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September 10, 2012 Articles

Extending Oil and Gas Leases to Their Secondary Term

Recent activity in the Marcellus Shale has revived interest in this issue.

By Kevin K. Douglass and Christopher M. Buell

The continuation of oil and gas leases has been a subject of interest, a point of contention, and a basis for litigation for lessors and lessees practically from the time that such leases were first entered into. Perhaps one of the most litigated areas in this fertile ground is the issue of whether an oil and gas lease reaches its secondary term, terminates at the conclusion of the primary term, or terminates even sooner.

It is no surprise that this issue has received renewed interest in the Appalachian Basin as the amount of leasing activity, development, and investment has skyrocketed with the focus on newly accessible shale-gas resources in that region. This new set of circumstances raises the stakes for all parties involved and presents both new questions of law and questions that have not been addressed in decades or more by the courts in the region—in other words, the perfect recipe for litigation. These issues can only be expected to continue or increase as many leases from the initial wave of shale-gas activity in the Appalachian Basin reach the end of their primary term and as operators are forced to make decisions on how best to preserve their investments in these leases.

Although the law relating to these issues is settled in many gas-producing states in the western part of the country, courts in the Appalachian Basin have not considered these issues in decades or even a century. Therefore, the issues are new to many courts and practitioners confronting them in the region. This set of circumstances is also likely to repeat itself as shale-gas development moves into other regions across the country where the common law is antiquated or nonexistent.

The primary driver of lease preservation into the secondary term is production from the leasehold. Indeed, production of natural gas is the central purpose of the oil and gas leases. However, a number of related questions and common lease provisions can also affect whether a lease will reach its secondary term, or terminate at the end of the primary term or sooner. While there are a number of such related issues, this article will offer an overview of several common issues that arise for operators in the Appalachian Basin as leases progress through and approach the end of their primary terms.

Commencement of Operations
A common question that lessees often face as a lease approaches the end of its primary term is what constitutes commencement of operations. This terminology—commencement of operations or some variation of it—may appear in various locations in an oil and gas lease, including in the habendum and drilling and rental clauses of a lease. Depending upon the language contained in the lease, commencement of operations will often be a means to extend a lease beyond its primary term or a requirement to ensure that the lease does not expire before the end of the primary term. As a result, a lessee will need to determine what action it must take to satisfy any obligations it may have under the lease and to ensure its continued interest in a leasehold.

Courts in the Appalachian Basin states have generally held that preliminary work prior to the actual drilling of a well is sufficient to satisfy a “commencement of operations”-type requirement in a lease if the work is a necessary part of drilling a well. Additionally, the courts have typically included some requirement of good faith on the part of the lessee, such that the lessee is performing the work to complete a well and produce gas, and not simply to hold a lease for speculative purposes. Finally, depending upon the posture of the cases, courts have generally required diligence on the part of a lessee in continuing the work to completion after having commenced it. See, e.g.Pemco Gas, Inc. v. Bernardi, 5 Pa. D. & C. 3d 85 (Pa. Com. Pl. 1977); Fleming Oil & Gas Co. v. South Penn Oil Co., 17 S.E. 203 (W. Va. 1893); Duffield v. Russell, 10 Ohio C.D. 472 (Ohio Ct. App. 1899), aff’d,63 N.E. 1127 (1902).

Each case is likely to turn on the precise language in a lease, of which there are seemingly unlimited variations. For instance, many of the cases in Pennsylvania, Ohio, and West Virginia considered lease language requiring “commencement of operations,” which arguably leaves open the question of whether the slightly different terminology of “commencement of drilling” or “commencement of drilling operations” in a lease would lead to a different result. Additionally, a lease may itself define what will amount to “commencement of operations,” and in such a case, a court is likely to enforce the lease terms agreed upon by the parties themselves. See, e.g.Burke v. GAPCO Energy LLC, 2012 WL 1038849 (W.D. Pa., Mar. 28, 2012).

