Is the Implied Covenant of Reasonable Development Irrelevant?

By Robert J. Burnett and William J. Blakemore

The Pennsylvania Superior Court has continued the unfortunate recent trend of eroding the implied covenant of reasonable development in Pennsylvania. Generally, upon discovery of hydrocarbons, the implied covenant of reasonable development places an obligation upon the lessee to drill as many additional wells as may be reasonably necessary to fully develop the underlying hydrocarbon formation.

In essence, the covenant imposes upon the lessee an ongoing duty to keep drilling after an initial well has been completed and put into production. The purpose of the covenant is to discourage the practice of drilling a single well and then allowing the balance of a leasehold to remain undeveloped and idle.

While Pennsylvania apparently continues to recognize this implied covenant in every oil and gas lease, several recent decisions have narrowed its application to the point where it is becoming nearly irrelevant.

In Seneca Resources v. S&T Bank, No. 2057 WDA 2014, Aug. 31, 2015, the parties’ 1962 lease covered approximately 25,000 acres in Elk and Jefferson counties. The lease had a primary term of 40 years and would continue thereafter so long as oil or gas was stored, produced or withdrawn from the leasehold. By 2008, approximately 300 shallow oil and gas wells had been drilled on approximately 15,000 acres. None of the wells had a depth greater than 5,000 feet. The landowner challenged the validity of the 1962 lease as to the undeveloped acreage and formations, contending that the lessee had breached the implied covenant of reasonable development. In its suit, the landowner sought an order severing the undeveloped acreage from the 1962 lease.

In September 2013, the trial court granted the lessee’s motion for summary judgment. The trial court reasoned that because the leasehold was already in development at the time the lessee, Seneca Resources Corp., acquired its interest, the implied covenant of reasonable development was inapplicable. The trial court noted that "because Seneca assumed the role of lessee to the lease already developed by its predecessors … the implied covenant is no longer applicable to the lease." The trial court’s reasoning was a departure from well-established oil and gas jurisprudence.

On appeal, the Superior Court disagreed with the trial court’s rationale and observed that "the fact that the leased premises [were] under production at the time of the entry of the lease does not, in itself, invalidate the implied covenant to develop." As such, the panel held that the trial court’s reasoning could not be the basis for granting summary judgment. The landowner’s victory, however, was short-lived.

While the Seneca court rejected the trial court’s reasoning, it nonetheless upheld the entry of summary judgment, but on other grounds. Unlike the trial court, the panel focused on the express language set forth in the habendum clause of the 1962 lease. This clause, like most habendum clauses, stated that the 1962 lease would remain in effect after expiration of the primary term so long as "oil or gas or either of them is stored in, produced or withdrawn from all or any portion of said leased premises."

The Seneca court seized on the phrase "any portion of the leased premises." Given this language, and because nearly 300 wells had been drilled on approximately 15,000 acres, the panel reasoned that such development was sufficient to hold the entire leasehold. Since the lessee was actively producing gas from a "portion" of the 25,000 acres, the court opined that the habendum clause trumped application of the implied covenant.

The court further noted that the 1962 lease was silent as to any affirmative duty or obligation to fully develop the entire leasehold. The court observed that the 1962 lease "makes no mention of any duty or mandate to drill or operate the unoperated acreage." As such, the court inexplicitly concluded that the absence of such language in the lease precluded application of the implied covenant.

Simply put, the Seneca court got this wrong. It failed to perform a separate analysis relative to the issue of the implied covenant of reasonable development, instead collapsing it into a singular analysis centered on the habendum clause. These are two distinct concepts. The habendum clause sets forth the duration of the leasehold interest. A lessee can satisfy and maintain this durational requirement by drilling and producing hydrocarbons. Satisfaction of this requirement, however, does not automatically alleviate or negate the ongoing obligation to fully develop the entire leasehold.

In Seneca, while it was true that nearly 300 wells had been drilled in a certain area, it was undisputed that no such drilling or production had occurred in a designated area consisting of 3,131 acres. The court erroneously relied upon the habendum clause to excuse and shield this nondevelopment. It is submitted that the court’s opinion overlooked or ignored the primary purpose of the implied covenant: to encourage the lessee to drill more wells and fully develop the underlying hydrocarbons.

Perhaps more puzzling is the court’s reference to the 1962 lease and the purported absence of any express duty to develop the entire acreage. In the context of implied covenants, this statement is illogical. By definition, an implied covenant is an obligation or promise that is not expressly stated in the parties’ lease. Rather, as almost all other oil and gas jurisdictions have recognized, implied covenants are designed to fill in the gaps not expressly addressed by the parties’ lease. The Seneca court, however, ignored this well-established principle and concluded that the absence of any express drilling commitment in the 1962 lease apparently negated application of the implied covenant.

As support for its novel interpretation of the covenant, the Seneca court erroneously relied on the Superior Court’s 2013 decision in Caldwell v. Kriebel Resources, 72 A.3d 611 (2013). In Caldwell, the Superior Court sustained preliminary objections dismissing the landowner’s implied covenant claim. Unlike the lease before the Seneca court, the lease in Caldwell contained a boilerplate but express provision stating that "no inference or covenant shall be implied as to either party hereto since the full contractual obligations and covenants of each party [are] herein fully expressed."

In no way did Caldwell reject the covenant; it simply upheld an express disclaimer and enforced the terms of the lease. As such, the holding of Caldwell is limited to those leases that contain an express disclaimer of the implied covenants. The lease in Seneca contained no such express language and, therefore, Caldwell was and is inapplicable.

The Seneca opinion also cited the controversial 2014 decision rendered by the U.S. District Court for the Western District of Pennsylvania in Delmas Ray Burkett II Revocable Trust v. Exco Resources, Civil Action No. 2:11-cv-1394. In Exco Resources, the landowner sought cancellation of the parties’ 1916 lease with respect to all hydrocarbon formations below 3,500 feet. At the time of suit, two conventional, vertical wells were producing gas from a shallow formation. The lessor argued the lessee has an implied obligation to "develop all economically exploitable strata." The district court, like the Seneca panel, rejected the lessor’s implied covenant claim under the auspices of the habendum clause. Since the two conventional wells were producing in paying quantities, the Exco Resources court concluded that such production was sufficient to maintain all strata and horizons.

It is submitted that the Exco Resources court made the same analytical error as the Seneca panel. Mere satisfaction of the durational requirement (i.e., production in paying quantities) set forth in the habendum clause does not automatically excuse or discharge the obligation to develop the entire leasehold. Neither the Seneca court nor the Exco Resources court appreciated this distinction.The Seneca decision compounds the uncertainty and confusion regarding the scope and application of the implied covenant of reasonable development under Pennsylvania law. As a result of the faulty reliance on the habendum clause in resolving such claims, the implied covenant of reasonable development is now nearing extinction in Pennsylvania. This is an unfortunate and troubling path for Pennsylvania landowners.