The Oil and Gas Addendum

The development of the Marcellus Shale in Pennsylvania has been facilitated by the marriage of modern drilling technology with the legal concept known as “pooling”. In short, a driller cannot drill a horizontal wellbore through the Marcellus Shale without the legal ability to pool or combine multiple leases. This is because the horizontal wellbore, which can exceed 5,000 feet, will likely pass through a number of separately owned parcels. Each parcel must be under lease and each lease must authorize pooling.

Pooling has been around for decades but its importance has been magnified by the advent of horizontal drilling. What has also been known for decades is that the right to pool acreage must be expressly granted by the landowner – there is no implied right to pool. This critical cornerstone of oil/gas jurisprudence is now under attack in the Appalachian Basin.

Generally, an oil and gas operator will combine many tracts of land into a production unit to promote conservation, share the production and expense of drilling a well and avoid unnecessary drilling of offset wells. In the Appalachian Basin, production units are generally between 400 and 1200 acres. The well-pad is typically located at or near the center of the unit and can often support four to eight separate horizontal wellbores.

Most modern oil and gas leases contain a “pooling clause” which authorizes and allows the operator to pool the leased acreage into a production unit. Older oil and gas leases may not contain a pooling clause and oftentimes an operator will attempt to secure a lease modification from the oil and gas interest holder that acts to modify the underlying lease and add language that will permit the operator to pool the tract. Obtaining a lease modification in such a circumstance is of paramount importance to the driller since it generally cannot drill a horizontal wellbore underneath multiple parcels, owned by different individuals, without the express authority to do so.

In a controversial opinion authored by Judge Hummel of the Circuit Court of Tyler County, West Virginia on April 15, 2016, it was held that a driller may have an implied right to pool a lease. The case, American Energy – Marcellus, LLC v. Poling, et al, Civil Action No. 15-C-34 H, was one of first impression in West Virginia and represents a departure from well-established oil and gas jurisprudence in the United States. American Energy – Marcellus LLC (AEM) was the successor in interest to the original lessee of an oil and gas lease dated June 7, 1894 covering 79 acres (the “1894 Lease”) in Tyler County. Defendants were the successors to the original lessor. The dispute centered upon what the 1894 Lease did not contain; that is, an express provision giving AEM the right to pool the leased premises into a production unit. Since the 1894 Lease was silent on this issue, the landowners contended that AEM could not “pool” the leased premises unless the parties’ lease was amended. AEM filed suit seeking a declaration from the court that it had an implied right to pool the 1894 Lease.

The court’s decision turned on what it believed was necessary to accomplish the ultimate purpose of the 1894 Lease, which, in its opinion, was to develop and produce oil and gas. The court reasoned that the production of oil and gas through horizontal drilling and hydraulic fracturing could not be effectuated in an economically viable manner without the creation of large production units. Since the deep shale formations could not be economically extracted without large production units and lengthy horizontal wellbores, the court rationalized that “the bargained-for leasehold benefits to the lessor and lessee…will be diminished and the purpose and intent of the lease will be frustrated” unless AEM could combine and pool the 1894 Lease with surrounding parcels. In short, the court used the end to justify the means.

The court then engaged in a peculiar and confusing analysis concerning the law of implied covenants. By way of background, the doctrine of implied covenants recognizes that the express terms of the parties’ lease may not cover all phases of the lessee’s obligations. Given the complex and fluid nature of oil/gas operations, even the most technical and thorough lease will not address the myriad of issues that can, and will, arise during the life cycle of a lease. In order to promote fairness and “fill in the gaps”, the courts have historically implied certain obligations on the lessee to ensure that the interests of the lessor are adequately protected. As one commenter noted many years ago, an oil and gas lease is a relational contract that is almost exclusively dependent on the actions and conduct of the lessee: “it is doubtful if any other character of legal instrument can be found in which one of the parties has so much potentially at stake with so little contractual protection.”

Over the last 120 years, the oil and gas jurisdictions in the United States have consistently recognized three implied covenants:

1. The implied covenant to market gas
2. The implied covenant to protect against drainage
3. The implied covenant of reasonable development

No court has ever recognized an implied covenant to pool. Although a detailed analysis of each covenant is beyond the scope of this article, it must be emphasized that the primary purpose and objective of each covenant is to protect the lessor. See, Lundin/Weber Company v. Brea Oil Company, 117 Cal. App. 4th 427 (5th District, Cal. 2004) (“[W]here express covenants do not cover completely all phases of the lessee’s obligation in regard to exploration, development and protection, implied covenants may coexist with express covenants…”). Although the covenants create unique and distinct obligations in the lessee, they are not to be confused with traditional contract law principles. These are substantive oil and gas legal concepts that have become part of the common law of most oil and gas jurisdictions. The AEM court failed to appreciate or recognize this critical aspect of implied covenant law.

