Texas Court of Appeals interprets Horizontal Pugh Clause in oil and gas lease

On January 26, 2005, Community Bank of Raymore, as Trustee or Agent (“CBR”) entered into an oil and gas lease with Chesapeake Exploration L.L.C. and Anadarko Petroleum Corporation (collectively “Companies”). The lease covered approximately 16,000 acres in Loving County, Texas, which was divided into four blocks. During the primary term, the Companies drilled thirteen (13) producing wells on Block 2, to a formation at 5,672 feet below the surface. When the primary term expired on January 26, 2010, CBR requested the Companies to release the mineral rights to all formations below 5,672 feet. When the Companies refused, CBR sued for declaratory judgment and breach of contract.

CBR argued that the Horizontal Pugh Clause in the lease had been triggered because there was no production in paying quantities from the deeper formations when the primary term expired.

Horizontal Termination: At the expiration of the Primary Term or the conclusion of the continuous development program, this Lease shall terminate as to all of the leased Oil and Gas rights in all formations below the depth of 100 feet below the stratigraphic equivalent of the base of the deepest formation from which the Lessee is then producing Oil and/or Gas in paying quantities from a well or wells located on such proration or producing unit.

The Companies countered that the clause had not been triggered because they had maintained the lease beyond the primary term by securing production in paying quantities from Block 2’s existing wells and by developing Block 2 in accordance with the lease’s continuous development clause.[1]

The trial court ruled for the Companies, finding that the Companies were continuously developing the acreage in accordance with the lease, and therefore, the lease “remains valid and in effect as to all of the Leased Lands in Block 2…so long as [the Companies] engage in a continuous development program…” This decision was affirmed by Texas’ Eighth Court of Appeals. While stating that,“[i]n general, a horizontal Pugh clause holds a lease only to the stratum or level from which production has been secured in the unit during the primary term of the lease and, thus, frees the mineral interests below that depth absent additional development,” the Court of Appeals found that the Pugh clause in this case was different, operating “[a]t the expiration of the Primary Term or the conclusion of a continuous development program” (emphasis added). This Pugh clause provides a choice between two mutually exclusive possibilities.

Because the Companies have continuously developed Block 2, the Court of Appeals determined that the Pugh clause had not been triggered; and giving full effect to all the lease provisions, including the habendum clause,[2] the Court of Appeals concluded that the lease was not terminated.

This post was written by Barclay Nicholson (barclay.nicholson@nortonrosefulbright.com or 713.651.3662) from Norton Rose Fulbright's Energy Practice Group.

[1] Continuous Development of Undeveloped Acreage: This Lease shall terminate as to the undeveloped Leased Land at the expiration of the Primary Term of this Lease unless Lessee commences a continuous development program on the undeveloped Leased Land and in accordance with terms and provisions hereinafter set forth: 
(1) If at the expiration of the Primary Term, a producing well or well capable of producing is located on the Leased Land or if Lessee is engaged in the actual drilling of a well in search of Oil and/or Gas…, then Lessee shall thereafter have the option to continuously develop the undeveloped acreage with no cessation of more than one hundred eighty (180) days…Should Lessee not opt to continuously develop the undeveloped acreage…, this Lease shall terminate as to the undeveloped acreage at such time as Lessee fails [sic] continuously develop as so provided herein. 
[2] According to the Court of Appeals, “[t]he lease’s habendum clause reflects the general principle that production from 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.”