• identification
• the grant
• the habendum
• habendum provisos
• the drilling clause
• the dry hole clause
• the 3rd, 4th and 5th provisos
• CAPL leases
• the interpretation clause
• the royalty
• ‘gross’ oil royalties
• ‘net’ gas royalties
• the Acanthus decision
• current market value
• the offset well clause
• the shut-in well clause
• pooling and unitization
• default
• miscellaneous clauses

• Land agents may attempt to include all of the mineral interests owned by a freehold owner in one lease agreement. If a freeholder owns more than a single quarter section of minerals, separate leases should be entered into for each quarter. Otherwise, a freehold owner-lessor may find himself in the position of having a lease of all of his mineral interests continued by operations or production on only one part of these interests, thereby reducing his opportunity to have all of his lands developed.

• Oil company-lessees have always attempted to define leased substances as broadly as possible so as to maximize their interest in the freehold owner’s petroleum or natural gas. However, nothing prevents a freeholder from excluding certain of the substances he or she owns from the lease agreement. For instance, most individual freehold owners hold title to all mines and minerals within, upon or under the surface area specified in their title certificate. The term ‘minerals’ includes not only petroleum and natural gas but other potentially valuable, naturally occurring substances such as sulphur, coal and helium (gold and silver are reserved to the Crown). Immense volumes of coal gas are absorbed in subsurface coal deposits underlying the western Canadian plains. If current high gas prices are sustained, some of this coal gas may become commercially viable. In most freehold lease agreements, coal is not defined as a leased substance, but gas or natural gas is. The issue of whether coal gas belongs to the owner of the coal from which the gas evolves or to the owner of natural gas has been litigated in the United States with mixed results. To date, there has been no litigation on this issue in Canada. FHOA suggests that, at least until the ownership of Canadian coal gas is judicially determined, a freehold owner would be wise to specifically exclude coal gas from the definition of leased substances - why should an oil company conducting conventional oil and gas exploitation on a freeholder’s lands obtain any interest in non-conventional resources which may exist within the owner’s lands?
• Many early lease forms imported terminology from the United States for use in the definition of leased substances. In the 1950's and 1960's, leased substances were frequently defined as “oil, gas, casinghead gas, casinghead gasoline, and related hydrocarbons”. Sulphur, which is not a hydrocarbon, has been recovered from sour gas pools in western Canada for decades. Due to the highly cyclical market for sulphur, during periods of depressed prices western Canadian producers have traditionally stockpiled sulphur production for future sale. Not only does the oil and gas industry have a less than stellar record in accounting to freeholders for their royalty share of sulphur when stockpile sales are made, but there is also some question as to whether oil company-lessees operating under freehold leases signed during the 1950's and 1960's have any right to the sulphur stockpiled and sold.
• A typical description of the exclusive rights and privileges granted in a lease form from the 50's or 60's is: “to explore, drill for, win, take, remove, store and dispose of the leased substances”. In later lease forms, the right to inject gas, air, water of other substances into wells on the freeholder’s lands was added. The ultimate recovery of oil from a subsurface pool can often be increased by injecting substances into selected well bores penetrating the pool, and freeholders should encourage their lessees to engage in these conservation measures. But the right to inject should only be granted by a freehold owner if it is clear from the wording of the clause that injection can be undertaken for no other purpose than obtaining, maintaining or increasing the production of leased substances on lands in which the freeholder has an interest.

The Habendum Clause: The habendum (from the Latin verb “to have”) clause is fundamental to a freehold lease agreement because it, together with its provisos, sets forth the conditions under which the lease agreement continues in force. The habendum typically begins with wording like this: “TO HAVE AND ENJOY the same for the term of ____ years from the date hereof and so long thereafter as the leased substances or any of them are produced from the said lands ...“.

• The fixed period of years set forth in the blank space is referred to as the ‘primary term’ of the lease (in most pre-1970 leases, there was no blank space and the primary term was “ten (10)” years). If production is not established during the primary term, the oil company-lessee’s legal interest in the freeholder’s mineral interests will expire. However if production is established during the primary term, then the lease agreement continues for as long as the production continues. This indefinite further period is known as the ‘secondary term’ of the lease.

