The form of freehold oil and gas lease introduced in western Canada following the 1947 Leduc discovery had been developed in the United States and provided for the freehold owner of the resource to grant the energy company-lessee the right, but not the obligation, to search for, develop and produce the leased substances for a period of years (the primary term) and, if production was obtained during the primary term, the right to maintain the lease as long as production continued.
Oil was the focus of industry activity in these early years as markets for natural gas had not yet developed in western Canada. The ‘shut-in wells’ or ‘suspended wells’ clause was incorporated into freehold leases to address situations in which an energy company-lessee had drilled a well during the primary term of its lease and found natural gas but was unable to produce the gas due to lack of market. In fact, the clause was originally referred to as the ‘capped gas well clause’. Typical wording was:
“Where all wells on the said lands are shut-in, suspended, capped or otherwise not being produced as the result of a lack of or an intermittent market, lessee shall pay as royalty the sum of $100.00 per year, and if such payment is made it will be considered that gas is being produced from the said lands.” 1
In the late 1940’s and early 1950’s a hundred dollar annual payment was significant to prairie farmers struggling to recover from the depression. Even for the energy company-lessee, the magnitude of the payment had some meaning. In the context of the times, it was fair and reasonable for an energy company-lessee to be able to continue its lease with an annual payment of this magnitude until markets for the gas it had discovered materialized.
Over time, the magnitude of the annual payment under the shut-in or suspended wells clause has not changed materially. In the vast majority of existing freehold leases the annual payment is $1 per leased acre per annum – a sum which today is basically meaningless to both freehold owner-lessors and energy company-lessees.
Also over time, the infrastructure necessary to gather and market natural gas has been put in place throughout the areas of the prairie provinces where freehold mineral rights with the potential for natural gas production exist. The lack of market for natural gas, which was the impetus for including a shut-in or suspended wells clause in a freehold lease, has not been an issue in most of these areas for many years. However, the shut-in or suspended wells clause continues to exist in Canadian freehold leases. Citing the 3rd edition of the Oil and Gas Lease in Canada by the late John B. Ballem, Madam Justice Hunt, for the majority of the Alberta Court of Appeal in Kensington Energy Ltd. v. B.& G Energy Ltd., stated: “As Ballem observes, the shut-in well clause has been changed many times over the years. Most often to improve the position of the lessee”2 (what Mr. Ballem actually said was, “It goes without saying that the changes were all designed to improve the position of the lessee”3) (emphasis added).
In a number of instances, these changes have proven ineffective in continuing freehold leases with shut-in wells where the energy company-lessee has been challenged in court.
In 1987, where an energy company-lessee had relied upon a shut-in well clause which referred to a ‘lack of or intermittent market’, a shut-in well and token annual payments to continue its lease, the Alberta courts accepted evidence that a discount gas market existed and struck down the lease4.
In 1997, where an energy company-lessee had relied upon a shut-in clause referring to “a lack of, or an intermittent market or lack of transportation facilities or any other cause whatsoever beyond the Lessee’s reasonable control”, an Alberta Court of Queen’s Bench judge accepted evidence that both pipeline access and a market existed and struck down the lease.5
And in 2005, where a lessee had relied on a lease in which the 4th proviso to the habendum (see “Understanding Freehold Leases") provided that: “subject only to Clause 3 [the Shut-in Wells Clause] hereof, if any well on the said lands ... is shut-in ... as the result of a lack or an intermittent or uneconomical or unprofitable market, or any cause whatsoever beyond the Lessee's reasonable control, ...”, the Alberta Court of Appeal accepted evidence that there was an economic and profitable market on the 1999 anniversary of the lease and struck down the lease.6
Clearly where a lessee is continuing a freehold lease with a shut-in well in reliance on shut-in or suspended well provisions which refer to a lack of market, an intermittent market or an unprofitable market, the Alberta courts have not been sympathetic to the lessee if the evidence supports the existence of a such a market.
