If you aren’t careful, a Pugh Clause may be a tripwire for the unaware in an oil or gas lease contract. The Pugh Clause is named for a Louisiana attorney, Lawrence Pugh, who took on Shell Oil in 1947 on behalf of a lessor.
The Louisiana Supreme Court sided with Shell Oil, and Pugh determined that the only way to prevent something similar from happening again was with a special clause in the lease contract.
Before the introduction of the Pugh Clause, lessors ran the risk of placing more property under lease than they planned, and for longer periods, too. A Pugh Clause, when properly written, locks down the amount of property a lease can include after its initial expiration date.
Defining the Pugh Clause
The primary thing to remember about the Pugh Clause is that there is no industry standard for it. Each clause is written specifically for the contract under consideration, and they tend to be pro-lessor. If you are the lessor, you need to ensure that any Pugh Clause drafted as part of the agreement is correctly written because the courts generally interpret them strictly and literally.
A Pugh Clause is meant to prevent a lessee from declaring all lands under an oil and gas lease as being held by production, even if production only occurs on a fraction of the property. A lessor with large amounts of acreage under lease could find those acres tied up by lease contract far beyond the initial lease dates, and unable to offer those lands for lease to anyone else.
A Pugh Clause also protects lessors if non-contiguous lands are pooled under lease or unitized in some fashion as to prevent the lessor from offering a portion of the property to another entity.
Types of Pugh Clauses
A Pugh Clause can be specified as horizontal, vertical, or both.
- A horizontal Pugh Clause covers acreage horizontally across the property.
- A vertical Pugh Clause is specified by depth into the soil.
A vertical Pugh Clause could provide a lease to a particular depth, such as 100 feet below the drilled well. The lessee would be limited to drilling to 100 feet but no further. Conceivably, the lessor could lease property below that range to another entity.
How Does a Pugh Clause Work?
Like any contract clause, a Pugh Clause seeks to create a limitation within the contract. A correctly written Pugh Clause contains a recognizable trigger that places it into operation. Without the trigger, the lessor may not have the protection expected.
Here is an example of a “generic Pugh Clause” from an Oil and Gas Report article:
“A producing well, or well capable of producing, will perpetuate this lease beyond its Primary Term ONLY as to those lands as are located within, or committed to, a producing or spacing unit established by Government authority having jurisdiction.”
This Pugh Clause is meant to separate leased lands at the end of the primary lease term according to whether the lands are within a drilling or spacing unit established by a government agency. The lease on lands located outside the unit would not be extended by production on any portion within the unit.
The trigger, in this case, is whether or not any portion of the land under lease has been left out of a producing pool or unit established by a government agency. If so, the lease on the land outside the pool will terminate as stated by the lease, even though part of the original leased land is productive.
In another example from the Oil and Gas Report article, an ineffective Pugh Clause lacks a trigger, and will not provide the protection expected by the lessor.
“Notwithstanding anything to the contrary herein, this lease shall terminate after the primary term as to all the lands not included within a drill site spaced as a unit as provided by the proper Government Authority…”
What’s wrong with this clause? It separates land only on the basis of whether it is within a “drill site spaced unit,” without specifying the spaced units must also be producing for the lease to be extended. In other words, the lease for the pooled lands would be extended past the primary term whether they were productive or not, as long as they were subject to a spacing order.
The Impact of a Pugh Clause
Without a Pugh Clause, a lessor may find that more land remains under lease than expected after the expiration of the primary term. If the clause specified production requirements on any part of a leased property without establishing the boundaries of a pool or unit, the lessee could claim an extension of the lease on all property under lease, not just the productive portion.
A lessor so bound by a lease loses a revenue-producing opportunity because none of the leased lands will be made available for lease to a different entity for any reason. All of the leased land is tied up until the lessor ends production and the extended term expires.
Poorly written Pugh Clauses can be created by cutting and pasting existing Pugh Clauses into a new lease contract. Since most of these clauses are written for specific circumstances, the clause may not strictly apply to the new lease lands. Cut and pasted clauses may be irrelevant to the current contract, cause inconsistencies within it, or omit essential phrases.
The sneakiest part of a Pugh Clause is that one or more parties may not realize its impact until the primary term of the lease has expired. It may only then come to light that the lessor is not protected as thought or that the lessee is locked out of a lease extension through ignorance of the true meaning of a Pugh Clause included in the contract.
Caution: Pugh Clause Ahead
Oil and gas landmen must become familiar with Pugh Clauses when negotiating leases with landowners. As mentioned before, most Pugh Clauses are placed in a lease contract at the behest of the lessor. If a landowner’s attorney experienced in oil and gas lease language creates the clause, it will favor the lessor.
Each party should review the contract in its entirety and ensure all clauses are clearly understood at the time of signing. It would be unfortunate for a lessor to discover more land remains under lease than expected after the primary term because of a poorly written clause. The lessee would be no happier if it turned out that previously leased lands revert to the owner because the lessee did not conform to the trigger for the clause to take effect.
When in doubt about any contract language, consult a knowledgeable attorney to assist in drafting the appropriate language, so there are no surprises years down the road.