THE IMPLIED COVENANT to MARK
LESSEE'S DILEMMA
Presented to
Richard V/. Hemingway
By
Rocky D. Crocker
"166
The Implied Covenant to Market:
Lessee's Dilemma
There is probably no other legal instrument in which
the parties have so much to gain or lose with so little
express contractual protection as in an oil and gas lease.
The amount of royalties and their rapidity of payment are
determined by the extent and promptness of the lessee's
drilling and producing operations, and, in the case of gas,
by the additional factor of the lessee's marketing of the
gas.
Nevertheless, the only clause usually found relating
to the obligations of the lessee regarding drilling operations is the clause governing the time within which the
initial well (or subsequent wells, if the first and subsequent wells prove nonproductive) shall be commenced, or
rentals paid in lieu thereof.^
The habendum clause does
nothing more than fix the maximum time within which production must be obtained for the lessee's estate to continue,
and the delay rental clause is usually worded to allow the
lessee the option of holding the estate throughout this
2
period without conducting any drilling operations.
Rare-
ly is any clause to be found in the usual type of lease imposing any obligations upon the lessee with regard to the
marketing or utilization of gas produced, although the
payment of gas royalties is in most leases entirely dependent upon the sale or use of the gas by the lessee.
Leases
are also normally silent with respect to the character of
development expected once production is obtained upon the
leasehold premises.
Nor is any clause usually to be found
obligating the lessee to drill in case production is had
upon neighboring lands which result in drainage of oil or
gas away from the leasehold premises.
One might expect that this void of clauses can be explained because the interest of the lessor and lessee are
the same.
In which case the lessor may rely for his protec-
tion upon the self-interest of the lessee.
is not the case.
However, that
More commonly the interest of the lessor
and the lessee frequently conflict.
The reason for this
void of express lease clauses may be because of the hazards
and uncertainties surrounding the development of oil and
gas properties.
As well, the transportation and marketing
of oil and gas make it practically impossible to prepare at
the time the lease is executed the specific clauses governing the details of development and operation.
Furthermore,
there is always the possibility that any agreed program of
development may be prescribed by legislative enactments or
by rules and regulations of a state's conservation board.^
Another possible explanation may lie in the fact that oil
and gas leases are usually prepared by the lessees, men
experienced in the oil and gas business, and the lessors,
frequently lacking in similar experience often sign the
lease forms without adequate information upon which to predicate a demand even for proper protective clauses of a
general nature.
This was especially true in the early days
of exploration.
Whatever the reason for the failure of oil and gas
leases to include express lease clauses, this dereliction
2
has been rendered harmless to a large extent by reason of
the diligence of the courts in safeguarding the lessor's
royalty interest through the medium of implied covenants.
The law is well settled today that the lessee in any oil
and gas lease assumes a number of implied obligations to
the lessor with reference to the operation and development
of the leasehold premises, in the absence of express provisions relieving the lessee of these obligations.
The court's basis for implying these covenants is not
clear.
However, most courts have implied them to carry out
the intentions of the contracting parties.^
If the parties
to an oil and gas lease express terms in the lease contract
that it clearly appears they contemplated such a covenant
or provision that they didn't find it necessary to include
it in the lease, or it is necessary to imply a covenant to
give effect to the purpose of the contract as a whole the
5
courts have implied such covenants.
In an oil and gas
lease the main consideration that moves to the lessor is
the royalty he will derive from the production of oil and
gas.
It is doubtful that a lessor would grant the exclu-
sive right to a lessee to explore and develop his property
for a period of years if such exploration and production
was never to occur.
And if oil or gas is found in paying
quantities it seems obvious that the lessor would intend
for such to be marketed.
benefit from leasing.
Otherwise, he would receive no
Therefore, the duty of diligently
promoting the productivity of the premises must be construed
as having been written into the lease.
"169
Another reason that the courts have implied covenants
may be found in the theory of enforcing that contract which,
under the circumstances, fair dealing between the lessor and
lessee fairly demands that the lessee pursue.^
Since the
lessee is the one who has the leases drawn, it would seem
that he would have a tremendous advantage over an unsuspecting land owner.
