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How implied covenants may cause a breach of an oil and gas lease

On Behalf of | Jul 30, 2020 | Business Law |

How can a court rule that one party in an oil and gas lease is in breach of contract when the supposed terms breached are not actually in the contract?

The answer lies in the legal concept of implied covenants, which are agreements that contract terms suggest but do not directly address. The LSU Journal of Energy Law and Resources explains how these may affect oil and gas leases.

History of court rulings

In the past, courts have ruled in favor of implied covenants, and they set precedents for oil and gas lease agreements.

For example, the implied covenant of reasonable development indicates that the lessee will continue to drill wells to thoroughly develop the underlying resources. This prevents a lessee from drilling one well and then leaving the rest of the property undeveloped for the remainder of the lease. The need for this unstated agreement arises from the uncertain nature of oil and gas discovery and extraction, which makes it difficult to initially determine and indicate how many wells the lessee will drill.

Prompt drilling of the initial test well, drainage protection, further exploration, surface restoration and marketing matters are other common implied covenants.

Standards of compliance

Determining whether the lessee complied with the duties of the implied agreement is not so cut and dried. The standard for lessees is to act as reasonably prudent operators, but courts do not necessarily hold lessees to a fiduciary standard or require them to exercise perfect judgment. However, lessees should be able to show that they acted in accordance with both their own interests and the lessors.

Defenses for breach of implied covenants

Often, the terms of the lease negate one or more of the commonly recognized but unstated agreements. Alternately, the lease may expressly state the extent of a particular obligation. So if, for example, the lessee agrees in the contract to drill a certain number of wells, then reasonable development would not apply.

Opportunity to cure

Lessors should provide the lessees of a perceived breach and give them time to correct the issue. While not all jurisdictions have this requirement, proving that the lessee is aware of the breach may be necessary. Often, oil and gas leases have express clauses requiring notification and opportunity to cure.

Many lessors seek termination of the lease as a remedy for a breach of an implied covenant.