The Oil and Gas Addendum

The oil and gas business has been defined by cyclical “booms” and “busts”. Increased investment, drilling and production during growth years can lead to oversupply in the marketplace, commodity prices can fall and drillers can have difficulty servicing the debt they used to finance their expansions during the “boom”. If a driller can no longer afford to pay its debts, then it may file for bankruptcy. Recently, the NYMEX price of natural gas hit its lowest level in 20 years, closing at $1.77/MMbtu on February 10, 2020. These low commodity prices not only result in lower royalties for landowners but impact driller cash flow. What happens when a driller files for bankruptcy? Does your oil/gas lease automatically expire? Can the bankruptcy proceedings unilaterally change your lease? We address these troubling questions below.

When a debtor files for bankruptcy, all of the debtor’s interests in property form the bankruptcy “estate”. 11 U.S.C. § 541(a). The bankruptcy trustee administers the bankruptcy estate. 11 U.S.C. § 704. Businesses (and individuals) that enter bankruptcy have a variety of contracts and obligations that they can no longer afford to honor. The Bankruptcy Code contains a section that addresses how certain contracts are handled.

Section 365 of the Bankruptcy Code is entitled “Executory Contracts and Unexpired Leases”. Subsection (a) of Section 365 states that, with certain exceptions “. . . the trustee, subject to the court’s approval, may assume or reject any executory contract or unexpired lease of the debtor. 11 U.S.C. § 365(a). More simply, if the debtor will perform under a contract, the contract will be “assumed”. If a debtor will not perform under a contract, the contract will be “rejected”. The debtor is allowed to use its business judgment to determine which contracts will be “assumed” and which contracts will be “rejected”, but those decisions must be in the best interest of the bankruptcy estate. In re Chestnut Ridge Plaza Associates, L.P., 156 B.R. 477 (Bankr. W.D.Pa. 1993).

Since Section 365 and the concepts of “assumption” and “rejection” of agreements apply only to “executory contracts” and “unexpired leases”, it is important to determine whether a particular agreement falls into these categories. Whether an agreement is an “executory contract” is a question of federal law. See, In re Terrell, 892 F.2d 469 (6th Cir.1989); Cameron v. Pfaff Plumbing and Heating, Inc., 966 F.2d 414 (8th Cir.1992); In re Cochise College Park, Inc., 703 F.2d 1339 (9th Cir.1983). On the other hand, the extent of a debtor’s interest in property is governed by state law. See, In re N.S. Garrott & Sons, 772 F.2d 462 (8th Cir. 1985); Butner v. U.S., 440 U.S. 48 (1979).

Unfortunately, neither the term “executory contract” nor “unexpired lease” is specifically defined in the Bankruptcy Code. An “executory contract” has been generally understood to be ” a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other.” Sharon Steel Corp. v. Nat’l Fuel Gas Distribution Corp., 872 F.2d 36, 39 (3d Cir. 1989) (citing V. Countryman, Executory Contracts in Bankruptcy, Part 1, 57 Minn.L.Rev. 439, 460 (1973).

As one may imagine from this background, there is no clear answer to “where” oil and gas leases stand in this framework, with decisions varying across the country. Courts in some jurisdictions have concluded that oil and gas leases are executory contracts. King v. Baer, 482 F.2d 552 (10th Cir.1973); Texaco Inc. v. Louisiana Land and Exploration Co., 136 B.R. 658, 668 (M.D.La.1992). Courts have also determined that oil and gas leases are not executory contracts. Laugharn v. Bank of America Nat. Trust & Savings Ass’n, 88 F.2d 551 (9th Cir.1937). Still others have determined that oil and gas leases are neither executory contracts nor unexpired leases based on the property laws of the jurisdiction. See, In re Clark Resources, Inc., 68 B.R. 358 (Bkrtcy.N.D.Okl.1986). In this regard, the determination of whether an oil and gas lease is subject to assumption or rejection under Section 365 of the Bankruptcy Code appears to be determined on a state-by-state basis.

Under Pennsylvania law, an oil and gas lease functions as both a contract and a conveyance of real estate. When a dispute arises associated with an oil and gas lease, principles of contract law control. J.K. Willison v. Consol. Coal Co., 637 A.2d 979, 982 (Pa. 1994). But, an oil and gas lease is not a typical “lease”, like an automobile lease, an apartment lease or even a commercial office lease. This distinction is critical to its treatment under the Bankruptcy Code.

When an oil and gas lease is signed, no real property rights are vested in the lessee. Instead, the lessee obtains the right to explore for and develop oil and gas for a defined period of time: the primary term. Prior to the development of oil and gas, the lessee has “inchoate” rights to the oil and gas, meaning that they are not fully formed or developed. Burgan v. South Penn Oil Co., 89 A. 823, 826 (1914); Hite v. Falcon Partners, 13 A.3d 942 (Pa. Super. Ct. 2011). If no oil and gas is produced by the end of the primary term, then the lease expires and the lessee has no further rights. T.W. Phillips Gas & Oil Co. v. Jedlicka, 42 A.3d 261, 267 (Pa. 2012). However, if oil and gas development is successful, the lessee is vested with a fee simple determinable in the oil and gas. Calhoon v Neely, 50 A. 967, 968 (Pa. 1902). That fee simple determinable continues on until a specific event, usually a failure to produce in paying quantities, at which time the rights automatically revert back to the oil and gas owner. T.W. Phillips Gas & Oil Co. v. Jedlicka, 42 A.3d 261, 267 (Pa. 2012).

