The Oil and Gas Addendum

Throughout Pennsylvania it is not uncommon to encounter gas wells that were drilled over 100 years ago. These ancient wells were drilled pursuant to oil/gas leases that often pre-date the turn of the century. In many cases, the original lessee only drilled a single well and never developed the remaining acreage under the lease. Can that single well drilled in the 1920’s now hold an entire 200 tract of land? This is a common and troubling issue for landowners throughout the Commonwealth. In a recent decision of the federal district court in Pittsburgh, the trial court recognized this hardship and allowed a lease cancellation suit filed by the landowner to move forward.

In Delma Ray Burkett Revocable Trust, et al. v. EXCO Resources, LLC, 2012 WL 1019025 (W.D. Pa. March 26, 2012), the plaintiffs owned 180 acres (“180 Acre Tract”) in Jefferson County, Pennsylvania. The 180 Acre Tract was subject an oil and gas lease dated July 13, 1916 (the “Lease”). The Lease contained a ten-year primary term and an indefinite secondary term for “as much longer as the Premises are being drilled or operated for the production of oil or gas or gas is found or produced in paying quantities…” During the primary term of the Lease, four (4) producing wells were completed, two (2) of which were later plugged and abandoned. No additional wells were drilled on the 180 Acre Tract after the primary term expired in 1926.

The Lease also contained a “Surrender Clause” which authorized the lessee to surrender and cancel the Lease if it determined that “any part” of the 180 Acre Tract “did not warrant further investigation or development.” Finally, the Lease contained a complicated “Development Clause” which essentially obligated the lessee to tender a delay rental of $0.25 per acre until a second producing well was completed. Once the second well was completed, no further delay rentals were to be paid.

In September 2011, the current owners of the 180 Acre Tract, the Delma Ray Burkett Revocable Trust and the Sheldon Jay Burkett Revocable Trust (the “Burkett Trusts”), filed suit against the current assignee of the Lease, EXCO Resources, LLC (“EXCO”), seeking judicial cancellation of the Lease with respect to the undeveloped portions of the 180 Acre Tract (i.e., 130 acres) and also the unexplored deep formations beneath the property. The Burkett Trusts argued that partial cancellation of the Lease was warranted due to EXCO’s failure to develop the remaining acreage over the last eighty-five (85) years. Specifically, in Paragraph 19 of their Complaint, the Burkett Trusts alleged that they were:

“…seeking a declaration that by failing to develop the remaining 130 acres of the leasehold for 85 years, the Lessee made a determination that part of the Leased Premises did not warrant further development, and thus, the Lessee had a duty to surrender and cancel the Lease as to the undeveloped acreage.”

The Burkett Trusts further argued that the lessee’s failure to develop not only constituted a breach of the Surrender Clause in the Lease but also was a breach of the implied covenant to develop the leasehold. See, Delma Ray Burkett Revocable Trust, et al. v. EXCO Resources, LLC, 2012 WL 1019025 at pp. 5-6. As such, the Burkett Trusts requested that the court “release and return…all acreage in excess of the 25 acre production area” surrounding each of the two (2) producing wells and also release all hydrocarbon formations below 3500 feet.

In response, EXCO filed a motion to dismiss the complaint (“Motion”) on the basis that: i) the Lease did not create any affirmative contractual “obligation” to surrender any part of the 180 Acre Tract and ii) the Lease contained express terms that pre-empted the implied covenant of reasonable development. Since there was no obligation or duty to develop the remaining acreage, EXCO argued that no breach occurred and, therefore, the complaint should be dismissed.

