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Court News Ohio

Ohio Declines to Recognize ‘Implied Covenant to Explore Further’ in Oil and Gas Leases


Ohio oil and gas leases do not have an implied requirement that drillers “explore further” into unexplored areas. (Thinkstock)

Ohio oil and gas leases do not have an implied requirement that drillers “explore further” into unexplored areas that is separate from the requirement that they “reasonably develop” the overall mineral rights they lease, the Ohio Supreme Court ruled today.

In a 6-1 decision, the Supreme Court rejected a claim by Washington County landowners that oil companies either abandoned or forfeited portions of an oil and gas lease signed in 1980, because the companies have not explored deeper underground into the Marcellus and Utica shale formations. The advent of hydraulic fracturing, or fracking, has allowed production of oil and natural gas from deeper formations that could not be reached before.

Writing for the Supreme Court majority, Chief Justice Maureen O’Connor stated there is no independent “implied covenant to explore further” under Ohio law. This places Ohio in line with decisions of the Texas and Oklahoma supreme courts, which have similarly declined to recognize the implied covenant.

Justices Terrence O’Donnell, Sharon L. Kennedy, Judith L. French, Patrick F. Fischer, and R. Patrick DeWine joined the opinion. Justice William M. O’Neill dissented without a written opinion.

Landowners Seek New Deal
Linda Griffith Alford and seven others, who own 74 acres near the Ohio River, sued Collins-McGregor Operating Co. and Winston Oil Company seeking the partial termination of their oil and gas lease. The lease was signed in September 1980 by Collins-McGregor and the landowners at the time. In return for the permission to drill, the company committed to making royalty payments based on the production of oil and gas.

The lease did not specify exactly how the mineral rights must be developed, such as by requiring production from a certain number of wells or from any particular depth. The lease also did not disclaim the application of implied covenants, a provision found in some oil and gas leases.

Collins-McGregor drilled a shallow well into a formation known as the Gordon Sand in 1981, and the well has been producing oil and gas ever since. The landowners contended that the exploration and production of oil and gas has been occurring near their property far below the Gordon Sand, into the Marcellus and Utica formations.

The landowners claimed that Collins-McGregor has failed to explore the deep formations because it does not have the equipment or financial resources to do so. In November 2015, the landowners sought a judgment terminating the portions of the lease below the Gordon Sand because those portions of the lease had either expired or been abandoned by the drillers. The landowners did not seek to terminate Collins-McGregor’s lease rights with respect to the shallow well that currently produces oil and gas.

In their lawsuit, the landowners claimed Collins-McGregor breached a number of implied covenants, including the implied covenant of reasonable development and the implied covenant to explore further. As a remedy, they asked for forfeiture of the right to drill below the Gordon Sand. Collins-McGregor describes this type of partial forfeiture as horizontal forfeiture — the right to drill to a particular layer or formation beneath the surface.

Lower Courts Side with Company
The Washington County Common Pleas Court dismissed the landowners’ suit. It ruled that under the terms of the lease, the continuing production from the 1981 well was sufficient for the company to hold the lease across all acres and at all depths. The landowners appealed the decision to the Fourth District Court of Appeals, which affirmed the trial court’s decision and ruled that Ohio law does not recognize the remedy of partial horizontal forfeiture of oil and gas lease rights.

The landowners appealed the Fourth District’s ruling to the Supreme Court, which agreed to hear the case.

Implied Covenants Analyzed
The majority opinion began by noting that an oil and gas lease is a contract and, as a result, the rights of the parties to such a lease are determined by the terms of the lease itself. However, the Court also explained that since its 1897 Harris v. Ohio Oil Co. ruling, it has recognized that oil and gas leases ordinarily include an implied covenant to reasonably develop the land.

Parties to a gas lease can prevent the application of the implied covenant by either disclaiming the application of implied covenants or describing the expected development of the land explicitly in the lease. The Collins-McGregor lease does neither of these.  “As a result, at least with respect to the matters at issue in this case, the lease is subject to the implied covenant of reasonable development,” the Court stated.

The landowners cited decisions from Ohio’s Fifth District Court of Appeals, which they claim recognized the implied covenant to explore further. But Collins-McGregor countered that while the provision is mentioned in these cases, it was not actually applied. The company also noted that none of the Fifth District decisions discuss what determines if an implied covenant to explore further has been breached. Finally, the company maintained that there is no need for the covenant because the implied covenant to reasonably develop the land sufficiently protects landowners concerned that drillers are not appropriately producing oil and gas.

Court Agrees with Company
The Court majority agreed with Collins-McGregor. It first noted that oil and gas leases typically compensate landowners with a royalty payment based on the amount of production from the land. The implied covenant of reasonable development protects this interest by requiring oil and gas companies to develop the mineral rights for oil and gas production.

On the other hand, the Court explained the obligation to reasonably develop the land is not one-sided in favor of the landowners. Oil and gas companies are often required to make substantial upfront investments with the uncertain potential for returns. The implied covenant of reasonable development only requires oil and gas companies “to act as a reasonably prudent operator would,” the Court stated. What constitutes a breach of the implied covenant of reasonable development is determined by the facts and circumstances of each case.

“In light of this,” the Court wrote, “the Landowners’ interests in exploration of deep formations below the Gordon Sand are sufficiently protected by the implied covenant of reasonable development.” Furthermore, “[r]ecognizing a separate implied covenant to explore further would prove unhelpful at best, as it would focus on just a small subset of factors relevant to the overall profitability of development to the lessor and the lessee.” The Court stated that it “decline[s] to recognize a separate covenant to explore further.”

The Court also stated that it expresses no opinion as to how a prudent operator would employ new technologies on the Washington County land under the implied covenant of reasonable development because that issue was not before the Court. Finally, the Court noted that “to the extent the parties wish to address exploration or the use of new technologies in the terms of the lease itself, they are of course free to do so.”

2016-1281. Alford v. Collins-McGregor Operating Co., Slip Opinion No. 2018-Ohio-8.

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