A more recent decision by a federal court in Pennsylvania illustrates the complexities that may be added to the analysis by a more detailed lease agreement. In Good Will Hunting Club, Inc. v. Range Resources, Inc., 2012 WL 722614 (M.D. Pa., Mar. 1, 2012), the federal district court denied cross-motions for summary judgment regarding whether a lease expired at the end of its primary term. In making its decision, the court noted that it was assuming for purposes of the cross-motions that the lessee had properly “commenced a well” during the primary term of the lease. But the court concluded that the lease language was ambiguous as to whether this was sufficient to continue the lease into a secondary term, and the issue therefore could not be decided at the summary-judgment stage. Specifically, the court found that the lease language contained a patent ambiguity that resulted from attempting to read two sections of the lease in conjunction with one another. In that case, the “commencement” requirement appeared in a covenant to commence a well during the primary term and an incorporation of that requirement in the habendum clause.

Delay Rentals
A covenant or an obligation to pay delay rentals in an oil and gas lease is another common provision that often may dictate the continued validity or early expiration of a lease. Although the rise of the paid-up oil and gas lease has limited the impact that delay rentals may have upon leases, many leases continue to include delay-rental provisions. The decisions by the courts of the Appalachian Basin states addressing delay rentals are myriad. Therefore, the following discussion attempts to set forth the general parameters of how courts in these states analyze and apply delay-rental provisions and treat non-payment of delay rentals.

Payment of delay rentals will generally only serve to excuse development under a lease during the primary term of a lease. Although leases will often clearly reflect this fact, even where lease language may suggest otherwise, courts have generally refused to permit parties to extend leases beyond their primary term merely through the continued payment of delay-rental payments. See, e.g.Hite v. Falcon Partners, 13 A.3d 942 (Pa. Super. Ct. 2011).

Delay-rental payments developed as a means to relieve a lessee of a duty to develop a leasehold promptly after entering into an oil and gas lease. Provisions addressing delay rentals are generally found in the portion of a lease referred to as the “drilling and rental clause,” which addresses the obligations of a lessee to continue a lease through its primary term.

A brief overview of the common types of drilling and rental clauses will assist in discussing how these lease provisions are treated in the Appalachian Basin. Based on the provisions of the drilling and rental clauses, leases are commonly described as one of two types: “or” leases and “unless” leases. Under an “or” lease, the “lessee covenants to do some alternative act, usually to drill a well or to pay periodic rentals, to maintain the lease during its primary term. Simply put, the lessee must ‘drill or pay.’” Warner v. Haught, 329 S.E.2d 88, 92 (W. Va. 1985). Under an “unless” lease, the lessee does not covenant to perform any act, but unless the lessee performs the action required—typically drilling or paying rental—by the time specified, the lease will automatically terminate. In other words, “‘if’ no well is drilled, the lease terminates ‘unless’ rentals are paid.” Id.

Courts in Pennsylvania, West Virginia, and Ohio have generally analyzed the impact that payment—and more importantly, non-payment—of delay rentals has on the validity of oil and gas in similar ways. As a general rule, under an “or” lease, a lessor will be limited to an action for damages in the event of non-payment of delay rental, unless the lease contains a forfeiture clause providing otherwise. See Girolami v. Peoples Natural Gas Co., 76 A.2d 375, 377 (Pa. 1950); Wohnhas v. Shepherd, 119 N.E.2d 861, 863 (Ohio Com. Pl. 1954). West Virginia has a unique statute that effectively inserts a forfeiture clause into “or” leases, providing lessors with a means to demand delay rentals that are due and to terminate the lease upon non-payment. See W. Va. Code § 36-4-9a. Under an “unless” lease, in the event of non-payment of delay rentals, the lease will expire automatically. See Bertani v. Beck, 479 A.2d 534, 535 (Pa. Super. Ct. 1984); Warner v. Haught, Inc., 329 S.E.2d 88, 96 (W. Va. 1985);Brown v. Fowler, 63 N.E. 76, 78 (Ohio 1902).

Equitable Estoppel
Courts in limited circumstances will equitably extend the life of an Appalachian oil and gas lease beyond its primary term despite the operator’s failure to satisfy the lease requirements. To satisfy the elements of an equitable-estoppel claim or defense, a party must generally establish a knowingly false representation or a concealment of material facts; its reliance on that representation to its prejudice without knowledge of the true facts; and that the representation was made with the intent that it be acted on. To raise an equitable estoppel, there must be a conduct, acts, language, or silence amounting to a representation or a concealment of material facts.

