15 Feb On the Nature of the Executive Right to Lease for Oil and Gas

by Rollin Wood

Property law typically describes ownership of land with a bundle of sticks analogy. From the starting point of fee simple ownership of land, someone holds the entire bundle. Each “stick” or right may then be conveyed in perpetuity or for a period of time, subject to statutory and common law limitations. In states with a history of oil and gas production, landowners historically severed the totality of their interest in land by separating ownership of the minerals from the surface via grant or reservation.[1] The result of such severance is the creation of a mineral estate, the “most complete ownership of oil and gas recognized in law.”[2] Attending the mineral estate are numerous rights, powers, privileges, and immunities which may also be severed or carved out even further.

Rights pertinent to oil and gas leasing are what the Texas Supreme Court has described as the five essential attributes of a severed mineral estate:

• The right to develop (the right of ingress and ingress);
• The right to lease (the executive right);
• The right to receive bonus payments;
• The right to receive delay rentals; and
• The right to receive royalty payments.[3]

There is some argument as to whether or not the right to develop and the executive right are actually distinct rights, instead being fused or correlative.[4]Setting aside theoretical differences for the moment, the second right is recognized in Colorado[5] as a unique component of the mineral estate. From this executive right flows various rights and privileges, but also obligations to the nonexecutive owner. This article is an attempt at a relatively narrow exposition of the law as it relates to carving out this categorical right to lease – or executive right – focusing on delineating the contours of its relationship with the remaining non-executive mineral interest from which it was carved.[6]

THE NON-EXECUTIVE MINERAL INTEREST

A non-executive mineral interest means the owner of the mineral interest has ceded their right to lease the interest. The non-executive mineral owner still reserves the right to receive their share of any bonus or royalty paid in relation to the involved mineral interest lease as granted by the holder.

Some parties to an oil and gas conveyance may find it agreeable to vest the executive right in one party over another for a variety of reasons. For example, a landowner grantor may convey the entire surface, but retain an undivided one-half interest. The parties decide that it is in the best interest of the new surface owner to be able to negotiate the terms of one or two leases due in part to owning the surface, their proximity to the land, issues of accessibility, and so on. Thus, the seller will make clear in the instrument of conveyance that they are also conveying the right to execute oil and gas leases.

To complicate matters, there are different categories of non-executive interests. The following are two prevalent examples:

• Royalty Interest. The right to receive part of the oil produced free of exploration and production costs. Royalties may be granted for the life an existing lease or in perpetuity. Assuming the grantee receives a perpetual royalty interest, they have no right to explore, develop, to execute leases, or to receive bonus and rental from any lease executed by the executive right holder.
• Non-Executive Mineral Interest. Essentially a royalty interest, but with the added benefit of sharing in bonus and rental from oil and gas leases.[7] All the same, an instrument of conveyance could exclude the NEMI owner from bonus or rental, or could specify that the owner participate in bonus and rental yet be excluded from royalty.[8]

Whether or not the parties intended to create one or the other may not appear straightforward based on the language used in the reservation or grant. In characterizing the type of interest created, courts attempt to ascertain the intent of the parties “as determined, if possible, within the four corners of the document.”[9]

THE RIGHT TO CONVEY THE EXECUTIVE RIGHT TO LEASE

Prior to 1991, no Colorado case discussed the right of a fractional mineral interest owner’s ability to convey the executive right to lease.[10] That year, with the passage of C.R.S. § 38-30-107.5, the Colorado legislature confirmed that “[a]ny conveyance, reservation, or devise of a royalty interest in minerals … , whether of a perpetual or limited duration, contained in any instrument executed on or after July 1, 1991, creates a real property interest which vests in the holder or holders of such interest the right to receive the designated royalty share of the specified minerals … in accordance with the terms of the instrument.”[11]

