Pennsylvania Superior Court Rules That Driller Abandoned Oil/Gas Lease By Failing To Pay Royalties For Over 20 Years
Pennsylvania Superior Court Rules That Driller Abandoned Oil/Gas Lease By Failing To Pay Royalties For Over 20 Years
Your family owns a 125 acre farm in Greene County. Back in 1966, your grandfather signed a lease with XYZ Oil Co. In that 1966 lease, XYZ Oil Co. promised to pay 12.5% on all oil and gas produced. One shallow vertical well was drilled in 1970, which produced modest royalties until the mid-1980’s. No other wells were ever drilled. In the 1990’s, XYZ Oil Co. sold the lease to Big Oil, Inc. In the years immediately after the sale, Big Oil, Inc. came out to the farm once or twice a year to inspect the well and perform general maintenance. Those visits stopped ten years ago. Now, Big Oil, Inc. wants to build a well pad on your farm and drill several deep horizontal wells. Is the 1966 Lease still valid? Can Big Oil, Inc. build a well pad and drill new wells even though no royalties have been paid in over 25 years? A recent decision by the Pennsylvania Superior Court strongly suggests that Big Oil, Inc. abandoned the 1966 Lease and no longer has any drilling rights.
At issue in SLT Holdings, LLC, et al. vs. Mitch-Well Energy, (542 WDA 2018, August 23, 2019) were two oil and gas leases concerning two separate parcels in Warren County, Pennsylvania (the “1985 Leases”). Both leases were signed in 1985 and would remain in effect for five (5) years and “as long thereafter as oil and gas or other substances covered hereby are or can be produced in paying quantities.” In 1986, two shallow vertical wells were drilled – one on each parcel. No other wells were ever drilled. The two shallow wells produced oil and gas for ten (10) years but production ceased in 1996. No royalties were paid to the landowner between 1991 and 2013. The landowners brought suit in 2013 seeking a judicial declaration that the 1985 Leases had been abandoned and were no longer in effect.
The lessee, Mitch-Well Energy (“Mitch-Well”), defended the suit, in part, on the grounds that it ceased production in the mid-1990s because it was no longer “economical” to sell the oil and/or gas. Following the completion of discovery, the landowners moved for summary judgment, arguing that Mitch-Well had effectively “abandoned” the leasehold. In addition to the lack of any royalty payment between 1991 and 2013, the compelling evidence of abandonment was summarized by the trial court as follows:
“Furthermore, there was no physical indication at the 1986 well sites that the wells were either producing or capable of producing oil and gas. Testimony indicated that no motor, brine tank, power source, equipment or other indication that the wells were producing or capable of producing was observed at or near either well. In fact, testimony indicated that the post upon which the motor had once rested was rusty, indicating the motor had not been there for some time. Additionally, no brine tank was found on site, and although testimony indicated that an oil and gas well need not necessarily have a brine tank nearby in order to be in production, the industry standard is for a brine tank to be placed nearby the well. Thus, the absence of a brine tank is rare. In fact, testimony indicated that the May 1986 Mitch-Well drill site was overgrown with weeks and undergrowth. The Affidavit of Jack E. McLaughlin indicated that fallen timber and logs blocked paths used to access the well site, and that said pathways were impassible for over two consecutive years…”
The trial court granted the landowner’s motion and concluded that Mitch-Well had “abandoned” the 1985 Leases. Mitch-Well filed a timely appeal to the Pennsylvania Superior Court. On appeal, Mitch-Well argued that the finding of “abandonment” was not supported by the record and that disputed issues of fact precluded the entry of summary judgment. Before we address the Superior Court’s opinion in SLT Holdings, a brief review of two lease expiration concepts is warranted.
Pennsylvania has historically applied the “automatic termination rule” during the secondary term of an oil and gas lease. 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”); Jacobs v. CNG Transmission Corp., 772 A.2d 445 (Pa. 2001) (“…the lessee has an affirmative obligation to enter and to develop and to produce the oil and gas or terminate the landowner’s contractual royalty…”); 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”). This basically means that any cessation of production during the secondary term of a lease, even one of short duration, will theoretically trigger the “automatic termination rule” and terminate the lease. The hallmark of the “automatic termination rule” is that it is automatic: cessation of production, unless excused by a savings mechanism in the parties’ lease1 , terminates the driller’s property interest by operation of law.
