As we reported previously, recent exploration and production in the Marcellus Shale has forced Pennsylvania courts to address interpretation of oil and gas leases which may be over 100 years old, relying on cases that are similarly over 100 years old, and to harmonize or reject those cases as they impact the people and property in the 21^stcentury.  On March 26, the Pennsylvania Supreme Court attempted to do just that in T.W. Phillips Gas and Oil Co. v. Jedlicka, No. 19 WAP 2009 (Mar. 26, 2012).  The case involved a 1926 oil and gas lease which provided, in relevant part, that the lease would continue for “as long . . . as oil or gas is produced in paying quantities” and required interpretation of the term “in paying quantities.” 

The landowner Plaintiff, Ms. Jedlicka, sought to terminate the lease when the successor to T.W. Phillips sought to drill several new wells on her property.  Ms. Jedlicka contended that the driller did not have this right because the lease terminated in 1959 when the wells on her and other parcels subject to the lease has a loss of $40.00 and thus had not produced “in paying quantities.”  Defendants disagreed, arguing, among other things, that a mere dollars-and-cents measurement of profitability over a one-year period of time was not the standard upon which to determine whether wells were producing “in paying quantities.” 

Both parties looked to and relied upon the case of Young v. Forest Oil Co., 194 Pa. 243 (1899), to support their claims.  The Pennsylvania Supreme Court had been faced with a similar question in 1899, and held that “in paying quantities” meant, first, quantities to the lessee and not to the lessor and, second, … well, what Youngheld was actually what the parties in T.W. Phillips disputed.  Plaintiff argued that the standard found in Young was that the lease must first produce a profit for the driller and if it did not, then the lease might still terminate if the driller failed to act in good faith, but instead maintained the wells merely for purposes of speculation of future profits.  The Defendants disagreed, arguing that Young stood for the proposition that so long as the lessee was operating in good faith, regardless of the actual profitability of the wells, then the lease would not terminate.  The Superior Court agreed with the Defendants, and held that the lease had not terminated because the Defendants had been operating the wells in good faith and did not appear to be holding the land for speculation. 

The issue that the Ms. Jedlicka raised on appeal was a narrow one:  “whether Pennsylvania employs a purely subjective test to determine whether an oil or gas lease has produced ‘in paying quantities.’”  And it is debatable as to whether the Supreme Court actually answered that question.  The four-justice majority affirmed the Superior Court’s ruling, but appear to have injected a dose of objectivity into the standard.  After expressly rejecting any calls for “modernization” of Pennsylvania law or the adoption of a definition that relies on a determination as to whether a reasonably prudent operator would continue to operate the well in light of marginal profitability, the Court announced that:

if a well consistently pays a profit, however small, over operating expenses, it will be deemed to have produced in paying quantities.  Where, however, production on a well has been marginal or sporadic, such that, over some period, the well’s profits do not exceed its operating expenses, a determination of whether the well has produced in paying quantities requires consideration of the operator’s good faith judgment in maintaining operation of the well.  In assessing whether an operator has exercised his judgment in good faith in this regard, a court must consider the reasonableness of the time period during which the operator has continued his operation of the well in an effort to reestablish the well’s profitability.

If that last qualifier reads to you like something of an objective standard, you are not alone.  It does to me, and it did to Justice Saylor, who points out in his dissenting opinion that “the majority evidently believes that the lessee’s good-faith judgment test is a component of (or perhaps subsumed within) the reasonably prudent operator standard.”  Justice Saylor also took issue with the Court’s rejection of what he believed was an absolute in Young, namely that one looks to the good faith of an operator only if the well has been, over some period of time,[1] profitable, but if it has not been, then the lease has terminated and no amount of good faith on the part of the lessee can cure the default.   

While the majority’s decision is intended to state a rule to be applied in all cases, there are some additional facts in this case that were probably relevant to the decision.  First, the Plaintiff, despite arguing that the lease terminated in 1959, was quite content to continue receiving free gas and royalty payments for decades, just as her family had received before she inherited the property.  In addition, the lease was what is known as a “pressure lease,” meaning that royalties were paid based upon the pressure in the well, not its profits, such that even in the years when the well did not make a profit, the Plaintiff (and her predecessors) were still paid royalties. 

These facts certainly played into Justice Eakin’s concurring opinion.  Justice Eakin commented on the fact that the lease termination provision could be either a shield or a sword to be used by either the lessor or the lessee to terminate a lease that was no longer wanted.  And  because it was the lessor, and not the lessee, who sought to terminate “even though she has received payments and gas throughout the life of the lease,” he opined that the good or bad faith of the lessee should not be the issue.  Justice Saylor, dissenting, also refers to these facts, but in a contrary way.  Without  expressly saying so, one might interpret his dissent as saying that the majority opinion was the archetypical situation of bad facts making bad law, and that the standard set by the majority will, under other facts, give rise to an unjust result.   

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[1] None of the Justices attempted to define what a relevant period of time for judging profitability would be, and even Justice Saylor did not automatically accept that measurement by calendar year was appropriate.

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