Supreme Court clarifies termination of oil and gas leases

The Pennsylvania Supreme Court recently clarified a century-old test to determine when an oil and gas lease will terminate after drilling has begun. In T.W. Phillips Gas & Oil Co. v. Jedlicka, the Court upheld the rule that a lease will terminate when it ceases production in paying quantities but also offered clarifications likely to impact all Realtors® who encounter older oil and gas leases.

Lease termination generally

An oil and gas lease generally is divided into two time periods: the primary term and the secondary term. The primary term is the initial period of years that a drilling company has to explore a property and, hopefully, drill a productive well.  If the lessee does not begin drilling operations, the lease terminates at the end of the term.

Once drilling begins, however, a lease enters the secondary term—a happy time for most landowners, full of fat royalty checks. But every well has a limited life and, when a gusher reduces to a trickle, a landowner may want an operator to move on. This is no simple task: lease termination typically is subject to the terms of a habendum clause.

A habendum clause defines the ultimate duration of a lease, the payment of royalties, and the terms of surrender. Most habendum clauses provide that a lease will remain in effect for as long as oil or gas is produced in paying quantities. But most leases don’t define in paying quantities, leaving such determination to the courts.

Production in paying quantities

The last definitive test from the Supreme Court to determine production in paying quantities came in 1899. According to the two-part analysis, a lease will terminate where the lessee operator fails to turn a profit, however small, over its day-to-day operating expenses. But where an operator does turn a profit which, nevertheless, fails to offset larger costs of the operation as a whole—exploration, drilling, and extraction—a lease will remain in effect so long as the operator exercises its good faith judgment and intends to seek a profit.

Recent clarifications

There has been much debate over whether century-old law should be applied to modern leases in the Marcellus Shale. In T.W. Phillips, the Supreme Court found that old law can still be good law and upheld the validity of its 1899 test. The Court also clarified aspects of the test relating to measuring profits over time and determining good faith judgment.

On the issue of time, the Court was silent a century ago. While the recent decision offers no firm rule in this regard, it acknowledges that since profits must be measured over some time period, a reasonable period should be based on the particular factors of an individual lease.

For the Supreme Court, the good faith judgment of the operator is the principal factor that should determine whether a lease is considered to produce in paying quantities. A prudent operator, in making its business decisions, would not continue with operations that consistently lose money. But such an operator may decide to wait longer for one well to become profitable than another. Courts, therefore, must now presume that an operator is acting in good faith, unless the lessor proves some fraudulent or dishonest intent.

The recent clarifications primarily protect drilling companies from landowners who seek to exploit brief periods of unprofitability by terminating leases and forcing fresh negotiations. The Supreme Court has acknowledged that lessees may not hold land indefinitely for purely speculative purposes—but it still has made it much more difficult for landowners, even those acting in good faith, to oust reluctant unproductive drilling companies.