In finding that the lessee had an implied right to pool, the court blatantly ignored the intent and purpose behind the well-established body of law relative to implied covenants. Instead, the court inexplicably relied upon the contract principle of “cooperation”, reasoning that because the original parties to the 1894 Lease intended for oil and gas to be produced, the successors and assigns of the original parties to the lease must cooperate to accomplish the purpose of the 1894 Lease “and the reasonable expectations of the parties.” The court also found that the implied covenant of good faith and fair dealing was an additional basis for implying the right to pool, reasoning that because the 1894 Lease permits the lessee to develop the leasehold, opposition to pooling denies that right and therefore “thwarts the purpose” of the lease in apparent bad faith. It should be noted that the implied covenant of good faith and fair dealing is not an oil and gas law concept but rather is a quasi-judicial remedy arising out of basic contract law. Using this rather circular logic, the court found that the implied right to pool an oil and gas lease “promotes development and prevents delay and unproductiveness” and was reasonably necessary for the extraction of hydrocarbons.

Recognition of this new right based on these contract principles is troubling. The use of horizontal drilling and hydraulic fracturing, and the need for pooling, were not, and could not have been within the “reasonable expectations of the parties” in the 1890’s. Advanced drilling techniques such as hydraulic fracturing and horizontal drilling were decades away from being in existence at the time that the Lease was signed in 1894. As such, it is unclear how the principle of “cooperation” apparently compels a successor to the original lessor to permit a practice that undoubtedly could not have been within the original parties’ “reasonable expectations.”

The court’s application of the implied covenant of good faith and fair dealing is also puzzling. The absence of a pooling clause in the 1894 Lease did not itself prevent the development of oil and gas, particularly by the methods that were in existence at the time of the execution of the 1894 Lease. Instead, it is indicative of what was actually contemplated by the original parties. The unfettered pooling of multiple leases together, likely leading to the dilution of the lessors’ royalty interests, certainly was not intended by the parties upon the execution of the 1894 Lease. Here, the lessor was not asserting that the operator could not drill, just simply that it could not pool without authority as that separate right clearly had not been bargained-for. Even so, the court construed the landowner’s purported opposition to pooling as an outright denial of the operator’s ability to produce oil and gas under the terms of the 1894 Lease, and, remarkably, outside the realm of good faith.

What can we take away from this perplexing decision?

Court’s Ruling Conflicts with Well-Settled Law

First and foremost, it must be stressed that the court’s ruling is in conflict with well-settled oil and gas law. No other jurisdiction has recognized an implied right to pool. On the contrary, it is well-established throughout the United States that absent express authority in the lease, a lessee has no power or authority to pool. See, Southeastern Pipe Line Co. v. Tichacek, 997 S.W.2d 166, 170 (Tex.1999) (“A lessee has no power to pool without the lessor’s express authorization, usually contained in the lease’s pooling clause”); Jones v. Killingsworth, 403 S.W.2d 325, 327–28 (Tex.1965) (“Absent express authority, a lessee has no power to pool interests in the estate retained by the lessor with those of other lessors.”). For pooling to be valid, it must be done in accordance with the method and purposes specified in the lease. See, Tittizer v. Union Gas Corp., 171 S.W. 3d 857 (Tex. 2005) (court recognizing that lessee has no implied power to pool); Amoco Production co. V. Heimann, 904 F.2d 1405 (10th Cir. 1990) (“Without such a clause, the lessee has no authority to pool or unitize the interests of the lessor”). Since the pooling must be expressly authorized, courts have refrained from implying such a right when the lease is silent. See, Leonard v. Barnes, 404 P.2d 292 (N.M. 1965) (since parties’ lease contained no express authority to pool, court will not strain to interpret contract to provide for pooling). The AEM court ignored these well-established principles of oil and gas law.

