The Oil and Gas Addendum

Let’s assume you own 125 acres in Greene County, Pennsylvania.  A landman from XYZ Gas Co. approaches you about a new oil and gas lease.  The lease purports to grant XYZ Gas Co. exclusive drilling rights to the Marcellus Shale formation and the deeper Utica Shale formation.  You are not inclined to lease the deeper shale formations.  Your counsel drafts what is commonly known as a “depth severance” clause and requests that the following clause be inserted into the lease addendum:

“This Lease does not grant any developmental and/or extraction rights in any formation or strata below the base of the Utica Shale.” 

XYZ Gas Co. agrees to the depth severance clause and you sign the lease. 

Several years later, you discover that XYZ Gas Co. has drilled four wells under your farm.  But, much to your surprise, none of the wells access or penetrate the Marcellus Shale or the Utica Shale.  Instead, all of the wells land in a deeper shale formation known as the Point Pleasant formation.  You raise this discrepancy with XYZ Gas Co. and contend that your lease’s depth severance clause did not allow that development.  XYZ Gas Co. tells you that “this is no big deal” and that “everyone knows the Utica and Point Pleasant are essentially the same thing.”  You are confused and frustrated. Does the depth severance clause apply or not?  Can XYZ Gas Co. drill wells into formations excluded by the depth severance clause?  A recent decision from the Ohio Court of Appeals puts teeth back into the proverbial depth severance clause.  This is good news for landowners. 

At issue in Tera LLC v. Rice Drilling D LLC, et al., Case No. 21 BE 0047 (Ohio Ct. App., 7^th Dist. January 18, 2023) were two (2) oil and gas leases, signed in 2013 and 2014, concerning approximately 271 acres in Belmont County, Ohio (the “Subject Leases”).  The granting clause in the Subject Leases stated that the lessor was leasing to Rice Drilling D LLC (“Rice”) “all the oil and gas, minerals and their constituents (not including coal) in the formations commonly known as the Marcellus Shale and the Utica Shale…”  All other formations were “reserved to the lessor.”  As further clarification as to the limited scope of the leasehold granted to Rice, the Subject Leases also contained the following depth severance clause:

“The Lessor reserves all rights not specifically granted to Lessee in the Lease.  Lessor specifically reserves the right to all products contained in any formation:  (1) from the surface of the Leased Premises to the top of the formation commonly known as Marcellus Shale, (2) in any and all formations below the base of Marcellus Shale to the top of the formation commonly known as Utica Shale, and (3) in all formations below the base of the Utica Shale.”

Rice subsequently drilled six (6) horizontal wells in and through the leasehold.  By 2017, all six (6) wells were in production.[1]  The landowner, however, discovered that the wells were actually producing from the Point Pleasant formation, which is deeper than the Marcellus Shale and the Utica Shale.  Since the Subject Leases were strictly limited to the Marcellus Shale and Utica Shale, the landowner asserted that Rice had no authority or right to extract hydrocarbons from the Point Pleasant formation.  The landowner filed suit in October 2017 seeking damages for bad faith trespass and conversion. 

Rice did not dispute or deny that the six (6) wells landed in the deeper Point Pleasant formation.  But Rice defended the suit by arguing that, in 2013 and 2014 when the Subject Leases were signed, the Point Pleasant formation was considered an “interval” contained within the Utica Shale formation.  Rice further argued that industry custom and trade usage in 2013 routinely recognized the Point Pleasant formation as being part of the Utica Shale formation.  As such, Rice contended that no subsurface trespass occurred because all six (6) wells were authorized under the Subject Leases.  In essence, Rice asked the trial court to broadly interpret the depth severance clause to expand the meaning of the term “Utica Shale” to include the Point Pleasant formation. 

The landowner moved for summary judgment on the issue of liability.  The landowner argued that the Subject Leases were unambiguous and that the depth severance clause plainly excluded all formations “below the base of the Utica Shale.”  Since it was undisputed that all six (6) horizontal wells landed in the deeper Point Pleasant formation, the landowner suggested that the only issue ripe for trial was the amount of trespass damages.  The trial court agreed. 

In June 2020, the trial court granted the landowner’s motion, noting that an oil/gas lease “conveys rights to extract all geological formations under the leased property, unless there is specific language of limitation.”  Here, the depth severance clause clearly limited the leased formations.  As such, the trial court concluded that Rice (and Gulfport) “acquired no interest in the oil and/or gas in the Point Pleasant formation.”  The trial court also ruled that “…Rice and Gulfport knowingly, willfully and recklessly drilled their wells into the Point Pleasant formation and are therefore willful trespassers.” 

