drilling operations

Pugh(eee)…Get Those Lands Outta Here: A Look at the Pugh Clause

For the unwary, Pugh clauses (pronounced “Pew”) can sometimes stink.  Although it is a fairly common provision in many fee oil and gas leases today, there is no industry standard Pugh clause.[1] As a result, the many variations of the Pugh clause can provide unpleasant surprises to both lessors and lessees who assume that all Pugh clauses operate similarly.  From an industry perspective, it is essential for landmen negotiating oil and gas leases to understand how a Pugh clause will operate an­­­­d potentially affect other provisions in the lease.  Additionally, with the sharp decrease in oil prices, many oil and gas companies have pushed drilling schedules into the indefinite future.  The delay in drilling necessitates a careful review of the underlying lease portfolios to determine when certain leases will expire. A thorough understanding of the effect of a  Pugh clause’s on a lease is vital to this review.

So What Is It?

As a general rule, production, or other operations, on “any part of the land, included in an oil and gas lease will perpetuate the lease beyond the primary term as to all of the land covered by the lease.”[2] Moreover, if lands are pooled or unitized, production or operations on any of the lands within the unit can extend all leases committed in whole, or in part, to the drilling or spacing unit.[3] This means that an oil and gas lease can be held past its primary term by production on only a small portion of the leased lands or on lands outside of the leased lands that are located in a drilling or spacing unit. Understandably, lessors can be less than thrilled to discover that all of their lands are locked-up by a lease when only a small portion of their lands are included within a drilling or spacing unit—preventing them from re-leasing their non-producing lands so that they can receive additional bonus payments, rentals, or production royalties from these lands. Without an “express provision in the lease, the lessor only has recourse to the implied covenant of reasonable development (or further exploration in a state that recognizes such a covenant)” to force additional development on the lessor’s lands or allow them to re-lease the lands altogether.[4]

A Pugh clause can prevent this scenario. Named after a Louisiana lawyer named Lawrence Pugh,[5]  the Pugh clause operates to sever the non-producing lands or interval based on some defined criteria, such as acreage or depth.[6] The impact of a Pugh clause “increases the burdens on the lessee who must take additional steps to maintain the lease as to the [non-producing portion]; this may include a return to delay rentals,” (if the lease is not a paid-up lease), “or initiation of drilling operations within a specified period.”[7] In other words, by including a Pugh clause in a lease, any production located on or attributed to leased lands will no longer be sufficient to extend the primary term for the entire leasehold. If the lessee takes no actions to extend the lease excluded by operation of the Pugh clause, the lease will expire as to these excluded lands. This provides an obvious benefit to lessors, who can once again make the forfeited lands available for lease. Since Pugh clauses are decidedly pro-lessor, they are “virtually always inserted into or attached to a lease at the insistence of the lessor’s attorney.”[8]

Horizontal and Vertical Pugh Clauses

It is important to note that Pugh clauses can be horizontal, vertical, or both.  A horizontal Pugh clause “has the effect of severing a leasehold as to the pooled and non-pooled portions on the basis of horizontal planes,” while a vertical Pugh clause “has the effect of severing a leasehold on the basis of vertical planes only.”[9] This means a Pugh clause can be structured by depth (e.g., severing all lands below 100 feet of a drilled well or the bottom of the producing zone), or by acreage.

Give Me An Example

Because there is no industry standard Pugh clause, there can be as many different forms of the clause as there are people drafting the clause.  The following is an example of a generic Pugh clause:

A producing well, or well capable of producing, will perpetuate this lease beyond its Primary Term ONLY as to those lands as are located within, or committed to, a producing or spacing unit established by Government authority having jurisdiction.[10]

This provision in an oil and gas lease operates to segregate the lease at the end of the primary term according to whether the leased lands were within a drilling or spacing unit established by the appropriate government agency. Any lands not located within a drilling or spacing unit would not be extended by production (keeping in mind, of course, that these lands could be extended by other provisions in the lease, such as those pertaining to drilling operations). As a title examiner, it’s not uncommon to see other triggering criteria in a Pugh Clause—such as one or two years after the end of the primary term, or when drilling operations on any portion of the leased lands cease for a specified amount of time.

It’s crucial to clearly specify how and when the clause will come into play, as illustrated by the following real-life Pugh clause:

Notwithstanding anything to the contrary herein, this lease shall terminate after the primary term as to all the lands not included within a drill site spaced unit as provided by the proper Governmental Authority….