Habendum Provisos - the Drilling Clause: In most pre-CAPL leases, what is known as the ‘unless drilling clause’ is the first proviso to the habendum clause. This proviso modifies the conditions under which the lease agreement continues in force by requiring the oil company to either drill or make a ‘delay rental’ payment to the freehold owner-lessor. Typical wording is as follows: 

“PROVIDED that if operations for the drilling of a well are not commenced on the said lands or the pooled lands within one year from the date hereof, this lease shall terminate and be at an end on the first anniversary date, unless the lessee shall have paid or tendered to the lessor on or before said anniversary date the sum of ____ dollars (hereinafter called the “delay rental”), which payment shall confer the privilege of deferring the commencement of drilling operations for a period of one year from said anniversary date, and that, in like manner and upon like payments or tenders, the commencement of drilling operations and the termination of the lease shall be further deferred for like periods successively.”

• Oil companies allocate their available drilling funds based on the their perception of the merit of the various drilling opportunities available to them. One of the factors determining merit is lease expiry - if a company has two drilling prospects but only enough money to drill one of them, and if the two prospects have the same perceived economic potential, the company will normally choose to drill the prospect which is located on the lease which expires first. This preserves drilling opportunities for the oil company. It also results in many situations where drilling is deferred until the final year of a freehold lease agreement, with the oil company-lessee relying on delay rental payments to continue the lease until this final year.
• Most leases contain a ‘Manner of Payment’ clause under which the freehold owner-lessor is deemed to have received a delay rental payment if it is mailed on or before a certain date. Usually this date is the anniversary date of the lease, but in some cases it is 48 hours, and in others 4 days, before the anniversary date. The Canadian courts have consistently interpreted the payment of delay rentals by an oil company-lessee under an unless drilling clause as an option which, if not properly exercised, results in automatic lease termination¹. Historically, many freehold leases containing unless drilling clauses have been terminated because the oil company-lessees either failed to pay delay rentals on time or failed to keep proper records of their payments.
• Normally, the legal onus is on the party relying on an option to demonstrate that the option has been properly exercised. For many years, it has been the practice of the oil and gas industry to make delay rental payments by registered mail, and to maintain records proving payment for at least as long as the lease continues. The extent to which the judicial pendulum has swung against freehold owners in recent years is demonstrated by a 1998 Alberta Court of Appeal decision upholding a lower court decision in which the onus was placed on the lessor to prove that a delay rental payment had not been mailed on time when the oil company-lessee had no record of the mailing². Such proof is clearly impossible in most circumstances as freehold leases almost invariably provide for delay rentals to be paid to a depository such as the freehold owner’s bank, and the freeholder has no control over their depository’s record keeping.

Habendum Provisos - the Dry Hole Clause: What is known as the ‘dry hole clause’ is the 2nd proviso in most pre-CAPL lease forms. This proviso addresses circumstances in which a well drilled on the freehold owner’s lands during the primary term of the lease is either dry and abandoned, or is productive but subsequently is abandoned during the primary term. Typical wording is as follows:

“PROVIDED FURTHER that if at any time during the primary term and prior to the discovery of production on the said lands, the lessee shall drill a dry well or wells thereon, or it at any time during such term and after the discovery of production on the said lands such production shall cease, then this lease shall terminate at the next ensuing anniversary of the effective date hereof unless operations for the drilling of a further well on the said lands shall have been commenced or unless the lessee shall have paid or tendered the delay rental, in which latter event the immediately preceding proviso hereof governing the payment of the delay rental and effect thereof, shall be deemed to have continued in force.”

Habendum Provisos - the 3rd, 4th and 5th Provisos: The typical habendum provides for the lease to continue during the secondary term for “so long thereafter as the leased substances or any of them are produced”. Implicitly, if no production is established during the primary term or if production ceases during the secondary term, the lease should terminate. The 3rd and sometimes 4th and 5th provisos found in many pre-CAPL leases attempt to modify the habendum so as to continue the lease in force in circumstances in which no production has been established during the primary term but the oil company-lessee is drilling or attempting to establish production at the expiry of the primary term, and in circumstances in which production established during the primary term ceases temporarily during the secondary term. 

In a number of decisions during the 1950's, 60's and 70's, Canadian courts strictly interpreted the wording in these provisos against the oil companies that had drafted them, resulting in the termination of valuable leases. Many different variations of the 3rd, 4th and 5th provisos resulted from this judicial battering. 

In most pre-CAPL leases, the 3rd proviso effectively provides for the lease to remain in force after production ceases during the secondary term, if the lessee commences drilling or working operations within 90 days and diligently pursues these operations to re-establish production. Usually the proviso also contains wording extending the 90 day period if production ceases “as the result of a lack of or intermittent market or any cause whatsoever beyond the lessee’s reasonable control”. Although this wording might appear to allow an oil company-lessee to suspend production for almost any reason, the courts have found that road bans are not a cause beyond a lessee’s reasonable control because annual road bans can be anticipated³. 

