What Is Held by Production Clause?
A Held by Production (HBP) clause is a provision commonly found in an Oil and Gas Lease that allows the lessee, typically an energy company, to maintain the lease beyond its initial, fixed Primary Term for as long as oil or natural gas is produced from the leased property in Paying Quantities. This clause is a fundamental component within Oil and Gas Law and governs the duration of the mineral leasehold estate. The Held by Production clause essentially transitions the lease from a fixed-term agreement into an indefinite one, contingent solely on ongoing commercial extraction.
History and Origin
The concept of "held by production" has deep roots in the early 20th century, a period marked by a rapid increase in demand for oil and gas. During this era, leases were structured to encourage prompt drilling and production to ensure that valuable resources were not left undeveloped. The Held by Production clause emerged as a critical mechanism to allow lessees to continue operations without needing to renegotiate leases, provided production continued.7 This provided stability for energy companies' long-term development plans.
The modern relevance and frequent use of Held by Production clauses intensified with the advent of advanced drilling techniques, such as horizontal drilling and hydraulic fracturing, particularly in shale plays across North America. The successful application of these technologies in the mid-2000s, exemplified by independent natural gas companies in areas like the Utica and Marcellus Shale plays, led to a surge in leasing activity and significantly escalated lease prices. This boom further cemented the importance of the Held by Production clause in maintaining control over vast mineral acreage once production was established.,6
Key Takeaways
- A Held by Production (HBP) clause extends an oil and gas lease beyond its initial term as long as the property produces oil or gas in paying quantities.
- It protects the lessee's right to continue operations without renegotiating the lease, transitioning from a fixed primary term to an indefinite secondary term.
- "Paying quantities" generally means that production is sufficient to cover the operating costs of the well.
- Disputes often arise regarding what constitutes "paying quantities" or continuous production, leading to legal challenges.
- HBP clauses are crucial for both landowners (ensuring continued royalty income) and operators (securing long-term access to resources).
Interpreting the Held by Production Clause
Interpreting a Held by Production clause primarily revolves around defining "production in paying quantities." This critical phrase generally means that the volume and value of the oil or gas produced from a well must be sufficient to cover the costs of operating that well. It does not necessarily mean the well must be profitable overall, only that it generates enough revenue to offset its direct operational expenses, such as electricity, maintenance, and labor.
The exact interpretation can vary based on state law, specific lease language, and judicial precedents. Courts typically consider a reasonable period for evaluating whether a well is producing in paying quantities, accounting for temporary interruptions due to maintenance or market fluctuations. If production ceases for an extended period without sufficient justification or without the application of a Shut-in Royalty clause or other saving provisions, the Leasehold Estate may terminate. Lessees engaging in Drilling Operations must demonstrate a good faith effort to maintain production to satisfy the conditions of the Held by Production clause.
Hypothetical Example
Consider Sarah, a landowner who signs an Oil and Gas Lease with XYZ Energy Company. The lease includes a five-year Primary Term and a Held by Production clause. During the primary term, XYZ Energy drills a well on Sarah's property and begins extracting natural gas.
Once the primary term expires, the lease remains active solely due to the Held by Production clause, as the well is producing natural gas. Sarah continues to receive her Royalty Payment, which is a percentage of the revenue from the gas produced. If, however, the well's production declines to a point where it no longer covers its operating costs (i.e., it is no longer producing in paying quantities), and XYZ Energy does not take steps to restore production or utilize another saving clause in the lease within a reasonable timeframe, the Held by Production clause would no longer be satisfied. In such a scenario, the lease would typically terminate, and Sarah would regain full control of her Surface Rights and mineral rights, allowing her to potentially negotiate a new lease with another operator.
Practical Applications
Held by Production clauses are integral to the ongoing management and valuation of Mineral Rights and oil and gas assets. For energy companies, these clauses provide long-term security, allowing them to amortize significant upfront investment costs associated with exploration and drilling over the entire productive life of a well. This indefinite extension is especially valuable in active basins where property prices are high, as it prevents companies from having to renegotiate leases at potentially much higher rates.