Especially where the land owner is poor and
uneducated it would seem that this would be the case.
Today,
however, many farmers and land owners are neither poor nor
uneducated and many times a land owner will have a competent
attorney look over the lessee's form of lease to prevent
such an unfair advantage.
7
If, as some authorities have proposed,' the basis for
implying covenants in oil and gas leases is to promote fair
dealing, it seems that they would not be implied where the
lessor and the lessee stood on equal footing.
The real
reason for implying covenants in leases may simply be that
the lav/ of oil and gas has just "grown up" over the years
implying these covenants.
To begin, now, looking at the
position of the parties and implying covenants only when
one of the parties to the lease has an advantage would cause
an unbelievable amount of litigation.
It would probably be
much simpler, considering the present state of the law, to
allow the present growth to continue.
One covenant that has seen such recent growth is the implied covenant to market oil and gas.
Although this covenant
may be applied to oil, it is usually associated with gas
production.
Royalty on gas is usually an agreed fraction
" 170
of the gas marketed or utilized by the lessee/'
Since in
most leases today, the royalty upon gas is payable not upon
the gas produced, but only upon the gas marketed by the lessee;
the prevailing view in most jurisdictions is that an implied
obligation to use reasonable diligence in marketing the gas
o
will arise upon its discovery in paying quantities.'
Texas
courts also follow the majority view and imply a covenant to
market when royalty payments are conditioned upon the marketing of oil and gas.^
The question becomes, when and at what price oil ana
gas must be marketed.
In the case of Cole Petroleum Co.
11
v. United States Gas & Oil Co.
a lease clause obligated
United States Gas & Oil Co., after completion of the first
or test well, to "proceed with such additional development as is reasonably necessary....to
1 2 develop this lease
to a normal stage of production." - The court stated
that after looking at all the terms of the contract, developing the lease to a normal stage of production necessarily
involved marketing oil or gas discovered in paying quantities in order to yield part of the oil or cash for the gas
13
as royalty. ^
Simply exploring and discovering oil or gas
lay the basis for marketing.
The court went on to state
that "under the ordinary oil and gas lease, the lessee is
not required to market the yield of leased land at any certain time or for any certain price." ^
The lessee's duty
is to exercise ordinary or reasonable care.
The court ex-
plained that the exercise of ordinary or reasonable care
meant reasonably diligent operation for the best advantage
15
and benefit of both the lessor and lessee.
it would scorn
then, that the time of marketing and the price received for
the product would be unimportant as long as the lessee was
diligent in his efforts to find a reasonably priced market
within a reasonable time.
Nevertheless, other cases seem
to suggest that this may not be the case, which is where
the lessee may encounter problems.'
In many instances, especially where gas is involved,
it may be years before a pipeline can be connected to a
well at some remote location.
Other times, but less often,
there may be an available pipeline but the price may not
be as economically beneficial as desired.
Of course there
is no problem where the pipeline and the price are available and adequate.
But, where this is not the case, the
lessee may face a dilemma especially if either price or
time is important in complying with the implied covenant
to market.
If a lessee sells the gas or oil too quickly
he may have missed the opportunity to receive the best available price possible or worse yet, not even a reasonable
price.
Where the lessee waits too long for a better price
he may be beyond the reasonable time limits of the marketing covenant.
In either case the lessee may have breached
his duty to the lessor to find a favorable market.
It is true courts have held that the lessee may withhold products from the market for1 a reasonable time in
order to receive the best price.
In addition, in the
17
r
case of Gazin v. Pan American Petroleum Corporation '
where a gas well was shut-in .from 1956 until I960 in order
"172
to obtain a hotter contract price, it v/as held that the
lessee had not breached the covenant to market because he
used due diligence during the period.
But, what if the
period had been form 1956 until 1961, or 1965?
the lessee used due diligence until 1981?
tinue to have the well shut-in?
