Watch your Language with Oil and Gas Leases in Ohio (#2)

By: Stephen D. Richman, Esq. - Senior Counsel- Kohrman, Jackson & Krantz

(A Watch Your Language Series Article)

It’s a lease, it’s a contract, it’s a lease and a contract.

Just as Faye Dunaway’s character in the movie Chinatown was both mother and sister to “Katherine”, an oil and gas lease in Ohio (and other jurisdictions) is both a contract and a lease.

An oil and gas lease is a lease, not because of its name, but because it is a transfer of a part of an interest in land for a specific period of time, or “term,” in exchange for the payment of rent, royalties or other standard of value. In other words, it fits the classic definition of, and contains the common characteristics of a lease. In an oil and gas lease, mineral rights/interests of the “dirt” are leased instead of the actual “dirt” itself. Both the dirt and the oil and gas underneath the same are “parts” of real property that can be leased.

As a transfer of property, the lease, like a deed contains certain written and unwritten (implied) covenants. A deed’s covenants, for example include the covenant that the grantee shall have quiet possession, that the grantor is lawfully seized (in fee simple) of the property and a covenant that the grantor will execute such further assurances of the land as may be requisite. A typical lease of real property contains the implied (sometimes express) covenant of quiet enjoyment (or possession); and oil and gas leases are held to contain the implied covenant of reasonable development.

An oil and gas lease is also a contract because it meets the following, legal definition of the same: “an agreement between two or more parties creating obligations that are enforceable or otherwise recognizable at law.” For an oil and gas lease to be an enforceable contract, the following general, contractual requirements must be present: (i) meeting of the minds; (ii) consideration; (iii) capacity; (iv) legality; (v) definiteness; and (vi) the lease must be in writing. The significance of an oil and gas lease also being a contract is that the general law of judicial contract interpretation applies. Namely, that courts will uphold language in commercial agreements, unless it is contrary to statutory law or public policy (and will not add language to the contract). As the reader may recall from other “Watch Your Language” articles for this Blog, because of this judicial deference to “commercial language”, you must say what you mean, precisely, or a judge will decide what you meant.

Apparently, the plaintiffs in the recent Supreme Court of Ohio case, Alford v. Collins-McGregor Operating Co., Slip Opinion No. 2018-Ohio-8, lost sight of the dual nature of oil and gas leases, the rules of judicial interpretation of contracts, and the failure to say, precisely what they meant to say therein.

 The facts of the case are as follows:

Seven individual landowners (the “Landowners”) hold interests in approximately 74 acres of land in Washington County, Ohio. The land is subject to an oil and gas lease (the “Lease”) entered into in 1980, between the owners of the property at that time and Collins-McGregor Operating Company (later assigned to Winston Oil Company). Collins-McGregor and Winston were the appellees in this case and will be referred to hereinafter as the “Oil and Gas Companies”. According to the Lease, “[T]he sole and only purpose [of the lease is to permit] mining and operating for oil and gas and laying pipe lines, and building tanks, powers, stations, and structures thereon, to produce, save and take care of said products.” In return for permission to mine the land, the Oil and Gas Companies committed to make royalty payments based on the amount of gas produced from the land and to deliver a portion of the oil produced from the land to the Landowners.

The Lease further provides that it “shall remain in force for a term of One (1) years from [the effective] date, and as long thereafter as oil or gas, or either of them, is produced from said land by the lessee.” However, other than the specific term and general purpose, the Lease contains few other material terms. The Lease is conspicuously silent as to details of drilling and production. For example, the Lease contains no requirement or other information re: the specific number of wells or the planned depth of any well. The Lease also does not disclaim any implied covenants (such as the implied covenant of reasonable development).

Pursuant to the Lease, a well was drilled in 1981, and has produced oil and gas in paying quantities since then from a formation called the Gordon Sand. As of the date of the opinion, however there had not been any production from the land at any depths below the Gordon Sand, where the Marcellus and Utica formations are located—(the Oil and Gas Companies claimed that they failed to explore whether production can be obtained from those deep formations because they did not have the equipment or financial resources required to do so).

In November of 2015, the Landowners filed suit against the Oil and Gas Companies alleging that they breached several implied covenants, and improperly failed to explore or drill for oil at depths below the Gordon Sand. The Landowners sought a judgement declaring the portion of the Lease covering depths below the Gordon Sand terminated, so that the Landowners could presumably contract with an alternative oil/gas company willing to drill into the Marcellus and Utica formations.