Second, in creating this “implied” right to pool, it is apparent that the AEM court may not have fully appreciated the legal concept of pooling. The ruling overlooks and ignores the unique concept of “cross-conveyance.” When an oil and gas lease is signed, the landowner conveys to the driller the exclusive right to extract hydrocarbons and also a working interest in the eventual production. In return for signing the lease, the landowner retains a royalty interest in the eventual production (i.e., production royalty). A royalty interest is generally recognized as an interest in real estate. See, 3 Kuntz, Law of Oil and Gas §38.2 (1967) (“…it is generally recognized that an unaccrued royalty is properly classified as real property”); Clyde v. Hamilton, 414 S.W.2d 434 (Tex. 1967) (“…a right to future royalty payments is an interest in land”); GeoStar Corp. v. Parkway Petroleum, 495 N.W.2d 61 (N.D. 1993) (“…an unaccrued oil and gas royalty is an interest in real property”). As an interest in land, it cannot be changed, altered, conveyed or diluted without the owner’s consent. See, Brown v. Smith, 174 S.W.2d 472 (Tex. 1942). Pooling, as a cross-conveyance of this royalty interest, can and does modify and change the landowner’s royalty interest. See, Montgomery v. Rittersbacher, 424 S.W.2d 210 (Tex. 1968) (“[P]ooling effects a cross-conveyance among owners of minerals…so that they all own undivided interests under the [pooled] tract in proportion their contribution bears to the [pooled] tract”). Given this impact, consent must be given before the royalty interest can be pooled:

“[S]uch a significant change in ownership rights, which reduces the percentage of ownership the mineral and royalty owners had in their original tracts, necessarily requires express authorization of the owner.”

See, PYR Energy Corp. v. Samson Resources, 456 F.Supp.2d 786 (E.D. Texas 2006). Permitting a driller to pool a lease (including the royalty interest) without the express consent of the lessor is akin to unilaterally reducing or modifying the acreage of a parcel in a recorded deed. The AEM court made no effort to address or harmonize this critical concept in its opinion.

Court May Have Misunderstood the Implied Covenant of Reasonable Development

Third, the court’s ruling is based on a misunderstanding of the implied covenant of reasonable development. In its opinion, the AEM court states that this newly created right to pool “…is the corollary of the common law implied covenant to further develop…” Because the driller is subject to an implied covenant to develop the entire leasehold, the court opined that it must also “have the concomitant implied rights” to pool the leasehold. The court appears to be suggesting that in order to satisfy the development covenant, additional rights in favor of the lessee must be implied in the lease. This logic represents a fundamental and alarming misunderstanding of the implied covenant of reasonable development.

It is well-settled in almost every oil/gas jurisdiction that a driller has an obligation to fully develop the leasehold. Upon the discovery of hydrocarbons in paying quantities, the implied covenant of reasonable development requires the lessee to drill as many wells as may be reasonably necessary to fully develop the reservoir. See, Clifton v. Koontz, 325 S.W.2d 684 (Tex. 1959) (the covenant requires the lessee to drill “additional wells in an already producing formation or stratum”); Baker v. Collins, 194 N.E.2d 353, 355 (Ill. 1963) (“[A]fter the discovery of oil and gas in paying quantities, the law, to accomplish the manifest intention of the parties, implies a duty of the part of the lessee to reasonably develop the premises…”); Stamper v. Jones, Shelburne & Farmer, 364 P.2d 972, 978 (Kan. 1961) (“[T]here is an implied covenant by the lessee…that the tract will be prudently developed, and where the existence of oil in paying quantities is made apparent, it is the duty of the lessee to continue the development of the property and to put down as many wells as may be reasonably necessary to secure the oil for the common advantage…”). In essence, the covenant imposes upon the lessee an ongoing duty to “keep drilling” after the initial, productive well is completed. The covenant therefore discourages the practice of drilling a single well and allowing the balance of the leasehold acreage to remain undeveloped and idle.

In AEM, the court clearly put the cart before the horse. The implied covenant to develop arises after an initial well is drilled. There can be no breach of the covenant unless and until a well is drilled. In AEM, the court suggests that in order to satisfy the covenant, an implied right to pool must exist. Typically, pooling and the formation of production units occur prior to the drilling of the first horizontal wellbore. Given this sequence, it is difficult to fathom how an implied right to pool operates as a “corollary” to the implied covenant to develop. If the court’s logic is sound, then the implied covenant of reasonable development should be triggered as soon as the lease is signed – no need to wait until the first well is drilled. This would essentially transform the implied covenant of reasonable development into an affirmative and immediate obligation to drill horizontal wells. The authors are not aware of any court that has interpreted the covenant in this manner.

Bad Law

The AEM decision is simply bad law. The court confused and misapplied the doctrine of implied covenants and ignored the significance and legal effect of cross-conveyance. And, in unilaterally manufacturing an implied right to pool, the court turned a blind eye to what was actually contemplated, intended and bargained-for by the original parties to the 1894 Lease. The original parties to the 1894 Lease could not have agreed or otherwise intended to allow the 1894 Lease to be pooled into a production unit given that such practices were not in existence. With this unfortunate ruling, the court is creating a slippery slope that drillers will likely view as an invitation to broaden and expand the scope of industry-friendly terms that may be “read” into the parties’ oil and gas lease.