However, in leases where the provisions regarding shut-in wells make no reference to markets or causes beyond the lessee’s reasonable control, a different and more troubling judicial ruling was rendered by Alberta’s high court in 2008. In Kensington Energy Ltd. v. B. & G. Energy Ltd., the courts considered a lease in which the 3rd proviso to the habendum provided that “if at the end of the said term the leased substances are not being produced ... or ... production of the leased substances has ceased .... then this Lease shall remain in force ... or if any well on the said lands ... is shut-in, suspended or otherwise not produced for any cause whatsoever which is in accordance with good oil field practice, the time of such interruption or suspension or non-production shall not be counted against the Lessee.” The shut-in wells clause provided: “Subject to the provisions hereinbefore set forth, if all wells on the said lands are shut-in, suspended or otherwise not produced during any year ending on an anniversary date, the Lessee shall pay ... a sum equal to the delay rental ... and each such well shall be deemed to be a producing well ...”.
The trial judge had ruled that the shut-in wells clause had to be interpreted in the context of the 3rd proviso. He found that the shut-in well “had become essentially a dry hole” and because shutting-in a well which was essentially a dry hole was not in his view in accordance with good oilfield practice, he struck down the lease7. The majority of the Court of Appeal overturned the trial judge’s ruling. According to Madam Justice Hunt for the majority, the habendum provided for the lease to be continued by production or deemed production and the shut-in wells clause provided that if the delay rentals were paid, which they were, then the well was deemed to be producing.8
The wording of the habendum and shut-in wells clause in the Kensington lease was fairly common before the advent of CAPL leases and, as a result of the Court of Appeal ruling, freehold leases with this wording can be continued indefinitely with any shut in or suspended well which is not abandoned, provided the token $1 per acre per annum payment is made.
In FHOA’s view, Kensington was wrongly decided. As stated by Madam Justice Romaine who dissented at the Court of Appeal: “Interpreting Clause 3 in the way suggested by the majority would mean that it applies "regardless of the requirements of the third proviso", rather than "subject to" the habendum clause with its provisos.”
In 2008, FHOA’s board of directors approved the association supporting B. & G. Energy Ltd. in an application to the Supreme Court of Canada for leave to appeal the Alberta Court of Appeal ruling in Kensington. Unfortunately, B. & G. was in the process of being acquired, the company did not wish to complicate its sale with ongoing litigation, leave to appeal was not sought, and the Kensington decision stands.
Historically, the Alberta courts have been the only venue in which the validity of freehold leases could be challenged. However, Section 16 of the Oil and Gas Conservation Act provides, in part:
16(1) “No person shall apply for or hold a license for a well ... unless that person ... is entitled to the right to produce the oil, gas or crude bitumen from the well ...” and
16(2) “If, after 30 days from the mailing of a notice by the Board to a licensee ... the licensee fails to prove entitlement under subsection 1 to the satisfaction of the Board, the Board may cancel the license or suspend the license on any terms and conditions that it may specify”.
In 2006, EnCana Corporation requested a review by the Alberta Energy Regulator (formerly known as the “Energy Resources Conservation Board”) Resources Conservation Board (the “AER (formerly known as the “ERCB”)”) of a well license issued to DeSoto Resources Ltd. (such reviews are provided for under Sections 39 or 40 of the Energy Resources Conservation Act). EnCana, as owner of the freehold mineral rights, asserted that DeSoto’s lease of EnCana’s mineral rights was not valid and subsisting and consequently DeSoto did not have the right to produce. The AER (formerly known as the “ERCB”) (at the time the Alberta Energy and Utilities Board) reviewed DeSoto’s lease with EnCana, ruled that the lease had terminated and, because DeSoto had not established the right to produce, suspended DeSoto’s well license9 and ultimately issued a closure order for DeSoto’s well.
