The Oil and Gas Addendum

Pennsylvania Superior Court Fumbles Lease Expiration Claim

Every oil and gas lease has essentially the same objective: the drilling of a well and the eventual payment of production royalties. But what happens when the operator delays development and puts off drilling a new well for years? For example, assume you signed a new lease with XYZ Oil in 2005. The lease had a three (3) year primary term. In lieu of drilling a well in 2006, XYZ Oil simply tendered you a “delay rental” of $5.00 per acre. The lease itself stipulates that the operator must pay a delay rental each year “until drilling operations commence”. XYZ Oil does not drill a well in 2006, 2007 or 2008 but continues to pay the “delay rental” each year. Can this cycle go on indefinitely? Can the operator keep the lease alive without ever drilling a well? This troubling scenario was recently before the Pennsylvania Superior Court in Wilson v. Snyder Brothers, et al. (734 WDA 2019, January 3, 2020). Unfortunately, as detailed below, the author submits that the Superior Court misread the underlying lease and existing precedent, and as a result, may have interjected unnecessary confusion into Pennsylvania oil and gas law.

At issue in Wilson were three oil and gas leases signed in the summer of 2003 (the “2003 Leases”). The 2003 Leases had a short primary term of 180 days. The habendum clause stated that the 2003 Leases would remain in effect beyond 180 days if: i) oil and gas was actually produced or ii) the lessee tendered a delay rental of $3.00 per acre per year. The clause itself was unusual insofar that it suggested that the lessee could pay delay rentals after expiration of the primary term.

The six month primary term of the 2003 Leases expired in the winter of 2004. At this time, no wells had been drilled on the leased premises. Instead of drilling a well and establishing production, the lessee, Snyder Brothers, Inc. (“Snyder”), simply tendered a delay rental each year. This continued for seven years.

In May 2010, Snyder obtained a permit to drill a vertical well on one of the tracts (the “Vertical Well”). Several weeks later, the landowners executed a lease amendment which increased the acreage subject to one of the 2003 Leases (the “2010 Amendment”). Pursuant to the 2010 Amendment, the landowners also “ratified” the 2003 Leases with the following language:

“Ratification. Lessors hereby ratify the Lease as being in full force and effect and not in breach, and that the said Lease will remain in full force and effect in accordance with its terms as amended by this Oil and Gas Lease Amendment Agreement.”

In May 2011, Snyder completed hydraulic stimulation of the Vertical Well. Thereafter, in June 2011, the Vertical Well began producing hydrocarbons. The landowners received their first production royalty later that summer, nearly eight years after the primary term expired.

In 2018, the Wilsons filed suit seeking a judicial declaration that, inter alia, the 2003 Leases had expired due to non-production in 2004. Specifically, the Wilsons argued that Snyder could not maintain the 2003 Leases beyond the 180 days simply by tendering delay rentals. The Wilsons contended that delay rentals, as a matter of law, can only operate to maintain a lease during the primary term. Here, the primary term expired in the winter of 2004. As such, the Wilsons argued that although Snyder had paid delay rentals annually between 2004 and 2010, these payments alone were legally insufficient to maintain the 2003 Leases.

In response, Snyder filed preliminary objections to the Wilsons’ complaint. Snyder suggested that the Wilsons’ lease expiration claim was legally deficient for three reasons: i) the Wilsons accepted all of the delay rentals between 2004 and 2010; ii) the Wilsons nonetheless ratified the 2003 Leases in May 2010, thereby waiving any potential claim and iii) the Wilsons failed to give written notice of the claim as required by the 2003 Leases. In March 2019, the trial court granted Snyder’s preliminary objections and dismissed the complaint. The Wilsons filed a timely appeal to the Pennsylvania Superior Court.