Despite the express statutory reference to July 1, 1991 and a lack of retroactive effect, it has been held by the Colorado Court of Appeals that the creation of nonparticipating royalty interests in oil and gas was were legally permissible prior to the passage of the act.[12] The legislative history makes clear that the purpose of the act was to clarify disagreements about the law, and bring it into line with the rest of the nation, not to reform it.[13] Despite being described as rooted in “considerable antiquity”, there remains potential conflict with earlier Colorado holdings at common law that the right to share profits from a mineral estate results in an ownership share in the mineral estate itself, rather than a non-participating royalty interest. [14]

That same year, Mull Drilling Company, Inc. v. Medallion Petroleum, Inc.involved competing operators who had signed leases with concurrent fractional mineral owners in the same land. The successor in interest to an undivided one-fourth mineral interest did not have the executive right to lease, but went ahead and executed an oil and gas lease with Medallion Petroleum. Plaintiffs claimed leasehold title pursuant to various leases by successors to the holders of other mineral interests, as well as the executive rights holders to the same one-fourth interest. [15]

The court’s analysis turned on the right to convey executive rights, distinguishing between non-executive mineral interests and royalty interests, and the differing lease benefits which flow from that distinction.

The reservation provision at issue stated:

Excepting and reserving out of the grant … an undivided one-fourth interest in and to all oil, gas and other minerals lying in, upon or under [the subject lands], such reservation and exception being non-participating in any leases, participation being limited to royalties only payable under said leases, and it shall not be necessary for [the] grantors, heirs or assigns, to join in the execution of any leases.[16]

First, despite the warranty deed lacking any words of inheritance, the court stated that the covenant to quiet and peaceable possession in statutory short form warranty deeds made the conveyance of the executive right binding upon the grantor and their successors in interest. Therefore, the right to execute oil and gas leases was effectively conveyed in perpetuity, subject only to the reserved right to receive royalties. [17]

Recognizing the dearth of executive rights cases in Colorado, the appellate court adopted the general rule found in Texas and espoused by leading commentators that “the owner of a mineral interest has a right to convey to another the executive right to lease such interest.” [18]

Second, the defendant Medallion Petroleum contended that the oil and gas leases executed by plaintiff operators were invalid, because they had not paid delay rentals or bonus payments to the non-executive owner. The court examined the deed’s reservation provision again, this time focusing on the “limited to royalties only payable under said leases” language. Since lease benefits inuring to a non-executive mineral owner are entirely dependent upon the terms of the deed creating his interest, the court held that the one-fourth interest in the oil and gas estate was limited to royalties, which participate only in production of oil or gas on the land, and not in bonus, delay rentals, or the right to execute leases. In other words, had the reservation expressly included the right to participate in bonus and delay rentals, it would have been considered a non-executive mineral interest, with those additional lease benefits.[19] In sum, the leases executed by the operators with the owners of the executive rights were valid, whereas the lease with the non-executive royalty owner was ineffective to cover those one-fourth interests.

The lesson to take home is that participation in lease benefits may be further limited or rearranged based on the language used in the provision of the instrument, as the parties see fit to negotiate.[20] Parties to a conveyance of the mineral estate must be mindful and precise in their choice of words, especially when severing rights inhering in the mineral estate. As each right is plucked away, certain attendant benefits may escape the unwitting and interfere with their true intent, both for themselves and their future successors.

DUTY OF UTMOST GOOD FAITH AND FAIR DEALING

A frequently recurring issue is the precise scope of the duty owed by the executive right holder to the non-executive in leasing for oil and gas. To paraphrase The Supreme Court of Texas, the executive’s duty is simple in explication, but difficult in application.[21] Due to the lack of Colorado jurisprudence on the matter, the rest of this article will provide examples of the majority opinion and its rationale.

