On March 26, 2012, the Pennsylvania Supreme Court issued its long-awaited decision in the case of T.W. Phillips Gas & Oil Co. v. Jedlicka, reaffirming that Pennsylvania law from 1899 requires the determination of whether a well is producing "in paying quantities" to be made "with reference to an operator's good faith judgment." Jedlicka, No. 19 WAP 2009, p. 1 (majority opinion). [1] Importantly, the burden of proof and persuasion is on the lessor to establish a lack of good faith on the part of the lessee. Id., at 23-24. The decision, issued almost two years after the Court heard oral argument, demonstrates the Court's "careful consideration" of this important issue.
In the case, appellant Jedlicka objected to construction of additional wells on her property, pursuant to an oil and gas lease from 1928, claiming that the existing wells failed to "produce in paying quantities" because in one year (1959) the operator suffered a $40 loss as a result of operations under the lease, voiding the lease. Because of that objection, appellees filed a declaratory judgment action to determine the rights of the parties under the pressure lease (as opposed to 1/8 royalty lease) that contained the following habendum clause:
To have and to hold the above-described premises for the sole and only purpose of drilling and operating for oil and gas with the exclusive right to operate the same for the term of two years, and as long thereafter as oil or gas is produced in paying quantities, or operations for oil or gas are being conducted thereon, including the right to drill other wells.
The trial court, after a bench trial, concluded that under the Supreme Court's decision in Young v. Forest Oil Co., 45 A. 1 (Pa. 1899) the existing wells produced in paying quantities despite the one year of a $40 loss. The trial court noted Young's language that consideration be given to a lessee's good faith judgment in determining whether the well produced in paying quantities. Finally, the trial court rejected Jedlicka's request to utilize an objective, mathematical test employed by some federal and other state courts. The Superior Court affirmed the trial court's decision. Jedlicka then appealed the decision to the Supreme Court, asking whether the lower courts mis-applied the Young decision by holding that Pennsylvania law employs a purely subjective test. As noted, the Supreme Court answered that question in the negative.
The Supreme Court began its decision by noting that an oil and gas lease is treated as a contract under Pennsylvania law and the lease must be construed by reference to the plain meaning of the language used, not a silent intention of the parties. The Court then discussed the property rights that are conveyed to a lessee under an oil and gas lease—an inchoate right initially that upon the finding of oil or gas creates a fee simple determinable in the lessee and a possibility of reverter in the lessor.
After a discussion of the effect of a habendum clause and a short history of those clauses, the Court turned to the question at issue before it—how is the phrase "in paying quantities" in a habendum clause defined under Pennsylvania law when it is undefined in the lease. Given that all parties agreed the decision was controlled by the Young decision, the Court began its analysis with a review of that case, including extensive quotation from that case – focusing on the subjective nature of the test expressed therein, such as:
The operator, who has assumed the obligations of the lease, has put his money and labor into the undertaking, and is now called upon to determine whether it will pay to spend some thousands of dollars more in sinking another well to increase the production of the tract, is entitled to follow his own judgment. If that is exercised in good faith, a different opinion by the lessor, or the experts, or the court, or all combined is of no consequence, and will not authorize a decree interfering with him.
…
The phrase 'found in paying quantities' means paying quantities to the lessee or operator. … But if a well, being down, pays a profit,—even a small one, over the operating expenses,—it is producing in 'paying quantities,' though it may never repay its costs, and the operation as a whole may result in a loss. … The phrase 'paying quantities,' therefore, is to be construed with reference to the operator, and by his judgment when exercised in good faith.
Jedlicka, No. 19 WAP 2009, pp. 11-12 (quoting Young, 45 A. at 122-123). The Court also made reference to the case of Colgan v. Forest Oil Co., 45 A. 119 (Pa. 1899), a case issued the same day as Young, which also discussed and strongly endorsed a lessee's good faith judgment in connection with the interpretation of rights and duties under a lease. However, the Court noted that its prior decision in Young was more than a century old and left some open questions. So, the Court welcomed the opportunity to address some of those open issues.