Given this finding, the trial court held that the damages “owed to the [landowner] are to be calculated without any deductions for the cost of drilling, operating, transporting and any other expense in removing the oil and gas from the [landowner’s] property.”  A jury trial was subsequently conducted in July 2021 solely on the issue of damages.  The jury returned a verdict in favor of the landowner in the amount of $40,129,357.62.  Rice and Gulfport filed a timely appeal to the Seventh Appellate District.

On appeal, Rice and Gulfport argued that the trial court erred when it concluded that the Subject Leases were unambiguous.  In so holding, the trial court excluded extrinsic and parol evidence regarding industry custom and trade usage.[2]  Rice and Gulfport argued that the phrase “commonly known as the…Utica Shale” in the granting clause was ambiguous and that the trial court erred by not admitting and considering evidence of what the oil and gas industry understood the “Utica Shale” to mean in 2013.

The Seventh Appellate District disagreed and held that extrinsic evidence was not necessary.  The panel observed that the phrase “commonly known as the …Utica Shale” was not ambiguous:

“It is undisputed that the Point Pleasant is a formation below the Utica Shale. Consequently we find that [the landowner] unambiguously reserved the Point Pleasant formation from the lease.  To the extent that ambiguity exists within the “grant of lease” provision, we conclude that it is clarified by the plain language of the reservation section…”

The Seventh Appellate District affirmed the entry of summary judgment in favor of the landowner.  The Seventh Appellate District also affirmed the finding of a bad faith trespass and the corresponding damage methodology presented to the jury.  The panel noted that in a “bad faith” trespass, the “measure of damages is the market value of the minerals at the mouth of mine, at the time of removal, without any deduction for the cost of labor and other expenses incurred in severing and transporting…”[3]

The Seventh Appellate District’s conclusion that “bad faith” damages were appropriate in Tera aligns with the Pennsylvania Superior Court’s evaluation of subsurface trespass damages in Sabella v. Appalachian Development Corp., 103 A. 3d 83 (Pa. Super. Ct. 2014).  In Sabella, the Pennsylvania Superior Court distinguished between a “good faith” trespass and a “bad faith” trespass, observing:

Stated broadly, when improvements to land are made by a good-faith trespasser, the injured party is entitled, in effect, to the trespasser's net profits, i.e., the revenues generated upon the land less the moneys expended in facilitating the profitable activity. However, when a party trespasses in bad faith, the injured party is entitled to all moneys derived from the trespass without any offset for the cost of generating those moneys.

Id. at 98.  Although Sabella did not deal with a depth severance clause, Sabella was similar to Tera because the lessee in Sabella drilled wells without a lease authorizing development.  In Sabella, the court concluded that “bad faith” trespass damages were warranted because the driller failed to fully investigate the public records, which would have identified that the driller did not have any leasehold rights to the oil and gas underlying the property where the wells were drilled.

Taken together, Tera and Sabella align Pennsylvania and Ohio law on this critical topic. These decisions are beneficial to landowners but fair for all involved in oil and gas production. Entities developing oil and gas have the ability and duty to search the public records and to honor contractual provisions that specify “what” oil and gas formations can be developed.  If a lease has a depth severance clause that prohibits development from a certain formation or a lessee does not have any lease rights in the first place, then the lessee cannot proceed with the drilling and development of those oil and gas formations.  See, Subsurface Trespass – Can they Take the Gas Under My Property Without a Lease? (July 2011).

It is reasonable that drillers’ failure to confine their operations to property or formations that they have contractual rights to produce from (whether a geographic stratum under the earth or within property boundaries on the surface) should be a basis for the imposition of “bad faith” damages where the costs of the development are not charged against the landowner’s recovery.  Lessees have the wherewithal and obligation to ensure that they have contractual rights to develop the oil and gas that they intend to produce.  If “bad faith” trespass damages did not exist in these types of cases, then the role of the oil and gas lease would be significantly reduced, because, in the event of litigation arising of such unauthorized drilling, the lessee would be able to reduce its exposure by simply deducting the developmental costs against any jury award.  As such, it is submitted that “bad faith” trespass damages operate as an appropriate disincentive for unauthorized drilling and development.

The Sabella court in 2014 and the Tera court in 2023 affirmed that drillers who fail to diligently verify that they have the contractual right to drill and develop a certain oil and gas formation can be liable for potentially substantial damages, with no offset.

[1] In 2016, Rice assigned a 31.3% interest in the Subject Leases to Gulfport Energy.

[2] Rice and Gulfport raised several other evidentiary issues on appeal.  However, the instant article will only address and discuss the “depth severance” clause and the court’s disposition of the same.

[3] The Seventh Appellate District did vacate the compensatory damage award and remanded the mater for a new jury trial “limited solely to the amount of compensatory damages sustained by Tera.”