The Oil and Gas Addendum

Let’s assume you own a 160-acre farm in Washington County. Your father purchased the farm in 1992 from a local farmer named Jones. (the “1992 Deed”). At the time your father purchased the farm, there was an oil and gas lease in effect with XYZ Drilling (the “XYZ Lease”). There was also a shallow, vertical well on the farm. The 1992 Deed contained an exception and reservation clause whereby Farmer Jones retained “all rights, title and interest” in the XYZ Lease. Per that exception in the 1992 Deed, Farmer Jones received the production royalties generated from the shallow well until all production ceased in 2001. Your family always assumed that the XYZ Lease, along with Farmer Jones’ interest, expired at that time due to non-production.

In 2021, you sign a new oil and gas lease with Big Oil, Inc. Shortly thereafter, you start to receive production royalties from a deep Marcella Shale Well drilled by Big Oil, Inc. The royalties suddenly stop in July 2023. Big Oil, Inc. informs you that the heirs of Farmer Jones believe that they own the oil and gas by virtue of the 1992 Deed. The heirs contend that after 2001, Farmer Jones allowed XYZ Drilling to resume operation of the shallow well and that this “revised” the XYZ Lease. You are confused, frustrated and angry. How can the heirs of Farmer Jones claim any ownership interest in the oil and gas under the farm? Didn’t Farmer Jones’ ownership interest expire when the XYZ Lease expired in 2001? A recent decision by the Pennsylvania Superior Court provides some much needed clarity as to nature, scope and duration of oil and gas leases under Pennsylvania law.

At issue in Douglas Equipment Inc., et al. vs. EQT Production Company, et al. was a 321 acre parcel located in Gilmore Township, Greene County (the “Subject Property”). In 1994, the owner of the Subject Property, the Willisons, entered into an oil and gas lease with Douglas Equipment, Inc. (the “1994 Lease”). The 1994 Lease had a one year primary term and would remain in effect thereafter so long as “gas or oil [was] found in paying quantities …” At the time the 1994 Lease was executed, there was one vertical well located on the Subject Property, which was subsequently transferred to Douglas Equipment, Inc. (the “Douglas Well”). In 1999, the Willisons conveyed the Subject Property to William and Nira Hold and Robert Lee (collectively “Holt/Lee”). The 1999 Deed contained several exceptions, including one pertaining to the oil and gas which provided as follows:

“[E]xcepting and reserving to J. Kenneth Willison Jr. and Sherry J. Willison … all right, title and interest in a certain oil and gas lease dated October 3, 1994 between Kenneth Willison Jr. and Sherry J. Willison and Douglas Equipment, Inc. . . .”

The Douglas Well ceased producing in October 2008. Douglas Equipment, Inc. nonetheless made shut-in payments to the Willisons annually between 2009 and 2018. The 1994 Lease, however, stipulated that the lease itself could not be maintained beyond three (3) years solely by the payment of shut-in royalties.

In February 2016, believing that the 1994 Lease had expired due to run-production, Holt/Lee entered into a new oil and gas lease with EQT Production Company (the “2016 EQT Lease”). A year later, Douglas Equipment, Inc. filed suit in Greene County seeking a declaration that: i) the 1994 Lease was in effect and did not expire when production ceased in 2008, ii) that the leasehold became an “at-will lease” subject to continuation by mutual consent, and iii) the 2016 EQT Lease would go into effect only upon expiration of the 1994 Lease.

In May 2022, the trial court granted EQT’s Motion for Summary Judgment and dismissed Douglas Equipment, Inc.’s complaint. The trial court opined that the Willisons only excepted and reserved an interest in the 1994 Lease, nothing else. When production from the Douglas Well ceased in 2008, the 1994 Lease expired and so did the Willisons’ interest. Douglas Equipment, Inc. appealed to the Pennsylvania Superior Court.

Before we address the substance of the Superior Court’s opinion, a brief review of the unique nature of an oil and gas lease is warranted.

When an oil and gas lease is executed, the lessee’s initial interest is “inchoate” for the exploration and development of oil and gas. See, T.W. Phillips Gas and Oil Co. v. Jedlicka, 42 A.3d 261, 267 (Pa. 2012). But, if oil or gas is found, the lessee’s rights transition into a fee simple determinable. Id. “A fee simple determinable is an estate in fee that automatically reverts to the grantor upon the occurrence of a special event.” Jacobs v. CNG Transmission, 332 F.Supp.2d 759, 773 (W.D.Pa. 2004). As such, it is important to note that while an oil and gas lease is a contract, the interest created by the contract (i.e., fee simple determinable) is governed by property law. See, Jedlicka , 42 A.3d at 267 (“[a]n oil and gas lease reflects a conveyance of property rights within a highly technical and well-developed industry….”); See also, Nolt v. TS Calkins & Associates, 96 A.3d 1042 (Pa. Super 2014) (“[A] fee simple determinable is an estate in fee that automatically reverts to the grantor upon the occurrence of a special event.”).

