On March 26, 2012, in T.W. Phillips v. Jedlicka, the Pennsylvania Supreme Court affirmed the test for determining whether an oil and gas lease has produced in paying quantities depends on the operator’s good faith judgment and endorsed the subjective test over the objective test. The Supreme Court confirmed that Pennsylvania courts must consider and analyze the operator’s subjective good-faith judgment in maintaining operation of the well to determine whether a well is producing “in paying quantities.”

The lawsuit stems from a 1928 lease of oil and gas rights in a 163-acre tract in Indiana County, Pennsylvania. The term of the lease was for “two years, and as long thereafter as oil or gas is produced in paying quantities.” Over the years, the parcel was subdivided and Ann Jedlicka eventually owned 70 acres. Her parcel contained a well that was drilled in 1929. In 2004, T.W. Phillips assigned the leasehold to co-defendant PC Exploration, Inc., who drilled four more wells on Ms. Jedlicka’s property and planned to drill four more.

TW Phillips and PC Exploration filed a declaratory judgment action in the Court of Common Pleas of Indiana County, Pennsylvania for a ruling that the lease remained in effect. Ms. Jedlicka argued that T.W. Phillips and PC Exploration had not “produced in paying quantities” for the entire lease term because, in 1959, the wells recorded a $40 loss. Ms. Jedlicka identified no other period in which the wells had not shown a profit. Nonetheless, she sought to have the lease terminated and argued that a tenancy at will was formed when the lease was not profitable and, as such, the lease was subject to termination at her pleasure. T.W. Phillips and PC Exploration argued that the lease remained valid because it had paid a profit over the long term and because they had operated the well in good faith.

The trial court held a nonjury trial on April 16, 2007, and found that the producers had produced gas “in paying quantities” throughout the life of the lease, notwithstanding the 1959 loss. The trial court relied on Young v. Forest Oil, 45 A. 1 (Pa. 1899), for the proposition that courts owe deference to a lessee’s good faith judgment that a well is producing “in paying quantities.”

Ms. Jedlicka appealed to the Superior Court, which affirmed the trial court’s decision. T.W. Phillips Gas & Oil Co. v. Jedlicka, 964 A.2d 13 (Pa. Super. Ct. 2008). Ms. Jedlicka petitioned the Pennsylvania Supreme Court to hear her case and to determine whether the trial court and the Superior Court had misapplied Young.

The Supreme Court’s opinion emphasized that while an old decision, Young, especially when read in conjunction with another one that was decided the same day, Colgan v. Forest Oil Co., 45 A. 119 (Pa. 1899), which emphasized the deference lessors and courts owed to lessees’ business judgment, remains the law of Pennsylvania. Justice Todd, writing for the majority said:

The Court did not define precisely over what period profitability should be judged, holding that this would have to be determined on a case-by-case basis.

Ms. Jedlicka argued that Young created a two-part test. The first step would be an objective determination of whether revenues under a lease exceeded operating expenses. Only if the revenues exceeded expenses would the analysis move to the second step, which would consider the subjective good faith of the lessee in operating the wells under the lease. Because the expenses exceeded revenues for a year under the lease at issue, Ms. Jedlicka argued that the lease had terminated for lack of production in paying quantities at that time. The Supreme Court rejected the two-part test suggested by Ms. Jedlicka and held that Young required consideration of the operator’s good faith. The Court included in its analysis a review of cases in other states, including Texas, Oklahoma and Kentucky on the issue and acknowledged that a majority of other states use a subjective approach to the question.

The Supreme Court also rejected the “prudent operator” standard favored by some jurisdictions. The Jedlicka decision emphasizes that the lessee’s own situation and conduct are what matters. This emphasis on the lessee’s perspective, the Court reasoned, is necessary to protect lessees from lessors who seek to terminate leases on the basis of isolated, long-ago periods of unprofitability, which is how the Court characterized Ms. Jedlicka’s lawsuit. The Court thus held that, in this specific case, Ms. Jedlicka had failed to establish the lessees’ lack of good faith. The Court also suggested that the trial court could have properly found that a single year was not a reasonable period over which to assess profitability, in which case the good faith inquiry would not have been necessary.

The Supreme Court’s holding in Jedlicka does not provide a bright-line rule in cases where production expenses exceed revenue, but it does offer parties to existing and future leases that use the “paying quantities” language in the habendum clause additional guidance regarding the duration of leases held by production. The Supreme Court confirmed that Pennsylvania applies a subjective good-faith standard to determine whether a lease produces “in paying quantities.”