Most jurisdictions that have addressed the issue hold that there is an implied duty of utmost good faith and fair dealing.[22] This standard “requires that the executive act with reasonable regard for the interests of the non-executive and be willing to execute a lease for the non-executive on the same terms and conditions as a reasonably prudent landowners would have done had there been no non-executive interest.”[23] Through a series of cases, Texas jurisprudence reiterates that the executive must acquire for the non-executive every benefit that he exacts for himself.[24]

This is not to say that the executive rights holder must execute oil and gas leases simply when the opportunity presents itself. This duty typically springs into being during the exercise of the power to execute leases, i.e., when the executive signs on the dotted line of an oil and gas lease.[25] The difficulty lies in defining the latitude and discretion of the executive in negotiating and obtaining benefits for itself as well as for the non-executive.[26]

The same standard is found in Louisiana Mineral Code § 109. The following passage succinctly elucidates the intent behind the Civil Law codification in that state:

Where the interests of the executive and non-executive coincide, the … improper exercise … [of the executive right] due to carelessness, inattention, indifference, or bad faith will result in liability. Where the interest of the executive and non-executive diverge, the executive will not be bound to a standard of selfless conduct, such as that imposed on trustees or guardians. He may exercise the executive right with the same self-interest in mind as if there were no outstanding royalty or non-executive mineral interest. But the executive cannot exercise … the executive right for the purpose of extinguishing the non-executive interest, or for the purpose of benefitting himself at the expense of the non-executive. If the conduct of the executive satisfies the ordinary, prudent landowner standard, the fact that the non-executive owner has been harmed is not actionable under this view. But if an ordinary, prudent landowner, not burdened by an outstanding non-executive interest, would have acted differently, then the executive’s conduct is actionable if it causes harm. We believe this standard fairly effectuates the intent of the parties; it does not require more than can be expected of ordinary landowners and it does not permit less, especially where the ‘less’ is due to the executive’s effort to profit at the expense of the royalty or non-executive mineral owner.[27]

This also epitomizes the majority rationale for turn of the 21st century jurisprudence on the duty of the executive to non-executives. Until recently, cases often focused on the implied covenant to develop, only exists as a result of an existing oil and gas lease.[28] If an executive never leases its own mineral estate then it cannot be said to have obtained a benefit to the non-executive’s detriment, i.e., it cannot breach a duty that does not yet exist.[29] The problem with this approach is most obvious when a surface owner holding the executive power to lease minerals may decide to never execute a lease in an effort to protect its investment in the surface estate. The ability to remedy this issue was partially examined in the 2011 Texas case Lesley v. Veterans Land Board.[30]

In Lesley, two conveyances resulted in a real estate developer receiving the surface estate to 4,100 acres, as well as the executive rights covering the entire mineral estate. Former landowners held an undivided one-half mineral estate lacking those executive rights.[31] The land was located above the Barnett Shale during a time of booming horizontal hydraulic fracturing development. The developer created a subdivision of 1,200 lots, and in an effort to induce purchase advertised that no oil and gas operations would take place.[32] The developer deeded lots to roughly 1,700 owners containing restrictive covenants forbidding oil and gas operations, despite evidence that the subdivision was “sitting on $610 million worth of minerals that, in large part, [could not] be reached from outside the subdivision.”[33] Numerous issues were at stake in the case, but the principal ones involved the nature of the duty that the executive right holder owes to the non-executive.[34]

From the starting point that an executive’s duty of good faith and utmost fair dealing is fiduciary in nature, the Texas Supreme Court declined to address whether a general rule was required due to widely differing circumstances in which these cases arise. Moreover, the court found that the developer “exercised its executive right to limit future leasing by imposing restrictive covenants on the subdivision.”[35]

The court noted “[i]t may be that an executive cannot be liable to the non-executive for failing to lease minerals when never requested to do so, but an executive’s refusal to lease must be examined more carefully. If the refusal is arbitrary or motivated by self-interest to the non-executive’s detriment, the executive may have breached his duty.[36] This is because revenue comes through leasing for most mineral owners. If the executive power were wielded arbitrarily or to the non-executive’s detriment it could destroy the mineral estate’s value while simultaneously appropriating other, non-mineral benefits for the executive. Thus, the developer breached its duty to the non-executive mineral owners, the remedy being cancellation of the restrictive covenants found in the deeds to the lot owners.[37]

CONCLUSION

The result in Lesley reflects the basic understanding that no matter what the parties’ intent was in vesting the executive right in someone other than the mineral owner, it surely was not done to stifle development of the minerals.[38] Rather, it serves many development minded functions. It is a useful tool to help facilitate leasing when placed in the hands of a single, sophisticated party.[39]The ability to convey the executive right also helps in cases of mineral owners who are minors or people with other legal disabilities requiring guardianship.[40]