So, after entering into an oil and gas lease, the landowner-lessor retains two distinct interests: a contractual right to receive royalties and a property interest known as a “possibility of reverter.” The “possibility of reverter” is a property interest which “reverts to the grantor upon the occurrence of a specified event” that terminates the fee simple determinable. See, Snyder Bros. Inc. v. Peoples Natural Gas, 676 A,2d 1226, 1230 (Pa Super,1996). In other words, when the fee simple determinable expires, complete ownership of the oil and gas estate reverts back to the landowner – lessor.

The “special event” or “limitation event” that automatically terminates the fee simple determinable estate is non-production. See, Jacobs, 332 F. Supp. 2d at 777-78. If at the end of the primary term there is no production, then the leasehold interest automatically terminates. This is known as the “automatic termination rule” and has been a part of Pennsylvania oil and gas law for over a hundred years. See, Non-Production During Secondary Term Results in Termination of Lease (November 2011).

This rule provides that the fee simple determinable acquired by the driller upon execution of an oil and gas lease will automatically terminate if the driller fails or ceases to produce hydrocarbons any time after expiration of the primary term. See, Brown v. Haight, 255 A.2d 508 (Pa. 1969) (“[T]herefore, in 1947 when oil and gas were not produced in paying quantities, the grantee’s fee interest terminated automatically and the property reverted to the grantor”); Cassell v. Crothers, 44 A. 446 (Pa. 1899) (“[W]here oil was no longer being produced in paying quantities, the lease was liable to be terminated”); Hite v. Falcon Partners, 13 A.3d 942 (Pa. Super. 2011) (“…when that primary term ended and Falcon failed to commence production, the agreement expired.”); Heasley v. KSM Energy, 52 A.3d 341 (Pa. Super. 2012) (“[W]hen production ceased, the lease became an at-will tenancy, subject to termination by the lessor at any time”). The hallmark of the “automatic termination rule” is that it is automatic: cessation of production, unless excused by a savings mechanism in the parties’ lease, terminates the driller’s fee simple determinable interest by operation of law.

On appeal, Douglas Equipment, Inc.’s argument was two-fold. First, Douglas Equipment, Inc. argued that the exception in the 1999 Deed included not only the contractual royalty interest in the 1994 Lease but also the purported “possibility of reverter.” Alternatively, Douglas Equipment, Inc. contended that after production ceased in 2008, the Willisons’ conduct nonetheless created an at-will tenancy which was superior to the 2016 EQT Lease. The Superior Court rejected both arguments.

The Superior Court opined that by virtue of the 1999 Deed, Hoyt/Lee acquired the “possibility of reverter.” This distinct property interest was not excepted or reserved by the Willisons – they only excepted and reserved the contractual right to receive royalties under the 1994 Lease: The Superior Court observed:

As explained above, the Douglas Lease expired by its own terms after production ceased in 2008 and shut-in payments were made. The Willisons could not have excepted any “right, title or interest” in the lease greater than the rights included in a lease itself. By virtue of the language of the lease, which expired under its own terms, coupled with the language of the 1999 Deed, which conveyed the right of the reversion to the Holts and Lee, the Willisons did not retain any “right, title or interest” in the Douglas Lease beyond the royalties. The Douglas Appellants’ argument lacks merit.

The Superior Court correctly ruled that when the Willisons signed the 1994 Lease, two separate property interests in the oil and gas estate were created: the lessee Douglas Equipment, Inc., acquired the fee simple determinable and the Willisons retained the reversionary interest known as the “possibility of reverter.” Since the 1999 Deed did not except or reserve the “possibility of reverter”, that property interest, along with the surface, was conveyed to Hoyt/Lee. When the 1994 Lease expired, the fee simple determinable terminated and the oil and gas estate reverted back to Hoyt/Lee.

With respect to Douglas Equipment, Inc.’s second argument, the Superior Court affirmed the trial court’s conclusion that if an at-will tenancy was created after the 1994 Lease expired, such tenancy could only arise between Hoyt/Lee, as the owner of the oil and gas estate, and Douglas Equipment, Inc. As noted above, once the 1994 Lease expired, the Willisons had no ownership interest in the oil and gas estate. As such, they could not engage in any conduct or activity which created a new tenancy regarding the oil and gas estate. Only Hoyt/Lee possessed such rights after 2008.

The author submits the Superior Court got this one correct. Landowners in Pennsylvania should be mindful of the distinction between holding an interest under an oil and gas lease versus ownership of the actual oil and gas estate – each interest can be owned simultaneously by different people. If you have a question about the nature, scope or extent of your oil and gas rights, please call attorney Robert J. Burnett at (412) 288.2221.