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In 1985, the 2nd edition of ‘The Oil and Gas Lease in Canada’ by the late John B. Ballem, Q.C. was published. In his book Mr. Ballem re-iterated his previous calls for a “‘standard’ oil and gas lease which would adequately protect the position of the oil company while at the same time treating the mineral owner fairly”.1

In response to Mr. Ballem’s suggestion, a joint committee of the Canadian Association of Petroleum Landmen (the “CAPL”) and the Natural Resources Section of the Canadian Bar Association was formed. In 1988, this joint committee released a standard form of freehold lease agreement for use in Canada known as CAPL 88. This lease form adequately protected the position of the oil company but was by no means fair to the mineral owner.

The royalty clause in the CAPL 88 lease provides that the oil company-lessee “shall pay to the freehold owner-lessor a royalty in an amount equal to the current market value at the wellhead as and when produced of _________ percent (__%) of all the leased substances produced, saved and sold ...” and that “The Lessor shall bear its reasonable proportion of any expense incurred by the Lessee for separating, treating, processing and transportation to the point of sale beyond the point of measurement.”

Subsequent to the release of CAPL 88, some freehold owner-lessors who had producing gas wells on their property began to receive invoices, rather than royalty checks from their energy company-lessees. The costs to make these freeholders’ natural gas market-ready apparently exceeded the market value of the gas. The obvious conundrum of why energy companies, those sometimes champions of ‘happy capitalism’, would sell gas at a loss can easily be explained - the ‘expense incurred by the Lessee for separating, treating, processing and transportation’ were not the actual costs but included intangibles such as an allowance for overhead and a ‘reasonable’ return on the capital invested in the facilities. A 5% rate if return on investment might seem like nirvana to an individual yet some energy companies considered 30% or more to be a ‘reasonable’ rate of return for their investment in gas gathering and processing facilities.

In 1989, following a deluge of complaints from freeholders to the Public Utilities Board, the Farmer’s Advocate and Alberta’s Energy Minister, then Energy Minister Rick Orman wrote to the principle industry associations suggesting that the industry develop a “system of peer arbitration” which would resolve the problem without requiring regulatory intervention2. (see “FHOA Concerns”, “Deductions from Freehold Royalties”). In response, a number of industry associations formed a task force (“JP 90”).

No system of peer arbitration was forthcoming but JP 90 did suggest that future freehold lease agreements contain a negotiated cap on deductions expressed as a percentage of the royalty revenue. In 1991, a new form of CAPL lease known as CAPL 91 was released for use. The negotiated cap suggested by JP90 was included in CAPL 91: “... the royalty payable to the Lessor hereunder shall not be less than ________ percent (__%) of the royalty that would have been payable to the Lessor if no such expenses had been incurred by the Lessee.”

In FHOA’s view, the negotiated cap on deductions in CAPL 91 was a fair and reasonable method of addressing the problem of excessive deductions from freehold natural gas royalties however the new lease form failed to address a multitude of other unfair provisions in CAPL 88.

For instance, the ‘Suspended Wells’ clause in CAPL 91 is identical to the clause in CAPL 88 and provides that: “If, at the expiration of the primary term or at any time or times thereafter, there is any well on the said lands, the pooled lands, or the unitized lands, capable of producing the leased substances or any of them, and all such wells are shut-in or suspended, this Lease shall, nevertheless, continue in force as though operations were being conducted on the said lands, for so long as all the said wells are shut-in or suspended ...” (emphasis added). Almost any well in Alberta is ‘capable of producing’ some gas and many oil companies interpret the suspended well clause in CAPL 88 and CAPL 91 literally so as to allow them to continue a freeholder’s lease indefinitely as long as they have run production casing in a well bore on the lands (see “FHOA Concerns”).

The CAPL 99 lease was released for use in late 2000. In CAPL 99 the Shut-In Wells clause states that if there is a well on the freehold owner-lessor’s lands or lands pooled or unitized with the owner’s lands at the end of the primary term or any time thereafter which is “completed for and capable of production of the Leased Substances ... and such well is shut-in, it shall be deemed that Operations are being conducted, for so long as such well is shut-in”. CAPL 99 also provides that if the well(s) on the freeholder’s lands or lands pooled or unitized therewith has not produced for at least 720 hours in any year after the primary term, the energy company-lessee shall pay to the freehold owner-lessor a shut-in well payment equal to the original bonus consideration for the lease divided by the number of years in the primary term.

