THE PRESENT STATE OF THE
IMPLIED COVENANT OF FURTHER DEVELOPMENT
JAMES
R.
LEETON) JR.
The Present State of the
Implied Covenant of Further Development
Many oil and gas leases impose on a lessee an express obl igation of further development and continuous exploration after securing initial production.
Even if no express provision is provided,
the courts imply this duty from the lessee on the grounds that the
underlying purpose of the parties - profit for mineral production suggests that this is within the intentions of the parties.
the implied covenant of further development exists.
Thu~,
This covenant
in oil and gas law is simply a branch of a law of contracts called
the principle of cooperation which is close to constructive conditions.
The constructive duty of cooperation requires the parties
to contract to cooperate for the purpose of carrying out the objects of the agreement, namely the exploration of the leasehold
for oi 1 and gas and t:hen the product ion and market i ng of the product after discovery.l
Two different views involving the impl ied covenant of further
development have evolved with one being the alleged "Texas fl view of
the prudent operator.
(I say
II
all eged ll becau se one of the pu rposes
of this paper is to show that Texas does not use this view primarily.)
The standard is that a lessee, after production is obtained,
is obliged to do whatever under the circumstances would be reasonable of a prudent operator of a particular lease, having a rightful
regard for the interest of the lessor and lessee. 2
Failure in meet-
ing the standard results in full or partial cancellation of the lease.
In considering whether a reasonably prudent operator would drill
on a lease, one considers: (1) the quantity of oil and gas capable
of being produced from the premises as indicated by prior exploration and development, (2) local market and demand, (3) the extent
and results of operation, if any, on adjacent lands, (4) character
of natural reservoirs - whether such as to permit the drainage of
large areas by each well, (5) usages In business, (6) cost of drilling, equipment and operation of wells, (7) cost of transportation,
(8) cost of storage, (9) the prevai 1 ing price, (10) the general
market conditions as influenced by supply and demand or by the
regulation of production through government agencies. 3
This cove-
nant is a continuing obl igation during the term of the 1ease. 4
Thus, if a lessor wants to charge a lessee with breach of imp1 ied
covenant to further develop, he must prove that the lessee failed
to act with reasonable dil igence under the circumstances, considering all the factors as they exist at that particular time. 5
If
a lessor fails to show this, then the lessee may maintain his grip
on the lease without ' further development.
In any case, the two
main factors in determining whether the lessee is proceeding reasonably to develop the lease is (1) whether lessee is developing
with reasonable di1 igence;6 and (2) whether a reasonable expectation of profit exists not only to the lessor, but also to the 1essee. 7
In the final analysis one sees that the "Texas" view is based on
the reasonableness of a prudent operator as to whether a profit can
be made, and if the lessor fails to show this, then the lessee may
hold on to the lease forever.
The second view of the implied covenant of further development,
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advocated by Oklahoma,8 Arkansas,9 and other jurisdictions, is of a
reasonably prudent operator, but with a 1 imiting time factor.
calls this the implied covenant of "further exploration. 1110
Myers
This
view still deals with the prudent operator, but allows that after a
certain period of time without development the lessee must either
drill or cancel the lease without regard to whether the lessor can
show profitabil ity. 11
This view was first advocated in Sauder v.
Mid-Continent Petroleum Corporation where the Supreme Court conditionally cancelled a lease which had gone undeveloped for seventeen
years, unless the lessee developed the lease within a reasonable
time. 12 It was later picked up by the other states such as Oklahoma that allowed cancellation of the lease based on their equity
powers.13
All the supporting courts have held that it is unfair
for the lessor to freeze a lease for unreasonable length of time
and prevent the owners from getting full development of their land.
Just how long the delay may be the courts say depends on the circumstances. 14 The factors to look at besides whether a prudent operator would drill are: (1) the time involved, (2) the size of the
lease, (3) the depth of the wells, (4) the number of wells, (5) the
location of the wells; and (6) the date the wells were drilled. 15
The courts seem to place a greater emphasis on the length of time
which the lessee has held the lease without further development.
