Lease washouts occur when operators release or allow a current lease to expire in order to get a “clean slate.” These “clean slates” take the form of a new lease that may increase net revenue interest (NRI) and/or do away with undesirable prior lease burdens and provisions. Not only is lease washout permissible in Texas, but it is usually given great deference by Texas courts.
It may seem perplexing to some that an operator can intentionally washout lease burdens such as an overriding royalty interest (ORRI) or a working interest (WI); but as previously stated, it is perfectly legal in Texas. Operators, ORRI owners and WI owners should be aware that no fiduciary duty exists between them in terms of lease washout. In Sasser v. Dantex Oil & Gas, a lease terminated due to a pooling error. The operating lessee took out a new lease on the same minerals, effectively “washing out” the ORRI owner. The San Antonio Court of Appeals held that no duty of good faith in business transactions existed between operators and other interest owners.
In order to protect from washout, parties obtaining an ORRI or WI craft anti-washout clauses into leases and assignments by including language such as “Said interest is to apply to all amendments, extensions, renewals or new leases taken on all of a part of the lease premises within one year after termination of the present lease.” SM Energy Co. v. Sutton. Though these clauses exist, Texas courts have repeatedly construed them very narrowly. In order to be somewhat effective for the ORRI owner and/or WI owner they must be drafted broadly to afford maximum protection under the law. Particular care must be taken to avoid running afoul of the Rule Against Perpetuities (RAP), as demonstrated by Yowell v. Granite Operating Co. In Yowell, the lease drafters crafted an anti-washout clause that included all “new leases”. They essentially attempted to create a “set it and forget it” clause in perpetuity which was ultimately too restrictive. The Texas Supreme Court held that this language violated the RAP; in order avoid such a violation, the clause should include language stating that it terminates as to the property interest within 21 years after the death of the last survivor if not already vested. The verbiage used in the example above which limits the clause’s effectiveness to one year after the termination of the lease would also satisfy the Yowell standard.
Texas courts have consistently reaffirmed that the intentionality of the washout is a non-factor in analyzing its permissibility. In Ridge Oil Co. v. Guinn Invs., Inc., an operator (Ridge) clearly intended to washout a WI owner (Guinn). An existing lease covered two neighboring tracts, with production from wells on one tract holding the lease as to both. Ridge owned the lease rights under the producing tract and Guinn owned rights under the non-producing tract. Ridge shut in the wells on the producing tract for 90 days in order to terminate the original lease as to both tracts, and subsequently obtained a new lease covering both tracts after Guinn had been washed out. Despite this clearly calculated move, the Texas Supreme Court of Texas reiterated that no special duty or relation existed between owners of leasehold interests and held that the washout was permissible.
Issues like this may be avoided through the use of carefully crafted washout clauses or timely and purposeful joint operating agreements which may preserve leasehold interests, prevent costly litigation for ORRI owners and WI owners, and provide operators with lease negotiation leverage.
Kuiper Law Firm, PLLC specializes in oil and gas issues; if you have any questions about how the information in this article may apply to you or your operations, do not hesitate to contact us.