The Oil and Gas Addendum

Over the last 18 months natural gas operators from all over the world have converged on Western Pennsylvania. Their goal has been to secure new leases from landowners holding valuable mineral rights in the deeper Marcellus Shale formation. This rush to access the Marcellus Shale is now creating tension between landowners with existing oil/gas leases and their respective lessees. The royalty payments generated from these older, shallow well leases pale in comparison to the large signing bonuses and high-volume royalties associated with deeper Marcellus wells. As such, many of these landowners are now trying to “get out” of their existing leases and sign new, potentially more lucrative, Marcellus leases.

Terminating a producing gas lease is difficult. Almost all gas leases have secondary terms of indefinite duration so long as gas is being produced “in paying quantities.” Essentially, this means that an operator can maintain and hold the leased acreage with a single producing well. Does the operator, however, now have an obligation to explore the deeper Marcellus formation? Put another way, can the operator ignore the Marcellus formation and still maintain the lease? Some states have recognized an implied lease covenant which requires the operator to drill exploratory gas wells into unproven formations and strata or risk cancellation of the unexplored portions of the lease.   This controversial covenant is popularly known as the “implied covenant of further exploration.” This covenant, if recognized in Pennsylvania, could give many landowners the grounds to cancel older, shallow gas leases in favor of a Marcellus lease.

Pennsylvania currently recognizes three (3) implied covenants: i) the implied duty to protect the leased premises from drainage caused by adjoining operations; ii) the implied duty to reasonably develop the leased premises; and iii) the implied duty to market the gas extracted from the land. These duties will be implied in every gas lease unless expressly negated by the parties’ written lease. In order to appreciate the significance of the implied covenant of further exploration, a brief description of the currently recognized covenants is warranted.

The implied covenant to protect against drainage requires the operator to drill an offset well in certain situations. Gas is fugitive and can migrate from one part of a reservoir to another. Without an offset well to capture the gas, the resource may be depleted by gas wells outside the leasehold but within a common reservoir. In the absence of an express clause to the contrary, Pennsylvania courts have recognized an implied covenant to drill a well “offsetting” those on adjoining tracts. In Kleppner v. Lemon, the Pennsylvania Supreme Court observed that the operator “…shall put down so many wells as may be reasonably necessary to secure the oil, for the common advantage of both lessor and lessee.” See, Kleppner v. Lemon, 35 A. 109 (Pa. 1896). A breach of this covenant results in the permanent loss of the gas resource and can justify cancellation of the entire lease.

Pennsylvania also recognizes an implied duty to reasonably market the gas. This covenant requires the operator to diligently market the gas. The covenant is generally implicated when the operator takes little or no effort to secure a pipeline to the well, thereby denying the landowner his or her extraction royalty. The Pennsylvania Supreme Court long ago noted that upon the discovery of gas, the operator is “under an obligation to operate for the common good of both parties” and pay the extraction royalty. See, Iams v. Carnegie Natural Gas, 45 A. 54, 54-55 (Pa. 1899). Without a pipeline to transport the gas to market, no royalty is ever generated and the operator runs the risk of breaching this covenant.

Finally, Pennsylvania law generally requires an operator to reasonably develop proven formations. 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 formation. The operator is required to engage in further development only if the additional wells would be “profitable” This covenant, however, was recently limited by the Pennsylvania Supreme Court in Jacobs v. CNG Transmission Corp., 772 A.2d 445 (Pa. 2001). In Jacobs, the court held that there is no duty to develop if the lease itself provides the lessor compensation (i.e., delay rentals, gas storage fees, etc.) during the period of non-production. “An implied covenant to develop…exists only when the only compensation to the landowner…is royalty payments resulting from extraction.” Jacobs, 772 A.2d at 455. If the lease provides for the payment of delay rentals or gas storage fees, Pennsylvania will no longer imply a duty to develop the leasehold.

