Opinion ID: 2286049
Heading Depth: 2
Heading Rank: 2

Heading: The Implied Covenant to Develop and Produce Oil or Natural Gas

Text: The second question is whether Pennsylvania jurisprudence recognizes an implied covenant to develop and produce oil or natural gas that would impose upon a lessee the obligation to produce oil and gas from property leased for that purpose. This Court has touched on this issue intermittently for more than one hundred years. In Stoddard v. Emery, 128 Pa. 436, 18 A. 339 (1889), the Court rejected the contention that an implied covenant existed obligating the lessee to drill oil wells every four months where the contract contained express terms regarding the number of wells to be drilled. The Stoddard Court recognized, however, that such an implication might arise if the parties had not specifically addressed the issue: The proposition that there was an implied covenant to bore wells every four months, or as often as it was customary to put down additional wells in the absence of any express contract, is altogether untenable. The parties provided by the express terms of their contract how many wells should be put down, and that provision of the contract determines the question. When the number is expressed, there is no room for any implication that there should be some other number. Had there been nothing said in the contract on the subject, there would of course have arisen an implication that the property should be developed reasonably, and evidence of a custom of reasonable development by boring a given number of wells in a certain space of time would have been competent, and perhaps controlling. But that doctrine has no application in a case when the parties have expressly agreed in the contract how many wells should be bored. Id. at 441-42, 18 A. at 339. Thus, the Stoddard Court recognized the existence of an implied covenant to develop, but rejected the application of the doctrine because the contract there clearly set forth the parties' expectations regarding development of the property. Three years later, in McKnight v. Manufacturers' Natural Gas Co., 146 Pa. 185, 23 A. 164 (1892), the plaintiff asserted that the defendant was under an implied covenant to drill oil wells upon the plaintiff's land in order to protect the oil and gas underlying the plaintiff's property from operations by other parties on adjoining properties. The trial court ruled in favor of the plaintiff. After analyzing the rationale behind implied covenants in farming, mining, and oil and gas leases, the McKnight Court declined to rule on the issue of whether such a covenant was breached or whether the defendant abandoned the property by failing to install wells, but instead remanded to the trial court for a new trial. Nevertheless, in dicta, the Court stated: The defendant cannot hold the premises and refuse to operate them. Id. at 204, 23 A. at 166. Thus, the Court at least suggested that an implied covenant does exist. In Aye v. Philadelphia, 193 Pa. 451, 44 A. 555 (1899), the Court quoted McKnight's rationale while agreeing with the Stoddard Court that the express intent and agreement of the parties may overcome any implied covenant: Where a right to mine iron ore or other minerals is granted in consideration of the reservation of a certain proportion of the product to the grantor, the law implies a covenant on the part of the grantee to work the mine in a proper manner and with reasonable diligence, so that the grantor may receive the compensation or income which both parties must have had in contemplation when the agreement was entered into. [ Koch & Balliet's Appeal, 93 Pa. 434, 442 (1880).] So, in Ray v. Gas Co., 138[Pa.] 576, 589, 20[A.] 1065 [ (1891) ], it was said by our late Brother Clarke: While the obligation on the part of the lessee to operate is not expressed in so many words, it arises by necessary implication.... If a farm is leased for farming purposes, the lessee, to deliver to the lessor a share of the crops, in the nature of rent, it would be absurd to say, because there was no express engagement to farm, that the lessee was under no obligation to cultivate the land. An engagement to farm in a proper manner, and to a reasonable extent, is necessarily implied. That was the case of an oil and gas lease, and it has been said that the doctrine is peculiarly applicable to such leases, owing to the nature of the product. McKnight v. Gas Co., 146[Pa.] 185, 23[A.] 164 [(1892)]; Oil Co. v. Fretts, 152[Pa.] 152[Pa.] 451, 25[A.] 732 [(1893)]. The rule in regard to contracts is that, where the parties have expressly agreed on what shall be done, there is no room for the implication of anything not so stipulated for, and this rule is equally applicable to oil and gas leases as to any other contracts. There is nothing peculiar about them in this respect.... The authorities are uniform that, [where the parties have not expressly agreed on what shall be done], there is an implied obligation on the lessee to proceed with the exploration and development of the land with reasonable diligence, according to the usual course of the business, and a failure to do so amounts to an abandonment which will sustain a re-entry by the lessor. Aye, 193 Pa. at 455-56, 44 A. at 555-56. These decisions, as well as others dating from the early 1900s, all derive from a recognition that, in many cases, the lessor's only source of consideration for the lease is royalty payments on minerals, oil or gas extracted from the property. If the lessee fails to conduct mining operations or drill for oil or gas, the lessor receives no consideration. The basis for the implied covenant, therefore, is a recognition that the lessor has entered into a bargain expecting to be