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T.W. Phillips Gas and Oil Co. and Pc Exploration, Inc v. Ann Jedlicka

March 26, 2012

T.W. PHILLIPS GAS AND OIL CO. AND PC EXPLORATION, INC., APPELLEES
v.
ANN JEDLICKA, APPELLANT



Appeal from the Order of the Superior Court entered December 29, 2008 at No. 1918 WDA 2007, affirming the Order of the Court of Common Pleas of Indiana County, entered October 19, 2007 at No. 10362 CD 2005. The opinion of the court was delivered by: Madame Justice Todd

CASTILLE, C.J., SAYLOR, EAKIN, BAER, TODD, McCAFFERY, ORIE MELVIN, JJ.

ARGUED: April 13, 2010

OPINION

This Court granted allowance of appeal in the instant case to determine the proper test for evaluating whether an oil or gas lease has produced "in paying quantities," as first discussed by this Court in Young v. Forest Oil Co., 194 Pa. 243, 45 A. 1 (1899). After careful consideration, we hold that, where, as here, production on a well has been marginal or sporadic, such that for some period profits did not exceed operating costs, the phrase "in paying quantities" must be construed with reference to an operator's good faith judgment. Furthermore, as we find the lower courts considered the operator's good faith judgment in concluding the oil and gas lease at issue in the instant case has produced in paying quantities, we affirm the order of the Superior Court affirming the judgment entered by the trial court in favor of T.W. Phillips Gas and Oil Co. and PC Exploration, Inc. (collectively, "Appellees").

Appellant, Ann Jedlicka, is the owner of a parcel of land consisting of approximately 70 acres located in North Mahoning Township (the "Jedlicka tract"). Title to the Jedlicka tract was conveyed from James and Anna Jedlicka, husband and wife, to Anna Jedlicka and Ann Jedlicka, mother and daughter, in October 1979. The Jedlicka tract is part of a larger tract of land consisting of approximately 163 acres, which was conveyed to Samuel Findley and David Findley by deed dated February 24, 1925 (the "Findley property"). In 1928, Samuel Findley and David Findley conveyed to T.W. Phillips Gas and Oil Co. ("T.W. Phillips") an oil and gas lease covering all 163 acres of the Findley property (the "Findley lease"), which included the Jedlicka tract. The Findley lease, characterized as a pressure lease, established royalty payments to the lessor based upon the pressure of the well. The lease also contains a habendum clause, which provides:

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 for 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.

Lease, July 2, 1928, at 1 (R.R. at 13a-14a). Notably, the term "in paying quantities" is not defined in the lease. Subsequently, the Findley property was subdivided and sold  including the Jedlicka tract  subject to the Findley lease.

In 1929, pursuant to the Findley lease, T.W. Phillips drilled four gas wells, identified as Well Nos. 1 through 4. Well No. 4 is situated on what is now the Jedlicka tract. Well No. 2 was temporarily abandoned in 1955, and Well No. 4 was temporarily abandoned in 1953. All four wells were fractured in 1967*fn1 and eventually assigned to PC Exploration, Inc. ("PC Exploration") on June 15, 2004. Thereafter, PC Exploration drilled four additional wells, identified as Well Nos. 6 through 9.*fn2 Jedlicka has received royalties and free gas throughout the life of the lease.

Subsequently, PC Exploration made plans to drill four more wells  Well Nos. 10 through 13  on the Jedlicka tract. Jedlicka objected to the construction of these new wells, claiming that T.W. Phillips failed to maintain production "in paying quantities" under the habendum clause of the Findley lease, and, as a result, that the lease lapsed and terminated. Specifically, Jedlicka argued that there has not been continuous production in paying quantities on the wells because, in 1959, T.W. Phillips suffered a loss of approximately $40 as a result of operations under the Findley lease.

In 2005, Appellees filed a declaratory judgment action against Jedlicka to determine their rights with regard to the Jedlicka tract under the Findley lease. Appellees maintained that the Findley lease remains valid; that the wells on the original Findley property have produced gas in paying quantities because they have continued to pay a profit over operating expenses; and that they have operated the wells in good faith to make a profit. Prior to trial, Jedlicka filed a motion in limine to exclude evidence of Appellees' post-1974 operating expenses and revenues for Well Nos. 1 through 4 because Appellees did not have any depletion schedules*fn3 for those wells after 1974. The trial court denied the motion and allowed Appellees to introduce other evidence of expenses, revenue, and production.