• Production from oil wells on freehold lands was suspended in some cases during the most recent oil price decline. Many of the involved oil company-lessees took the position that price declines were a cause beyond their reasonable control and that their freehold leases therefore remained in force. In fact, oil prices have declined precipitously many times in the past, and such price declines can be anticipated to occur in the future. FHOA recommends that all freeholders monitor production from their lands. If production ceases for more than 90 days, review your lease agreement and, depending on the wording governing the suspension of production, give consideration to seeking professional assistance.
• How much production is required to continue a freehold lease agreement during the secondary term? In the United States, the courts have consistently found that “produced” means “produced in paying quantities”. In other words, there must be enough production for the oil company-lessee to show a profit after paying operating costs⁴. In Canada, the issue has not yet been adjudicated. One of Canada’s foremost experts on oil and gas law, Mr. John B. Ballem, Q.C., acknowledges that “there are many marginal wells out there that are seemingly produced for no other reason than to maintain the lease in force”, but asserts that, in “view of the approach taken by the Canadian courts”, it is probable that any physical production whatsoever of the leased substances will be found to be sufficient to continue a freehold lease⁵ . Other legal experts disagree⁶. If your mineral interests are being continued by a producing well which generates little or no royalty to your account, it may be in your best interests to seek professional advice.

Habendum Provisos - CAPL Leases: The Canadian Association of Petroleum Landman (“CAPL”) leases, which were first introduced in 1988, differ structurally from the vast majority of lease forms previously used in Canada in their treatment of the provisos to the habendum clause. Canadian courts have historically interpreted these ‘unless’ provisos as options, and the failure of oil company-lessees to properly exercise these options has resulted in automatic lease termination in many situations. The CAPL lease forms replace the provisos to the habendum clause with covenants in the body of the lease agreement. The intended effect of this re-structuring is to change options which result in automatic lease termination into obligations which are subject to the default clause in the lease agreement. The default clause in CAPL leases provides that the lease will not terminate, if, within 30 days of a final judicial determination that a breach has occurred, the oil company-lessee begins to take action to remedy the breach (“Default”). As a result, in the words of one legal expert, oil company-lessees “have effectively put themselves in a position whereby they cannot lose their leases through lack of attention to detail and timing or through the failure to make timely payments” ⁷. 

Interpretation: Many early freehold lease forms contained no interpretation clause. In more modern leases, the habendum clause is followed by an interpretation clause which defines certain words used in the body of the agreement. Typically, ‘commercial production’, ‘spacing unit’, ‘said lands’ and ‘pooled lands’ are defined. In CAPL leases, the interpretation clause includes many more defined terms.

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Royalty: Once production begins from a freehold lease, the royalty clause becomes the most important part of the lease agreement from the standpoint of a freehold owner-lessor. Under the royalty clause in most pre-CAPL freehold lease agreements, the freehold owner-lessor: “reserve(s) unto himself a gross royalty of ___ per cent of the leased substances produced and marketed from the lands”, and the oil company-lessee commits to “remit to the lessor, on or before the 25th day of each month” an amount equal to that per cent of the “current market value” ... “at the wellhead” or “on the lands” of all leased substances produced and marketed (or produced, saved and sold) from the lands during the preceding month. 

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Gross Oil Royalties: ‘Gross’ means “exclusive of deductions”⁸ . A freehold owner who is subject to a lease agreement in which he has reserved a gross royalty on leased substances produced and marketed from his lands might reasonably assume that his royalty share should be free from production and marketing deductions. For the first 50 years after the 1947 Leduc discovery, the oil and gas industry apparently shared this interpretation, at least with respect to any oil produced from freehold lands. 
 
The fluids produced from an oil well typically flow through one or more separators where gas and water are removed from the oil. The separated gas is either flared or gathered in a pipeline for delivery to a gas plant; the water is usually disposed of in a water disposal well; and the oil is typically piped to storage tanks either near the wellhead or at a central battery servicing a number of wells. The sale or marketing of oil generally occurs at the outlet of the tank. Traditionally, oil company-lessees have paid royalties to freehold owners based on the price received for the oil at the tank outlet, without deduction for the costs of separation, water disposal, gathering pipelines to deliver the oil to a central battery, or oil storage, which costs are incurred by the lessee between the point of production at the wellhead and the point of sale. In other words, it has been historical Canadian oil and gas industry practice to pay freehold owners a ‘gross royalty’ on oil ‘produced and marketed’ from their lands.

A totally different industry practice has developed with respect to freehold royalties on gas. It is this industry practice which is at the root of many freehold owner concerns and complaints. 

