The Oil and Gas Addendum

There are thousands of shallow oil and gas wells across Pennsylvania. Many of these shallow wells were drilled pursuant to leases that were originally executed in the early 1900s, long before modern drilling techniques such as horizontal drilling and hydraulic fracturing were developed. Moreover, at the time these legacy leases were signed, neither the landowner nor the driller were aware of the deep shale formations such as the Marcellus or the Utica. Today, many landowners in Pennsylvania are becoming frustrated and angered because the “operators” of these older leases refuse to develop or explore the shale formations underlying the leasehold. The drillers contend that they have no obligation to drill a deep Marcellus well because that aging, shallow well on the leasehold is legally sufficient to hold and maintain the lease and all formations. Is this accurate? Can a shallow well drilled in 1906 maintain a lease indefinitely and excuse any exploration of the deep shale formations? Recently, the Ohio Supreme Court addressed this important issue and concluded that drillers in Ohio may not have an implied obligation to explore the shale. Although the decision in Alford v. Collins-McGregor Operating is not binding on Pennsylvania courts, the opinion may reflect a new judicial trend with respect to implied covenants.

At issue in Alford was an oil/gas lease signed in 1980 concerning 74 acres (the “1980 Lease”). In 1981, the lessee drilled a shallow vertical well into the Gordon Sand formation (the “Shallow Well”). Shortly thereafter, the Shallow Well began producing gas in paying quantities. No other wells were ever drilled on the 74 acres.

In 2015, the landowners filed suit alleging that the lessee had breached the 1980 Lease by failing to explore or drill for oil or gas below the Gordon Sand. The landowners argued that since nearby properties were producing gas from the Marcellus and Utica formations, the lessee had an implied obligation to at least “explore” these same formations underlying their 74 acre parcel. In their complaint, the landowners did not seek cancellation or termination of the entire 1980 Lease. Rather, they only sought cancellation of the 1980 Lease as to all depths below the Gordon Sand.

In response to the landowners’ complaint, the lessee filed a motion to dismiss. The lessee argued that Ohio simply does not recognize the remedy of “horizontal forfeiture”. The trial court agreed and dismissed the complaint. The trial court opined that production from the Shallow Well was legally sufficient to hold all depths and formations subject to the 1980 Lease. On appeal, the Fourth District Court of Appeals affirmed. Although the Fourth District acknowledged that vertical forfeiture (i.e., surface acreage) of an oil and gas lease had been recognized by Ohio courts in the past, it affirmed the trial court because Ohio had not yet recognized “horizontal forfeiture” as a remedy (i.e., cancelling particular strata or formations). The appellate court noted, however, that “this is a complex and evolving issue with no easy answer”. On March 15, 2017, the Ohio Supreme Court accepted the landowners’ discretionary appeal.

Before we address the substance of the Ohio Supreme Court’s opinion in Alford, a brief primer on implied covenants is warranted. Most oil and gas jurisdictions in the United States, including Pennsylvania, recognize the implied covenant of reasonable development in every oil and gas lease. Upon the discovery of gas in paying quantities, the operator is under an obligation to drill additional wells as reasonably necessary to recover as much of the gas from that producing formation. See, Clifton v. Koontz, 325 S.W.2d 684 (Tex. 1959) (the covenant requires that lessee to drill “additional wells in an already producing formation or stratum”). The operator is required to engage in further development only if the additional wells would be “profitable”. See, Sonat Exploration Co. v. Superior Oil Co., 710 P.2d 221 (Wyo. 1985) (“…a lessee is not required to further develop the lease in a proven field unless there is a reasonable expectation of profit”).

As noted above, the implied covenant of reasonable development only applies to proven formations. In other words, the obligation to further develop the leasehold only arises after gas is discovered “in paying quantities” from a known formation. What about unproven formations or strata such as deeper shale formations? A minority of courts and commentators have suggested that there exists an implied duty to explore such unproven formations.

The covenant, in essence, requires the operator to drill exploratory wells in the unproven formations or horizons located within the leasehold footprint. Colorado and Arkansas have both recognized this covenant as a means of discouraging the practice of holding a large leasehold with a minimally producing well. “Production on only a small portion of the leased land does not justify allowing the lessee to hold the entire leasehold indefinitely, thus depriving the lessor of receiving royalties from another arrangement. "Bryd v. Bradham, 655 S.W.2d 366, 367 (Ark. 1983). Colorado has further observed that the operator “may not hold the land merely for speculation in the hope that non-viable mineral holdings will become economic at some unknown time in the future . . . .” North York Land Associates v. Bryon Oil Industries, 695 P.2d 1188, 1191 (Colo. Ct. App. 1985). Thus, in jurisdictions that recognize this covenant, an operator cannot simply drill a well and then cease all further exploratory operations. See Ezzel v. Oil Associates, 22 S.W.2d 1015 (Ark. 1930) (lessee’s obligation to explore is ongoing, even after paying quantities are discovered); See also Davis v. Ross Production, 910 S.W.2d 209, 212 (Ark. 1995) (an implied covenant exists on the part of the lessee to explore the property with reasonable diligence). The operator is under a duty to investigate, test and explore other areas and formations subject to the leasehold or risk cancellation of the unexplored strata.