compensated for the lease of the land, and principles of fairness dictate that the lessee be obligated to make diligent efforts to ensure that the lessor receives the benefit of his bargain. See, e.g., Appeal of Baird, 334 Pa. 410, 6 A.2d 306 (1939); Burgan v. South Penn Oil Co., 243 Pa. 128, 89 A. 823 (1914). More recently, this Court has discussed the effect of payments in lieu of royalties upon an implied covenant of development in a coal lease case. See Hutchison v. Sunbeam Coal Corp., 513 Pa. 192, 519 A.2d 385 (1986). There, the defendant entered into a coal lease with the plaintiffs that provided for minimum advance royalties payable to the plaintiffs for at least three years if the defendant chose not to actively mine the plaintiffs' property. The defendant never conducted mining activities on the plaintiffs' land and instead paid the advance royalties. The issue was whether the lease expired at the end of the initial three-year term or whether it continued thereafter so long as the defendant continued to make the advance royalty payment to the plaintiffs. The plaintiffs refused to accept payment of the advance royalties after the expiration of the three-year term of the lease. The trial court found that the plaintiffs had granted a lease to the defendant that continued in effect as long as the defendant continued to pay advance royalties. The Superior Court reversed, finding that the lease expired because such leases contain an implied duty to mine diligently which the defendant had breached. This Court affirmed the Superior Court's holding that the lease had expired but held that the Superior Court erred in finding an implied covenant to mine where the lease provided for minimum advance royalties: In letting land for the extraction of minerals, an obligation to pay minimum advance royalties does not create an implied duty to mine under Pennsylvania law. We have never implied such a duty and decline to do so now. In coal mining leases, where the consideration for the privilege of removing the mineral is a royalty on the amount extracted, it is common for the parties to stipulate that a minimum advance royalty will be paid to the landowner if no mining is done. ... In Hummel v. McFadden, 395 Pa. 543, 150 A.2d 856 (1956), this Court implied a duty to mine in a lease agreement which did not provide for minimum royalties in the absence of mining. There, the implied covenant imposed upon the mining company a duty to commence operations in order to provide the landowner some return on his agreement. Our holding in Hummel leaves the contracting parties free to bargain for a provision addressing the amount and type of consideration to be paid in lieu of forfeiture should the mining company fail to commence mining operations. Pennsylvania courts have reasoned that minimum advance royalties are in the nature of liquidated damages for the lessee's failure to mine. ... Such reasoning recognizes minimum advance royalties as the consideration flowing from the coal company to the landowner in lieu of the tonnage royalties which would be paid if mining operations were undertaken. Implying a duty to mine in the face of a minimum advance royalty clause ignores the terms agreed to by the contracting parties. (citations omitted)    In Hummel v. McFadden, supra , the consideration flowing to the lessor was the expected receipt of tonnage royalties. Under that lease, the absence of a covenant to mine would have left the landowner without any consideration for his grant of the right to mine. In the present case, the parties have expressly agreed that minimum advance royalty payments of $420.00 per year shall be paid to the lessor if the lessee fails to work the mine. Therefore, during the lease term, whatever that term may be, there is no failure of consideration in the absence of mining and it is not necessary to imply a covenant to mine. The contracting parties themselves have dealt expressly with the possibility of a failure to mine by providing for minimum advance royalties. Hutchison, 513 Pa. at 197-99, 519 A.2d at 388-89 (citations and footnote omitted). The reasoning of the Hutchison Court is sound and consistent with our jurisprudence preceding it. An implied covenant to develop the underground resources appropriately exists where the only compensation to the landowner contemplated in the lease is royalty payments resulting from the extraction of that underground resource. Where, however, the parties have expressly agreed that the landowner shall be compensated if the lessee does not actively extract the resource, then the lessee has no implied obligation to engage in extraction activities. [5] Thus, so long as the lessee continues to pay the landowner for the opportunity to develop and produce oil or gas, the lessee need not actually drill wells. At the point where that compensation ceases due to the expiration of the term of the lease, or pursuant the terms of the lease itself, the lessee then has an affirmative obligation either to develop and produce the oil or gas or terminate the landowner's contractual obligations. As this Court stated in McKnight v. Manufacturers' Natural Gas Co., 146 Pa. 185, 204, 23 A. 164, 166 (1892): The defendant cannot hold the premises and refuse to operate them. This Court, of course, offers no opinion as to whether the agreement of the parties in this case forecloses implication of a covenant to reasonably develop the leasehold, as that is one of the ultimate questions facing the Third Circuit. We merely respond to the question under review by noting in the affirmative that Pennsylvania law recognizes an implied covenant but also recognizes that the specific agreement of the parties may preclude the application of the doctrine.