Until recently, most lessors and their lawyers were not educated about technical nuances of oil and gas law, such as implied lease covenants. But the recent shale boom and expected production from horizontal wells in the Marcellus, Utica, and Rose Run formations has revolutionized the relationship between lessors and lessees.
The disinterested, ill-informed masses of Ohio lessors that existed before 2010 are now driven by the prospect of life-changing bonus payments and fear of environmental ruination. Now lessors read their leases, attend oil and gas seminars, ask questions, and are eager to enforce their rights. The stakes are high enough that lessors and their attorneys are lining up for any opportunity to forfeit leases.
Lessees’ Legal Obligations are Evolving
The advent of horizontal drilling in Ohio may create a trap for unwary lessees. Small lessees may be especially vulnerable if their leases do not contain provisions to waive the implied covenants that Ohio courts automatically read into oil and gas leases. These implied covenants generally require a lessee to exercise “reasonable diligence” under an oil and gas lease, and specifically include, among other things, a “covenant of reasonable development.” Moore v. Adams, 2008-Ohio-5953, ¶31-37 (Fifth Dist.); citing 5 Williams & Meyers, Oil and Gas Law (1991); Beer v. Griffith (1980), 61 Ohio St.2d 119.
In recent times implied covenants have not been terribly burdensome to Ohio lessees because the opportunity for oil and gas production in Ohio was well known and could be exploited with conventional and affordable drilling techniques. However, as horizontal shale drilling and other emerging technologies gain acceptance, the concept of “reasonable development” will change and burdens on lessees will increase.
Just as hand dug wells would no longer satisfy a lessee’s implied covenants, lessees may soon have an obligation to develop shale resources through horizontal wells and other such technology.
Ignoring implied covenants in order to speculate on increasing oil and gas prices or because of an inability finance horizontal drilling operations is risky for lessees. There is legal precedent for awarding damages or forfeiting leases because of a lessee’s failure to meet implied covenants. Implied covenants have even been used to break leases even when the explicit terms of the lease were not violated and the leasehold was ostensibly held by production.
In Beer v. Griffith (1980), 61 Ohio St.2d 119, a lessor asked the court to forfeit a lease held by a financially troubled lessee that was only operating one well on a 150 acre leasehold. The Ohio Supreme Court found, “while lessee did not violate any express provision of the lease, lessee did breach an implied covenant to reasonably develop the lands.” Id. at 121. The Court ultimately forfeited the lease on all but the 40-acre unit that contained a productive well. The Court held, “with respect to the wells which will require further efforts to be productive, and also with respect to all unexploited acreage, forfeiture of lessee’s interest is warranted in order to assure the development of the land and the protection of lessor’s interests.” Id. at 122.
In Sauder v. Mid-Continent Petroleum Corp.(1934), 292 U.S. 272, the United States Supreme Court reached a similar conclusion on similar facts. In its decision to forfeit a lease on a 320 acre tract, the Court held, “production of oil on a small portion of the leased tract cannot justify the lessee’s holding the balance indefinitely and depriving the lessor, not only of the expected royalty from production pursuant to the lease, but of the privilege of making some other arrangement for availing himself of the mineral content of the land.” Id. at 281.
The rationale for a court to forfeit a lease when a leasehold is not being fully developed is that the “real consideration for the lease” is the lessor’s “expected return derived from the actual mining of the land.” Ionno v. Glen-Gery Corp., 2 Ohio St.3d 131, 133 (1983). ”The law of Ohio requires that potential production be translated into actual production.” American Energy Services v. Lekan (1992), 75 Ohio App.3d 205, 213 (Fifth Dist.).
What does this mean for Ohio Lessees?
As demonstrated by the Beer and Sauder decisions, implied covenants have sometimes been applied very much like a contractual Pugh clause. Under the right circumstances, implied covenants could be used against a lessee to seek damages or to strip a lessee of virtually all of its valuable lease rights.
Fortunately, until Ohio shale resources are proven and horizontal drilling or other advanced technologies are widely accepted in Ohio, the standard for what constitutes “reasonable development” and “reasonable diligence” under a mineral lease will not change. Lessees still have time to protect themselves by either exploring and developing deep rights on their own or by entering into farm-out agreements or similar arrangements with other operators to share the cost of those activities.
Fortunately, despite the existence of some troubling legal precedent, forfeiting oil and gas leases remains difficult for lessors, and such lawsuits can often be successfully defended by legal counsel who knows the nuances of oil and gas law.
The shale resources many oil and gas operators currently have under lease in Eastern Ohio may be worth untold millions of dollars. By any measure they are far too valuable to risk losing. Lessees should take steps to preserve their lease rights and identify legal counsel who can assist them with those arrangements and with the defense of any lease forfeiture lawsuits they may encounter.