Among the implied covenants that the Landowners claimed the Oil and Gas Companies breached are the implied covenant of reasonable development and an implied covenant to explore further. The Oil and Gas Companies described the judgement sought by the plaintiffs as “horizontal forfeiture” (i.e., forfeiture of the right to drill to a particular horizontal layer or formation beneath the surface) but moved to dismiss the case, arguing that Ohio law does not recognize the implied covenant to explore further, or the remedy of horizontal forfeiture. The trial court agreed with the Oil and Gas Companies and dismissed the case, holding that under the plain terms of the Lease, the still-productive well drilled in 1981 was “sufficient to hold the Lease across all acres and at all depths.” The Fourth District Court of Appeals affirmed, holding that Ohio law neither recognizes an implied covenant to explore further, nor partial, horizontal forfeiture of oil and gas rights as an available form of relief. The Landowners then applied to the Ohio Supreme Court.

Arguing before the Ohio Supreme Court, the Landowners cited several 5^th appellate district decisions that recognized the existence of an implied covenant to explore further. The Oil and Gas Companies countered that while cases from one appellate district in Ohio may have recognized such a covenant, none actually applied the covenant. Moreover, the Oil and Gas Companies argued that there was no need to recognize a new, state-wide implied covenant because the covenant of reasonable development provides sufficient protection for landowners. Furthermore, the Oil and Gas Companies argued that the plain language of the Lease contained no development details, no new covenants and no requirement to partially forfeit the lease, so it was not the court’s job to do any more than interpret the contract as written, and apply the only, universally recognized, implied (oil and gas lease) covenant; the covenant of reasonable development.

The Supreme Court of Ohio agreed with the Oil and Gas Companies and affirmed the ruling of the 4^th Appellate District.

In its opinion, the Supreme Court of Ohio first cited precedent, reiterating the dual nature of oil and gas leases. “Oil and gas leases are contracts, and therefore, ‘the rights and remedies of the parties to an oil and gas lease must be determined by the terms of the written instrument’ [however], notwithstanding this principle, we have long held that oil and gas leases are ordinarily subject to an implied covenant to reasonably develop the land.”

The court then explained that while the covenant of reasonable production is generally a protection implied to landowners (lessors), its standard is to only “impose on the lessee the obligation to act as a reasonably prudent operator would as it develops the land under the lease.” Applying the standard to the facts of the case, the court reasoned that since drilling below the Gordon Sand formation would cause the Oil and Gas Companies to lose profits in the venture, limiting production to the Gordon Sand formation only, would be reasonable. Citing the Oklahoma Supreme Court, the Ohio Supreme Court in Alford reasoned that ignoring the profit motive from the “reasonableness equation” “is to ignore the very essence of the contract.”

The court also agreed (quite emphatically) with the Oil and Gas Companies’ contract argument; stating, that the proposition of the rights and remedies of the parties to an oil and gas lease being determined by the terms of the written instrument was “uncontroversial” and “what this court has recognized since 1897.” The court reasoned that if the parties intended there to be specific drilling requirements beyond “reasonable development”, they would have specified same in their oil and gas…contract. However, the court noted that “the lease [in Alford]does not contain a disclaimer of implied covenants, nor does it otherwise address whether any specific number of wells must be drilled or the depth to which any wells must be drilled. As such, the lease, according to the Ohio Supreme Court was subject to the implied covenant of reasonable development, but no other covenants, express or implied.

What is the moral of this story?

Watch Your Language with oil and gas leases, and say what you mean, precisely, or a judge will decide what you meant. While oil and gas leases are often convoluted, and written in small font, “standard” forms; they are contracts, not holy tablets of stone, and accordingly, are negotiable. If you are expecting certain formations to be drilled, say so. If you want a minimum of wells drilled on your property, spell that out. Certainly, arguing for these types of clauses does not guarantee they will be included in your lease, but failing to include them before you sign will almost always guarantee that they will not be part of you contract.

Ohio Supreme Court Declines to Terminate Gas and Oil Lease Based on Its Plain Language

By: Connie Carr

A recent decision by the Ohio Supreme Court (the “Court”) highlights once again the importance of clearly stating in your contract what you mean or a court will decide for you.

Bohlen v. Anadarko E&P Onshore L.L.C., Slip Opinion No. 2017-Ohio-4025, involves Ronald and Barbara Bohlen, owners of approximately 500 acres in Washington County, Ohio, who entered into a gas and oil lease (the “Lease”) as lessors with Alliance Petroleum Corporation (Alliance) as the lessee. (Alliance later assigned a portion of the Lease to Anadarko.)