Appellees then filed a motion in limine, opining that Jedlicka's claims were barred by operation of Rule 1901 of the Pennsylvania Rules of Judicial Administration.*fn4 Appellees noted that, in 1988, Jedlicka commenced an action by writ of summons challenging the validity of the Findley lease, but that action was dismissed with prejudice as an inactive case pursuant to Pa.R.J.A. 1901. Appellees further noted that Jedlicka failed to allege any reasons for such inactivity in a timely petition for permission to reinstate the cause of action. Accordingly, Appellees argued that Jedlicka should be precluded from presenting any evidence or testimony regarding the production or operation of the wells on the Findley property prior to 1988. The trial court heard testimony on Appellees' motion and determined that the lease at issue in the 1988 action was the same as the lease at issue in the case sub judice; however, the trial court was unable to conclude that the issues in the two actions were identical, or that Jedlicka was attempting to argue the same claims, and thus denied Appellees' motion.*fn5

On April 16, 2007, a bench trial was held before President Judge William J. Martin of the Indiana County Court of Common Pleas. Following trial, President Judge Martin determined that, notwithstanding the $40 loss suffered in 1959, Appellees had produced gas on their leasehold in paying quantities, and, therefore, that the Findley lease remained in effect. In determining that Appellees produced gas in paying quantities, the trial court relied on this Court's 1899 decision in Young v. Forest Oil, wherein we held that consideration should be given to a lessee's good faith judgment when determining whether oil was produced in paying quantities. The trial court noted that Appellees "continued efforts in production after 1959 and [the owners of the Jedlicka tract] continued to receive royalty payments per the lease for more than thirty years without asserting that the lease had expired." T.W. Phillips Gas and Oil Co. and PC Exploration, Inc. v. Jedlicka, No. 10362 CD 2005, at 5.

Additionally, the trial court rejected Jedlicka's suggestion that, instead of the Young test, the court should apply a test utilized by federal and some state courts, under which courts "interpret[] gas leases in a more objective manner using a computation of production receipts minus royalty minus expenses including marketing, labor, trucking, repair, taxes, fees and other expenses." T.W. Phillips Gas and Oil Co. and PC Exploration, Inc., No. 10362 CD 2005, at 5-6. Recognizing that the objective approach favored by Jedlicka incorporates the concern that "lessees should not be allowed to hold land indefinitely for purely speculative purposes," the trial court noted that Pennsylvania has not adopted this objective approach, and nevertheless concluded that "based upon all of the testimony and other evidence presented, the rationale utilized in support of a completely objective test is not applicable herein." Id. at 6. The trial court explained, in particular, that the Findley lease "is a pressure lease, not a 1/8 royalty lease," and "[t]he evidence indicates that the lessees were operating the wells in good faith and there was no evidence that they were holding the land for purely speculative purposes." Id.*fn6

On November 26, 2008, the Superior Court affirmed the decision of the trial court in an unpublished memorandum opinion, which, upon joint motion of the parties, was subsequently published. T.W. Phillips Gas and Oil Co. and PC Exploration, Inc. v. Jedlicka, 964 A.2d 13 (Pa. Super. 2008). The Superior Court first concluded that our decision in Young, although more than a century old, remains good law. The Superior Court further found that, under Young, "the good faith of the lessee is a necessary determination," and held that Jedlicka failed to carry her burden of establishing that Appellees acted in bad faith. T.W. Phillips Gas and Oil Co. and PC Exploration, Inc., 964 A.2d at 19. Jedlicka petitioned for allowance of appeal, and, on July 29, 2009, this Court granted her petition to consider the following issue: "Did the Superior Court misapply the decision of this Court in Young v. Forest Oil Co.,194 Pa. 243, 45 A. 121 (Pa. 1899), by holding that Pennsylvania employs a purely subjective test to determine whether an oil or gas lease has produced 'in paying quantities.'" T.W. Phillips Gas and Oil Co. v. Jedlicka, 602 Pa. 154, 978 A.2d 347 (2009) (order).*fn7

When reviewing the findings of a court in equity, an appellate court's review "is limited to a determination of whether the chancellor committed an error of law or abused his discretion. A final decree in equity will not be disturbed unless it is unsupported by the evidence or demonstrably capricious." Kepple v. Fairman Drilling Co., 532 Pa. 304, 312, 615 A.2d 1298, 1302 (1992) (internal quotation marks omitted). Although facts found by the chancellor, when supported by competent evidence in the record, are binding, no such deference is required for conclusions of law, which we review de novo. Id.

