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Ohio Does Not (Any Longer) Recognize An Implied Covenant to Explore Further, An “At The Well” Royalty Calculation Decided Favorably to Operator

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On January 3, 2018 the Ohio Supreme Court, in Alford v. Collins-McGregor Operating Company, 2018-Ohio-8, again supported oil and gas well developers and pounded one more nail in the landowner’s coffin.  If you reviewed prior blogs, you know that the Ohio Supreme Court has consistently ruled against landowners and in favor of severed mineral interest holders and the oil and gas industry.  (Read my blog articles from February 18, 2015, March 17, 2015, June 25, 2015, February 26, 2016 and March 13, 2017, all either supportive of the oil and gas industry or not supportive of landowner interests.)  In Alford, the Supreme Court reviewed the protections afforded to landowners by the implied covenant of reasonable development.  This covenant, first enunciated by the Court in its 1897 decision in Harris v. Ohio Oil Co., 57 Ohio St. 118, 48 N.E. 502 (1897) requires a gas and oil well operator to act as a reasonably prudent operator would in developing production on land it holds under lease.

The vast majority of oil and gas leases executed in Ohio in the last 40 years have expressly disclaimed any implied covenants; accordingly, any covenant to be imposed on the oil and gas operator must be found in the lease.  The lease at issue in Alford, which was executed in 1980, was somewhat unusual because it did not disclaim implied covenants.

A well was drilled on the Alford property in 1981, and continued to produce oil and gas in “paying quantities”.  The well tapped into a rather shallow formation called the Gordon Sand.  There had been no production at any depths below the Gordon Sand, and specifically none in the Marcellus and Utica formations where enormous amounts of gas, industrial gases and limited amounts of oil have been found in Southeast Ohio.  The landowners wanted to cause horizontal forfeiture across the entire leased land below the Gordon Sand, presumably so they could enter into a new lease with an operator of their choosing, receiving a significant signing bonus and more favorable terms than included in the 1980 lease executed by their predecessors in title.

Because the oil and gas operator had not drilled below the Gordon Sand, the landowners alleged that the operator breached an implied covenant of reasonable development and the implied covenant to explore further.  The Washington County trial court 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 does not recognize partial horizontal forfeiture of oil and gas rights as an available form of relief.

On appeal, the Supreme Court first addressed the landowner’s second proposition of law: that Ohio should recognize an implied covenant to explore further.  In reviewing existing case law in Ohio, and in particular citing Harris, the Supreme Court reaffirmed the existence of an implied covenant of reasonable development – the lessee must drill and operate such number of wells as would be ordinarily required on the leased property for the production of oil or gas and for the protection of the lines.  In Harris and in other cases since then, the landowners were concerned that nearby wells on adjacent properties were draining their minerals, and they demanded that the oil and gas well operators drill additional wells on their lands to protect their mineral interests.  The Harris court found that, in the absence of language to the contrary in a lease, it was appropriate to impose an implied covenant of reasonable development on the lessee.  This serves to protect the landowner’s interest, since a landowner only receives a royalty based on the amount of production, and the amount of production is under the control of the lessee.

On appeal to the Ohio Supreme Court, the landowner did not argue that the lessee had breached the implied covenant of reasonable development.  Instead, the owner asked the Court to adopt the implied covenant to explore further.  The landowner argued that, like the implied covenant of reasonable development, an implied covenant to explore further would protect the landowner’s mineral rights, in this case to make sure that the lessee diligently proceeded to drill at various surface locations and depths, including horizontal drilling, when productive.  The landowner pointed to the Fifth District Court of Appeals, which had previously stated that an implied covenant to explore further was a commonly accepted implied covenant in the oil and gas leasing industry.

The Supreme Court disagreed, noting that although the Fifth District had mentioned an implied covenant to explore further, it had never actually enforced such an implied covenant.  Instead, the Court sided with the oil and gas well operator in finding that the landowner’s interest was sufficiently protected by the implied covenant of reasonable development; thus, it was not necessary to recognize a “new” implied covenant to explore further.

The Supreme Court provided guidance to lower courts when considering the implied covenant of reasonable development.  A court should focus on all facts and circumstances related to development, whether they relate to exploration (costs of exploration and likelihood of positive production results) or to some other aspect of development.  A court should determine whether a prudent operator would further develop, giving due consideration to the interests of both the lessee and lessor, considering all factors, including what is known about the market, the geology and activity on adjoining property.  If profitable wells have not been drilled in the immediate geological formations, or marketing of the gas may be difficult and costly, this would support the operator’s decision not to develop.  If, however, there is a risk of drainage of minerals from the landowner’s property, the operator may be required to engage in further development to protect the landowner’s mineral interests.

Because the Supreme Court rejected the creation of an implied covenant to explore further, and this was the only implied covenant on which the landowner had based his appeal, the Court did not determine how the implied covenant of reasonable development would be impacted by new drilling technologies that make deeper drilling practical and reasonable.  That issue was left for another day.  The Court also did not determine whether partial horizontal forfeiture would be an appropriate remedy for breach of the implied covenant of reasonable development, thereby kicking that can down the road as well.

In a case decided shortly before Collins-McGregor, the Fourth District Court of Appeals declined to recognize a landowner’s right to a partial forfeiture of deep horizontal rights.  In Fox v. Positron Energy Resources, Inc., 2017-Ohio-8700 (11/15/17, the court held that as long as gas and oil were found in paying quantities in the shallow part of the leasehold, the lessee did not breach the implied covenant to reasonably develop the property simply because it did not drill into deeper formations.  The court, after describing its research into horizontal forfeiture law, noted that this is a complex, evolving issue with no easy answer.  If one follows the trend of the Ohio Supreme Court, it will be an easy answer soon enough.  It is likely that partial horizontal forfeiture will not be recognized as a viable remedy absent specific language in the lease allowing such forfeiture, or some other unique circumstances.

Before the Supreme Court ruled in the Collins-McGregor case, another decision unfavorable to landowners was handed down by the U.S. District Court for the Northern District of Ohio in the case of Lutz, et al. v. Chesapeake Appalachia, LLC, No. 4:09-CV-02256.  The court was asked to determine whether lessees under oil and gas leases were obligated to pay the landowners royalties based on the “at the well” rule of pricing or the “marketable product” rule of pricing.  The district court asked the Ohio Supreme Court for guidance, but the Court declined to answer which rule Ohio would follow, instead directing the district court to review the specific terms of the lease and ascertain the intention of the parties.  The lease at issue provided that royalties would be paid based on “market value at the well”.  The district court rejected the landowners’ request to apply the marketable product rule, which would place post-production costs on the lessee.  The court explained that states usually use this rule when leases are silent as to post-production costs.  In contrast, the lease before the court specifically referred to “market value at the well”, which language, the district court concluded, the Ohio Supreme Court would interpret as incorporating the “at the well” rule of pricing, thus permitting the operator to deduct post-production costs, including typically significant expenditures for getting the product to market, state imposed severance taxes, and similar costs.

As these decisions make clear, it is critical to make sure that the language used in an oil and gas lease provides maximum protection to the landowner, because the courts are likely to rule in favor of oil and gas operators if there is any disagreement as to the interpretation of the lease’s terms.