Regulatory bodies, such as the Railroad Commission of Texas, play a role in overseeing production activities that relate to Held by Production status. While they do not typically adjudicate private lease disputes, their rules regarding well spacing, density, and production rates can indirectly affect an operator's ability to maintain a lease under a Held by Production clause. For example, new regulations on waste management or pipeline inspections can influence an operator's ability to cost-effectively maintain production.5 Furthermore, operators often use additional contractual provisions, like a Continuous Development Clause, to ensure continuous drilling activity across a larger leased area, even if only one well initially holds the lease by production.
Limitations and Criticisms
Despite their widespread use, Held by Production clauses are a frequent source of contention between lessees and lessors. A primary criticism is the ambiguity surrounding the "paying quantities" definition. Operators might maintain wells with minimal, barely economic production for years, effectively tying up acreage under an old lease while preventing landowners from seeking new, more lucrative lease agreements. This can be particularly frustrating for landowners in areas experiencing new drilling booms or where market conditions have significantly improved since the original lease was signed.4
Furthermore, the broad scope of some Held by Production clauses can lead to disputes over "retained acreage," where a single well's production is argued by the lessee to hold an entire, large tract of land, even if only a small portion is actively developed. Landowners may argue that the lease should partially terminate for undeveloped areas, especially if the operator has not diligently developed the entire leasehold. Litigation over such interpretations is common, often involving detailed financial analysis of well operating costs and production volumes to determine if a lease is truly "held by production." A Forfeiture Clause in a lease may offer recourse, but courts often interpret these clauses strictly, emphasizing that the primary purpose of a lease is development, not just the payment of Royalty Payments.3
Held by Production Clause vs. Pugh Clause
While both the Held by Production clause and a Pugh Clause relate to the duration and scope of an oil and gas lease, they serve distinct purposes. The Held by Production clause is a general provision that extends the entire lease's term indefinitely, as long as production in paying quantities occurs anywhere on the leased premises. It is fundamental to keeping a lease alive past its primary term.
In contrast, a Pugh clause is a specific addition to a lease designed to limit the amount of acreage or specific depths that can be held by production from a single well. Without a Pugh clause, a single producing well might hold an entire large lease, even if vast portions of the leased land are not being developed. A Pugh clause prevents this by stipulating that only the acreage within a defined drilling or production unit around a producing well will be held by production. Any acreage outside of that unit will typically revert to the lessor at the end of the primary term or after a specified period if not developed. This clause benefits landowners by incentivizing operators to develop all leased acreage or release undeveloped portions, potentially allowing the landowner to lease those portions to other companies.
FAQs
What does "paying quantities" mean in the context of a Held by Production clause?
"Paying quantities" generally refers to the production of oil or gas in amounts sufficient to cover the operational expenses of the well. It does not necessarily imply that the well is profitable after accounting for all initial drilling and completion costs, only that it generates enough revenue to offset its ongoing operating expenditures. This definition can vary slightly by jurisdiction and specific lease language.2
Can a lease held by production ever terminate?
Yes, a lease held by production can terminate if production in paying quantities ceases for an extended period and no other "saving clauses" in the lease (such as a Shut-in Royalty clause, a drilling operations clause, or a force majeure clause) are invoked. The lease typically specifies a period, often 60 or 90 days, within which production must be restored or remedial operations commenced to prevent termination.
How does an Assignment affect a Held by Production clause?
When an Assignment of a lease occurs, the new lessee (assignee) takes on the rights and obligations of the original lease, including the Held by Production clause. The clause continues to govern the lease's duration based on the production activities of the new operator. Landowners should be aware that the identity of the operator might change over the life of a lease.
Is a Held by Production clause the same as a Habendum Clause?
The Held by Production clause is a component within the Habendum Clause of an oil and gas lease. The habendum clause dictates the duration of the lease, typically stating a "primary term" (a fixed period) and a "secondary term," which is often tied to the Held by Production language (e.g., "so long thereafter as oil or gas is produced in paying quantities").1