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Net Gas Royalties: Unlike oil, which can be delivered to a refinery in trucks or in pipelines without extensive and expensive treatment at the well head, natural gas cannot be stored at a well head or trucked to market and, due to the corrosive impurities contained in most natural gas, typically requires considerable processing before pipelining. Whereas the infrastructure necessary to market oil is not expensive in comparison to the cost of drilling the well necessary to produce the oil, the infrastructure required to market natural gas may be many times more expensive than the cost of the gas well. 

In the United States, many courts have grappled with the issue of whether costs to make gas marketable are properly deductible from freehold gas royalties and, if so, how these costs should be calculated. The Louisiana and Texas courts follow the rule that the oil company-lessee and the freehold owner-lessor must share the costs to make gas market-ready after it is produced at the well head⁹. Other courts have found that “market value” is an ambiguous term to be interpreted against the oil company that drafted the lease with the result that costs to make gas market-ready are not deductible¹⁰. Still other courts have found that an oil company-lessee has an implied duty to market a freehold owner’s gas and that the lessee is therefore responsible for all costs involved in making the gas market-ready¹¹. 

The Canadian courts have not specifically addressed the ‘market value’ issue in the context of freehold gas royalties, but a system known as gas cost allowance or GCA has come to be applied and accepted by the industry as appropriate for the calculation of freehold gas royalties. 

The GCA system was originally set up for the calculation of Alberta Crown gas royalties. It allowed a producer of gas from Crown lands to deduct certain costs in arriving at the value of gas for Crown royalty payment purposes. Allowable costs included:

• small costs to operate the gas gathering and processing facilities during the year (actual costs plus 10% in deemed overhead);
  capital cost allowance - depreciation at the rate of 1/20th of the cost of all equipmentm
• used to make the gas ‘market-ready’, including compressors, gathering pipelines, plant equipment, etc., chargeable annually over a period of 20 years;
• return on capital invested - an annual return of 15% of the average capital invested in facilities during that year.

• Does “any expense incurred by the lessee” include the type of excessive custom processing fees the Crown would disallow? What about the cost of the Lexus that the oil company-lessee’s facility manager uses to commute from home to his downtown Calgary office? Clearly, the phrase is far too broad (“CAPL 99 Suggested Modifications", "CAPL 91 Suggested Modification”).
• What is a “reasonable return on investment”? Some oil company-lessees apparently believe a rate of return in excess of 30% is reasonable and have applied these rates to the calculation of deductions from freehold royalties (“CAPL 99 Suggested Modifications", "CAPL 91 Suggested Modification”).
• The Freehold Owners Association receives many calls from freehold owners who are concerned with the magnitude of the gas gathering and processing costs deducted from their royalties. If you are concerned, FHOA recommends that you write to the company that has leased your mineral interests, ask for a detailed written explanation of all deductions, and keep copies of all correspondence. You may wish to provide FHOA with copies. Although one appropriate or inappropriate response to a freehold owner’s concern may not be indicative of an oil company-lessee’s overall attitude to freeholders, members should be made aware of those companies that repeatedly respond either positively or negatively to their freehold owner-lessors.
• Most freehold leases provide freehold owner-lessors with the right to inspect their oil company-lessee’s books. If you believe that your royalties are being subjected to excessive gas gathering and processing fees, FHOA can provide you with the names of experts that you can retain on a fee for service basis to audit the fees charged by your oil company-lessee. Since 1999, many Alberta freeholders have been approached by a private company asserting that the freeholder has been subjected to excessive gas gathering and processing fees, in some cases in the millions of dollars, and offering to recover excessive charges on a contingency fee basis. The Freehold Owners Association urges freeholders who may be considering entering into such a contingency fee agreements to review the comments herein respecting the Alberta Court of Queen’s Bench cost decision in Anderson v. Amoco et al (“1990's - The Ownership Trial”), and protect themselves accordingly. 

