The Oil and Gas Addendum

In the early days of the Marcellus leasing boom, your grandfather executes an oil and gas lease covering the 100 acre family farm in Mercer County. The landman tells your grandfather that the lease “has a five-year term” that will remain in effect only as long as the $5.00 per acre delay rental is paid each year. That was ten years ago. Your grandfather has since passed away and you are administrating his estate. Although no well has ever been drilled on the farm, you receive an unusual check from the gas company in the amount of $500. The check is labeled “delay rental.” You investigate further and discover that your grandfather has received this same payment each year. You call the gas company and ask them why they are still sending rental checks since the five-year term expired in 2011. Much to your surprise, they tell you that the lease never expired and that there are no immediate plans to drill a well on the farm. You are frustrated and confused. Can they really hold your lease indefinitely by simply paying a $500.00 check year after year?

Fortunately, in most oil and gas jurisdictions, the payment of a delay rental after the expiration of the primary term cannot and will not operate to maintain the lease. Last month, the Supreme Court of Ohio affirmed this rule in State ex rel. Claugus Family Farm, L.P. v. Seventh Dist. Court of Appeals (Slip Opinion No. 2016-Ohio-178, January 21, 2016). The matter involved two separate lawsuits that were consolidated because they involved the interpretation of nearly identical oil and gas leases. In one case, Larry and Lori Hustack were the successors-in-interest to the original lessors, whom, in 2008, signed an oil and gas lease known in the industry as a “Form G&T (83) lease.” The other matter involved the Claugus family, who were the successors-in-interest to prior owners of their land that had also previously signed a Form G&T (83) lease. Although the leases did not include terms that expressly and specifically identified “primary” and “secondary” terms, the relevant portions of the leases stated that the lease “shall continue in force by lessee for a term of ten years and so much longer thereafter as oil and gas or their constituents are produced or are capable of being produced on the premises in paying quantities, in the judgment of the [l]essee….” The lease also required the driller to commence a well on the leased premises within 12 months or tender payment each year to the lessor, “until the commencement of a well.” This latter clause is known as a “delay rental” provision.

In 2011, the Hustacks filed a complaint seeking to have the lease rendered void under the theory that the lease “was in perpetuity” and therefore against public policy. The trial court ruled in favor of the Hustacks. On appeal, first, the Seventh District, and then the Supreme Court of Ohio, both held that the trial court had misinterpreted the relevant lease provisions, as well as Ohio law, and therefore had erred in ruling that the lease was perpetual in nature. Instead, the court held that the lease had a “primary term of definite duration and a secondary term that extends the lease if certain conditions are met.” Significantly, the court reasoned that the lease was not perpetual in nature because the payment of delay rentals can only hold the lease during the primary term. Inasmuch, upon the expiration of the primary term, the lease could only be maintained if the wells drilled on the leasehold produced hydrocarbons in paying quantities. The Claugus court correctly noted that tendering delay rental payments could not maintain the lease beyond the primary term:

“[D]elay rental provisions have been interpreted to apply only during the primary term of a lease.”

The Claugus opinion is consistent with the majority of oil and gas jurisdictions that have addressed this issue. Vaughn v. Hearrell, 347 S.W.2d 542 (Ky. 1961) (“…delay rental clauses of the standard oil and gas contract are intended to keep it in force only within the primary term”); Morriss v. First Nat. Bank of Mission, 249 S.W.2d 269, 279 (Tex. Civ. App. 1952) (“…option to pay rentals ordinarily will delay operations as long as the rentals are paid, but not beyond the primary term”); Humphreys v. Fletcher, 204 P. 70, 70 (N.M. 1922). Pennsylvania also follows this majority rule. In the landmark Hite v. Falcon Partners decision in 2011, the Pennsylvania Superior Court re-affirmed this principle under Pennsylvania law:

“To find as Falcon urges, that it may pay delay rental indefinitely, thereby denying Plaintiffs the opportunity to reap the financial benefits of actual production, would be contrary to the decisions of our courts, at odds with the presumed intention of the parties in executing the leases in the first place, and in stark contrast to the clear opinion of the courts of Pennsylvania that the obligation to pay delay rentals is intended to “spur the lessee toward development.”

The Hite panel concluded that the mere payment of delay rentals after expiration of the primary term could not, and did not, maintain the parties’ oil/gas lease. Accordingly, the court observed that “…when the primary term ended and Falcon failed to commence production, the agreements expired.” Hite remains the law of Pennsylvania.

In conclusion, delay rentals cannot be used to maintain a lease indefinitely. Once the primary term expires, delay rentals must cease. All landowners should carefully monitor the timing of their rental checks. Payments tendered after expiration of the primary term should not be deposited and should be immediately returned to the driller. As always, if you have any questions or concerns regarding the effect of delay rentals or the validity of your lease, please contact an experienced oil and gas attorney.