Does a Well Passing Horizontally Under a Property Trigger a "Payment in Lieu of Free Gas" Clause? The Pennsylvania Superior Court says "No"

Does a Well Passing Horizontally Under a Property Trigger a "Payment in lieu of Free Gas" Clause?  The Pennsylvania Superior Court Says "No".

By: Brendan A. O'Donnell

At the turn of the 20th Century, it was not uncommon for oil and gas leases in Pennsylvania to have "free gas" clauses, that entitled a lessee to a certain volume of "free gas" if a well was drilled on their property. Usually, lease specified that the purpose of the "free gas" allowance was for use in a residence, i.e. the "mansion house" and it was the landowner's responsibility to run a line from the well to the house. This "free gas" was of great use and value in rural areas without utilities and, in some areas without reliable natural gas service, has remained a tangible benefit of having a lease and well that avoids the cost and logistical issues of propane delivery. Although natural gas development has changed substantially over the last century, "modern" leases still contain artifacts of this past practice.

In Mitch v. XTO Energy, Inc., ___ A.3d___; 2019 PA Super 189 (Pa. Super. Ct. 2019), the Pennsylvania Superior Court addressed whether horizontal drilling beneath a property triggered a lease provision related to "free gas". In Mitch, the landowners entered into an oil and gas lease in 2012 (the "Mitch Lease") on 53 acres of property in Butler County, Pennsylvania. The Mitch Lease contained an addendum clause which was a type of "free gas" provision, entitling the "surface owner" to "300,000 cubic feet of gas multiplied by the average price received by Lessee during the preceding year of production, provided the surface owner has his primary residence on the lease premises" if any well drilled "on the leased premises" produced in paying quantities.

XTO Energy constructed a well pad on a nearby property, owned by Timothy A. Welter. The Mitch Lease, which allowed for pooling and unitization, was included within the "T. Welter Unit" formed around that well pad. From that well pad, XTO Energy drilled horizontally beneath the property subject to the Mitch Lease to access hydrocarbons. No well infrastructure was located on the surface of the property subject to the Mitch Lease.

After hydrocarbon production began, the landowner/lessor, whose primary residence was on the land subject to the Mitch Lease, filed suit against XTO Energy in the Court of Common Pleas of Butler County after XTO Energy did not tender a payment in lieu of free gas pursuant to the Mitch Lease.

While it was clear that the landowner's primary residence was on the property subject to the Mitch Lease and that there was a well producing in paying quantities, the third part of the "free gas" test under the Mitch Lease was that a well be drilled "on the leased premises". The Mitch Lease, like many other leases, defined the "lease premises" by the physical, surface boundaries of the land. The landowner contended that the term "well" was not defined in the Mitch Lease and could therefore be a "horizontal" or a "vertical" well. The landowner reasoned that the "free gas" clause was triggered because of the existence of a well within the bounds of the "lease premises" subject to the Mitch Lease.

On the other hand, XTO Energy argued that the "free gas" provision of the Mitch Lease required that a well be drilled on the surface of the property subject to the Mitch Lease. XTO Energy reasoned that ordinarily the word "on" makes reference to a location on the surface and that the Mitch Lease itself had elsewhere used the phrase "on the lease premises" to refer to surface activities.

Entering summary judgment in favor of XTO Energy, the trial court concluded that the "free gas" provision of the Mitch Lease was rooted in an impact of the landowner's use or enjoyment of the property if physical well infrastructure was located on the surface of the land. Essentially, the trial court found that the "free gas" provision was a benefit associated with a burden of the surface location of a well. The trial court reasoned that there was no burden or limitation on the landowner's use and enjoyment of the surface of the land if a well was only drilled horizontally below the property. The Court of Common Pleas of Butler County found that the "free gas" provision in the Mitch Lease was "unambiguous".

The landowner/ lessor appealed to the Pennsylvania Superior Court. Affirming the trial court, the Superior Court concluded that there was no ambiguity in the "free gas" provision of the Mitch Lease. The Superior Court reasoned that, under the Mitch Lease, the "free gas" provision, along with a provision related to crop damages, were payable to the "surface owner" - not necessarily the lessor. The court found this to be persuasive evidence that the "free gas" addendum was intended to address surface impacts that would come from the location of a well on the surface of the land, versus a well that was horizontally drilled below the property.

While it may seem to address a narrow issue, the Mitch case could have a widespread impact in Pennsylvania. Many leases across Pennsylvania that contain "free gas" provisions, or clauses that provide for a payment "in lieu of" free gas. If landowners have such provisions in their leases, they should carefully review the language to determine whether it may be impacted by the Mitch rationale. Beyond that, the Mitch case shows the importance of phraseology in leases - even down to what the word "on" means. Given the Superior Court's holding, it seems that, at least in this case, the court draws a distinction between "on" and "under" as it relates to a well location. It is unclear if Mitch can be interpreted as a definitive resolution of the meaning of the word "on" as it is used in oil and gas leases to describe a physical location, or whether its meaning is limited to this particular case based on the context that was provided by other provisions in the Mitch Lease. If nothing else, the Mitch case shows how a century-old concept in Pennsylvania oil and gas law continues to be a source of tension and controversy.