Energy Industry Update
Action Item: Lessees of oil and gas leases in Pennsylvania who have been assigned or are assigning less than all of the geologic strata under lease should give careful attention to whether those leases have been severed vertically by unilateral actions. A lease may not be held by production if that production is in a geologic strata not included in the assignment of rights.
In a 2-to-1 non-precedential decision, the Pennsylvania Superior Court has split from its own published precedent and created new law, finding that an oil and gas lease unilaterally can be severed horizontally and vertically—leaving lessees in limbo, possibly giving unscrupulous lessors a unilateral tool to terminate oil and gas leases, and ultimately harming both lessors and lessees in the process. Montgomery v. R. Oil & Gas Enterprises, Inc., No. 1164 WDA 2015.
As originally consummated, all oil and gas underlying 240 acres was leased to Quaker State Oil Refining. In the lease’s secondary term, Quaker State assigned its right to the oil and gas above the Onondoga formation (“shallow rights”), while retaining the apparently-developed deeper rights. While there was some subsequent development of shallow right, which ceased as of the end of 2001, the deeper development continued throughout. Thirty-five years after initial leasing, the original lessor sold a 3+ acre parcel of the leased property to the Montgomerys, subject to the oil and gas lease.
The Montgomerys filed suit against a subsequent lessee of the shallow rights, seeking a declaration that the shallow rights lessee no longer possessed those oil and gas rights. The trial court granted judgment in favor of the Montgomerys—finding the lease was severable and abandoned as to the shallow rights under the Montgomery’s property—despite the argument that Quaker State was an unjoined, indispensable party. The majority upheld the trial court’s decision.
According to the majority, there was no indispensable party that would need to be joined if the lease was, in fact, severable both horizontally (e.g., surface ownership) and vertically (e.g., the various geological strata underlying the surface). See Opinion, p.6. It then distinguished the operative lease from one found not to be severable in a prior case by noting the operative lease (i) covered “a number of distinct parcels,” (ii) expressly gave the lessee the right, among others, to “subdivide and release” the leased acreage, and (iii) expressly provided that the lease was “binding upon and extend[ed] to the parties hereto and their respective heirs, personal representatives, successors and assigns.” Opinion, p.9 (citing Seneca Resources Corp. v. S & T Bank, 122 A.3d 374 (Pa. Super. Ct. 2015)).
Those provisions, coupled with the unilateral action of the lessor in selling a part of the leased property and the unilateral action of the lessee in assigning the shallow rights, “support a finding that the Lease is severable, both with respect to surface land ownership and to the ownership of oil and gas rights above and below the top of the Onondoga Formation.” Opinion, p.9. Based on its conclusion that the lease was severable, the majority determined that there was no failure to join an indispensable party. “Thus, the record supports the trial court’s determination that it had subject matter jurisdiction over this case as the merits could be determined without prejudice to the rights of an absent party.” Opinion, p.10.
Judge Olson dissented. She addressed the language of the lease itself, concluding that it indicated the lease was not severable. See Dissent, pp.1-2. Concluding her decision that the lease was not severable vertically, Judge Olson noted that the majority’s decision was in conflict with a prior reported decision by the Superior Court—Loughman v. Equitable Gas Company, LLC, 134 A.3d 470 (Pa. Super. Ct. 2016)—where the Superior Court determined that a lessee who assigned the production rights but kept the gas storage rights under a lease did not sever the lease. Following from her conclusion that the lease was not severable vertically, Judge Olson determined that Quaker State was a necessary party as it had the deep rights under the lease at issue. Because the Montgomerys did not join Quaker State, Judge Olson concluded the trial court lacked subject matter jurisdiction over the dispute.
The majority erred. It ignored myriad precepts of Pennsylvania law and prior reported decisions, while focusing on the unilateral actions of a lease party, coupled with standard lease provisions, to find vertical severability. It ignored the longstanding principle of Pennsylvania law that oil and gas leases must be construed with references to the known industry practices and customs in place at the time of contracting. It also ignored the fact that Pennsylvania law plainly and clearly holds that once there is development of oil and gas rights, a property right vests in the holder of those oil and gas rights. Third, it ignored the accepted principle of Pennsylvania law that, when looking at the severability of a contract, if the consideration cannot be apportioned, the contract is not severable.
The majority also cherry-picked three form provisions of the lease to determine severability while ignoring contrary case law in Loughman and distinguishing Seneca Resources on points that are irrelevant or just plain wrong. Plus, the majority did not explain how it reached its decision in light of Pennsylvania law holding that there is no duty to develop other strata.
Despite its apparent win for lessors, the majority’s decision actually is likely to harm lessors in the long run. The actions undertaken by the lessee in the Montgomery case were actions undertaken to spur additional development of the lease. That additional development would have resulted in additional income to the lessors in the form of royalties (assuming the development was fruitful). But now, the market for post-primary term assignments is likely to dry up if the acreage to be assigned has not had some form of development prior to expiration of the primary term.