The lease provided for a one year term and would continue after the initial one year term for so long as gas or oil or their constituents are produced or are capable of being produced on the Bohlen’s property in paying quantities, in the sole judgment of the lessees, or are the lessee is conducting operations to search for oil or gas. The Lease also provided that Alliance must pay the Bohlen’s a “delay rental” of $5,500 per year “for the privilege of deferring the commencement of a well”, otherwise the Lease became null and void and the parties’ rights under it would terminate. The Lease stated that a well is commenced “when drilling operations have commenced on the leased premises.”

The parties also entered into an addendum to the Lease (the “Addendum”) that provided for a minimum annual royalty payment. If the royalty payments made by Alliance to the Bohlen’s was less than $5,500 in any calendar year, the it must make up the shortfall between the royalty payments and the minimum royalty payment.

Alliance drilled two wells during the first year of the Lease. The second well drilled was successful and produced gas.  The company paid the Bohlen’s $5,500 for the first year of the Lease. Thereafter, it paid royalty payments based on the gas produced each year from 2008 through and including 2013. The annual royalties paid in those years never reached nor exceeded $5,500.

The Bohlen’s filed a declaratory action against Alliance and Anadarko in the trial court requesting the court issue an order declaring the forfeiture of the Lease. Both sides of the case filed motions of summary judgment asking the court to issue a judgment in favor of their arguments. The Bohlen’s argued that (1) the Lease violated public policy and was void because it allowed Alliance and Anadarko to encumber their property indefinitely by paying delay rental payments, (2) the Lease should be terminated by its terms because Alliance and Anadarko did not pay the minimum annual rental of $5,500 as required by the delay rental clause, and (3) the Lease terminated under its own terms due to the lessees failure of oil and gas production.

The trial court agreed with the Bohlen’s arguments and ordered forfeiture of the Lease. Alliance and Anadarko appealed to the Fourth District Court of Appeals, who reversed the trial court on all three arguments. The Bohlen’s appealed to the Court, who upheld the appeals court.

Since it was the review of a summary judgment ruling, the Court conducted its own full review of the arguments made on both sides. The Court has long maintained that gas and oil leases are contracts to which contract law applies.  One key principle of contract law provides that unless there is an ambiguity in the contract language, a court will not give the contract any meaning other than what the plain language of the contract states.

Using this point of review the Court looked at the delay rental language in the Lease. Leases often provide for a primary term and a secondary term when it comes to the duration of the lease. In the Bohlen’ lease, the primary term was one year. The second term provides for a continued duration for so long as gas or oil or their constituents are produced or are capable of being produced on the Bohlen’s property in paying quantities, in the sole judgment of the lessees, or are the lessee is conducting operations to search for oil or gas.

As noted earlier, the Lease provided that it would be void and all rights of the parties to the Lease would terminate if Alliance failed to pay a delay rental of $5,500 per year for the privilege of deferring the commencement of a well.  Alliance drilled a well during the primary term which met the definition of a commencement of a well as defined in the Lease.

The Bohlen’s argued that the delay rental addressed in the Lease with respect to the primary term should be read in conjunction with the Addendum language regarding minimum annual rent and the termination provision in the delay rental clause should be extended beyond the primary term. However, the plain language doesn’t provide for the termination provision in question to apply beyond the application of the delay rental clause and the obligation for payment of delay rental ceased once drilling was commenced. The Court held that underpayments by the lessees under the minimum annual rental provision in the Addendum did not entitle the Bohlen’s to forfeiture of the Lease under the unrelated delay rental clause.  If the parties wanted the termination provision of the delay rental clause to apply to the minimum rental provision they should have stated that clearly in the Lease.

A no-term, perpetual lease violates public policy. The Bohlen’s argued that the Lease allowed the lessees to delay drilling on the undrilled acreage indefinitely by paying the $5,500 minimum annual rent.  The Court disagreed with the Bohlen’s interpretation of the Lease and Addendum, stating that the plain language of the Addendum does not modify the delay rental clause and therefore does not create a no-term, perpetual lease.

Whether the lessees owe the Bohlen’s money for their underpayment of the annual minimum rental is another issue that was not addressed by the Court since it was not raised by the parties in their appeals. The Court the case to the trial court for further proceedings.

As my colleague, Steve Richman, points out in his series of “Watch Your Language” articles for this Blog, “as a general rule, courts will uphold language in commercial agreements, unless it is contrary to statutory law or public policy. They traditionally presume that commercial parties are on more of an equal playing field and are more sophisticated concerning commercial real estate transactions, since both parties to a commercial transaction will usually have attorneys to review their documents. Because of this judicial deference to “commercial language”, you must say what you mean, precisely, or a judge will decide what you meant.”
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