Furthermore, a lease is in the nature of a contract and is controlled by principles of contract law. J.K. Willison v. Consol. Coal Co., 536 Pa. 49, 54, 637 A.2d 979, 982 (1994). It must be construed in accordance with the terms of the agreement as manifestly expressed, and "[t]he accepted and plain meaning of the language used, rather than the silent intentions of the contracting parties, determines the construction to be given the agreement." Id. (citations omitted). Further, a party seeking to terminate a lease bears the burden of proof. See Jefferson County Gas Co. v. United Natural Gas Co., 247 Pa. 283, 286, 93 A. 340, 341 (1915).

In order to better assess the parties' arguments in the case sub judice, we consider briefly the unique characteristics of an oil and gas lease. As this Court recognized in Brown v. Haight, "[t]he traditional oil and gas 'lease' is far from the simplest of property concepts. In the case law oil and gas 'leases' have been described as anything from licenses to grants in fee." 435 Pa. 12, 15, 255 A.2d 508, 510 (1969). Generally, however, the title conveyed in an oil and gas lease is inchoate, and is initially for the purpose of exploration and development. Calhoon v. Neeley, 201 Pa. 97, 101, 50 A. 967, 968 (1902); Burgan v. South Penn Oil Co., 243 Pa. 128, 137, 89 A. 823, 826 (1914) ("The title is inchoate, and for purposes of exploration only until oil is found." (internal quotation marks omitted)); see also Hite v. Falcon Partners, 2011 WL 9632 (Pa. Super. filed Jan 4, 2011) (same); Jacobs v. CNG Transmission Corp., 332 F.Supp.2d 759, 772 (W.D. Pa. 2004) (same).

If development during the agreed upon primary term is unsuccessful, no estate vests in the lessee. If, however, oil or gas is produced, a fee simple determinable is created in the lessee, and the lessee's right to extract the oil or gas becomes vested. Calhoon, 201 Pa. at 101, 50 A.2d at 968; Jacobs, 332 F. Supp.2d at 772-73. A fee simple determinable is an estate in fee that automatically reverts to the grantor upon the occurrence of a specific event. Brown, 435 Pa. at 18, 255 A.2d at 511. The interest held by the grantor after such a conveyance is termed "a possibility of reverter." Higbee Corp. v. Kennedy, 428 A.2d 592, 595 (Pa. Super. 1981). Such a fee is a fee simple, because it may last forever in the grantee and his heirs and assigns, "the duration depending upon the concurrence of collateral circumstances which qualify and debase the purity of the grant." Id. at 595 n.4 (quoting Slegel v. Lauer, 148 Pa. 236, 241, 23 A. 996, 997 (1892)).

Within the oil and gas industry, oil and gas leases generally contain several key provisions, including the granting clause, which initially conveys to the lessee the right to drill for and produce oil or gas from the property; the habendum clause, which is used to fix the ultimate duration of the lease; the royalty clause; and the terms of surrender. Jacobs, 332 F.Supp.2d at 764 (citing 3 Howard R. Williams & Charles J. Meyers, Oil and Gas Law § 601 (2003)). Further,

A habendum clause is used to fix the ultimate duration of an oil and gas lease. 2 Summers, THE LAW OF OIL AND GAS § 281. "The habendum clause of the modern oil and gas lease is the result of a long process of development, in which many influences have aided in shaping its final form," chief of which have been the [distinct] interests of the lessor and lessee, the peculiar needs of the industry and the interpretation and enforcement of certain phrases by the Courts. Id. at § 282 Experimentation in the industry for a suitable durational term progressed from definite term leases, which placed the lessee at a disadvantage if production was only attained late in the term or extended beyond the term, to a definite term with an option to renew, to long term leases with conditional clauses extending the term through the production life of the land. Id. at §§ 283-287.

Jacobs, 332 F.Supp.2d at 765 n.1.

Typically, as herein, the habendum clause in an oil and gas lease provides that a lease will remain in effect for as long as oil or gas is produced "in paying quantities."*fn8

Traditionally, use of the term "in paying quantities" in a habendum clause of an oil or gas lease was regarded as for the benefit of the lessee, as a lessee would not want to be obligated to pay rent for premises which have ceased to be productive, or for which the operating expenses exceed the income. Swiss Oil Corp. v. Riggsby, 67 S.W.2d 30, 31 (Ky. 1933). More recently, however, and as demonstrated by the instant case, these clauses are relied on by landowners to terminate a lease.