They seem to say that as time progresses, the duty to drill additional wells becomes progressively greater and the standard of the
prudent operator becomes progressively of less importance in determining whether the duty to drill exists. 16 However, the mitigating
facts of the either-or situation, of the impl ied duty of further exploration is that the burden of proof is shifted to the lessee to
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show either the unprofitabi1 ity of deve10pment 17 or the inequity of
cance11 ing the 1ease. 18 If the lessee does show this, cancellation
will be denied.
Thus, a court of equity may, when the lessor has
estab1 ished a prima facie case of an unreasonable length of time,
shift the burden of proof to the lessee to excuse or explain his inactivity.19
Thus, the two doctrines serve two different purposes.
The im-
p1 ied covenant of further development requires the reasonably prudent operator to drill wells in known producing areas.
It is to
assure a reasonable rate of production and the recovery of all economica1ly recoverable oil and gas beneath the leasehold, and the
additional drill ing in known producing horizons.
On the other hand,
the imp1 ied covenant of further exploration does not deal with reasonab1eness of the operator so much and only requires the lessee to
use due di1 igence in drill ing of exploratory wells, after initial
production has been secured and while the lease is still being held
by such production.
It differs from the reasonable development cove-
nant in that it relates to the drill ing of potentially productive
wells rather than to the drill ing of developmental we1ls. 20
These then are the two different duties in which supposedly the
different
stat~s
impose on their lessees.
The Oklahoma view is
founded on "equityJ' while the other view is said to be founded on
reasonableness of the prudent operator.
Although Texas has specifi-
cally accepted the impl ied covenant of further development and rejected the covenant of exploration in Clifton v. Koontz, if one forgets the terms involved and looks below the surface, it will be seen
that Texas has actually taken a partial equity stand to protect the
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lesser.
Although both states' views claim to be different from the
other, based on their terms, they might have their similarities based
on equity without the bother of the terms.
Having looked at both views, it can be seen that the latter,
Oklahoma, pol icy is the better system for deciding cases and for the
times.
A1though Myers speaks of the covenant as one lito further ex-
plore," I will speak of it only as the equity decisions because this
seems to be what the Oklahoma and Arkansas courts deal in, rather
than the term.
To understand the equity principal one must under-
stand the purpose of the oil and gas lease which is to obtain a profit for the lessor and lessee. 22 It is that the lessor desires the
lessee to fully explore and develop the lease and not to place some
of it beyond the possibil ity of exploration and development.
If the
lessee has sole operating rights and has no duty to search the remainder of the lease because a prudent operator would not have to,
no well will be drilled and this possibly deprives the lessor of
present profits. 23
Thus, the lessee must proceed with reasonable
'.
dil igence in the search for oil and gas throughout the whole lease
and production of oil and gas on a small portion of leased tract cannot justify the lessee's holding the lease indefinitely and depriving
the lessor of expected royalty and the privilege of making some other
arrangment for avail ing himself of the mineral contents of the land. 24
The rules of Sauder and Dorr were developed to impose on the lessee
the duty to drill within a reasonable time without regard to profitabil ity or suffer a partial cancellation of the lease.
Three reasons exist to support the Oklahoma view.
One is that
it might be in the national interest to promote as much exploration
as possible even to the extent of diminishing the lessee's contract
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rights.
The primary Texas cases opposing the impl ied covenant of
exploration came out in the late 1950 l s and early 1960 1 s.
At that
time not much concern over diminishing oil reserves existed.
Since
that time much concern has been centered around the diminishing oil
reserves and it might be that the Texas view that allows lessees to
sit on their lease without any further exploration is outdated.
By
requiring the lessee to explore without regard to profitabil ity,
this would promote the national
interest event to the extent of out-
weighing what one Michigan writer has said is the unfairness in depriving the lessee of what he has paid for and has invested money
in. 25
The second reason to uphold the Oklahoma view is based on the
purpose of the lease as compared to the equities involved.
As the
Dorr case said:
To permit the lessee to hold the lease for an unreasonable
length of time for merely speculative purposes, is to allow
him to protect his
own interest and to disregard the "inter,
est of the lessor.
