Babst Calland: Pennsylvania Supreme Court Clarifies Standard for Producing ‘In Paying Quantities’ Under Oil and Gas Lease

Babst Calland: Pennsylvania Supreme Court Clarifies Standard for Producing ‘In Paying Quantities’ Under Oil and Gas Lease

In a long-awaited decision issued Monday, March 26, 2012, the Pennsylvania Supreme Court held that a court must consider an operator's good-faith judgment in continuing to operate a well in determining whether a well is producing "in paying quantities" under the terms of an oil and gas lease. T.W. Phillips Gas & Oil Co. v. Jedlicka, 19 WAP 2009, ___ A.3d ___ (Pa. 2012) [enhanced version available to lexis.com subscribers]. The Supreme Court indicated that the subjective good-faith standard must be used where the well's revenues did not exceed its operating expenses. The Supreme Court rejected the argument that the question of whether the well was profitable was a threshold issue that, if answered negatively, would make irrelevant the lessee's subjective good faith. The Supreme Court had agreed to hear the case in 2009 to clarify whether a lower court correctly applied the Supreme Court's more than 100-year-old holding in Young v. Forest Oil Co., 45 A. 1 (Pa. 1899) [enhanced version available to lexis.com subscribers].

In Jedlicka, the successor to the original lessor under an oil and gas lease that was entered into in 1928 contended that the lease had terminated in 1959 when the lessee's expenses to operate under the lease exceeded its revenue by approximately $40. The lease contained a habendum clause providing that it would remain in effect as long as "oil or gas is produced in paying quantities." A successor to the original lessee sought a declaratory judgment in the Indiana County Court of Common Pleas that the lease remained valid. After a bench trial, the trial court relied upon the Young decision and held that the lease remained in effect and that the lessee had produced gas under the lease in paying quantities. The Superior Court affirmed this holding.

In its opinion, the Supreme Court began its analysis by revisiting its holding in Young, in which it had stated that "[t]he phrase 'paying quantities,' therefore, is to be construed with reference to the operator, and by his judgment when exercised in good faith." The Supreme Court acknowledged that Young, decided more than a century ago, left open the issues of what time period was relevant to the question of whether a well was profitable and when an operator's subjective judgment should be considered. The Court also acknowledged that, in the time since Young was decided, the very purpose of habendum clauses in many cases had shifted from protecting lessees to protecting lessors.

The lessor argued that Young created a two-part test. Under the lessor's theory, the first step would be an objective determination of whether revenues under a lease exceeded operating expenses. Only if the revenues exceeded expenses would the analysis move to the second step, which would consider the subjective good-faith of the lessee in operating the wells under the lease. Because the expenses exceeded revenues for a year under the lease at issue, the lessor argued that the lease had terminated for lack of production in paying quantities at that time. In contrast, the lessee opposed the threshold objective test and argued that Young required consideration of the operator's good faith as part of the overall analysis.

The Supreme Court rejected the two-part test suggested by the lessor and held that Young required consideration of the operator's good faith. The Court also pointed out that the objective calculation suggested by the lessor included making an inherently subjective decision about what time period should be considered. The Court included in its analysis a review of law in other states, including Texas, Oklahoma and Kentucky, on the issue and acknowledged that a majority of other states use a subjective approach to the question. Importantly, the Court also clarified that, where the revenues exceeded expenses, a lease will be deemed to have produced in paying quantities, and the good faith analysis does not need to be reached.

The Supreme Court's holding in Jedlicka does not provide a bright-line rule in cases where production expenses exceed revenue, but it does offer parties to existing and future leases that use the "paying quantities" language in the habendum clause additional guidance regarding the duration of leases held by production. The Supreme Court confirmed that Pennsylvania applies a subjective good-faith standard to determine whether a lease produces "in paying quantities," which aligns Pennsylvania law on the issue with that of many other gas-producing states. Jedlicka is likely to receive considerable analysis and application due to the number of disputes regarding leases held by production that have resulted from development of shale gas in Pennsylvania.

For more information regarding the Jedlicka decision and lease validity issues, contact Kevin K. Douglass at (412) 394-6562 or kdouglass@babstcalland.com, or Christopher M. Buell at (412) 394-5411 or cbuell@babstcalland.com.

Copyright 2012• Babst, Calland, Clements and Zomnir, P.C. • Two Gateway Center, Pittsburgh, PA 15222 • 412-394-5400 • Administrative Watch is privately distributed by Babst, Calland, Clements and Zomnir, P.C., for the general information of its clients, friends and readers. It is not designed to be, nor should it be considered or used as, the sole source of analyzing and resolving legal problems. If you have, or think you may have, a legal problem or issue relating to any of the matters discussed in the Administrative Watch, consult legal counsel.

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