The Acanthus Decision: In 1998, an Alberta Court of Queen’s Bench judge considered the issue of whether costs to make oil marketable were properly deductible from freehold oil royalties. In Acanthus v. Cunningham, the freehold owner-lessor had reserved unto himself a “gross royalty of seventeen (17) per cent of the leased substances produced and marketed from” his lands to be calculated based on “the current market value at the wellhead”. The trial judge rejected the freeholders’ argument that the royalty provision was “internally ambiguous since it provides for a "gross" royalty which suggests no deductions”. According to the trial judge, there was no ambiguity and, as a result, evidence of industry practice at the time the lease was entered into was inadmissible. The judge interpreted the royalty provision in the lease to mean that costs to gather, treat and store oil prior to its sale were properly incurred costs which could be deducted by the oil company-lessee. In assessing how these costs should be calculated, the trial judge accepted evidence that “the Jumping Pound calculation” is “commonly used”, and suggested that it would be appropriate to include the operating costs of all facilities downstream from the wellhead to the point of sale plus a rate of return on capital invested. ¹²

• But the Jumping Pound calculation is only ‘commonly used’ in the calculation of deductions from freehold and Crown gas royalties. The Alberta Government does not allow oil company-lessees to deduct water disposal costs, tank storage costs or any other gathering, treating or storing costs from Crown oil royalties. Furthermore, for more than 50 years, the common and accepted industry practice has been to make no deductions whatsoever from freehold oil royalties for the costs of gathering, treating and storing oil.
  
  The Acanthus decision has opened the door for unscrupulous oil companies to manipulate the deductions from freehold oil royalties in the same way that some companies have historically manipulated the deductions from freehold gas royalties. This decision may ultimately cost freehold owners many millions of dollars in oil royalties. In FHOA’s view, the learned trial judge erred in finding that there was no ambiguity in the royalty provision before him, and the trial decision should have been appealed.
• Freeholders should carefully monitor their oil royalty statements. If your oil royalties are substantially impacted by deductions which you have not previously been subjected to, you may wish to seek professional advice or contact FHOA.
• Freeholders approached to enter into CAPL lease agreements are advised to carefully review the royalty clause in these leases. The Alberta Crown does not allow deductions for separation, water handling, or oil storage. Why should you? (“CAPL 99 Suggested Modifications", "CAPL 91 Suggested Modification”).

Current Market Value: In the vast majority of Canadian freehold leases, the value upon which royalty is calculated is the “current market value” at the wellhead or on the freehold owner’s lands. Whereas the trial judge in Acanthus addressed the meaning of ‘market value’ in the context of proper deductions from oil royalties, no Canadian court has addressed the meaning of ‘current market value’ as it relates to how the price prior to deduction is to be determined for the purpose of freehold royalties. 

The Texas Supreme Court has found¹³ that where a freehold lease required a royalty to be paid on gas produced from a freeholder’s lands based on the ‘market value’ of the gas when sold off the premises, market value was to be computed based on sales comparable in time, quality, quantity and availability of market outlets, and the much lower gas contract price had no bearing on the current market value. This Texas decision has been followed in other United States jurisdictions. ¹⁴

Prior to Canadian gas market de-regulation in the mid-1980's, the vast majority of gas produced in Canada was sold under long-term contracts with built in fixed prices. During this period, there were seldom any sales comparable in time, quality, quantity and availability of market outlets which would call into dispute the fixed prices in long-term contracts as a measure of current market value. However the unpredictability of gas prices in the de-regulated market has resulted in the virtual disappearance of long-term contracts in today’s marketplace and their replacement by short-term contracts or gas sales on the ‘spot’ market. Many producers also engage in ‘hedging’ in the financial markets in order to protect themselves from unforseen gas price swings. 

The Alberta Government requires the lessees of Crown land to pay Crown gas royalties based on a ‘reference price’ equal to the weighted average price of all gas and gas by-products actually sold in the Province during the previous month, less an intra-Alberta transportation allowance. One effect of this policy is that a producer of both Crown and freehold gas can reduce its overall corporate royalty obligation by allocating gas contracts with prices below the Alberta reference price to freehold lands (“Gas Contract Manipulation”). 

• In FHOA’s view, the plain meaning of the phrase ‘current market value’ requires an oil company-lessee to calculate a freehold owner’s gas royalty based on the going price for the product under the criteria set forth by the Texas Supreme Court - sales comparable in time, quality, quantity and availability of market outlets - and does not provide the oil company with the authority to allocate its gas contracts so as to minimize freehold royalties.

The royalty clauses in CAPL leases can be interpreted to provide oil company-lessees with the contractual authority to manipulate their gas contracts in the above manner. For instance, CAPL 91 provides that “In no event shall the current market value be deemed to be in excess of the value actually received by the Lessee pursuant to a bona fide, arms length sale of transaction” (“CAPL 99 Suggested Modifications", "CAPL 91 Suggested Modification”). 

• The Freehold Owners Association recommends that freehold owners monitor the gas sale prices reported to them by their oil company-lessees and compare these reported prices with the weighted average Alberta prices published by the Alberta Resource Development Department. In circumstances where lessee-reported prices are substantially lower than average Alberta prices, write to your lessee asking for a written explanation. If no satisfactory explanation is forthcoming, please advise FHOA.

