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August 04, 2014

Must Energy Companies Drill at a Loss?

In an unexpected twist, on July 31, 2014, the United States Court of Appeals for the Second Circuit declined to decide the appeal of an oil and gas leasing dispute and, instead, certified two questions for the New York Court of Appeals to answer, namely: (1) whether the State’s ongoing drilling moratorium is a force majeure event, and (2) whether the force majeure clause modifies the habendum clause of the leases to extend the leases’ primary term.

The case, Beardslee v. Inflection Energy, LLC, involves an appeal by three Energy companies of a District Court ruling that leases entered into with landowners in the gas-rich Marcellus shale region of New York had expired, because the Energy Companies had failed to drill on the properties within the primary terms.  The habendum clause in each of the leases provided for a primary term of five years and “thereafter as the said land is operated by Lessee in the production of oil or gas.”  The leases also contained a force majeure clause that provided that if drilling was “delayed or interrupted,” for a reason beyond the control of the lessee, “the time of such delay or interruption shall not be counted against the Lessee.”

Drilling in New York requires a permit from the Department of Environmental Conservation (“DEC”).  In July 2008, then-Governor Patterson instructed DEC to undertake an environmental review of high-volume hydraulic fracturing (“HVHF”), which is used for the extraction of shale gas, to supplement the State’s Generic Environmental Impact Statement (“SGEIS”).  In 2010, he issued an Order requiring further review of the SGEIS and recognized that pursuant to State Law, no permits could be issued before the completion of a final SGEIS.  The review process, and resulting moratorium on the issuance of HVHF permits, have continued to this day.

The Energy Companies argue that the ongoing moratorium on drilling is a force majeure event, because they are unable to get the necessary HVHF permits to drill on the properties.  They also assert that the only commercially viable formation (Marcellus Shale) requires HVHF to be commercially productive.  The District Court, however, stated that the Energy Companies had an option, not an obligation to drill that would require protection from that obligation due to unforeseen circumstances.

More importantly perhaps, the District Court stated that the moratorium did not frustrate the purpose of the leases, because the Energy Companies could drill using conventional methods (i.e. vertical wells without using HVHF).  However, even the landowners did not dispute that conventional drilling on the properties would not be commercially viable.  The Energy Companies argued that they should not be forced to operate at a loss to preserve leases that have the very purpose of achieving paying production, even if the leases do not specifically say that the drilling to extend the lease must be profitable.

Given the lack of New York law on the issue, the Second Circuit has posed the question of whether the State’s moratorium preventing commercially viable drilling is a force majeure event.  In other words, does an energy company have to drill at a loss?  And even if the State’s moratorium is a force majeure event, the second question remains whether the force majeure clause in the leases modifies the terms of the habendum clause where such clause is not expressly made subject to the other terms of the lease.

Given the dearth of New York case law concerning oil and gas leasing issues, it will be interesting to see how the Court of Appeals responds to the certified questions.  Moreover, given its prior recognition in the context of its recent decision on the validity of local drilling bans that there is a moratorium on HVHF in the State, it will be telling to see how the Court of Appeals addresses this issue in the context of a leasing dispute.

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