Two Pennsylvania bankruptcy courts, sitting in the Middle District and the Western District, have addressed the question of whether oil and gas leases can be rejected under Section 365 of the Bankruptcy Code. In In re Powell, 482 B.R. 873 (Bankr. M.D.Pa. 2012), order vacated in part, No. 3:13-CV-00035, 2015 WL 6964549 (M.D. Pa. Nov. 10, 2015) the U.S. Bankruptcy Court for the Middle District of Pennsylvania confronted a situation where a landowner sought to “reject” the oil/gas lease it had previously signed with a driller. The landowner filed for personal bankruptcy before there had been any production under the lease. This fact was critical to the court’s analysis.

The In re Powell court reasoned that if gas had been produced prior to the bankruptcy filing, then Section 365 would not apply because at that point, the gas company would have been vested with a fee simple determinable interest (real property) in the oil and gas – so effectively the gas company would have been producing its own gas. That would moot the concept of a lease or executory contract under Section 365. But, oil and gas had not been produced at the time of the bankruptcy filing. Instead of analyzing whether the oil and gas lease was an executory contract, the In re Powell court concluded that the lease was an “unexpired lease” agreement “to use real property” and was subject to Section 365(m) of the Bankruptcy Code. Although the court found that the lease could be rejected under Section 365, the court determined that the lease should not be rejected.

A few years after In re Powell, the U.S. Bankruptcy Court for the Western District of Pennsylvania was confronted with a similar issue in In re Tayfur, 505 B.R. 673, 682–83 (Bankr. W.D. Pa.), aff’d, 513 B.R. 282 (W.D. Pa. 2014), aff’d, 599 F. App’x 44 (3d Cir. 2015). In this case, like In re Powell, the debtor was landowner seeking to reject an oil and gas lease, which was held by SWEPI. That lease too had not gone into production when the bankruptcy was filed. The Western District Bankruptcy Court analyzed In re Powell and found the reasoning to be persuasive. The court concluded:

In the instant case, SWEPI does not appear to object the characterization of the Lease as an unexpired lease subject to 11 U.S.C. § 365. As in the Powell case, there has been no production pursuant to the present Lease. Pursuant to Jedlicka and Powell, absent production, there has been no vesting of title. Absent such vesting, SWEPI’s interest would remain an inchoate one. Accordingly, the Lease would not result in a conveyance of property and 11 U.S.C. § 365 would be applicable.

The court conducted a further analysis and concluded that the lease should not be rejected.

Although the rationale employed in In re Powell and In re Tayfur is premised on the landowner being the debtor, the courts’ interpretation of Section 365 is instructive as to how the bankruptcy courts here in the Western District may view oil/gas leases. For that reason, the authors submit that the analysis should not differ between situations when the debtor is the landowner or when the debtor is the driller.

In this regard, “when” a driller files for bankruptcy appears to be crucial for the Pennsylvania oil and gas lessor as it pertains to the potential rejection of a lease. If the driller that holds your lease files for bankruptcy after oil and gas is produced under your lease, then it appears that Section 365 would no longer apply. The formerly inchoate title the driller possessed before production would have ended and the driller would be vested with a fee simple determinable – a real property interest – in the underlying oil and gas formations. That would make the oil and gas part of the bankruptcy estate under Section 541 of the Bankruptcy Code and not subject to rejection under Section 365. “If the lease is a conveyance of a mineral estate, i.e. a fee interest, as opposed to a true lease, then 11 U.S.C. § 365 is not applicable.” In re Tayfur, 505 B.R. 673, 681 (Bankr. W.D. Pa.), aff’d, 513 B.R. 282 (W.D. Pa. 2014), aff’d, 599 F. App’x 44 (3d Cir. 2015). In other words, the driller does not have the option to simply reject your lease.

On the other hand, if the driller files for bankruptcy before oil and gas is produced under the lease, it appears that, at least in Pennsylvania, your lease could be subject to the “assumption” or “rejection” procedure set forth in Section 365. The analysis performed by the In re Powell court (and followed by the In re Tayfur court), suggests that the lease is an “unexpired lease” to use real property and within the scope of Section 365(m). As such, it is possible the debtor-driller could reject the lease.

If a lease is subject to potential rejection under Section 365, then, as discussed at the beginning of this article, the driller’s business judgment will come into play – but the decision has to be in the best interest of the bankruptcy estate. Chestnut Ridge Plaza Assocs., L.P., 156 B.R. 477, 485 (Bankr.W.D.Pa.1993).

Whether a debtor-driller will assume or reject a lease will necessarily be decided on a case-by-case basis. Given this dynamic, it is difficult to predict what may occur in any particular situation. From a general perspective, the drillers need leases to drill and, ultimately, generate cash flow. If a lease is “paid-up” and no annual delay rentals are due to maintain it in effect during its primary term, it would not seem reasonable to reject such a lease. If it does not “cost” the driller anything to maintain the lease in effect, it would not seem to be in the best interests of the bankruptcy estate to reject such a lease and lose that particular “asset”.

Alternatively, if a lease requires annual rental payments to remain in effect, the costs of such activities would have to be weighed against the benefits to the bankruptcy estate of maintaining the acreage under lease so that it could potentially be developed. Access to oil and gas would seem to be a substantial motivating factor to an oil and gas driller in bankruptcy but it is not a foregone conclusion that a driller would “assume” oil and gas leases subject to Section 365, particularly if they are in locations that the driller is no longer targeting.

These are fluid concepts that need to be analyzed on a case-by-case basis. If your driller files for bankruptcy, it is important that you consult with legal counsel who understands the interplay between bankruptcy and oil and gas leases.