If conditions do not indicate to him
that further development will be profitable, it is but fair
that after a reasonable time has expired he surrender the
undeveloped portions of the lease and allow the lessor to
procure development by others or assume the burden of showing why in equity and good conscience the undeveloped portion should not be cancelled so that the owner may, if
possible, get it developed by others. 26
Flexibility is another reason why the equity view of Oklahoma
is superior.
Equity seeks justice rather than technicality.27
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Those
that have described the ruin of the lessee because of the Oklahoma
or Myers impl ied covenant of exploration doctrine have had to have
seen a turn around in the cases for the lessee.
consideration both the lessor and lessee.
Equity takes into
While the earl ier cases
such as Sauder, which held a 17 year interval between the last drilling and the suit to be unreasonable, or the Dorr case, which held 14
years to be unreasonable and held for the lessor or Crocker 28 which
held a 36 year interval to be unreasonable, the courts began to apply
the brakes.
As the court in Will ingham said:
The covenant of further explanation need not become a leasebreaking device and will not become one if the courts exercise control over it. 29
This contention is supported in various cases.
While the ear-
l ier cases put great emphasis on the time elapsed, other cases began
to look at all the circumstances with the question of length of time
only another factor to be considered. 3D
To support this contention
the Union Oil Company of California v. Jackson 31 case dealt with a
lessee who had failed to drill a well for approximately ten years.
The Supreme Court of Oklahoma held for the lessee because he had engaged in extensive drilling surrounding the lessor1s land and had
expended amounts of up to $4,500,000 for exploration and development
in the immediate area.
Also, the lessee had conducted extensive ge-
ological and geophysical surveys and engineering field studies relating to the lease.
The court held that cancellation of the lessee1s
lease would have been inequitable after so much expenditure of time
and money.
In Skelly Oil Company v. Boles no drill ing had been done for 16
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years, yet the court held for the lessee because the lessee had done
prel iminary work toward investigation of deeper strata. 32
Also in West v. Sun Oil Company a 1971 case, the court held
that they would not cancel a lease when the lessee had drilled a
well a year earl ier and had indicated a will ingness to drill to
deeper strata and had already conducted expensive exploratory operations. 33
Another aspect of equity principal for the lessee arose in
Trust Company of Chicago v. Samedan Oil Corporation where the lessee
took a 40 acre tract and drilled one well on the northwest 10 acres
and one well on the southeast 10 acres.
The lessor asked the lessee
to develop the other 20 acres and the lessee refused and the Federal
Appeals Court sustained the lessee.
In the case the lessor's geolo-
gist and the lessee's geologist advised against development and the
court said that it would be inequitable to impose on the lessee a
duty to drill additional wells when positive proof of unproductivity
existed. 34
The Ferguson v. Gulf Oil Corporation case said in summary:
The rule laid down in the Dorr case is to protect the lessor
from inequabil ity of position that exists between the lessor
and the lessee and to correct the inequity arising from the
failure of a lessee to carry out the purposes for which the
lease was given, yet it is a rule of equity and should be
appl ied only where it will effectuate justice.
It should
not be used to permit a lessor to secure cancellation so that
he may sell a new lease on the land at a speculative price
made possible by large expenditures of a lessee in drill ing
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nearby tests.
Neither should it be used to penal ize a lessee for
the exercise of caution in the conduct of an expensive and hazarcous enterprise, which if successful will aid both the lessor and
lessee. 35
What these last few cases have shown is that "Equity regards
substance and not form" and to understand the cases one must look
at the circumstances of each to determine on which side 1 ie the
demands of justice and fair play.
When in cases such as Dorr and
Sauder, the lessor has shown an unreasonable time elapsing, the
courts have held for the lessor.
While with Union Oil Company of
Cal ifornia or West when the lessee has demonstrated a will ingness
to investigate or test for other producing formations, the courts
have held for the lessee.
It would be inequitable to do otherwise.
The requirement for the lessee is that the activities be calculated
to ultimately conclude with production from the lessor's property.36
Then there will be no cancellation.