Although CAPL 99 is preferable to CAPL 91 from the standpoint of freehold owners because of its more lessor-friendly Suspended Wells clause, all three lease forms allow lease continuation with wells which are “capable of producing the leased substances” or “completed for and capable of production of the Leased Substances”. In 2008, the meaning of the phrase ‘capable of producing the leased substances’ in a CAPL 91 lease of one of FHOA’s members came before the Alberta Energy Regulator (formerly known as the “Energy Resources Conservation Board”) the AER (formerly known as the “ERCB”). FHOA intervened in the AER (formerly known as the “ERCB”) hearing. The AER (formerly known as the “ERCB”) ruled that the phrase meant that a well must be capable of producing leased substances in “meaningful quantities” in its existing configuration and state of completion3. The (AER (formerly known as the “ERCB”)) decision was appealed to the Court of Appeal of Alberta on the issue of whether the AER (formerly known as the “ERCB”) erred in its interpretation of the phrase. FHOA supported the intervention of its member before the Court.

In a unanimous September, 2011 ruling, the Court of Appeal dismissed the appeal4 stating that: “The lease is a contract through which the lessor and the lessee agreed to develop the leased substances for mutual benefit” and forcefully denouncing the concept of freehold leases being continued for speculative purposes. Both before the AER (formerly known as the “ERCB”) and the Court of Appeal, FHOA argued that the ‘capable of producing leased substances’ phrase should be interpreted as it is interpreted in oil and gas producing jurisdictions in the United States – produced in paying quantities. Neither the AER (formerly known as the “ERCB”) nor the Court of Appeal was prepared to go that far however the Madame Justice Carole Conrad, for the unanimous Court stated: “I do not see a significant difference between “meaningful” quantity and “paying” quantity ...”.

One might think that a ruling from Alberta’s highest court would be respected by the Canadian Association of Petroleum Landmen (the CAPL) and the Natural Resources Section of the Canadian Bar. Apparently not. The draft form of CAPL 2012 released by these entities for approval by industry associations contains a ‘Lease Continuation Beyond the Primary Term’ clause pursuant to which any shut-in or suspended well, irrespective of its ability to produce a meaningful or any quantity of leased substances, may continue the lease if the energy company-lessee makes a payment of $10 per acre per year to its freehold owner-lessor.

If you are approached to lease your mineral rights by a land agent using a CAPL lease, FHOA recommends that you attempt to negotiate a number of changes to the lease in order to more adequately protect your property rights (see “CAPL 99", "CAPL 99 Addendum", "CAPL 91" and "CAPL 91 Addendum" Addendums available to members - please log in).

Freehold owners should recognize that convincing a land agent, or the energy company that the agent represents, to accept an amendment to a CAPL lease form may be more difficult than negotiating a higher royalty rate or bonus consideration. In many instances a land agent and his contact at the energy company he represents will have been provided with an upper limit by company management for the bonus consideration, primary term, royalty rate and processing cap to be negotiated in a freehold lease. The job of a land agent is to secure a lease of your mineral interests at the lowest cost to his client, consequently the initial offer seldom represents the company’s upper limit and the agent or his energy company contact generally has the authority to accept a counteroffer. But land agents seldom have authority to amend the form of freehold lease used by an energy company. This authority often rests with the energy company’s upper management. Landmen dealing with requests to amend freehold lease agreements are sometimes reluctant to involve senior management in their relatively insignificant problems. Oftentimes your request for an amendment, although eminently reasonable, never crosses the desk of anyone with the authority to approve it.

 

End Notes:

1. The Oil and Gas Lease in Canada, Ballem J.B., 2d, [1985] University of Toronto Press, Preface
2. August 4, 1989 Letter, The Honourable Rick Orman, Alberta Minister of Energy, to Industry Associations
3. AER (formerly known as the “ERCB”) Decision 2009-037 (see www.ercb.ca under ‘Industry Zone’, ‘Decisions and Cost Orders’)
4. Omers Energy Inc. v. Alberta Energy Regulator (formerly known as the “Energy Resources Conservation Board”), Alta C.A. [2011] A.J. 2587

Freehold Petroleum & Natural Gas Owners Association

"Freehold Owners Association"

901, 1000 5th Ave SW, Calgary, AB, T4P 4V1 Telephone: 403-245-4438