What if
Could he con-
It would seem doubtful
that a lessee could prove that he used due diligence
where a well is shut-in for such a period of time.
How-
ever, if the lessee had marketed the gas as soon as the
well "came in" in 1956 he may have breached the marketing
covenant if he did not receive at least the fair market
value for the gas.
There is considerable authority for the proposition
that the lessee owes a duty to the lessor to obtain the
best price possible for gas.
This duty can arise either
under a "market value" or a "proceeds" royalty clause.
Professor Merrill has stated "the concept of diligence in
marketing should include the duty to realize the highest
price obtainable by the exercise of reasonable effort...
1Q
he is bound to get the best price he can."
It has also
been stated that "at all events, it is well settled that
the lessee is impliedly obligated to 'market' - to sell or
otherwise utilize - the production obtainable from a commercial well.
Probably this requires the lessee to secure
19
the highest price reasonably obtainable...."
y
Several courts
have also found an implied duty or obligation on the part of
the lessee to obtain a market for gas at the best price
available.20
-7-
The recent Texas case of Amoco Production Company v.
21
First Bantist Church of Pyote
inn covenant ovon further.
seems to push the market-
Amoco owned oil and gas leaser,
covering several small tracts of land in the townsite of
Pyote.
Each of these leases provided for a one-eighth
royalty to be paid based on the "proceeds" realized on the
gas sold at the wells.
Amoco pooled its leases with other
leasehold estate owners in the same section to form the
Caprito 100 unit.
In 1973 the working interest owners
drilled a well in this unit which was completed as a producer.
Each working interest owner had been selling gas
from this well to various purchasers.
Amoco was selling
its percentage of the gas (about 17%) from the well to
Pioneer Natural Gas Company and Odessa Natural Gasoline
Company, which acquired its rights under Pioneer.
The
price Amoco was receiving from Pioneer for this gas was
based on a purchase contract entered into in November,
1969 which covered six of eithteen leases involved here.
In June, 1975j Amoco entered into a supplemental agreement v/ith Pioneer by which Amoco dedicated the other
twelve leases to the 1969 contract.
In return for this
dedication Amoco's price for gas v/as increased from 17tf
per MCF to 70c per MCF for gas produced from August 197^
for twelve months, 710 por MCF for the next twelve months
and 720 per MCF for the remaining months through June,
1977.
This price was about one-half the amount at which
gas was being sold to other purchasers from the same well
by the other working interest owners.
The court concluded
that Amoco had an implied covenant or duty to act in good
faith when marketing the gas of its royalty owners even
under a lease provision providing for "payment of royalty
based upon the proceeds realized from the sale of gas."
Amoco was found to have breached its duty to act in good
faith by failing to receive the fair market value for the
22
gas sold under the contract.
However, there was no
evidence of bad faith present anywhere in the record;
only proof that the lessee sold his gas for less than
others sold theirs.
Therefore, under this holding a
lessee has a duty to market gas at its fair market value.
Failure to enter into a contract for sale of gas for at
least the going fair market value is a breach of the
lessee's duty to act in good faith and thus, a breach of
the implied covenant to market.
Where the gas has been
marketed at less than the fair market value the lessor
is entitled to recover the difference between that and
its selling price.
Since the holding in the Amoco Production Company
case the dilemma of the lessee seems to have become more
closely defined.
If the lessee is not held to breach the
covenant to market by receiving less than fair market value,
he at least will be required to pay the difference between
the selling price of the gas and the going fair market
value.
But, where the lessee holds the gas off the mar-
ket to obtain a better price or in some instances, just
the fair market value, he may be in jeopordy of breaching
the implied covenant to market by not selling the gas
9
within a reasonable period of time.