As noted supra, the habendum clause contained in the lease at issue provides that Appellee shall have the right to drill for oil and gas 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." Lease, July 2, 1928, at 1 (R.R. at 13a-14a). It is the meaning of the term "in paying quantities," which is not defined in the lease, that is the crux of the dispute between the parties; however, the parties agree that the lease is controlled by our 1899 decision in Young.*fn9

In Young v. Forest Oil, the plaintiff landowner sought a declaration of forfeiture of an oil lease held by the defendant due to the defendant's alleged failure to develop the land. The trial court found that the defendant had "sufficiently developed" the west end of the plaintiff's farm. However, the court determined that the drilling of a single well on the north and east portions of the plaintiff's farm, which admittedly revealed no oil or gas, did not support the defendant's refusal to drill additional wells on the remainder of the farm, because "[t]here remains a large portion of plaintiff's farm which . . . ought to produce oil in paying quantities, with a reasonable degree of certainty." Id. at 248-49, 45 A. at 122. As a result, the trial court determined, "under the circumstances of this case the defendant's refusal to sink additional wells on plaintiff's farm is a wrongful act, amounting to a fraudulent use of the lease, to plaintiff's injury." Id. at 249, 45 Pa. at 122.

On appeal, this Court reversed, noting that the trial court's conclusion "proceed[ed] from an erroneous view of the law,"*fn10 and stating:

In the present case the conclusion of the court rests on nothing else than such a difference of judgment. There is not a scintilla of evidence for any other basis. The lessee contracted to put down one paying well. He did in fact put down five, four of which produced oil for a time. Even considering the plaintiff's side alone, the weight of the evidence in favor of the court's conclusion is exceedingly light. Passing over the plaintiff's extraordinary reasoning, that, because one well put down in the alleged insufficiently tested part of the farm proved to be a dry hole, therefore another hole in the same portion would produce a paying well, we have looked in vain for any testimony that even the experts are willing to stake their judgments on any such result. Not a single witness says so. . . . Even if [a witness] had said so, with sufficient positiveness to convince the court as a matter of judgment, it would not have been enough. . . . 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.

Id. at 249-50, 45 A. at 122.

With regard to the plaintiff's argument to this Court that the lease had expired because oil was no longer produced in paying quantities, we noted that, despite declining to grant the plaintiff relief on this ground, the trial judge found it unnecessary to determine the exact meaning of the phrase "in paying quantities." However, we nevertheless agreed the trial court was correct not to grant relief on this ground, explaining:

The phrase 'found or produced in paying quantities' means paying quantities to the lessee or operator. If oil has not been found and the prospects are not such that the lessee is willing to incur the expense of a well (or a subsequent or second well, as the case may be), the stipulated condition for the termination of the lease has occurred. So, also, if oil has been found, but no longer pays the expenses of production. 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 cost, and the operation as a whole may result in a loss. Few wells, except the very largest, repay cost under a considerable time; many never do; but that is no reason why the first loss should not be reduced by profits, however small, in continuing to operate. The phrase 'paying quantities,' therefore, is to be construed with reference to the operator, and by his judgment when exercised in good faith.

Id. at 250-51, 45 A. at 122-23.

In Colgan v. Forest Oil Co., 194 Pa. 234, 45 A. 119 (Pa. 1899), which we issued on the same day as our opinion in Young, we elaborated on the concept of good faith judgment. Therein, the owner of land (lessor) filed a bill in equity against the lessee for specific performance of convenience contained in an oil lease, or, alternatively, for forfeiture of the lease. The lessee challenged the number of wells put down by the lessor, as well as the location of the wells. Concerning the lessee's good faith judgment, we stated:

So long as the lessee is acting in good faith on business judgment, he is not bound to take any other party's, but may stand on his own. Every man who invests his money and labor in a business does it on the confidence he has in being able to conduct it in his own way. No court has any power to impose a different judgment on him, however erroneous it may deem his to be. Its right to interfere does not arise until it has been shown clearly that he is not acting in good faith on his business judgment, but fraudulently, with intent to obtain a dishonest advantage over the other party to the contract. Nor is the lessee bound, in case of difference of judgment, to surrender his lease, even pro tanto, and allow the lessor to experiment. Lessees who have bound themselves by covenant to develop a tract, and have entered and produced oil, have a vested estate in the land, which cannot be taken away on any mere difference of judgment.

Id. at 242, 45 A. at 121 (emphasis added).

Jedlicka argues that the lower courts in the instant case erroneously interpreted our decision in Young as providing for a "purely subjective," rather than objective, test to determine whether a gas or oil lease is producing in paying quantities.*fn11 Specifically, Jedlicka argues:

[W]hile there are some subjective factors to consider in the overall analysis, the test is not purely subjective, as the trial court found in the instant case. Rather, the threshold inquiry is whether, objectively, the lease is making a profit, "however small" over its operating expenses. The operating expenses referred to here are the day to day costs of operating the well. Some courts have referred to these expenses as "lifting expenses." The Court in Young was ...


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