Oil and gas leases typically contain a habendum clause

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1 Page 28 In Pennsylvania, does production really mean production in paying quantities? Author: Alison L. Bush, Esq. Barnes Dulac Watkins Oil and gas leases typically contain a habendum clause which governs the term of the lease. Most habendum clauses provide for a primary and a secondary term. The primary term is a fixed period of time within which the lessee may hold the leasehold without being required to develop it. To prevent the lease from expiring at the end of the primary term, the lessee must act to propel the lease into its secondary term. One way a lease can be extended into its secondary term is if oil or gas, or both, is produced in paying quantities. Under such a lease, the secondary term will continue until oil and gas are no longer produced in paying quantities. In Pennsylvania, the meaning of in paying quantities was announced in T.W. Phillips Gas & Oil Co. v. Jedlicka. 1 In Jedlicka, the Supreme Court established a two-part test to determine if a well is producing in paying quantities. First, objectively, a well produces in paying quantities if it consistently pays a profit, however small, over operating expenses. Second, if a well has only marginally or sporadically produced, the determination of whether the well has produced in paying quantities relies subjectively on the operator s good faith judgment in continuing to operate the well. Jedlicka clarifies the amount of production that will propel and, subsequently, sustain a lease s secondary term in a habendum clause requiring production in paying quantities. Some oil and gas leases, however, do not include the phrase in paying quantities and provide that the secondary term is triggered and sustained as long as oil or gas is produced from the leasehold. Is the Jedlicka test applicable to leases that do not require production in paying quantities? The answer depends on whether Pennsylvania courts would imply in paying quantities into the meaning of production or whether the courts would strictly construe the oil and gas leases according to their express terms. If Pennsylvania courts implied in paying quantities into the meaning of production, then the Jedlicka standard for production in paying quantities would govern the lease. If not, the lease would likely not fall within the purview of Jedlicka and any production, whether in paying quantities or not, would suffice to continue the lease. In habendum clauses requiring only production to enter into and sustain a lease s secondary term, many states have expressly held that in paying quantities should be implied into the clause even though the lease does not expressly include the phrase. In Garcia v. King, 2 the Supreme Court of Texas held that the term produced in a habendum clause meant produced in paying quantities. The court reasoned that without profitable production, the lease s purpose could not be accomplished and any extension of the lease into its secondary term would be improper. The majority of other states follow versions of the Garcia rule. 3

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3 Page 30 More locally, in South Penn Oil Co. v. Snodgrass, 4 the West Virginia Supreme Court of Appeals held that the terms produced, produced in paying quantities and found in paying quantities, as used in oil and gas leases, are synonymous. Additionally, in Tisdale v. Walla, 5 the Ohio Court of Appeals held that produced means produced in paying quantities and rejected the contention that production of gas for domestic use, without more, operates to extend a lease into its secondary term. General Pennsylvania legal principles relating to oil and gas leases suggest Pennsylvania courts would not imply in paying quantities into the meaning of production. The Pennsylvania Supreme Court has consistently held that an oil and gas lease is a contract and should be construed according to principles of contract law. 6 According to Pennsylvania law, oil and gas leases must be interpreted in accordance with the express language of the agreement, rather than the silent intentions of the parties. 7 Based on these overarching contract principles, it seems likely that Pennsylvania courts would not hold that production means production in paying quantities because the parties did not expressly include it in the lease. However, in certain instances, Pennsylvania courts have not followed the general principle that oil and gas leases should be construed according to their express terms. A recent example of such a deviation is the Superior Court s decision in Hite v. Falcon Partners. 8 In Hite, the lease s habendum clause provided, in pertinent part, for a one year primary term and a secondary term for as long as Lessee shall continue to pay Lessors two dollars ($2.00) per acre as delayed rentals... The lessors sought to terminate the lease on the grounds that lessee failed to develop the property during the primary term. The lessee argued that since it had paid the lessors two dollars per acre annually, it had complied with the express terms of the lease and could maintain production rights indefinitely by continuing to pay lessors two dollars per acre. The Superior Court rejected the lessee s argument and held that the lease expired because an indefinite delay rental would be at odds with the presumed intention of the parties in executing the leases in the first place. The holding in Hite suggests that although Pennsylvania law requires oil and gas leases to be construed according to their express terms, exceptions will be made in situations where the court believes the express lease terms are perhaps unfair to the lessor, against public policy or contrary to traditional property rights conveyed by a lease. Would the omission of in paying quantities in the habendum clause constitute a situation in which Pennsylvania courts would deviate from the principle that oil and leases should be construed according to their express terms? Although the Pennsylvania Supreme Court has not decided the issue, Pennsylvania cases suggest the answer is no. First, a 1978 Court of Common Pleas case, Mealy v. Clark, 9 dealt with a habendum clause stating the lease s primary term would be for six months and so long thereafter as oil or gas is produced from the land and royalties and rentals paid by lessee therefor. The lessor sought a forfeiture of the lease on the grounds that lessee had abandoned or surrendered the lease, but the court ultimately ruled against the lessor. Among other considerations, the court in Mealy reasoned that, although the meager production from the lease was not in paying quantities, the terms of the lease did not require it and concluded the lessee did not equitably surrender the lease. Second, in a more recent Superior Court case, Responsible Reclamation An opportunity to restore diversity ernstseed.com sales@ernstseed.com (fax)