In establishing a breach of this covenant, the landowner does not have to demonstrate that the unproven formations or horizons would be profitable. “[T]he implied covenant of further exploration does not need such proof, but rather requires the lessor to show unreasonability by the lessee in not exploring further . . . .” See Gillette v. Pepper Tank Co., 694 P.2d 369, 372 (Colo. Ct. App. 1984). The inquiry does not focus on whether gas “in paying quantities” would be found. Instead the focus is on whether a reasonably prudent operator would have “tested” the unproven formations. The loss or damage to the landowner from the lack of exploratory testing is difficult to quantify. As such, the usual remedy has been cancellation of the unexplored formations.

The exploration covenant has been applied to shale formations. In Acre v. Spindletop Oil & Gas, 2011 WL 902186 (Feb. 22, 2011, E.D. Arkansas), the landowner brought suit seeking cancellation of the parties’ lease as to the undeveloped Fayetteville shale formation. The lease covered 640 acres in Faulkner County, Arkansas. The lessee had drilled a single well known as the “Sowesh #1-4 Well” into the Hale formation. Several years after the Sowesh #1-4 Well was completed, geologists confirmed the hydrocarbon potential of the deeper Fayetteville shale formation and other companies began extracting gas from that formation. The landowner argued that the lessee had breached the exploration covenant by failing to drill and exploit the deeper Fayetteville shale formation. The court denied the lessee’s motion for summary judgment and held that it could not conclude that the lessee had complied with the exploration covenant:

“… Spindletop has developed only one well which extracts gas from the Hale formation, upon a 640 acre tract. Geologists have determined that the Fayetteville formation has the potential to produce marketable gas. Further, there are multiple wells in close proximity to the Sowesh well and surrounding it which are producing gas…. The court cannot conclude as a matter of law that Spindletop has diligently developed the tract so as to produce … gas upon the entire tract.”

Spindletop, 2011 WL 902186 at 3. The Spindletop litigation eventually settled in the spring of 2012.

Texas and Oklahoma have expressly rejected the exploration covenant. Texas has held that no implied covenant of further exploration exists independent of the implied covenant of reasonable development. Sun Exploration & Prod. Co. v. Jackson, 783 S.W.2d 202 (Texas 1989). In Jackson, the Supreme Court of Texas explained that there is no distinction between an exploratory well and a developmental well: the operator need not drill unless there is an expectation of profit. The Jackson court further held that, in a “failure to explore” case, the landowner must still prove a “reasonable expectation of profit” in the unproven formations. See Jackson, 783 S.W.2d at 204. This standard requires the landowner to prove that a reasonably prudent operator would have “a reasonable expectation of profit” in drilling on an unproven formation Id. at 204; see also Clifton v. Koontz, 325 S.W.2d 684 (Texas 1959). Colorado, Arkansas, Louisiana and possibly Kansas have rejected this approach and do not consider profitability when analyzing a breach of the implied covenant of further exploration.

In Alford, the Ohio Supreme Court elected to follow the Texas approach and declined to recognize the implied covenant of further exploration as a separate lease covenant. The panel opined that the landowners’ interest in securing “development” of the entire leasehold “is sufficiently protected by the implied covenant of reasonable development.” The Alford court further noted that recognition of the exploration covenant “would not support the overreaching purpose of an oil and gas lease” because it does not take into account the reasonable expectation of profit. Although the Alford court concluded that the implied covenant of reasonable development may have been implicated by the landowners’ claim, it nonetheless affirmed the dismissal of the suit because the landowners did not rely on that particular covenant in their original complaint. Interestingly, the Alford court left open the question of whether Ohio recognizes “horizontal forfeiture” as a potential remedy:

“We therefore hold that under Ohio law concerning oil and gas leases, there is no implied covenant to explore further separate and apart from the implied covenant of reasonable development. As a result, it is unnecessary for us to address the Landowners’ second argument concerning the availability of partial horizontal forfeiture as a remedy, and we express no opinion on the appellate court’s decision on that issue to the extent it applies to the implied covenants raised by the Landowners other than the implied covenant to explore further.”

Alford is therefore a mixed bag for landowners. The court suggests that the implied covenant of reasonable development is the vehicle to address claims challenging a lessee’s failure to develop particular strata and horizons. As noted earlier, the development covenant only applies to proven formations which are currently producing. This doctrinal limitation would appear to foreclose application of the development covenant to claims involving undeveloped and, hence, unproven formations such as the shale in the Alford case. The Alford court failed to address this doctrinal limitation. On the other hand, the Alford court also suggests that “horizontal forfeiture” may be available as a remedy if a landowner can prove and establishes a breach of the development covenant. This is potentially good news for landowners, as horizontal forfeiture makes sense in those situations where a shallow well operator has no intention or ability to fund, drill or operate a deep shale well. By cancelling only the unexplored formations, horizontal forfeiture actually encourages and promotes the efficient development of all hydrocarbon strata and horizons.