The Offset Well Clause: Offset obligations are frequently misunderstood by freehold owners. To assist freehold owners, FHOA has prepared an animated illustration. Most freeholders understand that petroleum and natural gas are not like hard minerals in that they may about move about within the confines of the subsurface pool in which they are trapped in response to reservoir pressure changes induced by producing wells. Most freeholders also recognize that the location of a petroleum or natural gas pool in the subsurface is defined by nature, that pools are seldom confined within the vertical boundaries of a single 1/4 section tract of land, and that petroleum or natural gas in a pool beneath their lands may be drained away by production from a well adjacent to their lands in the same pool. Many freeholders do not understand what their rights are in these circumstances.

The Judicial Committee of the Privy Council, then the highest court of appeal in the Commonwealth, considered these circumstances almost 50 years ago and pronounced what has come to be known in Canadian oil and gas law as the ‘rule of capture’:

“The only safeguard is to be the first to get to work, in which case, those who make the recovery become owners of the material which they withdraw from any well which is situated on their property or from which they have authority to draw.” ¹⁶ By virtue of the rule of capture, a fee simple owner does not own the petroleum or natural gas which may exist within the lands described in his certificate of title in the same way as he might own other real property. The fee simple owner ‘owns’ two things - the right to recover petroleum or natural gas from a well on his lands and any petroleum or natural gas withdrawn from the well after it is recovered and withdrawn. The rule of capture applies equally to the Crown and to freehold owners. Therefore, even if the hydrocarbons that are recovered and withdrawn from a well on a freeholder’s lands initially existed within the land of the freeholder’s neighbour, once they are withdrawn they belong to the freeholder and his neighbour has no legal recourse against him. Conversely, under the rule of capture, you have no legal recourse against the owner of a well producing on lands adjoining yours and, as stated by the Privy Council, your “only safeguard is to be the first to get to work”. 

In a freehold lease agreement, the freehold owner-lessor grants the exclusive right to drill wells and recover hydrocarbons from his lands unto the oil company-lessee. This means that if production is established from a well adjacent to the freeholder’s lands, the freeholder no longer has the right to ‘get to work’ - this right belongs to his oil company-lessee. The fundamental purpose of the offset clause in a freehold lease is to protect the freehold owner-lessor from drainage resulting from the inaction of his oil company-lessee. 

Although offset well clauses typically contain some of the most convoluted language in freehold lease agreements, most have a common structure which provides that:

“If” commercial production is obtained from a well drilled on a spacing unit laterally adjoining the freehold owner-lessor’s lands and not owned by the freehold owner-lessor, “then unless“ a well has been drilled or is drilling on the freehold owner’s lands to the formation that commercial production is being obtained from, the oil company- ”lessee shall” .... . 

• There are many hundreds of unsatisfied freehold offset obligations in western Canada. The principal reason for this is that many freeholders do not realize that it is up to them to monitor the production from spacing units offsetting their lands and to serve notice on their oil company-lessee if the company defaults on its offset obligations. If your lands are already leased, FHOA can help you to protect your valuable mineral interests from drainage by providing you with production information on wells offsetting your lands (“Technical Information Request”).

In the early years of oil exploration and development, the rule of capture resulted in wells being drilled on even the smallest tracts of land within productive pools as owners attempted to drain their neighbours before their neighbours drained them. Far more wells were drilled than were necessary to efficiently produce the pool’s reserves. In many cases, pools were damaged as a result of wells being produced too rapidly. Conservation legislation was introduced, in part, to curb the ‘race to waste’ fostered by the rule of capture. 

Most conservation statutes prescribe a certain minimum area known as a ‘spacing unit’ within which no more than one well can be produced from a pool. Under the Alberta Oil and Gas Conservation Act, the normal spacing unit for gas is one section and the normal spacing unit for oil is 1/4 section. Most conservation statutes also prescribe target areas for wells within spacing units, and apply penalty factors on the amount of production that is allowed from wells drilled outside of these target areas so as to discourage a proliferation of wells on opposite sides of the fence lines dividing spacing units. Typically, the farther away a well is from the center of its target area (or the closer it is to the fence line), the greater the penalty applied to its production. 