4 June 2014 Page 31 Caldwell v. Kriebel Resources Co., 10 the court upheld the trial court s dismissal of the lessors complaint holding the lessee had no implied duty to develop all strata. Additionally, the Superior Court agreed with the trial court that leases in Pennsylvania do not include an implied duty to produce in paying quantities based on all strata. It agreed with the trial court s conclusion that the Jedlicka test did not apply because: the parties in [the Jedlicka] case had placed the term paying quantities into the lease, thereby making the issue the interpretation of an explicit contractual term not an implied duty. Here, the lease only required that oil or gas is produced from the property. Thus, Jedlicka has no bearing on the case at hand. Nevertheless, where the only production from the leasehold is for domestic use, one Pennsylvania case suggests production does in fact mean production in paying quantities. Under the holding of Babb v. Clemensen, 11 not all production will propel a production only lease into or sustain its secondary term. In Babb, the three habendum clauses at issue each provided, in pertinent part, for a primary term of 10 years and for so long thereafter as oil or gas is produced from the premises, as oil or gas...be produced therefrom, and as oil or gas is produced therefrom hereunder, respectively. Although the lessors were using gas produced from the premises for domestic use, they argued that the lease had expired due to the lack of commercial production. The Superior Court, citing the Ohio Court of Appeals in Tisdale, agreed and held that everyday use of the gas...did not constitute production as contemplated by the leases so as to extend the duration thereof. In its reasoning, the Superior Court MSHA, OSHA or EPA Woes? The Law Office of Adele L. Abrams PC focuses its practice on defending employers in MSHA, OSHA and EPA litigation nationwide. Our 10 attorneys include Certified Mine Safety Professionals and Certified Industrial Hygienists who can evaluate citations, represent your company in settlement conferences, and be strong advocates for you in litigation. We provide safety training (MSHA Part 46 and 48), safety and health audits, and program development and review services. Our attorneys are admitted in PA, OH, MD, MI, DC, MTandSC,andmanyfederalcourts. Don t go it alone. call the pros!

5 Page 32 agreed with the reasoning in Tisdale, that production meant production in paying quantities. Conclusion Whether Pennsylvania courts would imply in paying quantities into an oil and gas lease is still very unclear. For leases with production other than for domestic use, both Mealy and Caldwell indicate that production does not mean production in paying quantities unless the parties specifically include it in the express terms of the lease. Adding the Mealy and Caldwell holdings to the general principles of oil and gas lease interpretation, the weight of Pennsylvania authority suggests that, in Pennsylvania, courts would likely not imply in paying quantities into a habendum clause which omits it. Babb is the only outlier, but is distinguishable in that Babb dealt with a lease under which only domestic production occurred. Therefore, for leases with production other than for domestic use, it is likely that the Jedlicka in Have You Registered? 2014 PIOGA PIG ROAST, EQUIPMENT SHOW & CONFERENCE July Seven Springs Mountain Resort Visit the PIOGA Events section at paying quantities test does not govern the amount of production required to enter into and sustain the secondary term of production only leases. However, it is also possible that Pennsylvania courts may agree with the Hite court s position, disregard the express terms of the lease and find that allowing production not in paying quantities to sustain an oil and gas lease is contrary to a lessor s presumed intention in entering into a lease. In such a case, the Jedlicka test would govern the amount of production required to sustain the secondary term of a production only lease, even though in paying quantities was not expressly included in the lease s habendum clause. Ms. Bush is an associate with the law firm Barnes Dulac Watkins, a boutique firm located in Pittsburgh that specializes in oil and gas law. The views expressed in this article do not necessarily reflect those of Barnes Dulac Watkins or its clients Pa. 199, 42 A.3d 261 (2012) Tex. 578, 164 S.W.2d 509 (1942). 3 See 2 Summers Oil and Gas 14:8 (3d ed.) W.Va. 438, 76 S.E. 961 (1912). 5 No. 94-A-0008, 1994 WL (Ohio Ct. App. Dec. 23, 1994) (unpublished opinion). 6 Jedlicka, 615 Pa. at 208; See Jacobs v. CNG Transmission Corp., 565 Pa. 228, 242, 772 A.2d 445 (2001). 7 Jedlicka, 615 Pa. at 208; See Jacobs, 565 Pa. at A.3d 942 (Pa. Super. 2011). 9 9 Pa. D. & C.3d 566 (Pa. Com. Pl. 1978) A.3d 611 (Pa. Super. 2013) A.2d 1120 (Pa. Super. 1996). Insurance Brokers & Consultants Side by Side With You Into the Future WINNER Northeast 2013 Digging Out Potential Savings Adrianne Vigueras Vice President Energy Division avigueras@ecbm.com ext Sycamore Rd., Suite 320 Montoursville, PA Additional Offices Allentown, PA Pittsburgh, PA