Before we examine the decision of the Superior Court, a brief discussion about “delay rentals” is warranted. Many older oil and gas leases required the operator to either drill a well or tender a “rental” payment in lieu of actual drilling. This obligation to drill or pay was triggered each year during the primary term. The failure to satisfy this annual obligation (i.e. drill a well or pay a rental) would typically terminate the lease, even if the primary term had not yet expired. Given this harsh outcome, many operators, especially in the Marcellus region, moved away from the delay rental concept and instead adopted a policy of offering “paid up” leases. Under this approach, the delay rentals and in years one (1) through five (5) of the primary term are bundled together and paid in one lump sum amount at execution of the lease. This eliminates the risk of possibly losing the lease due to the inadvertent non-payment of a delay rental. As such, delay rentals have become nearly obsolete and are now relatively uncommon here in Pennsylvania.

But, there are a number of older, pre-Marcellus leases that still have a delay rental mechanism. These older leases are generally subject to the well-established delay rental rule: the payment of delay rentals can only maintain a lease during its primary term. See, State ex rel. Claugus Family Farm LP v. Seventh Dis. Court of Appeals, 145 Ohio St. 3d 180 (Ohio 2016) (“[D]elay rental provisions have been interpreted to apply only during the primary term of a lease”); Vaughn v. Hearrell, 347 S.W.2d 542 (Ky. 1961) (“. . . delay rental clauses of the standard oil and gas contract are intended to keep it in force only within the primary term”); Morriss v. First National Bank of Mission, 249 S.W. 2d 269, 279 (Tex. Civ. App. 1952) (“. . . option to pay rentals ordinarily will delay operations as long as the rentals are paid, but not beyond the primary term”). Pennsylvania has long followed this general rule and reaffirmed this principle as recently as 2011 in Hite v. Falcon Partners, 13 A.3d 942 (Pa. Super. 2011).

In Hite, the Pennsylvania Superior Court concluded that the mere payment of delay rentals after expiration of the primary term could not maintain the parties’ oil/gas lease. The panel opined that such an arrangement would be “inconsistent with the established rulings in public policy” that lessees should not be able to “postpone development indefinitely by the payment of delay rentals." Hite, 13 A.3d at 948. Although the underlying lease in Hite arguably contained language that authorized the payment of delay rentals after the primary term expired, the Superior Court refused to give effect to such language. Following Hite, it was generally understood and acknowledged that Pennsylvania adhered to the general rule that delay rentals only apply during the primary term of an oil/gas lease.

On appeal, the Wilsons argued that the trial court’s decision was contrary to the holding set forth in Hite. Remarkably, the panel in Wilson opined that Hite was inapplicable. The panel placed unusual weight on the fact that the Wilsons “ratified” the 2003 Lease in May 2010. The court concluded that “. . . the Wilsons waived any claim that they may have had to dispute the validity of the subject leases based on non-production for 2003 until the 2010 ratification. . .” Because there was no ratification in Hite, the Wilson panel assumed that Hite was inapplicable. The author submits that this was clear error.

After a landowner executes a lease ratification, the landowner is essentially representing to the driller that any prior defects, omissions or breaches in the underlying lease are being waived and are now “cured.” The ratification, however, is not prospective – it only cures or waives existing defects. It does not provide a “free pass” in the future. When the Wilsons signed the 2010 Amendment, it only “ratified” the time period between June 26, 2003 and May 24, 2010, the date they actually signed the instrument. It did not, and could not, operate to “waive” any lease expiration claim that may have accrued the very next day (i.e., May 25, 2010). In other words, unless there was actual production or ongoing operations occurring on May 25, 2010, the 2003 Leases may have expired that day. The purported ratification would have no effect on periods of non-production occurring after May 24, 2010. Since Snyder did not begin producing gas from the lone Vertical Well until June 2011, the Wilson panel erred by not applying Hite to that interim period.

The Wilson decision appears to be at odds with the bright-line rule set forth in Hite. The author believes that Wilson has interjected confusion and ambiguity into Pennsylvania oil and gas law. Until this issue is resolved, landowners should not accept or deposit delay rental payments tendered after expiration of the primary term. In addition, landowners should carefully review and study any lease ratification proposal presented to them by drillers. Any such ratification proposal should be reviewed by competent oil and gas counsel. The Wilson decision suggests that a ratification agreement executed years after a lease expired may nonetheless have the effect of reviving and resurrecting that expired lease. That is alarming news to all landowners.