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Kentucky Court Rules That Lease Expired Due To Driller’s Failure To Market And Produce Gas

By: Robert J. Burnett, Esquire

There are thousands of older vertical wells scattered across Pennsylvania. Many of these wells have not produced oil or gas in years and have fallen into disrepair. Despite this non-production, drillers often contend that these idle wells can and do maintain the underlying oil and gas lease. These drillers often tell the frustrated landowner that they will operate the lease again “when the market rebounds” or “when the wells can be repaired.” In the meantime, the landowner is trapped in marketing limbo: he cannot enter into a new lease with a Marcellus operator because the old, shallow lease remains “in effect,” yet he is receiving no royalties or income from that non-productive lease. In a recent opinion, the Kentucky Court of Appeals recognized this dilemma and ruled that the failure to market gas and tender a production royalty resulted in the automatic termination of the parties’ lease.

At issue in Crisp v. Blackridge Appalachian Land LLC was an oil and gas lease executed in 1980 concerning acreage located in Lawrence County, Kentucky (the “1980 Lease”). The 1980 Lease contained a five-year primary term and would remain in effect beyond 1980 so long “as oil and gas was being produced” from leased premises. After the 1980 Lease was signed, the lessee drilled a single shallow gas well on the property (the “Blackburn Well”). No other gas wells were ever drilled. The Blackburn Well supplied “free gas” to three separate houses located on the leased premises. In 2000, Magnum Drilling Inc. (“Magnum”) purchased the 1980 Lease. Between 2000 and 2015, Magnum performed little to no maintenance on the Blackburn Well and never made any effort to market or sell gas from the well. During this time, no production royalty was ever tendered to the landowner. The Blackburn Well, however, continued to supply “free gas” to the three households.

In 2015, the landowner executed a new oil and gas lease (the “2015 Lease”) with Big Star Energy L.P. (“Big Star”). Big Star then assigned a 50% interest in the 2015 Lease to Blackridge Appalachian Land LLC (“Blackridge””). When Blackridge attempted to enter the property formerly subject to the 1980 Lease and drill a new well, Magnum protested and objected to Blackridge’s leasehold claim. Magnum argued that the 1980 Lease remained in effect and that the 2015 Lease was therefore invalid and void. Blackridge filed suit seeking a declaration that the 1980 Lease had expired and terminated due to non-production.

Blackridge moved for summary judgment based on the testimony of Magnum’s own witnesses. These witnesses admitted that Magnum had neither collected nor sold gas from the Blackburn Well since 2000. They also admitted that no royalties had ever been paid to the landowner and that no Magnum employee had inspected or serviced the Blackburn Well in over ten years. In opposition to Blackridge’s motion, Magnum argued that the 1980 Lease was still in effect and never expired because the Blackburn Well was still supplying gas to the three households. In essence, Magnum argued that the “free gas” being supplied to the three households was sufficient to meet and satisfy the “production in paying quantities” standard. The trial court rejected Magnum’s theory and entered judgment in favor of Blackridge.

On appeal, Magnum argued that the trial court erred by refusing to equate “free gas” with commercial production. The Kentucky Court of Appeals correctly rejected this argument. The panel noted that for an oil and gas lease to be “producing” (and therefore transition beyond the primary term), the production must be “in paying quantities”. This in turn means that there must be sufficient revenue to pay all operating costs including the payment of production royalties. Here, although there was sufficient production to supply the three households with “free gas”, no gas was ever sold on the open market and no production royalty was ever generated. The supply of “free gas” alone was not enough to maintain the 1980 Lease. The panel implicitly recognized that the one of the underlying assumptions in any oil and gas lease is the payment of a royalty generated from commercial production. The panel opined that given the lack of any commercial production in over 15 years, the 1980 Lease terminated pursuant to its own terms.

The Crisp opinion is consistent with the majority of oil and gas jurisdictions that have addressed this reoccurring issue. The mere fact that a legacy well continues to supply “free gas” does not mean the underlying oil and gas lease is, in fact, producing “in paying quantities”. The courts generally require some evidence of commercial production. See, Babb v. Clemens, 687 A.2d 1120 ( Pa. Super. 1996)( the landowner’s “everyday use of the gas provided by the lessee’s wells did not constitute production as contemplated by the lease”); Tisdale v. Walla, 94-A-008 (Ohio Ctr. of Appeals 1994)( domestic use of gas was not production in paying quantities); Metz v. Doss, 252 NE2d 410 ( Ill. App. 1969) (“free gas” does not constitute “production” which will maintain the lease). The author submits that the Crisp panel reached the correct outcome by refusing to equate domestic gas consumption with actual commercial production “in paying quantities.”

 

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