In the context of an oil and gas lease, the lessor may hinder the lessee’s performance, and that hindrance may provide the lessee with a continuing legal excuse for not performing. In such cases, the doctrine of equitable estoppel effectively extends the primary term of the lease for the reasonable time that justice may require for the lessee to begin oil and/or gas production unhindered and avoid the express limitations contained in the lease. For example, a court equitably extended the primary term of the lease where a landowner improperly ordered the lessee’s driller to leave the landowner’s property even though the primary term of the lease did not expire for another 12 hours and the driller would have produced gas in that time period if permitted to complete the work. Eastern Oil Co. v. Coulehan, 64 S.E. 836, 840–41 (W. Va. 1909). A West Virginia court has also equitably extended the primary term of a lease where the lessor by his conduct and by accepting the benefits of the lease “leads the lessee to believe that he will not insist upon production in paying quantities during the primary term. Ohio Fuel Oil Co. v. Greenleaf, 99 S.E. 274, 275 (W. Va. 1919). In Greenleaf, the landowner advised the lessee that he would not complain in the event the lessee stopped gas production during the primary term because it was anticipated that a second well would be drilled. Moreover, the lessor insisted that the lessee continue to provide free gas to his residence from another source during the time that the original well was abandoned and after the expiration of the lease’s primary term.

At least one court in Ohio has equitably extended the primary lease term for the period of time that the lessor wrongfully enjoined the lessee from engaging in production activities.Staho v. Van Vleck, 41 N.E. 35 (Ohio 1895). In a West Virginia case, the court equitably extended the lease where the lessor failed to deliver clear title to the property despite an express warranty and otherwise engaged in “foot-dragging and conspiracy” designed to delay production to ensure the expiration of the original lease. Wilson v. Xander387 S.E.2d809, 811 (W. Va. 1989).

However, to take advantage of the doctrine of equitable estoppel, the lessee must demonstrate that it exercised due diligence toward production. Id.; see also Jolynne Corp. v. Michels, 446, S.E.2d 494, 505 (W. Va. 1994). The Wilson court noted that the lessee could be criticized “for waiting two years of a three-year lease before attempting to clear the title and obtain drilling permits.” 387 S.E.2d at 811. Nonetheless, the court found that the due-diligence issue was a jury question because the lessor’s warranty of the title “might well justify reliance by the lessees and explain their slowness off the mark in clearing the title to the property.” Id. In contrast, in Jolynne,the court held as a matter of law that the lessee failed to exercise due diligence where the lessee did little or nothing to return a well to production for 18 years. 446 S.E.2d at 505.

In the absence of an injunction, courts in Pennsylvania have refused to equitably extend a primary lease term during the time litigation is pending between the landowner and lessee. For example, the Superior Court refused to equitably extend a lease term for the period necessary for the lessee to obtain a judicial resolution of a cloud on the lessor’s title to the land. Derrickheim Co. v. Brown, 451 A.2d 477 (Pa. Super. Ct. 1982). The Derrickheim court agreed that, given the possible title defect, the lessee had no affirmative duty to drill for oil or make rental payments. However, the court found that the cloud on the title did not stop the running of the lease term.

Similarly, the U.S. District Court for the Middle District of Pennsylvania recently held that the lessor’s filing of a lawsuit seeking a declaration that certain leases were invalid did not equitably extend the lease term for the time that the lawsuit was pending. Lauchle v. Keeton Group LLC, 768 F.Supp.2d 757 (M.D. Pa. 2011). In Lauchle, lessors sought a declaration that certain leases were invalid under Pennsylvania’s Guaranteed Minimum Royalty Act. The court initially found that the leases remained valid by relying on a recent Pennsylvania Supreme Court opinion analyzing the act.Thereafter, the lessees filed a counterclaim seeking to equitably extend the term of the leases during the time the litigation was pending, and the parties filed cross motions for summary judgment. The lessees cited case law in Louisiana, Oklahoma, and Texas to support their position and argued that equitable extension was proper because the lessors had repudiated the leases by initiating litigation challenging the validity of the leases. The court rejected the lessees’ contention and granted summary judgment for the lessors, finding that equitably extending the lease term would potentially have a chilling effect on landowners who filed meritorious challenges to leases since they would risk a finding that they had repudiated the leases if their action was unsuccessful.