As far as the Texas cases go involving the impl ied covenant of
further development, they have held that a lessee has no duty to develop a lease unless a reasonably prudent operator would have developed it.
They have not said anything about equity and have directly
overruled the impl ied covenant of further exploration in Cl if ton v.
Koontz.
If one however forgets Myers impl ied covenant of further
exploration and just looks at the equities involved in the various
cases, one can see the similarities between the Oklahoma cases and
the Texas cases.
In fact, in Cl if ton, the court although not call ing
it equity in 1 imiting its opinion to situations not involving large
tracts with production from small areas or situations involving un-
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reasonable lengths of time since the last development of ,the leased
premises was showing that there could be times when the equities
fall
in favor of the lessor and he would be entitled to cancellation
of the lease without regard to the reasonableness of a prudent operator.
This can be substantiated by looking at the substance of the .
Cl if ton and Felmont Oil Corporation 37 cases, rather than at the rules
used.
In Cl if ton , the court held for the lessee, holding that the
lessee was not required to drill a second well.
One of the princi-
pal factors was that it was a 350 acre tract in which the Railroad
Commission 1 imited the number of wells and the allowable and the
total allowable for two wells would have been the same allowable for
one well.
Thus it would have been unproductive for the lessee to
develop further and as the Oklahoma Court of Samedan Company of Chicago said in holding for the lessee that there is no absolute duty
on the lessee to drill additional wells in face of positive proof
of unproductivity.
The equities are against it.
Likewise here the
equities were against the lessee drill ing another well.
Also in Felmont Oil Corporation, the appeal court held for the
lessee.
The case involved a 31,000 acre lease and very few wells
being drilled over a long period of time.
At first glance the case
would seem to be opposite the Oklahoma decisions and require a decision for the lessor because of the time factor and lack of development involved.
As in the facts of the case, however, it shows the
1essee as engag i ng ina cont i nuous Ilexp 1orat i on" of the 1ease by
geophysical methods and surveys.
This, like the Oklahoma West v.
Sun Oil Company case, demonstrated a will ingness on the part of the
lessee to investigate or test for producing formations even though
over a long period of time.
Thus since the lessee was engaging in
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activities calculated to ultimately conclude in production, the
equities would have prohibited the court from holding for the lessor.
What I am saying is that although the Texas courts have not
spoken in terms of equity, these two cases do fit into a pattern
deal ing with fairness.
Since C1 if ton did limit its decision so
that the burden would not fall too heavily on the lessor if the
lessee failed to further develop on large acreage or for long periods of time, some
precede~ce
does exist for equity in Texas not-
withstanding the refusal to use the imp1 ied covenant of future exploration.
A case following this rationale was Sinclair Oil & Gas Company
v. Masterson 38 which held that when only 7 wells had been drilled
on 90,000 acres this placed too heavy a burden on the lessor thus
holding for him.
As the Sauder and Sinclair case said, IINecessari1y
each case depends for dec i s i on upon its own facts. 1139
Thus the Texas courts have said that they would not use Myer's
imp1 ied covenant of exploration.
However, they have turned around
and left open that in certain circumstances they might use the basis
of the doctrine, that is the equity principal.
Likewise the Texas
courts have said that they would use the implied covenant of further
development based on the reasonably prudent operator but then in
C1 if ton they turned around and said that this might not be the case
in all circumstances.
in the paper.
This did not fit the rule as defined early
Thus the court said that they were not going to use
equity of Myers, but yes they would use equity in some situations.
Therefore, the underlying basis of the imp1 ied covenant of further
exploration, equity : already exists without regard to the terms used.
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Even if it is insisted that the Texas courts do not now use an
equity standard, basing their cases absolutely on the prudent operator test, they should go to an equity test, keeping in mind the purposes of the lease, the fact whether a reasonably prudent operator
would drill, the time factors involved and whether the lessees activities are reasonably calculated to conclude in production.
This
would still keep the Texas standard, but also add time as a factor,
although not requiring the lease to be terminated after a particular
time.