This Pugh clause is poorly drafted because it segregates the leased lands only on the basis of whether they are within a “drill site spaced unit,” without clearly specifying that the spaced units must also be producing in order for the lease to be extended beyond its primary term for those lands.  Read literally, the provision raises the question of whether a lease would be extended for lands that are merely subject to a spacing order (and thus presumably within a drill site spaced unit) when there is no production within the drilling or spacing unit, assuming that there is production elsewhere on the lease lands, as was the case in this instance.[11] Although it’s likely that the parties to the lease intended that the clause include a production requirement, it’s uncertain how a court would rule if this clause was litigated, particularly since Pugh clauses tend to be strictly construed.[12]

Problematic Pugh clauses, such as the example above, often arise when the Pugh clause is merely copied and pasted from another oil and gas lease, which can result in omitted words or phrases, or inconsistencies with other provisions of the lease. Problems can also arise when a Pugh clause is drafted by a person who does not fully understand the impact of words or phrases included in, or excluded from, the provision.

Be Careful

As illustrated by the poorly drafted Pugh clause above, not all Pugh clauses are created equal, and it’s important to review and understand the specifics of a Pugh clause when negotiating an oil and gas lease, or when later evaluating how a Pugh clause affects the extension of a lease.

 


[1] 1 Bruce M. Kramer and Patrick H. Martin, The Law of Pooling and Unitization, § 9.01 (LexisNexis Matthew Bender 2015), hereinafter referred to as “Pooling and Unitization,” citing Robin Forte, “Helpful Hints: The ‘Pugh’ Clause,” 42 Landman 9 (May/June 1997) (“Just as there is no standard oil and gas lease, today there is no standard ‘Pugh’ clause.”).
[2] Adams, James W., Jr., “Lease Issues for Opinion Purposes,” Nuts and Bolts of Mineral Title Examination, Paper 11, Page No. 517 (Rocky Mt. Min. L. Fdn. 2015), hereinafter referred to as “Lease Issues”.
[3] Id.
[4] Pooling and Unitization § 9.01.  For a discussion on the implied covenant to develop as it relates to Montana law, see Miller, Adrian, “The Implied Covenant to Drill and Develop in Montana,” available at:  https://www.hollandhart.com/implied-covenant-to-drill-and-develop-in-montana.
[5] Pooling and Unitization § 9.01, ft. 3.
[6] Patrick H. Martin and Bruce M. Kramer, Williams & Meyers, Oil and Gas Law § 669 (LexisNexis Matthew Bender 2015), hereinafter referred to as “Oil and Gas Law.”
[7] Pooling and Unitization § 9.01.
[8] Pooling and Unitization § 9.04.
[9] Oil and Gas Law § H Terms. According to one commentator, the terms “horizontal Pugh clause” and “vertical Pugh clause” are often mistaken with one another and, as a result, are used somewhat interchangeably within the industry.  Consequently, the commentator suggests that Pugh clause should clarify whether the provision affects depth or acreage. See http://landmaninsider.com/pugh-clauses/.
[10] This example is given in Lease Issues, p. 518.
[11] The question regarding this Pugh clause’s operation might be even more muddled in some states, such as New Mexico, which have standard spacing requirements.  See N.M. Admin. Code 19.15.15.
[12] Pooling and Unitization § 9.01. The treatise notes, however, that “strict construction is by no means uniform,” and “a few courts have seemed almost eager to interpret such provisions in favor of the lessor through readings that do not appear entirely reasonable.”  Id.

A Roadmap for Commencement of Drilling Operations: Are We There Yet?

For oil and gas lessees, the journey from signing a lease to having a producing well can be a long and arduous one. Countless turns, speedbumps and stops along the way can reasonably be expected. The habendum clause alone can quickly bring the lease to a screeching halt. Savings clauses have been inserted into modern fee oil and gas leases to prevent automatic termination of the lease while the lessee conducts certain operations. Discussed herein is the commencement of drilling operations savings clause which, in the majority of states, will permit a lease to be preserved after the expiration of the primary term without production if certain operations are being conducted.1 However, even with this savings clause, lessees should be particularly wary of the roadblock approaching at the end of the primary term when determining whether drilling operations were properly commenced before expiration of the primary term. Well-constructed language in a fee oil and gas lease can allow continued operations even if the primary term has expired and the drill bit has not yet broken ground.2

Which lease provision is the commencement of drilling operation clause?

The following is an example of a commencement of drilling operations savings clause:

Notwithstanding anything in this lease contained to the contrary, it is expressly agreed that if Lessee shall commence drilling operations at any time while this lease is in force, this lease shall remain in force ….

Such clauses may include variations such as “commence operations to drill a well,” “commence drilling or re-working operations,” “commence or cause to be commenced the drilling of a test well,” “commence the drilling of a well in search for oil or gas,” “commence to drill a well,” “if no well be commenced,” “lessee is then engaged in drilling for oil or gas,” “lessee is then engaged in drilling or reworking operations thereon,” or “start drilling for oil.” 3 The question to be answered is what operations must a lessee commence to preserve the lease?4

What does commence mean?

