An essential function of the law is to provide predictability as questions arise. When legal questions arise in the oil field regarding ownership rights, a consensus in the law — especially in the common law — is crucial. With that consensus, the attributes of conveyances related to those hydrocarbons (rights) can be examined. Specifically, what are the landowner’s rights with regard to the hydrocarbons under a piece of land in Ohio? Does he or she actually own them, or do they just have the right to capture them? If he or she would grant a lease to an oil company, what does the oil company own — is it an interest in real estate or is it simply a right to search? And, if found, what is the nature of the interest owned by the oil company pursuant to the lease? These fundamental questions have not been answered clearly in Ohio despite the fact that courts have struggled with them for over a century.
This ambiguity in the law puts federal courts in a potentially difficult position. Absent a clear indication of state law, federal judges deciding these issues under Ohio law are required to consider how the Ohio Supreme Court would decide the issue. Recently, a federal judge weighed in on the nature of an oil and gas lease in the case of Wellington Resource Group LLC v. Beck Energy Corporation, Case No. 2:12-CC-104 in the United States District Court for the Southern District of Ohio, Eastern Division, Sept. 20, 2013.
Whether the interest granted in the lease is an interest in real estate, or is something other than that, has implications in a variety of laws and contexts. Does the lease need to be in writing? Does the lease need to be recorded? Is a mechanics’ lien able to attach to it? How is the lease characterized in a bankruptcy context? (Read more in previously published articles about bankruptcy and mechanics’ liens.)
In Wellington, the dispute arose in the context of a broker’s right to a commission for the sale of oil and gas leases. Faced with such a claim, Beck argued that oil and gas leases are an interest in real estate and those who list, offer, or negotiate the sale of a lease must be licensed real estate brokers under Ohio law to collect a fee. Because the broker was not licensed, Beck asserted that no fee was due.
The federal judge did not agree, holding that if the Ohio Supreme Court had to answer this question, it would likely hold that an oil and gas lease would not be considered an interest in real estate. The court noted that an 1889 case (see citations in the court’s opinion) interpreting Ohio law sets the tone:
Oil and gas leases are not a right in the land as such, but a right to enter upon the land.
Later, in 1898, the Ohio Supreme Court held:
An agreement giving the lessee the sole right to produce oil and gas was not a lease, but merely a grant of an exclusive right to produce during the term.
Yet the same court, in 1897, found:
A lease granting for the purpose and with the exclusive right of drilling all that certain track of land was more than a mere license; rather, it was a lease of the land for the purpose and period therein, and the lessee has a vested right to the possession of the land to the extent reasonably necessary.
More than 50 years later, in 1953, the Ohio Supreme Court had to decide if oil and gas leases must be recorded. It found that:
A grant of all the oil and gas in and under a tract of land, as well as the right and privilege of operating upon said premises for the obtaining of such oil and gas was NOT a grant of real property.
Instead, harkening back to the rule of capture, the court said that possession of migratory oil and gas was achieved only by production and that the conveyance was “no more than a license to effect such severance.”
Then the federal court examined more recent Ohio cases. Most relevant is a 2007 federal case interpreting Ohio law, which held:
An oil and gas lease, while governed by contract law, also creates a limited property right, such that the lessee has the right to possess the land to the extent reasonably necessary to perform the terms of the lease on his part.
A right to possess would seem to be an interest in real estate. Nevertheless, given the weight of authority of the earlier cases, the federal court presumed that the Ohio Supreme Court would not agree. It gleaned support from proposed legislation granting ODNR authority to regulate landmen. The court reasoned in its opinion: “Why would the legislature do this if negotiating the purchase and sale of oil and gas rights does not currently fall under the ambit of the real estate laws?”
The court also found support in Oklahoma and Kansas court cases, both “non-ownership” states. Finally, Beck’s arguments notwithstanding, the court aligned itself with Oklahoma — a lease is not an interest in real estate in Ohio.
Of course, Texas goes the other way. There the mineral owner owns the oil and gas and when it grants a lease, it grants an interest in real estate.
The Jedlicka case
In an example closer to home, a recent case decided by the Supreme Court in Pennsylvania: 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.”
