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Kentucky Federal Court Fumbles Lease Expiration Claim

March 30, 2022

Let’s assume you own a 110 acre farm in Washington County. The farm is subject to an oil and gas lease which was signed by your grandfather in 1983. There is one well on the farm but you have not received a production royalty since March 2019. The well itself is in disrepair and the well meter indicates that there has been no gas production in years. Your counsel sends a letter to the last known operator, XYZ Drilling, requesting that the 1983 Lease be surrendered and the well plugged. XYZ Drilling never responds to his letter. Weeks go by and XYZ Drilling has still not responded to the letter nor resumed gas production from the well. Your counsel then files a lawsuit seeking to compel XYZ Drilling to record a lease surrender instrument pursuant to Pennsylvania Rule of Civil Procedure 1061(b)(3). In response to the lawsuit, XYZ Drilling files a motion to dismiss on the grounds that you did not provide them prior “notice” under Paragraph 10 of the 1983 Lease. This clause essentially says you must give XYZ Drilling written notice of any breach or default and that no lawsuit can be filed until 90 days after such notice in order to give XYZ Drilling time to “cure” the alleged breach or default. The trial court agrees with XYZ Drilling and dismisses the complaint. You are confused and frustrated. How can Paragraph 10 be applicable to a lease expiration claim? How can XYZ Drilling go back in time and cure several years of non-production? Unfortunately, this “notice and cure” defense is gaining momentum with drillers and some courts. As detailed below, the traditional “notice and cure” clause has no relevance or bearing on whether an oil and gas lease has expired due to non-production. Nonetheless, as illustrated by the recent decision in Bluegrass Materials Company LLC v. Frank Freeman, et al, courts are incorrectly treating non-production under an oil and gas lease as a contractual “default” that can be cured or corrected.

At issue in Bluegrass was a 1985 oil and gas lease covering approximately 100 acres in Warren County, Kentucky (the “1985 Lease”). The 1985 Lease had a primary term of one year and would remain in effect beyond 1986 “as long thereafter as oil or gas, or either of them, is produced from said lease by the lessee…..” Two wells were drilled on the leasehold in the early-1990’s. The wells produced oil each year between 1995 and 2018, except for an eleven (11) month period between September 2015 and August 2016 when no oil or gas was produced. The landowner, who operated a limestone quarry on the surface, filed suit in December 2018 alleging that the 1985 Lease terminated and expired because the leasehold had failed to produce oil or gas in paying quantities. In addition to the eleven (11) months of non-production, the landowner noted that the wells only produced 45 barrels of oil in 2015 and just 20 barrels in 2016.

The driller filed a motion to dismiss on the grounds that Kentucky law required the landowner to give the driller prior notice and adequate time to cure the alleged default before filing suit. The driller argued that, under Kentucky law, whenever a suit is based on forfeiture for breach of express or implied obligations in the lease, the lessor must provide notice and give an opportunity to cure. No such notice, however, is required in the event of abandonment or ceased production. See, Hiroc Programs Inc. v. Robertson, 40 S.W. 3d 373, 378 ( Ky. App. 2000). Nonetheless, despite the eleven (11) month period of non-production, the driller suggested that this inadequate production, at best, was a breach of an express obligation in the 1985 Lease and, therefore, prior notice was required before seeking judicial forfeiture of the 1985 Lease. It was undisputed that the landowner had not provided any notice prior to filing suit. The trial court agreed with the driller and characterized the eleven (11) month period of non-production simply as “unsatisfactory production”. Given this conclusion, the trial court opined that the landowner’s suit was based on a breach of an express lease obligation and therefore the failure to provide prior notice “bars the Plaintiff from the termination it seeks in this action”. The author submits that Pennsylvania should not adopt or follow the rationale espoused by the Kentucky court.

There is a distinction between a driller’s default of an express contractual obligation under an oil and gas lease and the expiration of the leasehold interest due to non-production. For instance, if a driller produces and sells oil or gas and fails to pay the royalty, that is a “default” of the contractual obligation to pay a royalty. In our example above, that would trigger Paragraph 10, because XYZ Drilling was contractually obligated to pay a royalty if it produced oil or gas. But, that is different from Bluegrass, where the driller failed to produce any oil or gas for eleven (11) months. A review of the unique nature of oil and gas leases is important here, and it is something that the trial court largely did not address in the Bluegrass decision.

