Leases still partially valid: Federal Court decisions yield mixed results for Ohio oil and gas producers

The United States District Court for the Southern District of Ohio recently issued two companion decisions in Curtis v. Hess Ohio Resources, 2014 U.S. Dist. LEXIS 119584 (S.D. Ohio 2014), and DeRosa v. Hess Ohio Resources, 2014 U.S. Dist. LEXIS 119587 (S.D. Ohio 2014). On one hand, the court agreed with the producer, Hess Ohio Resources (“Hess Ohio”), that the oil and gas leases at issue were extended under two provisions: (i) the drilling-operations clauses; and (ii) the shut-in provisions. On the other hand, the court held that Hess Ohio violated the implied covenant to develop certain non-pooled acreage, and ordered that such acreage be released from the underlying oil and gas lease.

Both cases arose in Belmont County and centered on two groups of landowners who signed identical five-year oil and gas leases in 2006. The primary issue was whether the actions of the current lessee (Hess Ohio) and/or prior lessee (Marquette Exploration (“Marquette”)) properly extended the oil and gas leases beyond their primary term. Specifically, the court analyzed whether: (i) the preparation of the well pad, spudding of the well, and completion of at least partial fracturing operations constituted being “engaged in drilling or reworking operations”; and (ii) whether the subsequent shutting in of the well from June 2011 through the present was reasonable.

The court started by analyzing the drilling-operations clause in the leases. It specifically focused on the language stating that, if “oil or gas is not being produced on or from said land but lessee is then engaged in drilling or reworking operation, thereon, then this lease shall continue in force [after the primary term] so long thereafter as drilling or reworking operations are being continuously prosecuted on said land.” Noting this to be an issue of first impression in Ohio, the court held that the phrase requires “a significant step toward drilling, if not drilling itself.” In doing so, the court rejected Hess Ohio’s arguments that preliminary steps (like requesting initial permission from ODNR) sufficed. Still, the court concluded that Marquette satisfied the “significant step” standard because of its drill site preparation activities, construction of the well pad and access road, and placement of equipment on-site. In addition, the court noted that it would be unfair to terminate the leases given that the plaintiff–lessors knew drilling preparation work had begun, yet waited six months after the primary term expired to consult a lawyer and over two years to file their complaint.

Second, the court briefly turned to the applicability of the shut-in provision in the underlying leases—namely whether the triggering event (“a well capable of producing gas”) had been established. Acknowledging that the wells were flow tested and “capable of production,” the court concluded that the wells were properly shut-in, and thereby constructively treated them as producing wells for purposes of the habendum clause in the leases.

Finally, the court voiced concern that the combined effect of the drilling-operations and shut-in clauses might allow the underlying leases to exist “in perpetuity”—a conclusion Ohio courts disfavor. To remedy this problem, the court turned to the law of implied covenants, specifically the implied covenants to reasonably develop the land and to market the product. Based on the application of the implied covenants in this case, the court concluded that it was “unfair” for Hess Ohio to hold all of the plaintiffs’ land when only some of the acres at issue had been pooled. As a result, the Court held that Hess Ohio violated the implied covenants and imposed a judicial remedy of partial forfeiture of the “undrilled or unexploited acreage,” or those portions of the underlying leases not included in the drilling unit.