Generally, the majority of the states hold that, unless otherwise provided for in the lease, actual drilling is not necessary in order to reach the threshold for commencement of operations. Courts have proved willing to find commencement of operations even when only “modest” preparations for drilling have been made, such as erecting a part of an oil derrick and working on providing a water supply for drilling.5 Other preparatory activities such as obtaining drilling permit, staking and leveling the well location,6 building board roads to the drill site and a turn-around,7 moving tools and equipment onto the drill site, digging slush pits,8 and similar on-site activities have been held sufficient to be considered commencement of drilling operations.9 In order to reach the commencement of drilling operations threshold, a lessee should conduct as many on-site work activities as it can before the primary term expires. When determining adequate operations for commencement, courts favor active earthwork, clearing, construction, structure placement, etc., as opposed to gathering data, developing reports, obtaining permits, having meetings, and filing paperwork.

Courts have further required that such operations must be performed with the bona fide intention to proceed with good faith and diligence to the completion of the well.10 In a case where the preliminary commencement activities were performed by a company that had not yet acquired the rights to drill due to negotiations over the terms of a farmout agreement, the Wyoming Supreme Court held that the drilling operations were not done in good faith with the intent to complete insofar as the operator’s rights were qualified and contingent and may not ever be realized.11

When does the clause require actual drilling?

Some jurisdictions have differentiated between “commence operations” and “commence drilling operations.” California, Kansas, and Montana courts have made such distinctions and held that “commence drilling operations” or similar language required the drill bit to penetrate the ground prior to the end of the primary term.12 However, a Wyoming court held that there is no such distinction13 and “commence to drill a well” may be satisfied if preliminary commencement activities are not mere pretenses or a holding devise to retain the lease, if the acts are commenced and prosecuted with good faith and bona fide intention to drill and complete the well, and performed with diligence.14 Additionally, the Eighth Circuit Court of Appeals, applying North Dakota law, dismissed an argument that “engaged in drilling or reworking operations” meant “engaged in drilling” (meaning actual drilling was required) or “engaged in reworking operations;” rather, the court interpreted the clause as being engaged in “drilling operations” or “reworking operations.”15

What about off-lease operations?

With the advent of off-lease surface locations for horizontal wells, the question arises as to whether operations on or from off-lease surface locations will qualify as commencement of drilling operations on the leased lands. There is currently little guidance to answer this question. As suggested by other authors, we recommend that new oil and gas lease forms and existing oil and gas leases be amended to include a provision similar to one of the following:

(1) As used herein, the term Operations shall mean any activity conducted on or off the leased premises that is reasonably calculated to obtain or restore production, including without limitations, (i) drilling or any act preparatory to drilling (such as obtaining permits, surveying a drill site, staking a drill site, building roads, clearing a drill site, or hauling equipment or supplies); (ii) reworking, plugging back, deepening, treating, stimulating, refitting, installing any artificial lift or production-enhancement equipment or technique; (iii) constructing facilities related to the production, treatment, transportation and marketing of substances produced from the leased premises; (iv) contracting for marketing services and sale of Oil and Gas Substances; and (v) construction of water disposal facilities and physical movement of water produced from the leased premises;16 or

(2) All operations conducted off the leased premises that are intended to result in the completion of, or restoration of production from, a producing interval on the leased premises or lands pooled or unitized therewith shall be considered operations conducted on the leased premises for purposes of extending and/or maintaining this lease in effect under any other paragraph or provision hereof.17

The lease, of course, would need to be further reviewed to confirm that the use of either of the above suggestions does not create any inconsistencies or confusion and all capital terms (if applicable) are appropriately defined.

What should I do?

In determining whether a lease has been extended beyond its primary term by the commencement of certain operations less than spudding the well, it is critical the specific language of the lease, the specific facts, and case law for the state in which the leased lands are located are reviewed. Even then, it may be difficult to conclusively determine whether the lessee’s actions are sufficient absent actual penetration of the ground with a rig sufficient to reach a producing zone. Facing any uncertainty, if the lease and case law lack clear standards, the safest course of action, if possible, would be to get an extension of the lease.