The one basic feature would be that the Texas courts would
have to recognize that the lease is for the lessor also and that he
has a right to receive royalties from the lease or have the privilege of making some other arrangement for the mineral contents of
the lease.
Because of this, Texas should, if it already has not, go
to an equ i ty "test" as to whether the 1essee has fu 1fill ed his "dut i es ll
as a lessee.
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lMeyers, The Effect of Express provisions in an Oil &
Gas Lease on Implied Obligations, 14th Ann. Inst. on Mineral
Law 90 (1967).
2u.s.
v. City of Pawhuski, 502 F.2d 821,824 (10th Cir. 1974).
3Sanders v. Birmingham, 214 Kan. 769, 522 P.2d 959 (1974).
4l&. at 965.
5Id . at 965.
6TemPle v. Continental Oil Co., 182 Kan. 213, 320 P.2d 1039
(1958).
7Felmont Oil Crop. v. Pan Am. Petroleum Corp., 334 SW.2d
449 (Tex. Civ. App. 1960).
8Dos s Oil Royalty Co. v. Texas Co., 192 Okla. 359, 137
P.2d 934 (1943).
9Nolan v. Thomas, 228 Ak. 572 SW.2d 727 (Ark. 1958).
10Meyers, The Implied Covenant of Further Exploration" 34
Texas L. Rey. 553 (1956).
llDos s Oil Royalty Co. v. Texas Co., 192 Okla 359, 137 P.2d
934 (1943).
12292 U.S. 272 (1934).
13Dos s Oil Royalty Co. v. Texas Co., 192 Dkla 359, 137 P.2d
934 (1943).
14Skelly Oil Co. v. Boles, 193 Okla. 308, 142 P.2d 969 (1943).
15Meyers, The Implied Covenant of Further Exploration, 34
Texas L. Rey. 553 (1956).
l~cKenna v. Nichlos, 193 0 lao 526, 145 P.2d 957, 960 (1944).
17Trust Co. of Chicago v. Samedan Oil Corp., 192 F.2d 282,
286 (10th Cir. 1951)
(0
18Union Oil Co. of California v. Jackson, 489 P.2d 1073
1971).
la~
19Wolfson Oil Co. v. Gill, 309 P.2d 282 (Okla. 1957).
20Meyers, The Effect of Express Provisions in an Oil &
Gas Lease on Implied Obligations, 14th Annual Inst. on_Mineral
Law 90 (1967).
21 160 Tx. 82, 325 SW.2d 684 (1959).
22Sauder v. Mid-Continent Petroleum Corporation, 292 U.S.
272 (1934).
23willingham v. ' Bryson, 294 SW.2d 421 (Tex. Civ. App. 1956).
24ReynoldS v. Smith, 231 Ak. 566, 331 SW.2d 112 (1960);
Sauder v. Mid-Continent Petroleum Corp., 292 U.S. 272 (1934).
25Decker, Covenants Implied in Oil & Gas Leases, 42 Mich. S.B , J
21,25 ~ (1963).
26Doss Oil Royalty Co. v. Texas Co., 192 Okla. 359, 137 P.2d
934,938 (1943).
27lQ. at 93 6 .
28Crocker v. Humble Oil & Refining Co., 419 P.2d 265 (Okla. 1965).
29Willingham v. Bryson, 294 SW.2d 421,423 (Tex. Civ. App . 1956).
30McKenna v. Nichios, 193 Okla. 526, 145 P.2d 957,960 (1944).
31 489 P.2d 1073 (Okla. 1971).
3 2193 Okla. 308, 142 P.2d 696.
33490 P.2d 1073 (Okla. 1971).
34 192 F.2d 282 {10th Cir. 1951).
35192 Okla. 355, 137 P.2d 940,943 (1943).
36west v. Sun Oil Co., 490 P.2d 1073,1076 (Okla. 1971).
37Felmont Oil Corp. v. Pan Am. Petroleum Corp., 335 SW.2d 449
(Tex. Civ. App. 1960).
3 8 271 F.2d 310 (5th Cir. 1959).
39 Id . at 321.