Wash-Out of Overriding Royalty Interests
How can an operator maximize its profit from a well that is burdened by multiple overriding royalty interests, which reduce the operator’s net revenue interest? The operator can choose to eliminate the overriding royalty interests. In Stroud Prod., LLC v. Hosford, 405 S.W.3d 794 (Tex. App. – Houston 2013, pet. denied), the Court addressed whether the intentional termination of a lease to eliminate overriding royalty interests was actionable. Briefly, the Court concluded that the owners of the overriding royalty interests did not have a cause of action arising from the intentional termination of the lease and elimination of the overriding royalty interests. Id. at 811.
The dispute in Stroud arises from a lease taken by Houston Domestic Oil Company (“HDOC”) that contained a 25% royalty interest. Subsequently, HDOC granted overriding royalty interests to Patrick E. Hosford, Morris L. Etheridge, David T. Threinen and Nelson E. Woods (collectively, the “ORRI Owners”) totaling 5%. Id. at 798. None of the assignments of overriding royalty interests to the ORRI Owners contained a “renewals and extensions” clause to protect against a wash-out of the overriding royalty interests.  After HDOC drilled wells that produced in commercial quantities, Stroud Production, LLC (“Stroud”) acquired the leases in 2003. Id. at 799. At the time Stroud acquired the leases, there was only one producing well operating on the leasehold. On January 13, 2014, Stroud learned that the assignments of overriding royalty interests to the ORRI Owners did not have “renewals and extensions” clauses. Id. Several days after learning that the overriding royalty assignments did not contain renewals and extensions clauses, a “polished rod” broke on the only producing well and production ceased on January 20, 2004. Id. Although repairs would not be expensive or time-consuming, Stroud took no action to repair the polished rod and return the well to production to terminate the leases. Id. As a result the leases terminated on April 20, 2004. Id. On February 20, 2004, Stroud obtained new leases covering the same tract of land that were not burdened by overriding royalty interests. Stroud repaired the well in May 2004 for an approximate cost of $7,500 and the well was returned to production in June 2004. Id. at 799-800. After the well returned to production, Stroud sold the new leases for approximately $2.5 million. Id. at 800. Importantly, the Court recognized that Stroud acted intentionally to terminate the leases and eliminate the overriding royalty burdens:
“Stroud admitted that he intentionally returned the well to production in June 2004 only after the B&G leases had terminated, new leases had been obtained, and the 90-day continuous-operations period had passed. He also admitted that he ‘did not want any overriding royalty interest on the new leases’ and [the ORRI Owners’] overriding royalty interests had been ‘washed out.’”
Stroud, 405 S.W.3d at 799-800. The Court explained that the evidence established that Stroud intentionally terminated the leases to terminate the ORRI Owners’ interests in the leases. Id. at 804.
In reaching its conclusion that intentional termination of a lease to eliminate the interest of another party is not actionable under Texas law, the Court focused on the lack of a duty owed by Stroud to the ORRI Owners. The Court stated: “[b]ecause no evidence supported the existence of a ‘confidential or fiduciary relationship’ and the provisions of the leases and assignment were ‘controlling,’ the [Texas Supreme Court] held that the overriding royalty interest expired with the original lease and no constructive trust was warranted.” Id. at 805 (citing Sunac v. Petroleum Corp. v. Parkes, 416 S.W.2d 798, 805 (Tex. 1967)). The Court, after discussing several other Texas cases, concluded that “no Texas court has yet recognized that a lessee generally owes any type of duty, whether it be an implied contractual covenant or fiduciary-type duty, to protect the interest of an overriding royalty interest holder so as to require the lessee to make repairs to well equipment, perpetuate the lease, and ensure that such overriding royalty interests are not extinguished.” Id. at 809.
Turning to the facts of the instant case, the Court found that “there is no evidence of any special relationship of trust and confidence” between the ORRI Owners and Stroud. Stroud, 405 S.W.3d at 809. The Court explained that the assignments to the ORRI Owners did not contain “renewals and extensions” clauses and that the ORRI Owners did not identify any language in the assignments that obligated Stroud to repair the well or take other action to preserve and maintain the leases. Id. at 810. Before reaching its conclusion, the Court noted that there is a possibility under Texas law that “a party that engages in conduct to intentionally wash-out an overriding royalty interest may be subject to liability.” Id. at 811 (citing Ridge Oil Co. v. Guinn Invs., Inc., 148 S.W.3d 143 (Tex. 2004) and In re GHR Energy Corp., 972 F.2d 96 (5th Cir. 1992)). However, the Court refused to impose any liability arising from the intentional termination of the leases to eliminate the overriding royalty interests “[b]ecause there is no evidence that [Stroud] violated any express or implied contractual duty and there is no evidence of the existence of a fiduciary or confidential relationship.”
Based on Stroud, and prior Texas caselaw, an operator has the ability to terminate a lease intentionally to eliminate an overriding royalty interest. However, an owner of an overriding royalty interest may be able to protect his interest by including in the assignment creating the overriding royalty interest (1) a renewals and extensions clause and (2) a provision creating a duty owed by the lessee to the owner of the overriding royalty interest. It is important for an operator seeking to wash-out an overriding royalty interest to examine the language of the assignment and consult legal counsel prior to terminating a lease to avoid liability.
 “’[R]enewals and extensions’ clauses may be used to protect overriding royalty interests by ensuring that such interests apply to any leases that qualify as renewals or extensions of prior leases. Stroud, 405 S.W.3d at 799. However, a “renewals and extensions” clause, alone, may not be sufficient to prevent a wash-out of overriding royalty interests. See Sunac v. Petroleum Corp. v. Parkes, 416 S.W.2d 798, 804 (Tex. 1967) (construing both a renewals and extension clause and a surrender clause, and explaining that a lessee had no duty to continue the lease, but could surrender the lease at any time without consent of the overriding royalty interest owners); Exploration Co. v. Vega Oil & Gas Co., 843 S.W.2d 123, 126 (Tex. App. – Houston 1992, writ denied) (declining to impose a fiduciary duty on a lessee even though the assignment contained a renewals and extension clause and the lease did not contain a surrender clause).