PNG Leases – Suspension or Termination?

Petroleum and natural gas leases often contain a provision which permit the lessee to suspend production with payment of “delay rental” instead of the agreed royalty because of “lack of or an intermittent market”. However, where there is a continuing market for production, does the fact that such production is unprofitable justify the lessee terminating production and suspending royalty payments?

In a recent decision of the Alberta Court of Queen’s Bench, in an action by landowners for a declaration that production leases had terminated as a result of non-production, the court was required to consider whether a well becoming uneconomical to produce at current pricing justifies suspension of production and royalty payments. The leases at issue permitted the lessee to suspend production “as a result of a lack of or an intermittent market, or any cause whatsoever beyond the lessee’s reasonable control”. The defendant lessees acknowledged a market for production but asserted that production had been suspended because it was uneconomical.

In interpreting the lease provisions, the court commented:

“The Plaintiffs further submit that the Defendants’ proposed interpretation of ‘any cause whatsoever beyond the Lessee’s reasonable control’ would reallocate the business risk of an unprofitable market to the freeholder lessors by allowing the Lessees to hold the leases indefinitely based on their internal rates and the profitability of their oil and gas operations. The Defendants do not suggest that an interpretation of [the lease] language should depend on the particular hurdle rates of the Defendants. They have adduced expert evidence to establish that the [well] would not have been profitable to produce during the shut in period from the perspective of a prudent operator, a more objective standard.”

In dismissing the landowners’ action and upholding the continuing validity of the subject leases, the court concluded:

“ … I accept that the [well] was shut in in July, 1995 for causes beyond the Lessees’ reasonable control, in that it was uneconomical to produce during the shut in period given the low price of gas and relatively high costs of production and processing, effectively a lack of an economic market.

“ … The question remains whether circumstances changed during the shut in period such that a prudent operator would have foreseen profitability and taken steps to produce from the [well], and when that change occurred.

“For reasons I’ve already given, I accept … that the reactivation of the [well] during the shut in period was never economical, and that it would not have been commercially prudent to consider taking steps to recomplete [production] until the second or third quarter of the year 2000.”

Whether or not suspension of production by a lessee under a production lease may be justified because of market conditions, or may result in termination of lease, will depend upon the specific language of the lease. Even where non-production may be justified because of market conditions, it is the objective standard of the reasonable operator which is to be applied and not simply the internal financial considerations of a particular operator.