry talk to each other (or write agreements between each other), using those words or phrases, they are expected to know what they are talking about even if we don’t.

Call it “context.”

Why is context important? Here’s an example. Consider the contronym, “cleave.” It means both “to cling” and “to split.” How would you know which was intended in a particular case? Answer – by context. Closer to Ruminations readers, think of “to rent.” It means both “to borrow from” and “to lend to.” Which one when? Think context.

Well, the kind of contract in front of a court and the kind of industry to which that contract applies provides “context.” It today’s discussion, the lease and industry were “oil and gas.” That’s the context under which this particular lease was written.

Now, we’ll drill down to specifics. The words in question were: “shut-in royalty.” We learned (and now, most readers are learning) that a “shut-in royalty” is understood to involve or require a well that is capable of producing product in the contractually required amount but for which no current market for its output exists. The thirteen wells on the land were seemingly not capable of producing the minimum required output, market demand levels notwithstanding.

The lower court (the one that ruled against the tenant’s exercise of the extension option) concluded that there was no ambiguity as to whether the wells had to be “capable” of producing oil or gas in order that the “shut-in royalty” extension be exercisable, and therefore there was no reason to reach outside of the lease to find out what the parties meant when they negotiated the document. Again, to the heretofore mentioned legal aficionados, we’re saying that the lower court refused to entertain “parol” evidence. Even ignoring the relevant provision’s caption (SHUT-IN ROYALTY), the provision’s language itself made express reference to “shut-in” and “shut-in royalty.” Yes, though section captions can be used to aid in interpretation (unless the lease or contract specifically says not to do so), the terms of an actual “operative contractual clause” are a more powerful aid. And, since “everyone” knows what a shut-in well is and what a shut-in royalty clause means – “case done and over.”

Now, we’ll offer a “take-away.” Don’t use words or phrases that sound “real neat” if you don’t know what they mean. Don’t take on work in arenas you haven’t visited before unless you’ve really learned about those arenas first. Don’t use technical or industry terms unless you know what they really mean.

We have another “take-away.” Be careful when relying solely on the strength of language that “everyone in the industry knows what we mean” because there are plenty of courts that think that if there is a street or “common person’s” understanding of a word or phrase, there is no need to explore what industry experts might understand the same words to mean.

Multiply those two take-aways by each other and you get a “take-away squared.” Write agreements in ordinary language and if you feel the need to use “vernacular” (industry-specific) terms, define them in your agreement.

To sum up where we are at this point in our telling of the PNP Petroleum story (that’s the case we’ve been writing about): (a) the tenant argued that the extension option was applicable so long as the wells were not producing oil or gas regardless of the reason; (b) the relevant provision used the term “shut-in” royalty; (c) the court found that term to have a special meaning requiring the wells to be operative but shut down because there was no market for the production; and (d) the tenant lost.

Did today’s title include: “And (Maybe) Save Those Drafts?” Oh, Yeah – that’s actually what we in the trade call a “teaser.”

If you’ve looked at the written decision in the PNP Petroleum case, you’ll know that the tenant successfully appealed and eventually prevailed. In doing so, the appellate court did nothing to diminish the stature of what we call the “dictionary rule.” What it used to overturn the lower court were red lined drafts of the oil and gas lease before it was executed, while still abiding by the “parol” evidence rule. Yes, it agreed that the term “shut-in” royalty was unambiguous and there was no basis to use earlier drafts and negotiations to find out what that term meant. Yet, the earlier lease drafts were still important and changed the case’s outcome. That’s your cliffhanger. See you next week – don’t touch that dial – same time, same station – keep those cards and letters coming.

Print

Comments

  1. Interesting. Currently, I am litigating a breach of contract case where I am relying on previous drafts to help establish and prove that the final contract is the true contract of the parties. While the facts here are not quite as similar, there are some issues pertaining to ambiguity and mutual assent regarding certain terms and conditions

Leave a Reply