A Mess for Hess: Why the Oil and Gas Giant may lose more than 300 gas leases in the Utica Shale Region

Author: Bradley Dunkle, Associate Member, University of Cincinnati Law Review

Oil and gas giant Hess Corporation may have a sticky situation on its hands following a federal court decision from September 24, 2013.  The Southern District of Ohio ruled that two gas leases held by the energy giant lapsed after Hess failed to drill on the property.[1]   Now as many as 300 similar leases held by Hess could be affected in the same manner.[2] Although multiple issues were presented for summary judgment in the case, the main dispute involved the “delay rental” provisions of the leases. Because the court correctly construed the “delay rental” provisions in a way that did not needlessly restrict the alienability of these leases and others like them, landowners in western Ohio will be able to take advantage of the area’s burgeoning natural gas industry.

Background

David Cameron, Melissa and Stephen Griffith, and other unnamed plaintiffs brought suit to challenge leases they entered into with Mason Dixon Energy between 2007 and 2008.[3] The plaintiffs own farms in Jefferson County, Ohio, and were approached by Mason Dixon Energy, on behalf of Marquette Exploration, LLC, to lease the rights to oil and gas on their farms.  The leases disputed in the case were just a handful of leases entered into by Mason Dixon and subsequently assigned to Marquette; approximately 308 such gas and oil leases were researched, negotiated, and leased.[4]  These leases were then assigned to Hess Ohio Resources, LLC. [5]

Although both the Griffith lease and the Cameron lease were similar, there are a few significant differences in the wording of the conveyances.[6]  The Griffith lease contained a “habendum clause” that created a five-year lease as long as oil and or gas was produced on the premises; this portion of the agreement ended the lease in June 2012.  However, the “habendum clause” also allowed the lease to be extended beyond the primary term at the discretion of the lessee (at the time of the suit, Hess).  The lease automatically terminated after 12 months if drilling had not started unless Hess paid a “delay rental” payment. [7]  Neither party disputes the length of the lease per the “habendum clause,” the payment of all “delay rental” payments by either Hess of its predecessors, or the lack of drilling activity.   Rather, the dispute centered on whether the “delay rental” payments applied only to the primary term or whether Hess could unilaterally extend the lease by continuing to pay the “delay rental” payments after the primary term. [8]

The Cameron lease had a “habendum clause” and a provision allowing for a “delay rental” payment but did not provide for annual “delay rental” payments like the Griffith lease.  Instead, the lease language stated that if drilling had not started within one year, then Hess could pay a “delay rental” payment once to extend the lease for one more year. This language led Cameron to argue that Hess was only entitled to a two-year primary term followed by an option for five-year extension to be paid by Hess in order to continue the lease.[9]

Although the court examined both the Cameron and Griffith leases in this case, only the Griffith lease was determined unambiguous as a matter of law, and therefore automatically terminated in June 2013. The court ruled that the plaintiffs were entitled to summary judgment and Hess could not unilaterally extend the lease beyond the primary five-year term.[10].

The court determined that the Cameron lease contained material issues of fact that should be submitted to a jury.[11] Although Cameron was not granted summary judgment, Hess was not able to unilaterally extend the lease. While Cameron undoubtedly wanted summary judgment granted, this ruling allows Cameron to continue to contest the lease.

Getting out of the “delay rental”

The aforementioned provisions had kept the parties in lease agreements that are now well below market value. The Griffiths and Cameron are now able to enter into more profitable oil and gas leases after the primary term of the Hess leases; but the court’s ruling could have dramatic implications well beyond the parties in Cameron v. Hess Corp.

Hess was able to purchase over 300 leases negotiated by Mason-Dixon for a small percentage of market value.  Some of these leases included bonuses for mineral rights as low as $10 per acre, while the current market value can be up to $5,000 or $6,000 per acre.[12]  These leases were entered into well before the potential of Utica shale[13] was public knowledge; parties like the Griffiths had been waiting for years to have the opportunity to terminate their initial agreements in order to seek a more lucrative lease.[14]

Ramifications for Hess

Hess intends to appeal the court’s decision, stating “[w]e are surprised by the court’s decision and intend to challenge it vigorously through the appropriate court procedures.”[15]  If it is unable to win on appeal, Hess stands to lose thousands of dollars in profits.  The company would either lose the leaseholds on the property, allowing the Griffiths and other plaintiffs to enter the free market, or Hess would be forced to pay full market value in order to retain the oil and gas rights.

Some believe that the Utica Shale formation may contain billions of dollars of natural gas; therefore, Hess will have the best opportunity to maximize earnings if it is able to retain as many gas and oil leases for as long as possible.  Drilling for natural gas is not like drilling for crude oil. Each individual site requires research and investment in order to determine the most effective method for production.  There are also storage concerns that are more complicated than storing crude oil.  Furthermore, the depth of the Utica Shale requires more research and development money than other shale formations, such as Marcellus Shale; therefore, losing these leases would result in lost exploration and development costs in addition to lost profits.  The court’s decision seems to place Hess in a classic Catch-22.

Chances on Appeal

Although Hess promised to fight the judgment as much as it can within the law, it is unlikely the appellate court will overturn the Cameron decision. First, the district court did not take up the validity of the leases.  Even though there was no discussion of this issue in the decision, this is another area of contention for Hess to overcome.  Although the appellate court will review this matter de novo, “[t]he plain language of the Griffiths Lease does not support Hess’s position that the phrase ‘primary term’ refers to both the initial five year term and any subsequent extension.”[16]  Furthermore, Hess is in the position of the bargaining party; through the fault of its successor, the contract’s “delay rental” provision only provided for extensions within the primary term.  Furthermore, the district court correctly ruled that it is unfair to hold the party with inferior knowledge of issues related to the contract responsible for ambiguities. [17]

Conclusion

Hess could quickly be facing a serious problem if it is unable to find a solution for the over 300 leases it acquired from Mason-Dixon and Marquette.  Whether its delay in production is caused by the complicated research required to begin drilling, a desire to withhold natural gas wells from the market, or whatever other reason, Hess is best situated to grow in the natural gas market if it is able to maintain these leases.  On the other hand, the plaintiffs in Cameron, as well as the other landowners in similar leases across Ohio, need to continue to fight to uphold the court’s decision.  Although both Hess and the landowners stand to lose a considerable amount of money if they lose, the marginal utility of each dollar is much less for Hess than for individual landowners.

Five years ago, when these leases were formed, few people understood the potential value of shale gas.  The oil and gas rights associated with many properties across western Ohio have increased in value, in some situations tenfold.  Cameron could prove to be an important landmark in the development of shale gas production in western Ohio, and the winning party will reap major rewards.