Penalty factors applied to off-target wells may discourage an oil company from drilling in what is considers to be the most optimal technical location within a spacing unit. For a number of years in Alberta, the Alberta Energy and Utilities Board (the “Board”) resolved this problem by waiving off-target penalties in circumstances where a special production spacing unit was formed. For instance, if an off-target gas well was drilled near the fence lines in the NW/4 of one section, off-target penalties could be avoided by forming a special one section gas spacing unit comprising the NE, SE and SW/4's of the adjoining 3 sections. This allowed wells to be drilled in the best possible technical location and discouraged a proliferation of wells along fence lines, while still protecting the equity interests of owners on the ‘other side of the fence’. However in 1994, as part of the de-regulation process advocated by the oil and gas industry, the Board changed its policies with respect of off-target wells. Pursuant to Board Interim Directive ID 94-2 ¹⁷, the Board transferred the responsibility for monitoring off-target wells to the industry and revised its off-target well policy so that off-target penalties would only apply to wells drilled after April 1, 1994 “upon the successful request from a competitive operator” and would not apply to the “first well in a pool”. The Board takes the position that its role is to “to afford each owner the opportunity of obtaining his share of the production of oil or gas from any pool”¹⁸ , and that its revised policy does not deny freehold owners this opportunity. 

• In the case of freehold lands adjacent to a producing off-target well where the freehold owner has leased his mineral interests to an oil company, the freeholder has no right to drill himself. If the neighbouring off-target well is a good producer, it may make economic sense for the freeholder’s oil company-lessee to drill a well on his lands. But what if the oil company-lessee has no funds for drilling, or what if it has other drilling opportunities elsewhere that it prefers? More critically, what if the oil company-lessee has an interest in the neighbouring off-target well and it is not in the oil company-lessee’s economic interests to drill on the freeholder’s lands? In these circumstances, the freehold owner must rely on the offset well clause and the default clause in his lease agreement.

The offset well clause in the vast majority of existing freehold lease agreements only provides protection to the freehold owner-lessor from producing wells drilled “on a spacing unit laterally adjoining the freehold owner-lessor’s lands”. In the case of gas, freehold owner-lessors have protection from wells producing from the sections immediately east, west, north and south of the section containing their mineral interests, but no protection from wells producing from diagonally offsetting sections. The draftors of the CAPL 99 freehold lease, introduced in the fall of 2000, are to be commended for modifying the offset well definition in this lease to include wells producing from both laterally and diagonally offsetting spacing units. But this doesn’t help the tens of thousands of freeholders who are bound by older forms of freehold leases. 

The ‘laterally adjoining’ wording was incorporated into freehold lease agreements at a time when the Board’s policies and procedures effectively precluded extremely off-target wells. The effect, if not the intent, of the Board’s 1994 policy change has been to encourage the drilling of off-target wells, some of which have been completed in the extreme corners of spacing units where they are clearly draining diagonally offsetting lands. The Board appears to have changed the rules to accommodate the industry’s desire for de-regulation without taking into account the impact that the change would have on freehold owners who had leased their lands under the old rules. 

• In the case of a freehold owner whose un-leased mineral interests are adjacent to an off-target producing well, the freeholder could conceivably attempt to obtain his share of production by drilling a well himself. But few freehold owners have the knowledge, financial resources or inclination to become involved in the business of drilling and operating wells. A freehold owner’s only practical alternative is to lease his mineral interests to an oil company. But at least one acknowledged legal expert suggests that the offset well definition in CAPL 88 and CAPL 91 leases may only apply to wells drilled after the lease is executed¹⁹. There is no doubt whatsoever that this is the intent and effect of the offset well definition in CAPL 99. In a worst case scenario, an unscrupulous company may drill an off-target well on your fence line, enter into a lease with you, and then drain your reserves without compensation. Furthermore, under the offset clause in both the CAPL 88 and the CAPL 91 freehold leases, if “a well has been drilled or is drilling” on the spacing unit containing the freehold owner’s lands to the depth of the zone productive in the neighbouring well, a freehold owner has no protection under the offset clause. This means that a dry hole anywhere on your section could prevent you from forcing your oil company-lessee to drill a well to prevent drainage from an adjoining producing gas well. The CAPL 99 freehold lease is fairer to the freehold owner-lessor as it does not allow a dry hole to defeat the offset obligation.

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• With the highly developed gas gathering and marketing infrastructure which exists in Alberta, the current high price of gas, and the growth of short term and spot market gas sales, FHOA finds it hard to envision any circumstances where a gas well in Alberta would be shut-in as a result of a “lack of or intermittent market”.
  
• The reasonable shut-in well provisions belatedly introduced in CAPL 99 do not assist those freehold owners whose mineral interests are being continued by uneconomic shut-in wells under the unreasonable suspended wells clause contained in CAPL 88 and CAPL 91 leases.
  
