The Oil and Gas Addendum

Preliminary Operations Not Enough To Extend Lease into Secondary Term

In a recent decision, the Arkansas Court of Appeals concluded that conducting preliminary drilling operations was not enough to extend the lease into the secondary term. The Arkansas Court of Appeals in Petrohawk Properties, LP v. Heigle, ___ S.W.3d ____, 2011 WL 5562654 (Nov. 16, 2011) ruled that the parties’ lease required the gas operator to be engaged in both drilling operations and the production of natural gas at the end of the primary term. Because the gas operator’s drilling operations had not yet resulted in actual production, the Petrohawk court determined that the subject leases expired. While the Petrohawk decision is not binding on Pennsylvania courts, the rationale adopted by the Petrohawk panel could impact the interpretation of similar lease clauses throughout the Commonwealth.

At issue in Petrohawk were four oil and gas leases executed by various Heigle family members. The leases were signed in May 2005 and contained a primary term of five years with the possibility of extension if certain conditions were met. Specifically, each lease contained the following habendum clause:

“It is agreed that this lease shall remain in force for a term of Five (5) years from the date (herein called primary term) and as long thereafter as oil or gas, or either of them, is produced from said land by the Lessee, and as long thereafter as operations, as hereinafter defined, are conducted upon said land with no cessation for more than ninety (90) consecutive days.”

See, Petrohawk, 2011 WL 5562654 at 1. No gas was produced on the leased properties prior to the May 2010 expiration date. In April 2010, however, the operator obtained a drilling permit, began clearing a roadway and constructed a well-pad site. Id. at 2.

In June 2010, the Heigles filed suit seeking a declaration that the leases expired in May 2010. The Heigles alleged that their leases could not be extended by simply commencing operations during the primary term but required that production of natural gas also be commenced within the primary term. Id. at 2. The operator defended the suit on the grounds that its preliminary operations conducted both before and after the end of the primary term, satisfied the conditions necessary to extend the leases. Id. The trial court agreed with the Heigles and cancelled the leases. The operator appealed.

On appeal, the Court of Appeals observed that the duration of an oil/gas lease is generally defined by the “thereafter” provision in the habendum clause of the lease. Typically, a habendum clause will state that the lease is to last for a fixed term and “as long thereafter” as oil or gas is produced. See, Jacobs v. CNG Transmission Corp., 332 F.Supp.2d 759 (W.D.Pa. 2004). Alternatively, the Petrohawk court noted, some habendum clauses state that the lease will be of a fixed term and then will continue “as long thereafter” as drilling operations are conducted. Id. In Petrohawk, the subject leases contained both “thereafter” clauses connected by the word “and.” As such, the court held that the use of the word “and” required both conditions to be met in order to extend the lease. “[W]here two conditions are joined by that term, both must be met in order to carry out the meaning of the contract.” Id. Since no production occurred prior to the expiration of the primary term, the Petrohawk court concluded that the preliminary drilling operations conducted in April 2010 alone were not enough to extend the leases and affirmed cancellation.

The Petrohawk decision, in essence, rendered the “operations” language in the habendum clause meaningless. It should be noted that the term “operations” was specifically defined by the subject leases:

“Whenever used in this lease the word ‘operations’ shall mean operations for and any of the following: drilling, testing, completing, reworking, recompleting, deepening, plugging back or repairing of a well…or production of oil, gas or other minerals, whether or not in paying quantities.”

See, Petrohawk, 2011 WL 5562654 at 1. In Petrohawk, the gas operator argued, unsuccessfully, that the court’s interpretation of the habendum clause would create absurd and unintended results. For example, the gas operator observed that, under the court’s interpretation, a producing lease would theoretically expire at the end of the primary term unless the operator was also engaged in other “operations” on the leased premises. The Petrohawk court dismissed this argument by pointing out that the subject leases defined “operations” to include “production” of oil and gas.

Nonetheless, the gas operator’s contention does have merit. Why include the term “operations” in the habendum clause if preliminary operations alone are not enough to extend the lease? Such “operations” and “commencement of operations” clauses are commonly used throughout the industry. As one prominent author has noted:

“These clauses have been construed as meaning if a lessee commences a well within the primary term of a lease and carries on the drilling operations diligently and in good faith, although he does not actually complete the well and secure production until after the end of the primary term, the lease remains in force…”

See, 2 Summers, Oil and Gas, §300.1, p. 252 (1959). Moreover, most oil/gas jurisdictions, including Pennsylvania, recognize that the good faith commencement of preliminary drilling operations prior to the expiration of the primary term can extend the lease into the secondary term. See, Peterson v. Robinson Oil & Gas Co., 356 S.W. 2d 217 (Tex 1962) (preliminary drilling operations such as staking the site, constructing an access road and erecting drilling rig found sufficient to extend lease); 21st Century Inv. Co. v. Pine, 734 P.2d 834 (Okla. App. 1986) (acts preparatory to drilling held sufficient to constitute commencement of a well); Henderson v. Ferrell, 38 A. 1018 (Pa. 1898); Pemco Gas, Inc. v. Bernardi, 5 D&C.3d 85 (Armstrong County 1977). The Petrohawk decision is inconsistent with these principles. Remarkably, the Petrohawk court also ignored the fact that the April 2010 drilling operations eventually resulted in a producing gas well on the Heigle property. Evidence of the good faith commencement of drilling operations should have been given more weight by the court. As such, the Petrohawk decision is suspect. As noted earlier, the Petrohawk decision is not binding on Pennsylvania courts. It is unclear whether any Pennsylvania court would adopt and apply the same rationale when construing a similar habendum clause. If adopted, the Petrohawk approach would represent a departure from existing Pennsylvania oil/gas jurisprudence.