As mentioned earlier, it has been held that a lessee
may wait for a better price and need not sell at the first
opportunity, but to avoid breaching the marketing covenant
he must use due diligence to find a market during the per25
iod he is withholding the gas. ^
Whether a lessee is ex-
ercising due diligence is a question of fact which of
necessity depends upon the circumstances of each case,^^
In one case where the only market for a gas well was onehalf mile away, the.court held that a reasonable time in
which to market was the reasonable time it would take 25
the
lessee to lay a pipeline to the only available market.
y
The court went on to say that it was incumbent upon the
lessee under the circumstances to forthwith begin operations with reasonable diligence
and dispatch until the
26
gas reached the market.
In some instances, however,
there may not be an available buyer and no amount of
diligence will aid in finding a market.
Another possible
situation would be where there is a buyer but he is unwilling to pay a price for the gas that others are receiving in the same area.
What can a lessee do to avoid the problems he may
face with regard to marketing oil or gas within a reasonable time or waiting to receive at least the fair market
value for the product?
The simplest answer would be to
write an express provision into the lease.
As in the
case of other implied covenants, an express covenant on
the same subject will displace the implied covenant to
10
. . 27
mantes.
There are several different clauses that can be
used to solve the problem.
In some instances a general
clause may be the best approach.
28
Texas Company
In the case of Gex v.
Louis S. Gex ana his wife, Kate, executed,
to the Texas Company a mineral deed.
vided in part as follows:
The instrument pro-
"It is agreed that the Texas
Company, its successors or assigns, shall never be under
obligation to drill or mine oil or gas or other minerals,
but such mining or drilling, both before and after -production, shall be wholly at the ontion of said grantee,
its successors or assigns."
(emphasis added) The grantor
was to receive one-eighth royalty if there was production
from the property in paying quantities.
The court cited
as authority Cole Petroleum v. United States Gas & Oil C o . ^
which involved a lease situation where there were covenants
requiring the lease to be developed to the normal state
of production.
It was held in the Cole case that the
clause "to develop said lease to a normal state of production" necessarily involved marketing.^
Analogizing
this holding the court in the Gex case found the expression,
"wholly at the option of the grantee," as used in the deed
precluded any implied covenant to develop or produce.
The
court stated, "By the same reasoning, conversely the expressed covenant in the mineral deed here involved by eliminating any implied covenant to develop or produce precludes any
implied covenant to market."-"^
A general lease clause providing that "all develop-11-
177
menL shall be at the discretion of the lessee" may also
provide an adequate solution to the aforementioned prob32
lem.
In the case of Cowden v. Broderick & Calvert^
the
lessor was trying to have a lease cancelled because of
failure of lessees, after discovery of oil in payingquantities upon a 160 acre tract, to continue reasonably
to develop the said tract by drilling and equipping other
wells.
The lessors claimed that the implied obligation to
develop with reasonable diligence arose after the discovery of oil in paying quantities in the first well.
The court stated that implied obligations do arise where
a lease is silent upon the subject.
The clause requiring
"other development to be at the discretion of the lessee"
required the lessee only to act in good faith and is not
the same obligation as would arise under an implied covenant. v
Although this case did not specifically deal
with the marketing covenant, arguably a clause to the
effect that "marketing shall be within the sole discretion of the lessee"
would have the same effect.
Such a
clause would require a lessee only to exercise good faith
and though not as adequate as other clauses, may take
some of the sting out of the implied covenant to market
without restricting the lessee -to strict time and price
constraints.
Although these general lease clauses may be found to
displace the implied covenant to market, the better approach
may be to include a specific express clause in the lease.
In this way both the lessor and the lessee can be assured
-12-
178
of the terms they are agreeing to in the lease.
With-
out such an express clause there is no way the lessee
can be assured that the implied covenant to market has
been rendered harmless.
One common lease clause thought to effect the implied marketing covenant is the shut-in gas royalty clause.
Under this clause the lessee may continue the life of the
lease by paying a stipulated sum in lieu of the royalty a
lessor would receive if oil or gas was being produced.^
Although it is arguable that the implied duty to market
is negated by the right of the lessee not to market upon
the payment of shut-in royalty, some authorities believe
this view to be unsound because it misapprehends the pur55
pose of the shut-in c l a u s e . P r o f e s s o r s Williams and
Meyers of Stanford University follow this view on the
reasoning that the shut-in royalty clause was intended
to modify the habendum clause so that the lease may be
preserved in the interim between discovery of gas and
marketing thereof, although there is no production.