1Williams & Meyers, Oil and Gas Law § 617 at 297 (2012).
2This article is limited to fee oil and gas leases. As to federal oil and gas leases, actual drilling operations must be commenced prior to the expiration of the primary term – the bit must be “turning to the right” prior to 11:59 p.m. on the last day of the primary term. 71 Interior Dec. 263 (July 10, 1964). Site preparation and even moving a rig onsite do not qualify as actual drilling operations. 43 C.F.R. § 3100.0-5(g).
3Williams & Meyers, supra note 1, § 618.1 at 311.
4Not addressed herein is whether the commencement of drilling operations clause in the habendum clause of the lease also has the effect of being a continuous drilling clause, i.e., if the well is drilled as a dry hole, does the lessee have the right to commence a second well?
5Williams & Meyers, supra note 1, § 618.1 at 320.
6Petersen v. Robinson Oil & Gas Co., 356 S.W.2d 217 (Tex. App. 1962).
7Breaux v. Apache Oil Co., 240 So.2d 589 (La. App. 1970).
8Walton v. Zatoff, 125 N.W.2d 365 (Mich. 1964).
9See Oelze v. Key Drilling, Inc., 135 Ill. App. 3d 6, 481 N.E.2d 801 (5th Dist. 1985) (a drilling rig was moved near the site, brush cleared and one of three pits were dug before the end of the primary term was found to be “commence operations for drilling”); Johnson v. Yates Petroleum Corp., 981 P.2d 288 (N.M. Ct. App. 1999) (any activities in preparation for, or incidental to, drilling a well).
10See Sword v. Rains, 575 F.2d 810 (10th Cir. 1978); Wold v. Zavanna, LLC , 2013 WL 6858827 (D.N.D. Dec. 31, 2013); Murphy v. Amoco Prod. Co., 590 F. Supp. 455 (D.N.D. 1984); Stoltz, Wagner & Brown v. Duncan, 417 F. Supp. 552 (W.D. Okla. 1976) (not required to cause the bit to pierce the earth before the end of the primary term, but must have the good faith intention to unqualifiedly drill the well, commence drilling the well on such date and pursued such drilling as a reasonably prudent operator); Haddock v. McClendon, 266 S.W.2d 74 (Ark. 1954); Oelze v. Key Drilling, Inc., 135 Ill. App. 3d 6, 481 N.E.2d 801 (5th Dist. 1985); Illinois Mid- Continent Co. V. Tennis, 122 Ind. App. 17, 102 N.E. 2d 390 (1951) (lessee lacked good faith); Flanigan v. Stern, 265 S.W. 324 (Ky. 1924) (requiring after spudding reasonably diligence and bona fide effort); Smirth v. Gypsy Oil Co., 265 P. 647 (Ok. 1928); Bell v. Mitchell Energy Corp., 553 S.W.2d 626, 632 (Tex. App. 1977); LeBar v. Haynie, 552 P.2d 1107, 1111 (Wyo. 1976).
11True Oil Co. v. Gibson, 392 P.2d 795 (Wyo. 1964).
12Lewis v. Nance, 20 Cal. App. 2d 71, 66 P.2d 708 (4th Dist. 1937); Hall v. JFW, Inc. 893 P.2d 837 (Kan. 1995); Soldberg v. Sunburst Oil & Gas Co., 235 P. 761 (Mont. 1925) (“commence drilling operations for oil”).
13Fast v. Whitney, 187 P. 192 (Wyo. 1920) (“commences drilling”).
14LeBar v. Haynie, 552 P.2d 1007 (Wyo. 1976) (“commence to drill a well”); True Oil Co. v. Gibson, 392 P.2d 795 (Wyo. 1964).
15Anderson v. Hess, 733 F. Supp. 2d 1100, 1106-07 (D.N.D. 2010) aff’d 649 F.3d 891, 898 (8th Cir. 2011) (insofar as the lessor conceded that the lessee was engaged in drilling operations before the primary term expired, the court did not address whether the lessee’s preparatory activities were satisfactory to constitute drilling operations.). See also Wold v. Zavanna, LLC , 2013 WL 6858827 (D.N.D. Dec. 31, 2013) (granting summary judgement in favor of the lessee based on Anderson v. Hess and finding “drilling or reworking operations” had been commenced when lessee obtained all drilling approvals, engaged in actual on-site construction, hauling of equipment and materials on site, installing culverts and cattle guards, and digging reserve pit prior to the expiration of the primary term and finding that the lessee had capability to drill the well and good faith intent to complete the well with reasonably diligence).
16Milam Randolph Pharo & Gregory R. Danielson, “The Perfect Oil and Gas Lease: Why Bother!,” 50 Rocky Mt. Min. L. Inst. 19-1, 19-18 (2004).
17John W. Broomes, “Spinning Straw Into Gold: Refining and Redefining Lease Provisions for the Realities of Resources Play Operations,” 57 Rocky Mt. Min L. Inst. 26-1, 26-12 (2011).