Before deciding that issue, the court reviewed the respective interests of the parties to a lease and determined the interest granted in an oil and gas lease is inchoate. That is to say 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. If development during the agreed upon primary term is unsuccessful, no estate vests in the lessee. If, however, oil or gas is produced, then an interest in the property is created in the lessee, and the lessee’s right to extract the oil or gas becomes vested.
Explaining further, the court said that the interest created in the lessee is a “fee simple,” meaning that it may last forever in the lessee and in his heirs and assigns. The duration of the interest depends on the concurrence of an event — here, it would be in 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.”
Lease forfeitures shed light
Examining the nature of a lease in Ohio, Neal Pierce [author of “The Quick and the Dead: Cessation of Production and Shut-Ins During the Secondary Term of an Oil and Gas Lease,” 88 North Dakota Law Review 727, 838 (2012)] says: “(I)t is worthwhile to note recent oil and gas cases at the appellate court level, expressing the view that in Ohio oil and gas leases create a fee simple determinable estate, rather than a profit or hereditament.” He cites Tisdale v. Walla, No 94-A-0008, 1994 Ohio App. LEXIS 5941, where the court says:
“The terminology utilized in the habendum clause (“and as long thereafter as”) is generally construed to create a determinable fee interest, such that the lessee’s interest automatically terminates upon lessee’s failure to satisfy any of the listed provisions which would serve to extend the term of the lease.”
Pierce also cites Kramer v. PAC Drilling Oil & Gas, LLC, 197 Ohio App. 3d 554, 2011 Ohio 6750, 968 N.E.2d 64, 2011 Ohio App. LEXIS 5573 (Ohio Ct. App., Wayne County 2011). The Kramer court said that in conjunction with the examination of a free gas clause:
“[The oil company] became the fee-simple owner of the conveyed oil and gas estates while the [land owners] retained a possibility of reverter as provided in the lease. Because of the possibility of reverter, [the oil company’s] fee-simple estate in the oil and gas was a fee simple determinable rather than a fee-simple absolute. Harris v. Ohio Oil Co., 57 Ohio St. 118, 130-31, 48 N.E. 502 (1897) (noting that, when an oil and gas lease ends, ‘whether caused by the exhausting of the oil and gas, or by the permanent abandonment of production, the lease will cease, and the whole estate in the premises will become the property of the owner of the fee, not by forfeiture, but by virtue of the terms of the lease.’); see Moore v. Indian Camp Coal Co., 75 Ohio St. 493, 499, 80 N.E. 6, 4 Ohio L. Rep. 673 (1907) (recognizing that fee-simple mineral estate is determinable upon the exhaustion of the minerals).”
The reasoning is much like that in the Jedlicka opinion.
The Kramer court then cites Texas law, Natural Gas Pipeline Co. of America v. Pool, 124 S.W.3d 188, 192 (Tex. 2003):
“[A]n oil and gas lease is not a ‘lease’ in the traditional sense of a lease of the surface of real property. In a typical oil or gas lease, the lessor is a grantor and grants a fee simple determinable interest to the lessee, who is actually a grantee. Consequently, the lessee/grantee acquires ownership of all the minerals in place that the lessor/grantor owned and purported to lease, subject to the possibility of reverter in the lessor/grantor. The lessee’s/grantee’s interest is ‘determinable’ because it may terminate and revert entirely to the lessor/grantor upon the occurrence of events that the lease specifies will cause termination of the estate.”
Again, Texas is an ownership state where the lease is viewed as a grant of the minerals, which is clearly an interest in real estate. A reliance on Texas law would seem to be misplaced. But the automatic forfeiture is an attribute of a fee simple determinable regardless of how the interest owned by the lessor is characterized.
The question in Ohio, then, is whether a lease creates a fee simple determinable. The idea that the interest created by the lease is a fee simple determinable, and therefore an interest in real estate, seems to be a more likely conclusion. After all, leases are notarized and recorded. They are assigned, can remain in effect forever, include the right to use the surface and create obligations that run with the land. But is it possible for a land owner who doesn’t “own” the minerals in place, but merely captures them, to grant such an estate?