While the ad hoc nature of deciding cases based less on a bright line rule and more on circumstances may open the door to more litigation on the issue,[41]this flexible approach should help better define the ill-defined nature of the executive’s duty to the non-executive while serving public policy in the mineral development process. In the post-Lesley landscape, these non-executive interests are further protected by buttressing the classic self-dealing formulation with an additional prohibition on arbitrariness on the part of executive right holders. Such an approach should enhance the balance between the parties’ bargained-for rights. While the duty of an executive to the non-executive may not rise to the height of a true fiduciary, the fundamental inquiry remains the same: whether the executive engaged in acts of self-dealing that unfairly diminished the value of the non-executive interest.[42]

• [1] Richard C. Maxwell, et al, Oil and Gas: Cases and Materials at 511 (8th Ed. Foundation Press 2007), citing Martin & Kramer, Williams & Meyers Oil and Gas Law § 301.
• [2] Id.
• [3] Altman v. Blake, 712 S.W.2d 117, 91 O&GR 346 (Texas 1986).
• [4] For a modern point of view that the executive right is not separate from, but rather correlative to, the development right, see French v. Chevron, 896 S.W.2d 795, 134 O&GR 111 (Tex. 1995).
• [5] For examples of jurisdictions which follow the principle that the sticks making up the mineral estate may be conveyed separately, see e.g., Mull Drilling Co., Inc. v. Medallion Petroleum, Inc., 809 P.2d 1124 (Colo. Ct. App. 1991); Westbrook v. Ball, 222 Miss. 788, 77 S.2d 274 (1955);Antelope Production Co. v. Shriners Hospital for Crippled Children, 236 Neb. 804, 464 N.W.2d 159 (1991); Boley v. Greenough, 22 P.3d 854 (Wyo. 2001).
• [6] For a thorough discussion of various non-executive interests in minerals, see Meyers & Ray, Perpetual Royalty and Other Non-Executive Interests in Minerals, 29 Rocky Mtn. Min. L. Inst. 651, 663 (1983); Patrick H. Martin, Unbundling the Executive Right: A Guide to Interpretation of the Power to Lease and Develop Oil and Gas Interests, 37 Nat. Res. J. 311 (1997); seealso Christopher S. Kulander, The Executive Right to Lease Mineral Real Property in Texas Before and After Lesley v. Veterans Land Board, 44 St. Mary’s L.J. 529 (2013).
• [7] This is due to the relationship between certain forms of ownership and the benefits derived from oil and gas leases. The cash bonus is often described as a premium paid as down payment, based on a per acre basis. Similarly, rental refers to consideration paid in exchange for the privilege of delaying drilling operations. Maxwell at 512-13. Compare these to the oil bonus or royalty bonus, which is payable directly out of production. Id.
• [8] Maxwell at 513.
• [9] Mull Drilling Company, Inc. v. Medallion Petroleum, Inc., 809 P. 2d 1124, 1125 (Colo. App. 1991), citing Brown v. Kirk, 257 P.2d 1045 (Colo. 1953); First National Bank v. Allard, 506 P.2d 405 (1972) aff’d, 513 P.2d 455 (1973).
• [10] Mull Drilling, 809 P.2d at 1125.
• [11] C.R.S. § 38-30-107.5.
• [12] Keller Cattle Co. v. Allison, 55 P.3d 257, 263 (Colo. App. 2002).
• [13] Keller Cattle, 55 P.3d at 263, citing Hearings on S.B. 34 Before the House Committee on Agriculture, Livestock, and Natural Resources, 58th General Assembly, First Session (Feb. 27, 1991); see also F. Erisman & D.G. Ebner, Grant or Reservation of Royalty Interests in Colorado: Senate Bill 91-34, 20 Colo. 1193 (June 1991).