Force Majeure
A New York court recently addressed whether a force majeure clause in a lease can serve to extend the primary term of a lease. A force majeure event occurring during the primary term of a lease, which allegedly prevents the lessee from engaging in production activities, cannot serve to extend the lease beyond the primary term if the lessee fails to make the required delay-rental payments. Wiser v. Enervest Operating, L.L.C., 803 F.Supp.2d 109 (N.D.N.Y. 2011). In Wiser, landowners commenced an action seeking a declaration that certain leases had terminated due to the expiration of the 10-year primary term of the lease. The lessees filed a counterclaim contending that a memorandum issued in July 2008 by the governor of New York constituted a force majeure event and extended the primary term of the lease because it “effected a de facto moratorium on exploration of the Marcellus Shale formation utilizing horizontal high-volume fracking.” Id. at 112–13. The lessors countered by arguing that, even if the moratorium constituted a force majeure event, the lease expired because the lessees failed to make the required delay rental payments during the primary term.

The parties both filed motions for summary judgment. The court initially concluded that, even assuming a force majeure event occurred, the terms of the lease required that the lessee make delay-rental payments to indefinitely extend the primary term of the lease. The lease inWiser effectively provided that, after 90 days, the primary term of the lease expired automatically unless gas was produced in paying quantities or the lessee made delay-rental payments during the primary term of the lease. The lessee conceded that it stopped making the required delay-rental payments during the time following the moratorium. The court reasoned that the application of the force majeure provision during the primary term of the lease did not excuse the requirement that delay-rental payments continue to be made. To avoid this conclusion, the lessees argued that the lease was automatically extended into the secondary term as a result of the force majeure event. The court disagreed and distinguished a Louisiana case cited by the operators because the specific force majeure provision at issue in that case expressly contemplated that the lease would continue beyond the primary term in the event of a force majeure.

Good-Faith Pooling and Unitization
Generally, Ohio, West Virginia, and Pennsylvania recognize the right of operators and landowners to agree to voluntarily pool lands to form a drilling unit. Ohio and West Virginia also have adopted mandatory pooling provisions. At least one trial court in Pennsylvania has expressly held that production from a well located on property that has been unitized will extend the term of all leases in the unit as if the well were located on the leased premises.Fox v. Wainoco Oil & Gas Co., 46 D. & C. 3d 439 (Pa. Com. Pl. 1986). In Fox, the court noted that the issue was one of first impression in Pennsylvania. After favorably discussing the policy reasons for pooling and unitization—namely, to promote development with the minimal amount of waste—the court held that “we believe that the drilling of a well on any tract in the unit satisfies the habendum clause of each tract in the unit and continues the lease in full force and effect so long as oil and gas are produced.” Id. at 444.

However, unitization generally must be carried out in good faith to extend a lease to its secondary term. See Kamuck v. Shell Energy Holdings GP, LLC, 2012 WL 1463594, at *1 n.1 (M.D. Pa., Mar. 19, 2012) (citations omitted) (noting that “[a]n oil and gas lessee’s pooling decision will be upheld unless the lessee pools in bad faith. Where a lessee pools oil and gas leases in good faith, the lessee is relieved of the obligation to reasonably develop each tract separately. . . .”), rev’d in part on other grounds 2012 WL 466490 (M.D. Pa., April 27, 2012). For example, in a Pennsylvania case, a lessor alleged that the lease should be declared null and void because the lessee had unitized in bad faith “and . . . only to hold onto the . . . lease because drilling had not yet commenced” on the lessor’s tract. Snyder Bros., Inc. v. Peoples Natural Gas Co., 676 A.2d 1226, 1231 (Pa. Super. Ct. 1996). The court, without much analysis, found no bad-faith unitization where the one-year primary term of the lease expired in November 1992 and the operator had formed the unit in April 1992 and commenced drilling in September 1992.

Keywords: environmental litigation, Marcellus Shale, delay rental, equitable estoppel, force majeure

Kevin K. Douglass is a shareholder and Christopher M. Buell is an associate at Babst, Calland, Clements and Zomnir, P.C., in Pittsburgh, Pennsylvania.

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