A district court judge in the Middle District of Pennsylvania recently vacated a bankruptcy court’s decision allowing rejection of an oil and gas lease under section 365 of the Bankruptcy Code.  The District Court held that a debtor’s oil and gas lease was a conveyance of an interest in real property and not an executory contract or unexpired lease that could be rejected in bankruptcy under Section 365 of the Bankruptcy Code.

Section 365(d)(2) of the Bankruptcy Code provides that a trustee or debtor in possession may, subject to the court’s approval, “reject an executory contract or unexpired lease of residential real property or of personal property of the debtor.”  In Chesapeake Appalachia, LLC v. Powell (In re Powell), 2015 BL 370462, No. 3:13-cv-00035-RDM (M.D. Pa. Nov. 10, 2015), District Court Judge Robert D. Mariani reviewed the bankruptcy court’s decision on the applicability of Section 365 to oil and gas leases.

Debtors Mark Powell and Powell Development Company had entered into an oil and gas lease granting Anadarko E&P Company oil and gas subsurface rights on Powell’s land.  Anadarko later assigned an interest in the lease to Chesapeake Appalachia, LLC, the creditor in the bankruptcy.  The debtors sought to have the lease rejected under Section 365 of the Bankruptcy Code.  In its decision, the bankruptcy court relied heavily on a recent Pennsylvania Supreme Court opinion, T.W. Phillips Gas & Oil Co. v. Jedlicka, 42 A.3d 261 (Pa. 2012). Jedlicka discussed the unusual nature of oil and gas leases, finding that title conveyed in an oil and gas lease is inchoate and initially gives only a right of exploration and development.  If exploration proves unsuccessful, no estate vests in the lessee.

The bankruptcy court interpreted Jedlicka to find that title to oil and gas under a lease does not vest in the lessee at the time of execution, but rather only allows exploration until oil and gas is found, regardless of the words used in the lease.  However, even though no oil or gas had been produced under the lease and the bankruptcy court believed the lease was subject to rejection, the debtor’s motion seeking rejection of the lease was denied because of a lack of evidence presented to support the decision to reject.

In his November 10, 2015 decision, Judge Mariani addressed two errors in the bankruptcy court decision and provided two important holdings. First, Judge Mariani held that oil and gas leases are conveyances of interests in real property, not contracts subject to rejection under Section 365.  The “inchoate nature” of the title merely affected the value of the conveyance, not its nature as an interest in real property.  Accordingly, debtors could not reject the lease merely because of its categorization as an oil and gas lease.

Second, the court found that the bankruptcy court erred in concluding that oil and gas leases can be subject to Section 365 “regardless of the linguistics used in the lease.” Instead, the court held that oil and gas leases should be interpreted pursuant to principles of contract law, i.e., according to their written language.  The judge found that it was an error for the bankruptcy court to disregard the language of the lease, and therefore he remanded the case to the bankruptcy court for further proceedings, including an evaluation of “the creditor’s lease in accordance with its actual terms.”

The implications of this decision are significant. Oil and gas cases are always difficult conceptually. On at least one level, the District Court’s holding seems problematic. An oil and gas lease can be granted on property where no oil and gas is actually located. It seems hard to envision a current conveyance of an interest in something that does not actually exist. At the same time, it seems peculiar to characterize the creditor’s interest in the oil and gas as a “lease,” since a lease ordinarily connotes the right to use an asset for a term certain. With an oil and gas lease, the grantee under the agreement is given the right to extract the minerals, a very permanent “use.”

For debtors, this case suggests that rejecting oil and gas leases will not be simple or automatic. Rather, an oil and gas lease may be viewed as a conveyance of an interest in real property, not as an executory contract subject to rejection.  Additionally, the case has placed greater significance on the language of each agreement.  Thus, it will be increasingly important for parties entering an oil and gas lease to carefully characterize the nature of their arrangement in the words of the agreement itself.  Debtors may not now simply reject (and presumable re-shop) an oil and gas lease in bankruptcy, making this case a win for creditors.