With respect to the Surrender Clause argument, EXCO argued in its Motion that the Clause itself was “purely for its own benefit” and that it never declared, expressly or implicitly, that the unused 130 acres would never be the subject of “further” investigation or development. The Burkett Trusts countered this construction of the Surrender Clause by arguing that EXCO’s “persistent” lack of any investigation or development for nearly a century was an implicit determination by EXCO (or its predecessors) that such undeveloped portions were not suitable for hydrocarbon exploration or development. The district court carefully reviewed the Surrender Clause and noted that the express language of the clause contemplates that the lessee either engage in “further investigation and development” and, if it declined to do so, return the unused acreage to the landowner. The court expressed concern over the lack of development and observed that Pennsylvania law “disfavors an interpretation of a lease that would create an implicit non-producing fee simple interest” in the lessee. As such, the district court concluded that the allegations in the complaint set forth a plausible theory of recovery and denied EXCO’s Motion as to this claim:

“…the facts pled regarding this failure to drill for further production on the Premises…are sufficient at this point to permit, but not necessarily compel, a finding that EXCO, by its inaction, has necessarily made a determination that the undeveloped segment of the property did not warrant any further exploration or investigation…”

See EXCO Resources, 2012 WL 1019025 at 5.

EXCO also argued that the complaint should be dismissed because no breach of the implied covenant of reasonable development occurred by virtue of the express terms of the Lease. Under EXCO’s interpretation, the Lease itself specified that only two (2) wells were to be drilled during the primary term. According to EXCO, this express term, mandating the drilling of two wells, negated the implied covenant. In support of this position, EXCO relied on the Pennsylvania Supreme Court’s decision in Stoddard v. Energy, 18 A. 339 (Pa. 1889). In Stoddard, the Pennsylvania Supreme Court held that where the number of wells to be drilled is specified in the lease, that number controls and no implied covenant to develop further can be read into the lease. Stoddard, A. at 339. EXCO argued that the Stoddard holding foreclosed the Burkett Trusts’ implied covenant claim.

The district court rejected EXCO’s interpretation of the Lease and its reliance on Stoddard. First, the court noted that the Lease did not “fix” the number of wells – it merely altered the compensation formula after the first two wells were completed. Second, the court observed that the Pennsylvania Supreme Court in Jacobs v. CNG Transmissions Corp., 772 A.2d 445 (Pa. 2001) recognized that an implied covenant claim could be maintained post-Stoddard. In Jacobs, the court held that there is no duty to develop if the lease itself provides the landowner 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. According to Jacobs, if the lease provides for the payment of delay rentals or a gas storage fee, the implied covenant is suspended while such payments are being made. Id.

The Lease in EXCO Resources, however, did not provide for the payment of delay rentals or gas storage fees after the primary term expired in 1926. Since that time, the landowner received only production royalties from the two (2) wells located on the 180 Acre Tract. The court opined that, under Jacobs, once the delay rental payments ceased in the 1920’s, EXCO’s predecessor had “an affirmative obligation either to develop and produce the oil or gas or terminate the landowner’s contractual obligations…” EXCO Resources, 2012 WL 1019025 at 6. As such, the court concluded that the allegations of almost ninety years of non-development were sufficient to state a valid claim for breach of the implied covenant. EXCO’s motion was therefore denied on this ground as well.

The EXCO Resources decision, although favorable for landowners, must be viewed through the lens of the procedural stage at which the district court ruled. The court simply ruled that the Burkett Trusts had alleged sufficient “facts” in their complaint to state a claim for breach of the implied covenant and a breach of the Lease’s Surrender Clause. While it is encouraging that the court recognized that nearly ninety years of non-development may violate the implied covenant of reasonable development, the case itself is far from over. Both sides must now create a factual record to support their respective claims and defenses. Once this factual record is complete, the district court will be in a better position to issue a more definitive ruling on the implied covenant question. Nonetheless, this preliminary ruling in EXCO Resources is consistent with the principles set forth by the Pennsylvania Supreme Court over 120 years ago. In McKnight v. Manufacturer’s Natural Gas Co., 23 A.164 (Pa. 1892), the Supreme Court observed that a gas producer “cannot hold the premises and refuse to operate them.” Landowners and producers alike should carefully monitor the outcome of EXCO Resources as any decision by the court could impact hundreds of leases with undeveloped and unexplored acreage.