They believe that the shut-in royalty clause is a saving
clause to counteract decisions holding that discovery of
gas does not satisfy the requirement of production in
the habendum clause and that, under such circumstances,
the lease terminates at the end of the primary term for
lack of production in paying q u a n t i t i e s . T h e r e being
no inconsistency between the shut-in royalty clause and
the implied marketing covenant, the paying of such does
nothing to relieve the lessee of his duty to market within
a reasonable time at a fair market price.
They sight as
authority for this view the Louisiana case of Risinror v.
57
Arkansas-Louisiana Gas Co.
In that case a gas well pro-
ducing a large volume of salt water was shut-in and shut-in
royalty was paid by the lessees.
The lessors sought to
cancel the lease because of failure on the part of the
lessees to market the gas.
The court found that for the
lessee to market the gas under the present technology
would not be profitable.
Therefore, the lessee had not
violated the express provisions of the lease to use due
diligence in the operation of the well.
Professors Williams
and Meyers state that "if the court had thought that the
shut-in gas royalty clause barred enforcement of the implied marketing covenant, we believe that it would have
said so and disposed of the case in this easy fashion
rather than weighing the evidence to determine breach of
-2
duty."^
O
This seems to be a very questionable reading of
the holding in the Risinger case.
The lessees in that
case never argued the position that they could permanently
and indefinitely continue to make shut-in royalty payments.
Nor did they urge that the shut-in royalty clause displaced
the implied covenant to market.
The lessees' only defense
was that they had used due d i l i g e n c e . A s a result, the
court in coming to its conclusion never discussed the
effect of shut-in payments on the implied covenant to market.
The court did state in its holding "the fact that
they (the lessees) succeeded in obtaining a well producing
gas, entitles them, under the express provisions thereof,
"180
to continue the leases in effect by paying 'i!>200.00 per
year per well until such time as the gas shall be utilized or sold off the premises."^0
Professor Williams and Professor Meyers views also
seem questionable for another very subtle reason.
They
state that the shut-in clause is used to preserve the
lease between discovery of gas and the marketing thereof,
1
I
where there is no production.
Although the definition
of "production" varies among jurisdictions and one construction of the term does not include marketing, the
ma.jor line of construction does include marketing in the
term "production."^
Therefore, if the shut-in royalty
clause is intended as a substitute for production,^ it
seems only logical that such payments would necessarily
be substituted for marketing as well.
There is little authority on the question of the
effect of the shut-in royalty clause on the implied covenant to market and there is no authority squarely in point.
However, there are a few cases that at least suggest that
payment of shut-in royalty does effect the implied covenant
to market.
In the case of Cox v. Miller*^ a gas well was
productive in paying quantities but gas was not produced
because there was no market available.
The court held
that the lease had terminated for lack of production at
the end of the primary term.
The court, however, went on
to say "the rule is otherwise where the lease provides in
the alternative for a stipulated rental for each gas well
L, 5
and the rental is paid."^ Professor Summer of the Univer-
",5I81
sity of Illinois has also stated that in some cases where
gas has been discovered in paying quantities and where
the lessee was unable to market the gas because of an unavailable market or otherwise, it has been held that the
lessee could extend the lease beyond the primary term by
payment or tender of a gas well rental.^
Most of the
scant authority suggest the sounder view to be that the
shut-in royalty clause does affect the implied covenant
to market.
The exact effect is still speculative, how-
ever.
Conclusion
The lessee of an oil and gas leasehold who is interested in protecting his property should consider the use
of express lease provisions.
Admittedly, express provisions
cannot be used in every instance because of the very nature
of oil and gas exploration and development.
Also, it
would be very difficult for a lessor to be convinced to
accept many lease provisions.