As noted above, the implied covenant of reasonable development, even in its post-Jacobs form, only applies to proven formations. In other words, the obligation to develop the leasehold only arises after gas is discovered “in paying quantities.” What about unproven formations or strata? Is there a duty to explore all horizons and strata located within a leasehold? 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 of the leasehold or risk cancellation of the lease. See, Carter v. Arkansas Louisiana Gas Co., 36 So. 2d 26 (La. 1948) (it is an implied condition that the lessee will test every part of the leased premises).

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 portions of the lease. See, Gillette v. Pepper Tank Co., supra; North York Land Associates v. Bryon Oil Industries, supra.

Several prominent oil and gas jurisdictions, such as Texas and Oklahoma, have expressly rejected the covenant. Texas has held that no implied covenant of further exploration exists independent of the implied covenant of reasonable development. Sun Exploration & Production Company 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 a unproven formation. Id. at 204; See also Clifton v. Koontz, 325 S.W.2d 684 (Texas 1959). A landowner in Texas has a steep burden and must prove that gas exists in profitable quantities.  See Jackson, 783 S.W.2d at 204; See also Mitchell v. Amerada Hess Corp., 638 P.2d 441, 449 (Okl 1982) (following Texas and holding there is no implied covenant to further explore after paying production is obtained). 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.

It is unclear whether Pennsylvania recognizes this covenant. In Aye v. Philadelphia Co., 44 A. 555 (Pa. 1899), a lease provided that a test well would be drilled within six months and, if oil was discovered, a production well would be drilled. Aye, 44 A. at 556. A test well was drilled but it was dry and no oil was discovered. The operator never conducted any further exploration. The Pennsylvania Supreme Court held that there was an implied duty to drill other test wells:

“… there is an implied obligation on the lessee to proceed with the exploration and development of the land with reasonable diligence… “

Aye , 44 A. at 556. Because the operator had failed to conduct any further exploratory activities, the Aye court found that the operator had abandoned the lease. See also, Calhoon v. Neely, 50 A. 967, 968 (Pa. 1902). (failure to explore premises for over nine years after drilling dry hole constituted surrender of the lease).  While the Aye court did not expressly announce or state that an implied covenant of further exploration exists in Pennsylvania, the court did recognize an implied duty to drill test wells.

More recently, in Jacobs v. CNG Transmission Corp., 332 F. Supp. 2d 759 (W.D. Pa. 2004), the Western District of Pennsylvania concluded that the operator had surrendered its rights to the deeper gas formations by failing to conduct any exploratory activities for nearly forty years:

“[H]ere the defendant failed to conduct any exploration or development of the leasehold during the primary term and in the subsequent thirty-eight years that followed.”

Jacobs, 332 F. Supp. 2d at 796. The Jacobs court further than noted that the operator’s protracted inactivity had deprived the landowner “of the right to have exploration of the property undertaken.”  Id. at 796. In order to remedy this breach, the court cancelled the operator’s rights in any substrata  below “the hundred foot sands” where the operator had been engaged in gas storage. Id. The unexplored, deeper gas formations were therefore severed from the original lease so as to give another operator the opportunity to explore and develop those deeper horizons. In support of this remedy, the Jacobs court cited the Aye opinion and observed that “[P]ennsylvania law has consistently recognized that an unexplained failure to develop an oil and gas lease.. . . gives rise to a fair presumption of abandonment.” Id. at 796.  Although the Jacobs court did not specifically reference the implied covenant by name, it arguably applied the policy behind the covenant and prevented the operator from holding unexplored horizons for an indefinite period of time. But see, Penneco Pipeline Co. v. Dominion Transmission Inc., 2007 WL 1847391 (W.D. Pa. 2007) (rejecting landowner’s claim that deeper strata should be severed due to inactivity and non-production). As such, Jacobs could be a subtle sign that Pennsylvania may soon be joining the minority of jurisdictions that recognize this implied covenant.

This article first appeared in the ACBA’s Lawyer’s Journal on January 14, 2011 and is being re-published with the ACBA’s permission.