by Robert J. Burnett, Esq.
The Pennsylvania Superior Court recently addressed the issue of whether the mere payment of delay rentals can extend a gas lease beyond its primary term. In Hite v. Falcon Partners, et al., 2011 WL 9632 (January 4, 2011), the Superior Court rejected the gas producer’s argument that a non-producing lease can be preserved indefinitely simply by making delay rental payments. In siding with the landowner, the Superior Court affirmed the trial court’s cancellation of the non-producing lease and sent a clear warning to gas operators throughout the Commonwealth. Following Hite, there is no question that the so-called “automatic termination rule” is alive and well in Pennsylvania. As such, landowners and gas operators alike should carefully review the Hite decision and its potential impact on non-producing leases.
In order to appreciate the significance of the Hite decision, a brief summary of several unique gas lease concepts is warranted. Oil and gas leases generally consist of two terms: a primary term and a secondary term. The primary term is typically fixed and is one to three years. The secondary term is generally of indefinite duration so long as gas is being produced “in paying quantities”. During the primary term, the lessee has the opportunity, but not the duty, to explore, drill and produce gas. See, Calhoon v. Neely, 50 A. 967 (Pa. 1902) (the title conveyed by the primary term is “inchoate and for purpose of exploration only...”). The lease is maintained during primary term by either actual production or the payment of the delay rentals.
Delay rentals have long been used in the industry as a means to suspend the implied obligation to develop the leasehold during the primary term. By paying the delay rental, the operator can preserve and maintain the lease without actual production. As long as the operator pays the delay rental, it is under no obligation to drill a well or conduct any exploratory activities. Such payments are “in the nature of liquidated damages for the lessee’s decision to forego production” and are viewed as the consideration paid to the landowner in lieu of a production royalty. See, Hutchinson v. Sunbeam Coal Corp., 519 A.2d 385, 388 (Pa. 1986); see also, Jacobs v. CNG Transmission, 332 F.Supp.2d 759, 785 (W.D. Pa. 2004) (“[I]t is customary for the parties to an oil and gas lease to agree that a minimum advance royalty shall be paid for the lessee’s right to forgo immediate development...”); Marshall v. Forrest Oil Co., 47 A. 927 (Pa. 1901) (delay rental compensates the lessor for the lessee’s delinquency in commencing production). In the absence of actual production, the failure to make a timely delay rental payment can result in the automatic forfeiture of the lease during the primary term. See, Bertani v. C.E. Beck, 479 A.2d 534 (Pa. Super. 1984).
Extending the lease into the secondary term is not automatic. At the expiration of the primary term, courts have historically applied a harsh doctrine known as the “automatic termination rule.” Under this rule, a lease will terminate at the end of the primary term unless there is a well producing gas “in paying quantities”. See, Brown v. Haight, 255 A.2d 508 (Pa. 1969) (“...when oil and gas were not produced in paying quantities, the grantee’s fee interest terminated automatically...”); White v. Young, 186 A.2d 919 (Pa. 1963) (failure to produce gas in paying quantities resulted in termination of lease after primary term expired). Given the harshness of the “automatic termination rule”, the industry developed several lease saving devices such as the shut-in royalty clause, the continuous operations clause and the dry hole clause. The clauses, however, generally require the operator to conduct some drilling activity short of actual production prior to the expiration of the primary term. See, Pemco Gas, Inc. v. Bernardi, 5 D&C.3d 85 (Armstrong County 1977). As explained below, these clauses were not available to the operator in Hite.
In Hite, the operator was the assignee of several gas leases executed in 2002 and 2003. Each lease contained a fixed primary term of one year:
“3. Term. Lessee has the right to enter upon the Property to drill for oil and gas at any time within one (1) year from the date hereof and as long thereafter as oil and gas or either of them is produced from the Property, or as operations continue for the production of oil and gas, or as Lessee shall continue to pay Lessors two ($2.00) dollars per acre as delayed rentals.”
Hite, 2011 WL 9632 at 1. The primary terms expired in 2003 and 2004, respectively, without any production being achieved. Id. at 1. No well was ever drilled or even attempted. The operator, however, continued to make the delay rental payment for several years after the primary terms expired. Id. In 2008, the landowners demanded that the operator either commence drilling or surrender the leases. The operator refused and the landowners filed suit. Id.
The operator contended that the leases were extended into the secondary term by virtue of the delay rental payments. In essence, the operator argued that it could maintain the leases “indefinitely” so long as delay rentals were paid to the landowner. The trial court rejected this application of the delay rental clause and cancelled both leases due to non-production. In so ruling, the trial court opined that “a lease will not be construed to create a perpetual term unless the intention is expressed in clear and unequivocal terms.” Id. at 3. The trial court further noted that if the lease could be “extended in perpetuity” through the payment of delay rentals, there “would be little need for the parties to agree to a one-year lease term.” Id.
On appeal, the Pennsylvania Superior Court closely examined the historical role and purpose of delay rental clauses. The Hite court noted that delay rentals have long functioned “to relieve the lessee of the obligation to develop the leasehold during the primary term of the lease.” Hite, 2011 WL 9632 at 5. The payment of delay rentals, the court observed, has traditionally been viewed to “spur the lessee toward development” and not as a reward for inactivity. Id. at 5. The operator’s interpretation of the delay rental clause was contrary to this historical role. Delay rentals are not, as suggested by the operator, a “savings” mechanism that can extend a non-producing lease into the secondary term. The Hite court correctly limited the scope and effect of delay rental payments to the primary term:
“[A]s such, a single two dollar rental payment relieved Falcon of any obligation to develop the leasehold during the one year primary term. Once that one year primary term expired, however, the mere payment of delay rentals alone did not preserve Falcon’s drilling rights.”
Id. at 5. The Hite court also rejected the operator’s delay rental argument on public policy grounds. Pennsylvania has long frowned upon the practice of holding acreage with a non-producing lease. See, McKnight v. Manufacturers Natural Gas, Co., 23 A. 164, 166 (Pa. 1892) (“The defendant cannot hold the premises and refuse to operate them”); see also, Jacobs v. CNG Transmission Corp., 772 A.2d 445 (Pa. 2001) (“...the lessee has an affirmative obligation either to develop and produce the oil and gas or terminate the landowner’s contractual obligations”). In Hite, the Superior Court reaffirmed this long-standing policy and once again opined that Pennsylvania will not allow an operator to postpone development indefinitely by the mere payment of a delay rental:
“[F]alcon was permitted to delay production during the year long primary term of the leases by the tender of a delay rental payment, but when that primary term ended and Falcon failed to commence production, the agreements expired.”
Hite, 2011 WL 9632 at 6. Although the Hite panel did not mention or reference the “automatic termination rule” by name, it clearly applied the rule in affirming the trial court’s cancellation of both leases. Both landowners and operators should be aware that non-producing leases are not favored in Pennsylvania and that the Superior Court will not hesitate to affirm cancellation of such leases.