When an oil and gas lease is executed, the lessee’s initial title is “inchoate” for exploration and development of oil and gas. T.W. Phillips Gas and Oil Co. v. Jedlicka, 42 A.3d 261, 267 (Pa. 2012). But, if oil or gas is found, the lessee’s rights transition into a fee simple determinable. Id. “A fee simple determinable is an estate in fee that automatically reverts to the grantor upon the occurrence of a special event.” Jacobs v. CNG Transmission, 332 F.Supp.2d 759, 773 (W.D.Pa. 2004). As such, it is important to note that while an oil and gas lease is a contract, the interest created by the contract (i.e., fee simple determinable) is governed by property law. See, Jedlicka , 42 A.3d at 267 (“[a]n oil and gas lease reflects a conveyance of property rights within a highly technical and well-developed industry….”); See also, Nolt v. TS Calkins & Associates, 96 A.3d 1042 (Pa. Super 2014) (“[A] fee simple determinable is an estate in fee that automatically reverts to the grantor upon the occurrence of a special event.”).

The “special event” or “limitation event” that automatically terminates the fee simple determinable estate is non-production. See, Jacobs, 332 F. Supp. 2d at 777-78. So, if at the end of the primary term there is no production, then the leasehold interest automatically terminates. This is known as the “automatic termination rule” and has been a part of Pennsylvania oil and gas law for over a hundred years.

This rule provides that the property interest acquired by the driller upon execution of an oil and gas lease will automatically terminate if the driller fails or ceases to produce hydrocarbons any time after expiration of the primary term. See, Brown v. Haight, 255 A.2d 508 (Pa. 1969) (“[T]herefore, in 1947 when oil and gas were not produced in paying quantities, the grantee’s fee interest terminated automatically and the property reverted to the grantor”); Cassell v. Crothers, 44 A. 446 (Pa. 1899) (“[W]here oil was no longer being produced in paying quantities, the lease was liable to be terminated”); Hite v. Falcon Partners, 13 A.3d 942 (Pa. Super. 2011) (“…when that primary term ended and Falcon failed to commence production, the agreement expired.”); Heasley v. KSM Energy, 52 A.3d 341 (Pa. Super. 2012) (“[W]hen production ceased, the lease became an at-will tenancy, subject to termination by the lessor at any time”). The hallmark of the “automatic termination rule” is that it is automatic: cessation of production, unless excused by a savings mechanism in the parties’ lease, terminates the driller’s property interest by operation of law.

In Bluegrass, the 1985 Lease was well beyond its primary term. The 1985 Lease provided that it would remain in effect as long as oil or gas was produced in paying quantities. It was undisputed that the two shallow wells did not produce any oil or gas between September 2015 and August 2016. The driller’s failure to produce oil or gas was not a breach of the 1985 Lease per se. Instead, it was, and is, a determinable event that automatically terminated the fee simple property interest created when the 1985 Lease was executed.

Oil and gas leases with “default” provisions are somewhat common and drillers oppose lease termination claims by arguing that contractual “default” provisions control and govern resolution of such claims. The implication of this faulty reasoning is apparent: the drillers then argue that they should have the ability to “cure” the purported “default” by resuming or restarting production. In other words, they want a second chance. However, the “automatic termination rule” is not subject cure and the leasehold estate automatically terminates when there is non-production. The Bluegrass decision, although not binding on Pennsylvania courts, appears to sanction and encourage this troubling and misplaced argument. Pennsylvania should reject this approach.

According to the trial court in Bluegrass, if there is a “default”, the landowner must provide the driller with “notice” and the ability to “cure” the “default”. This means that a “default” is something that necessarily can be cured or fixed by some affirmative action on the part of the driller. This cannot apply to the driller’s failure to produce oil and gas or to otherwise reverse or override the automatic termination rule.

The driller’s “fee simple determinable” estate automatically terminates when the habendum is not satisfied. Those leasehold rights automatically revert back to the landowner. To argue that non-production does not terminate a lease absent an opportunity to “cure” completely ignores the basic nature of a driller’s leasehold title. This results in obvious absurdities because any “cure” would be prospective. The driller in Bluegrass could not go back in time and produce oil or gas during the eleven (11) month period when there was no production. So, a “cure” would not even resolve or address the issue. This confirms that a failure to satisfy the “habendum” is not an occurrence or event that is subject to “cure”. See, Woodson Oil Co. v. Pruett, 281 S.W.2d 159 (Tex. Civ. App 1955) (“There is no principle of forfeiture involved when a lease is terminated by its own provisions for cessation of production.”). If the driller satisfies the “habendum”, it retains developmental and exploration rights granted by the lease. If the driller does not satisfy the “habendum” (i.e., non-production), the developmental and exploratory rights automatically expire and terminate. The Bluegrass decision fails to appreciate this critical distinction and therefore should not be followed by Pennsylvania courts.

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