The Court then addressed—and rejected—Jedlicka's argument that Young required a two-part test, the first part of which was an objective, mathematical test.[2] According to the Court, the argument overlooked the fact that profits must be measured over some time frame and setting that time frame "necessarily implicates the operator's good faith judgment." Jedlicka, No. 19 WAP 2009, p. 15. Later in its opinion, the Court noted that only one state – Kansas – has established an arbitrary period over which profits must be measured. The Court expressly declined to join Kansas, explaining that an operator using good faith judgment may be willing to wait longer for a profit on one well than on another. "Ultimately, under Young, we conclude that even the determination of what constitutes a 'reasonable time period' by which to evaluate whether a well has produced in paying quantities must be based on the unique circumstances of each individual case, and be driven by consideration of the good faith judgment of the operator." Jedlicka, No. 19 WAP 2009, p. 22.
Instead of the objective test advocated by Jedlicka, the Court determined that Young, and the decisions from other states, such as Texas, that cite to Young, require consideration of a number of elements, not just a simple mathematical calculation, that reference an operator's good faith or reasonableness.
Ultimately, the Court held that if a well consistently pays a profit, no matter how small or large, over operating costs, the well is one that is producing "in paying quantities." However, when those profits have been sporadic or marginal, consideration of an operator's good faith judgment in maintaining operation of the well is necessary to determine whether a well is producing "in paying quantities." That consideration, though, must include an inquiry into the reasonableness of the time period during which the operator has attempted to reestablish a well's profitability. According to the Court, this test has the benefit of protecting lessors from lessees who are holding onto oil and gas rights for purely speculative reasons and protecting lessees from lessors who are attempting to exploit a brief period of unprofitability to invalidate a lease to gain a more profitable leasing arrangement. Jedlicka, No. 19 WAP 2009, p. 23.
Importantly, the Court's opinion places the burden of proof and persuasion on the lessor to demonstrate a lack of good faith on the part of the lessee, regardless of the person seeking protection under the subjective test. In the context of a lessor who is trying to invalidate the lease on the basis the lessee is holding oil and gas rights for speculative purposes: "Under the standards set forth above, a lessor will be protected from such acts because, if the well fails to pay a profit over operating expenses, and the evidence establishes that the lessee was not operating the wells for profit in good faith, the lease will terminate." In the context of a lessor seeking to invalidate a lease based upon a period of unprofitability, i.e., the facts of the Jedlicka decision: "Here, Jedlicka presented no evidence to suggest that Appellees have not operated those wells in good faith." Jedlicka, No. 19 WAP 2009, p. 7 ("Further, a party seeking to terminate a lease bears the burden of proof.").
This article was prepared by Jeremy A. Mercer (jmercer@fulbright.com or 724 416 0440), Matthew H. Sepp (msepp@fulbright.com or 724 416 0421), Michael P. Gaetani (mgaetani@fulbright.com or 724 416 0429) and Mark R. Wasem (mwasem@fulbright.com or 214 855 7433) of the firm's Energy Practice Group.
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[1] Madame Justice Todd's majority opinion was joined by three other Justices; Mr. Justice Eakin filed a concurring opinion, and Mr. Justice Saylor filed a lone dissenting opinion. Madame Justice Orie Melvin did not participate in the consideration or decision of the case.
[2] In the dissent, Justice Saylor disagreed with the majority's interpretation of the "paying quantities" test outlined in Young, finding the Young test to be a "two-part, hybrid standard," consisting of both an objective and subjective analysis. First, as to the objective threshold inquiry, "profits must exceed operating expenses." Jedlicka, No. 19 WAP 2009, p. 1 (Saylor, J., dissenting). If that threshold is met, then the second, subjective, component comes into play. (Presumably, if that first threshold is not met, the well is not one in paying quantities and the analysis ends.) For the second component, a rebuttable presumption arises that the lessor is operating in good faith and the lease is producing in "paying quantities." Id. However, this formulation of the test leads to an absurd result: the analysis of good faith only comes in to play when it has already been determined that a well is profitable. And, a finding of lack of good faith can invalidate an otherwise profitable lease.