DeSoto subsequently sought leave to appeal the AER's (formerly known as the “ERCB”) ruling to the Court of Appeal of Alberta on the basis that the AER (formerly known as the “ERCB”) did not have jurisdiction to determine the validity of its lease. In dismissing the leave to appeal application, the Appeal Court stated: “There is no merit to the argument that the Board does not have jurisdiction to deal with the validity of the lease, at least to the extent and only to the extent of establishing entitlement to apply for the well licence.”10
Oil and gas industry lawyers were not pleased that a hearing before the AER (formerly known as the “ERCB”) could potentially offer freeholders a less expensive and more timely alternative to the courts in disputes over freehold lease validity. “Is the Board Bored?” read the headline of a May, 2009 CAPL Negotiator article in which the author stated: “What an absolutely brilliant way for lessors to go after lessees years before a Court decides whether a lease is valid and subsisting.”11
The concerns of industry lawyers were validated in June of 2008 when Montane Resources Ltd. sought, pursuant to Section 39 of the Energy Resources Conservation Act, a review by the AER (formerly known as the “ERCB”) of two well licenses issued to Omers Energy Inc. Omers had leased the mineral rights in issue from a FHOA member using a CAPL 91 lease and had drilled and suspended two wells on the property after the expiry of the primary term of the lease. Montane had ‘top-leased’ (entered into a lease which would become valid if the Omers lease terminated) the FHOA member’s mineral rights.
In August of 2008, the AER (formerly known as the “ERCB”) granted Montane’s request for a review. A hearing was held in early 2009. The fundamental issue before the AER (formerly known as the “ERCB”) in its review was the meaning of the CAPL 91 suspended wells clause. This clause provides for the lease to be continued beyond the primary term with a well which is shut-in or suspended irrespective of the reason. The only requirements are that a token annual payment (typically $1 per leased acre) be made to the freeholder and that the well be “capable of producing the leased substances”. The suspended wells clause in CAPL 88 is identical to that in CAPL 91. The ‘capable of producing the leased substances’ phrase is also found in the shut-in or suspended wells clause of many pre-CAPL leases.
In the 3rd edition of The Oil and Gas Lease in Canada, published in 1999, the late John B. Ballem stated: “more than 95 per cent of the leases currently being negotiated follow the CAPL form ...”12. Based on FHOA’s experience, the percentage is now higher.
The courts of the United States have almost uniformly interpreted the word ‘producing’ to mean ‘producing in paying quantities’ or in volumes sufficient for there to be a reasonable expectation of profit. However, most Canadian legal experts, including the late John B. Ballem, considered it “highly unlikely” that a Canadian court would expand the ‘capable of producing’ wording “to include any economic or volume conditions”13.
The Freehold Owners Association sought intervener status and was granted the right to fully participate in the 2009 AER (formerly known as the “ERCB”) hearing on its own behalf and on behalf of the FHOA member whose mineral rights were in issue. FHOA also supported the intervention of the FHOA member in the subsequent appeal of the AER (formerly known as the “ERCB”) ruling to the Court of Appeal of Alberta in 2011.
1. The Oil and Gas Lease in Canada, Ballem J.B., University of Toronto Press, 4d, 2008, p. 207
2. http://www.albertacourts.ab.ca/jdb/2003-/ca/civil/2008/2008abca0151.cor1.pdf, Par. 16
3. The Oil and Gas Lease in Canada, Ballem J.B., University of Toronto Press, 3d, 1999, p. 177 - 178
4. Blair Estate Ltd. v. Altana Exploration Co., (1987) A.J. No. 554 (Alta. C.A.)
5. 549767 Alberta Ltd. v. Teg Holdings Ltd., (1997) A.J. No. 321 (Alta. Q.B.)
6. Freyberg v. Fletcher Challenge Oil and Gas Inc., (2005) A.J. No. 108 (Alta. C.A.)
7. Kensington Energy Ltd. v. B. & G. Energy Ltd., (2005) A.J. No. 1672 (Alta. Q.B.)
8. Kensington Energy Ltd. v. B. & G. Energy Ltd., (2008) A.J. No. 440 (Alta. C.A.)
9. AER (formerly known as the “ERCB”) Decision 2008-047, http://ercb.ca/decisions/2008/2008-047.pdf
10. Desoto Resources Ltd. v. Alberta (Energy Utilities Board), (2008) A.J. No 1156 (Alta C.A.) Par. 2
11. The Negotiator, May, 2009, p. 9, http://www.landman.ca/publications/Negotiator/2009/may/may09_layout.pdf
12. The Oil and Gas Lease in Canada, Ballem J.B., University of Toronto Press, 3d, 1999, p. 4
13. Ibid, Note 1, p. 154