Especially a general
"blanket" type provision disclaiming all implied covenants
which would be very beneficial to the lessee.
Neverthe-
less, there are some provisions that should be included in
the lease if possible.
One such provision would be one
which would protect the lessee from the implied covenant
to market.
This is especially true now that the implied
covenant to market may include an obligation to sell gas
at fair market value at the very least.
16
However, a lessee
may reccive some protection if he fails to include an
express lease provision regarding the marketing of gas,
where the common shut-in royalty clause has been included
in the lease.
The wise lessee will not simply rely upon
the shut-in royalty clause but will try instead, to have
a provision included in the lease that deals specifically
with the implied covenant to market.
FOOTNOTES
1
A. W. Walker, Jr., The Nature of the Property
Interest Created By An Oil And Gas Lease in Texas, 8 Tex.
k> Rev. 483, 520-540(1930).
2
Id. at 511-520.
3 Helmerick v. Roxana Pet. Corp., 136 Kan. 254, 14
Pac. (2d) 663 (1932).
Lf
R* Hemingway, The Law of Oil and Gas, § 8.1 (1971).
5
Id.
^ M. Merrill, Covenants Implied in Oil and Gas Leases,
§ 221, 222 (2d. ed. 1940)
8
Id at § 34,
9
1A
L. Summers, Oil and Gas, § 131 (1927).
Where
a fixed sum per year on gas wells is paid as royalty it has
been held immaterial whether the gas was marketed so long
as the fixed sum was paid.
Id.
-18-
184
10
Stanolind Oil & Gas Co. v. Barnhill, 107 S.W.
(2d) 746 (Tex. Civ. App. 1937 error ref'd).
11
41 S. W. (2d) 414, 415 (Tex. Sup. 1931).
12
Id. at 416.
Id. at 417.
Hemingway, supra n. 4, at I 8 . 9 .
^
17
1^
Okl., 367 P. (2d) 1010.
M. Merrill, sunra n. 6, at § '34.
19
Siefkin, Rights of Lessor and Lessee with Respect
Sale of Gas and as to Gas Royalty Provisions, 4th Annual
Institute
Oil & Gas Law & Tax, 182 (1953).
20
Livingston Oil Corporation v. Waggoner, 273 S. IV.
903 (Tex. Civ. App. - Arnarillo 1925, no writ).
21
579 S. W. (2d) 280 (Tex. Civ. App. - El Paso 1979,
reh. denied)
2t
" Id at 235 •
23
Cazin v. Pan-America Petroleum Corp, 367 P. (2d) 1010,
24
Id.at 1012.
Union Oil Co. of California v. L. B. Ogden, 278
S. W. (2d) 246 (Tex. Civ. App. - El Paso 1955, no writ),
26
27
w.
Hemingway, supra n. 16.
10
25
337 S. W. (2d) 820
(Tex. Civ. App. - Amarillo 1960,
reh. denied).
29
41 S. IV. (2d) 414, (Tex. Sup. ^1931).
50
Id at 416.
31
337 S. W. (2d) 820, 826 (Tex. Civ. App. - Amarillo
1960, reh. denied).
52
114 S. W. (2d) 1166 (Tex. Sup. 1938).
Id. at 1171.
3 Williams and Meyers, Oil and Gas Law, § 631-635 (1962)
20-
3? 5 .Villiams ana Meyers, Oil and Gas I,aw, § 858.2 (1964).
id.
37
58
39
3 So. (2d) 289 (1941).
5 'Villiams and Meyers, supra n. 35«
3 So. (2d) 289, 292.
Id at 293.
I
1
5 Williams and Meyers, supra n. 35.
^
R. Hemingway, supra n. 4 at § 6.4.
^
3 Williams and Meyers, Oil and Gas Law § 632.13
(1962) (Variants of Shut-in Royalty Clause:
Effect of Pay-
ment or Tender) The customary shut-in royalty clause begins
as follows: "and if such payment is made it will be considered that gas is being produced throughout such year..."
Id.
-21-
187