• [14] See Corlett v. Cox, 333 P.2d 619 (Colo. 1958); Simson v. Langholf, 293 P.2d 302 (Colo. 1956).
• [15] The court is unclear as to whether or not the executive rights holders had executed a lease on behalf of the non-executive.
• [16] Mull Drilling, 809 P.2d at 1125 (emphasis added).
• [17] Id.
• [18] Id., citing Klein v. Humble Oil & Refining Co., 86 S.W.2d 1077 (Tex. 1935); 2 H. Williams & C. Meyers, Oil & Gas Law §§ 301 and 338 (1988); E. Kuntz, Law of Oil & Gas §§ 15.3 and 15.7 (1987).
• [19] Id. at 1126.
• [20] Id.
• [21] KCM Financial, LLC v. Bradshaw, 457 S.W.3d 70, 83 (Tex. 2015).
• [22] John S. Lowe, Oil and Gas Law in a Nutshell at 103 (Thomson Reuters 2009); See also Louisiana Mineral Code § 109 (“The owner of an executive interest is not obligated to grant a mineral lease, but in doing so, he must act in good faith and in the same manner as a reasonably prudent landowner … whose interest is not burdened by a nonexecutive interest.”).
• [23] Id.
• [24] Mims v. Beall, 810 S.W.2d 876 (Tex. App. 1991); see also Manges v. Guerra, 673 S.W.2d 180, 183 (Tex. 1984) (employing a fiduciary standard to impose punitive damages where the executive rights owner entered into a “sham transaction” in an effort to deprive the non-executive of her full interest).
• [25] See Maxwell at 641, citing 2 Williams & Meyers, Oil & Gas Law § 339.2 (stating that it “is the overwhelming majority position in the United States that the owner of an executive mineral interest owes to the owner of a nonexecutive interest some form of duty in exercising the executive right.”) (emphasis added).
• [26] Id.
• [27] Maxwell at 641-42, citing 2 Williams & Meyers § 339.2 at 209-210. For more in depth discussion, see C. Randall, Protecting the Rights of the Nonparticipating Mineral Owner, 20 Tulsa L. J. 433 (1984), available at http://digitalcommons.law.utulsa.edu/tlr/vol20/iss3/3.
• [28] See In re Bass, 113 S.W.3d 735 (Tex. 2003), citing Danciger Oil & Ref. Co., 154 S.W.2d 632, 635 (Tex. 1941).
• [29] In re Bass, 113 S.W.3d 735, 745 (Tex. 2002); accord Aurora Petroleum, Inc. v. Newton, 287 S.W.3d 373, 377 (Tex. App. 2009) (holding the executive had no duty to ratify a non-executive’s invalid lease because the executive did not enter into its own lease).
• [30] Veterans Land Bd. v. Lesley, 281 S.W.3d 602 (Tex. App. 2009) aff’d in part, rev’d in part sub nom. Lesley v. Veterans Land Bd. of State, 352 S.W.3d 479 (Tex. 2011).
• [31] Lesley v. Veterans Land Board of State, 352 S.W.3d 479, 481-82 (Tex. 2011).
• [32] Id.
• [33] Id. at 482.
• [34] Id. at 487.
• [35] Id. at 491.
• [36] Id.
• [37] Id.
• [38] Christopher S. Kulander, The Executive Right to Lease Mineral Real Property in Texas Before and After Lesley v. Veterans Land Board, 44 St. Mary’s L.J. 529, 569 (2013).
• [39] Id. at 582, citing Patrick H. Martin, Unbundling the Executive Right, A Guide to Interpretation of the Power to Lease Oil and Gas Interests, 37 Nat. Resources J. 311, 311-15 (1997), and John S. Lowe et al., Oil and Gas Law 602 (5th ed. 2008).
• [40] Kulander at 582.
• [41] See KCM Financial, LLC v. Bradshaw, 457 S.W.3d 70 (Tex. 2015).
• [42] KCM Financial LLC v. Bradshaw, 457 S.W.3d 70, 82 (Tex. 2015) (holding that the lease and circumstances in its execution must be considered as a whole, and while the failure to negotiate a market-rate royalty is a relevant factor it is not entirely dispositive of the question of breach of duty of utmost good faith and fair dealing).