  The Alberta Court of Appeal has applied the principle of ‘reasonable construction’ to freehold lease agreements in situations where it was beneficial to the oil company-lessee. The Court stated this principle as follows: “No lessee would enter into such a lease and no reasonable lessor would expect a lessee to consent to such a term. If the language clearly provided for such a result, so be it; but where there is any other reasonable construction, such should be adopted.”²⁶ Does the language “capable of production”, which is relied upon by so many oil company-lessees to continue CAPL 88 and CAPL 91 freehold leases with wells which are capable of ‘any’ production, clearly provide for this result? Would any freehold owner-lessor enter into such a lease and would any reasonable oil company-lessee expect a freehold owner-lessor to consent to such a term? Is there not another more reasonable construction? Is another more reasonable construction ‘capable of production in paying quantities’? In FHOA’s view, the issue of whether the principle of reasonable construction should apply to the Suspended Well clause in CAPL 88 and CAPL 91 is one of the many issues impacting freehold owners which should be brought before the courts.
  
• If your lease is currently being continued by a shut-in well, FHOA recommends that you seek professional advice or contact the association.

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Pooling and Unitization: The concepts underlying pooling and unitization are similar to the extent that both involve the sharing or combining of production and the allocation of royalties amongst the owners impacted by this sharing based on a formula. However, the impact of pooling and unitization on freehold owners is vastly different.

Pooling involves the sharing of production within a single spacing unit. A spacing unit is an area prescribed by conservation legislation within which no more than one well may be drilled for production from a particular oil or gas pool. In Alberta, the normal spacing unit for gas production is one section (640 acres or 256 hectares), and the normal spacing unit for oil production is a 1/4 section (160 acres or 64 hectares). Production from a well is not permitted unless the well operator has the right to the oil or gas produced from the entire spacing unit. The vast majority of individually-owned freehold mineral rights in western Canada were originally included in 1/4 section, farm-sized parcels of land granted or sold to settlers for homesteading purposes. Consequently, the titles to most freehold mineral interests in western Canada cover an area of a quarter section and a company entering into a typical 1/4 section lease with a freehold owner acquires a normal spacing unit for oil but does not acquire a normal gas spacing unit. 

The purpose of the pooling clause is to provide an oil company-lessee with the right to pool or combine its freehold owner-lessor’s lands with other lands in order to form a spacing unit for gas production. 

Like most of the other clauses in freehold lease agreements, the pooling clause has been subjected to judicial battering by the Canadian courts, and oil company lawyers have modified the language in the pooling clauses of early lease forms to more fully protect their clients. The pooling clause in CAPL leases provides the oil company-lessee with an unfettered right to pool its freehold owner-lessor’s lands with other lands provided the size of the resultant pool does not exceed one spacing unit and provided that the pooling is done on an acreage basis. The pooling clause also allows the freehold owner’s lease to be continued by operations on the pooled lands. 

There are technical circumstances in which a freehold owner should refuse to provide a prospective oil company-lessee with the right to pool on an acreage basis - for instance, if existing well control clearly demonstrates that any reserves that may be found to exist within the spacing unit will exist predominantly beneath the freeholder’s lands. By and large however, the pooling clause in CAPL leases is one of the more innocuous clauses in the lease.

The unitization clause is a different matter entirely.

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• For all intents and purposes, the unitization clause in CAPL leases provides an oil company-lessee with a carte blanche to do as it likes, and the Freehold Owners Association strongly recommends that freeholders demand appropriate amendments to CAPL leases (“CAPL 99 Suggested Modifications", "CAPL 91 Suggested Modification").

• FHOA recommends that freeholders whose lease agreements do not include a unitization clause seek the advice of competent technical and legal professionals if they are approached to enter into a unit agreement.

• If the intent of the default clause in CAPL leases is not to discourage freehold owners from filing default notices, there can be no doubt about the effect of the clause. Oil and gas litigation is exceedingly expensive, and the costs awarded to a successful litigant seldom approach the actual costs incurred. A freeholder filing a default notice under a CAPL lease agreement runs the risk that his oil company-lessee will commence litigation ostensibly to determine whether a breach has occurred and subject the freeholder to years of costly litigation. When the freeholder ultimately succeeds in establishing that a breach has occurred, the oil company-lessee can commence to remedy the breach within 30 days and carry on as before, leaving the freeholder with whatever legal costs he has not recovered. In FHOA view, the default clause in CAPL leases can only be described as oppressive (“CAPL 99 Suggested Modifications", "CAPL 91 Suggested Modification”).

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