Ohio Appellate Court Interprets “Producing In Paying Quantities” and “Continuous Operations”

In Gardner v. Oxford Oil Co., Monroe App. No. 12 MO 7, 2013-Ohio-5885; 2013 Ohio App. LEXIS 6192, the Seventh Appellate District addressed the interpretation of common lease provisions and specifically whether an oil and gas lease expired pursuant to the terms of the habendum clause.  In Gardner, the Plaintiff, Michael Gardner,was the record title owner of a tract of land in Monroe County, Ohio, and the successor-in-title to a 1976 oil and gas lease (the “Miracle Lease”) to Oxford Oil Company (“Oxford”), which contained the following habendum clause:

…5 years and so much longer thereafter as oil, gas or their constituents are produced in paying quantities thereon, or operations maintained on…” all or part of the land.

Oxford drilled one well on the property, known as the Ivan Miracle #1 well (the “Miracle Well”).

In February 2001, Gardner purchased the well, and Oxford Oil recorded an Assignment and Bill of Sale in the Monroe County Recorder’s Office, dated March 23, 2001.  Along with the well and equipment, said Assignment conveyed Oxford’s right, title and interest to the Miracle Lease, retaining the deep rights from the bottom of the producing zone to the center of the earth.

Although the record was unclear as to the last date Oxford last produced in paying quantities from the Miracle Well, the Court noted that the last possible date would have been March 23, 2001, the date Oxford filed the Assignment and Bill of Sale to Gardner.  This was the only well Oxford drilled on the property under the Miracle Lease.

After purchasing the Miracle Well, Gardner never commenced operations to produce oil and gas — but he did obtain gas for buildings on his property via a domestic gas line attached to the well head.

After Gardner sold the pump jack from the Miracle Well, he filed a Notice of Forfeiture, taking the position that the lease had expired due to Oxford’s failure to produce oil or gas from the leased premises since 2001.  Oxford responded and filed a Notice that the oil and gas lease had not been forfeited.

Oxford focused on three main arguments to argue that the Miracle Lease remained in force and effect, all of which were rejected by the Court.

First, Oxford claimed that the Assignment and Bill of Sale was a separate agreement from the Miracle Lease and that the assignment does not condition Oxford’s retention of the deep rights upon “production in paying quantities.”  Oxford argued that the assignment had the legal effect of a novation; specifically, it was a separate agreement in which Gardner granted Oxford the deep rights in the property.  Under Ohio law, a contract of novation is created “…where a previous valid obligation is extinguished by a new valid contract, accomplished by substitution of parties or of the undertaking, with the consent of all the parties, and based on valid consideration.” Williams v. Ormsby, 131 Ohio St.3d 427, 2012-Ohio-690, 966 N.E.2d 255, P. 18.

The Court concluded this argument lacked merit.  If Gardner did convey the deep rights to Oxford via the Assignment and Bill of Sale and it truly was a separate agreement, then it must meet all of the elements of a contract.  The evidence in the record did not indicate that Gardner was offered any consideration for the deep rights retained by Oxford Oil, or that he was told or otherwise had notice that the Assignment and Bill of Sale reserved the deep rights to Oxford; rather, Gardner was aware of only referenced the sale of the Miracle Well and ancillary equipment.   Because there was no evidence of mutual assent between the parties, the Assignment and Bill of Sale did not constitute a novation and the retention of the deep rights remained subject to the terms of the Miracle Lease.

Second, Oxford argued that the Miracle Lease and Oxford’s deep rights would terminate only when Gardner plugs and abandons the well.  The Miracle Lease’s Primary Term had long expired, and the secondary term provided that the Miracle Lease would remain in force and effect for “so much longer thereafter as oil, gas or their constituents are produced in paying quantities thereon, or operations are maintained on” all or part of the land.  By the Assignment and Bill of Sale Oxford transferred to Gardner “a portion of its right, title and interest in and to [the Lease],” retaining the deep rights.  In rejecting Oxford’s argument, the Court explained that  Oxford could have drilled a productive well elsewhere on the lease or negotiated a right of first refusal provision in the Assignment and Bill of Sale to repurchase the Miracle Well from Gardner if he chose to take it out of production.  Gardner, the Court reasoned, does not have a duty to continue production after taking ownership of the well to preserve Oxford’s leasehold interest.

Third, Oxford argued that the Miracle Lease remained in force and effect, pursuant to the terms of the habendum clause, because there was production in paying quantities and/or operations arising from Gardner’s use of gas from the Miracle Well to a rental property owned by Gardner.  To address Oxford’s argument, the Court first looked to the Ohio Supreme Court’s seminal decision defining “production in paying quantities”:

The term “paying quantities,” when used in the habendum clause of an oil and gas lease, has been construed by the weight of authority to mean ‘quantities of oil or gas sufficient to yield a profit, even small, to the lessee over operating expenses, even though the drilling costs, or equipping costs, are not recovered, and even though the undertaking as a whole may thus result in a loss.

Blausey v. Stein, 61 Ohio St. 2d 264, 265-66, 400 N.E.2d 408 (1980).

Oxford argued that Yoder v. Stocker & Sitler Oil Co., 5th Dist. No. CA-465, 1993 Ohio App. LEXIS 1813, 1993 WL 95604 (March 30, 1993) (concluding that non-commercial use of free domestic gas by a landowner did not constitute production in paying quantities) should control. In this case, Gardner was using the domestic gas arguably for a commercial purpose, i.e. to fuel a rental home on his property.   Oxford asserted that Gardner’s use of the gas for a commercial purpose transformed the use from domestic to “production in paying quantities.”

In rejecting Oxford’s argument, the Court relied upon Tisdale v. Walla, 11th Dist. No. 94-A-0008, 1994 Ohio App. LEXIS 5941, 1994 WL 738744 (Dec. 23, 1994).   Tisdale explained that domestic use plus use for a commercial activity (pig farming) was insufficient to constitute “production in paying quantities.”  1994 Ohio App. LEXIS 5941WL at *3.  Tisdale concluded that production pursuant to the lease must stem from commercial drilling operations, not merely any commercial use of the domestic gas.  Id. (emphasis added).

“In other words,” the Court of Appeals stated, “the court in Tisdale concluded that these types of uses by the lessors were incidental to the purpose of the lease; thus only commercial oil and gas production by the lessee oil and gas companies would preserve their interest under the habendum clause. We agree with this rationale.”

Gardner at 40.

Gardner reasoned that the use of domestic gas for a rental property is an incidental use, and not the primary purpose of a well.  “Both uses [Gardner’s use of the domestic gas as fuel for his rental homes and Tisdale‘s use for pig farming] are incidental to the purpose of the lease:  commercial production of gas by the lessee for sale to third parties.” Id. at 41.

The Court, following Yoder, explained that operations meant those conducted by the oil and gas company, not the landowner, even though the landowner had been assigned rights to the well; the landowner’s use of domestic gas did not constitute operations under the terms of the lease. 1993 Ohio App. LEXIS 1813, [WL] at *3, cited in Gardner at 42.  Again sticking with the primary purpose of the lease, the Court stated that “[o]perations, just as production in paying quantities, are assessed from the perspective of the lessee oil and gas company; the party under the lease with the right and duty to drill for oil and gas.  The incidental use of gas by the property owner is insufficient to constitute operations.”  Gardner at 42.

Operators in Ohio should take notice of cases such as Gardner, which serve to clear up issues of interpretation surrounding older leases.  Operators conducting operations in Ohio under older leases should have a thorough knowledge of not only the factual circumstances of the operations that purportedly hold the leases in force and effect, but also how courts will interpret those clauses.