Alternatively, Pennsylvania courts also recognize that an oil and gas lease may terminate if the lessee abandons the leasehold. The abandonment doctrine was first applied to oil and gas leases in 1899. See, Aye v. Philadelphia Co., 44 A. 555 (Pa. 1899)(observing that an “unexplained cessation of operations” for over four years gave rise to a presumption of abandonment). Under Pennsylvania law, to successfully establish a claim for abandonment, a party must demonstrate an “intentional relinquishment” of rights. See, MacCurdy v. Lindey, 37 A.2d 514 (Pa. 1944) (“[M]ere nonuse does not constitute abandonment; there must be an intention to abandon together with external acts”). Oil and gas leases can be abandoned if there is evidence that the lessee intended to abandon the lease and commits some positive act of abandonment. Unlike the “automatic termination rule,” an abandonment claim typically requires the lessor to proffer evidence demonstrating or proving the lessee’s intent to abandon the lease. See, Hummel v. McFadden, 150 A.2d 856 (Pa. 1959) (noting that abandonment “differs from a forfeiture in that it is based on an intentional relinquishment of rights by the lessee, and not upon a breach of obligation”). No such evidence is required under the “automatic termination rule”. As such, it is generally recognized that the concepts are mutually exclusive: if a lease terminates due to non-production it is unnecessary to examine or assess the lessee’s intent to abandon.
Returning to SLT Holdings, the undisputed cessation of production between 1996 and 2013 would appear to fall squarely within the parameters of the “automatic termination rule.” The Superior Court, however, affirmed that trial court’s finding that the 1985 Leases expired due to abandonment, as opposed to non-production. This conclusion is peculiar. A possible explanation for the trial court’s focus on “abandonment” versus the “automatic termination rule” may be the fact that Paragraph 12 of the 1985 Leases stipulated that the leaseholds would remain operative for as long as the lessee (i.e., Mitch-Well) determined the oil and gas could be produced in paying quantities. From this, the trial court reasoned that “[M]itch-Well [had] the exclusive power to end the term of the Lease.” Since Mitch-Well ostensibly had the “exclusive power” to determine whether the leasehold was producing “in paying quantities”, the trial court may have surmised that the “automatic termination rule” was superseded by the parties’ unique lease language. As a result, the trial court, and the Superior Court, turned to the alternative doctrine of abandonment.
In addition, the trial court further observed that Paragraph 12 of the 1985 Leases required the lessors to give written notice of an event of default. Here, the event of default was, arguably, the failure to produce hydrocarbons and pay any royalties. Upon receipt of said notice, Mitch-Well had thirty (30) days to “cure” the default. From the record, it was unclear whether such a formal notice was ever tendered under Paragraph 12.
It seems plausible that, given the facts of the case (no production for 16 years, overgrown wells, etc., no valid explanation for non-production by the operator) the doctrine of abandonment achieved the necessary and fair result – a finding that the 1985 Leases were no longer operative – without requiring an investigation into the procedural issues under Paragraph 12 of the 1985 Leases about whether notice of default was proper or whether the lessee could (or did) attempt to “cure” the default – and whether the only “cure” available, re-starting production, was viable. In other words, the trial court and the Superior Court may have side-stepped the thorny question of whether a non-production “default” is capable of being “cured” by simply invoking the doctrine of abandonment.
Finally, the trial court, and the Superior Court, were also persuaded by the rationale adopted by the court in Jacobs v. CNG Transmission Corp., 332 F.Supp.2d 759 (W.D.Pa. 2004). In Jacobs, the federal district court in Pittsburgh concluded that the lessee had abandoned the leasehold by not producing any oil or gas in almost forty (40) years. The Jacobs court observed that there is an implied obligation on the lessee to proceed with the development of the oil and gas formations and the failure to do so can amount to abandonment. Following this rationale, the Superior Court adopted the trial court’s finding that Mitch-Well had abandoned the 1985 Leases:
“[I]n the instant case, there was a prolonged period of inactivity by [Appellants] concerning production at the relevant wells. This period was approximately sixteen years long, which is far longer than the four year period contemplated by the Aye court. Mr. Mitchell’s deposition testimony suggests that his explanation for this inactivity is that the price of OGM had fallen so dramatically that [Appellants] could not make money by producing the wells in question. Transcript of Deposition of William Mitchell[5/19/17,] at  75-76, 84. The [c]ourt does not find this to be a valid explanation that will defeat the presumption of abandonment. If the [c]ourt found otherwise, then the leases would be reduced to mere options and the implied covenants to produce would be practically insignificant.
It should be noted that SLT Holdings is the second “abandonment” decision issued by the Superior Court in the last three years. In March 2017, the Superior Court issued the non-precedential opinion in Montgomery v. R. Oil & Gas Enterprises, (1164 WDA 2015), which affirmed the trial court’s finding that the lessee had abandoned the underlying oil and gas lease. Like the trial court in SLT Holdings, the trial court in Montgomery opined that the lessee:
“…had breached its implied obligation to explore and develop the property with reasonable diligence. The failure to do so amounted [to] an abandonment of the Lease.”
Given the recent decisions in Montgomery and SLT Holdings, it appears that the doctrine of abandonment is gaining favor with the Pennsylvania Superior Court. As such, when examining a potential lease expiration claim, landowners would be wise to explore both a traditional claim under the “automatic termination rule” as well as a parallel claim under the doctrine of abandonment.