The Point: Oil and gas leases are specialized instruments of real estate and contract law. The very existence of the lease can turn on court opinions over 100 years old (with little between now and then) and the court’s interpretation of something as ephemeral as “good faith” can be determinative. Curative documents, a royalty check endorsement, division orders and the like may clarify ambiguities when a lot of money is at stake.

Discussion: The relationship between the owner of minerals (which may be different from the owner of the surface, the subject of a future blog) and the oil company is typically defined in and oil and gas lease where the Owner, in a contract, grants to Lessee defined rights to the property in exchange for promises and money. The length of the lease, the term, is addressed in one of the most important provisions the lease — the “habendum” or term clause, which usually appears near the beginning of the lease. The term clause in an oil and gas lease is the product of long development and experience. It attempts to reconcile the competing interests of the parties. Owner wants a well and its royalty payments quickly (a short term) while Lessee wants flexibility and as much time as possible (a long term). Given the new interest in oil and gas production in Ohio, it is crucial to understand the term clause for both old/existing leases and new ones.

There are many variations and the addition or deletion of a word or a phrase can have dramatic consequences. An example of a typical provision:

 “This lease is for a primary term of 12 months, and as long thereafter as oil or gas is produced.”

As the so-called “thereafter” clause can extend the lease indefinitely, it often is the source of controversy. It may extend the fixed or primary term so long as oil or gas, “is produced from said land.”
Other variations include:

• “is or can be produced”
• “is or can be produced in Lessee’s judgment”
• “is produced from said land or the premises are being developed or operated”
• “is produced in paying quantities”
• “is produced from said land or land with which the land is pooled hereunder”
• “is produced from said land by Lessee, or drilling operations are continued, as hereinafter provided.”

A recent case decided by the Supreme Court in Pennsylvania illustrates the controversy. T.W. Phillips Gas and Oil Co. and PC Exploration, Inc. v. Ann Jedlicka, decided March 26, 2012. The land owner, Jedlicka, sought to have an old lease terminated for the failure to produce “in paying quantities.”

First, the Court reviewed the respective interests of the parties to a lease. The interest granted in an oil and gas lease is inchoate. That is, it is an interest that is likely to vest but has not yet actually done so. Vesting is dependent on the occurrence of an event. Here, if development during the agreed upon primary term is unsuccessful, no estate vests in the lessee. If, however, oil or gas is produced, an interest in the property is created in the lessee, and the lessee’s right to extract the oil or gas becomes vested.

The interest created in the lessee is a “fee simple” meaning that it may last forever in the lessee and his heirs and assigns, the duration depending upon the concurrence of an event, here the termination of production. Since the fee can end, the interest is a “fee simple determinable.” It automatically reverts to the grantor upon the occurrence of the event. The interest held by the grantor after such a conveyance is termed “a possibility of reverter.”

The lease is also a contract. As the Court points out, it must be construed in accordance with the terms of the agreement as manifestly expressed, and the accepted and plain meaning of the language used, rather than the silent intentions of the contracting parties, determines the construction to be given the agreement. Further, a party seeking to terminate a lease bears the burden of proof.

In short, Jedlicka argued that the lease had suffered a loss in 1959 and was therefore terminated and that “lessees should not be allowed to hold land indefinitely for purely speculative purposes.” Lessee argued that the lease remained valid; that the wells on the property have produced gas in paying quantities because they have continued to pay a profit over operating expenses; and that they have operated the wells in good faith to make a profit.

What’s a “paying quantity?” Jedlicka argued that it is simple math – an objective test — using a computation of production receipts minus royalty minus expenses including marketing, labor, trucking, repair, taxes, fees and other expenses. Rejecting that approach and reaffirming an 1899 decision, the Court held that consideration should be given to a lessee’s good faith judgment (that is, a subjective test) when determining whether oil was produced in paying quantities.

Jedlicka argued that, “if only a subjective standard is used to determine paying quantities, oil and gas companies may choose to hold onto otherwise unprofitable wells for merely speculative, as opposed to productive, purposes.”

The Court disagreed, “a lessor will be protected from such acts because, if the well fails to pay a profit over operating expenses, and the evidence establishes that the lessee was not operating the wells for profit in good faith, the lease will terminate. Consideration of the operator’s good faith judgment in determining whether a well has produced in paying quantities, however, also protects a lessee from lessors who, by exploiting a brief period when a well has not produced a profit, seek to invalidate a lease with the hope of making a more profitable leasing arrangement.

The Ohio Supreme Court considered a similar case in 1955. Hanna v. Shorts. There, lessee’s argument that “lessee’s good faith judgment that production is paying must prevail” in determining whether there is production in paying quantities did not survive the fact that there had been no production at all. (It took the Supreme Court to figure that out? It just goes to show that when there is a lot of money at stake, controversy and litigation abound.)