The Oil and Gas Addendum

The practice of deducting post-production costs from landowner royalties remains a controversial and contentious issue here in Pennsylvania. Many landowners sought to insulate their royalties from such deductions by negotiating royalty clauses which require the hydrocarbons to be sold “free of cost in the pipeline.” The intent of this language was to prohibit the driller from deducting any costs incurred between the well-pad and the downstream point-of-sale located on the interstate pipeline network. Unfortunately, many of these royalty clauses neglected to define or designate the “pipeline” as being an interstate transportation pipeline. This omission was largely based on the assumption that gas sales typically occur on the interstate pipeline network. Nonetheless, the failure to identify exactly what “pipeline” the gas will be delivered into “free of cost” has created an ambiguity. And drillers have now seized on this ambiguity. They now routinely argue that any reference to a “pipeline” in the royalty clause must necessarily meant the gathering pipeline located at the edge of the well-pad. The impact of such a designation is severe. The drillers can then argue that all costs incurred downstream of the gathering pipeline meter are beyond the “free of cost” limitation. Costs to gather, compress, dehydrate and process the gas, which all occur after the gas flows into a conventional gathering system, can now be deducted by the driller. The effect on the landowner royalties can be dramatic and costly. Is such an interpretation valid and enforceable? The Texas Supreme Court recently addressed this issue in Nettye Engler Energy v. Bluestone Natural Resources and ruled in favor of the driller. As detailed below, the Nettye Engler Energy decision is troubling news for landowners.

At issue in Nettye Engler Energy was a 1986 deed covering a 645 acre parcel in Tarrant County, Texas (the “1986 Deed”). In the 1986 Deed, the grantor reserved a 1/8th non-participating royalty interest “in and to all of the oil, gas and other minerals on, in or under the Subject Property…” As was common language in the mid-1980s, the 1986 Deed further provided that the 1/8th royalty was to be “free of cost” into the pipeline:

“…a free 1/8th of gross production of any such oil, gas or other mineral said amount to be delivered to Grantor’s credit, free of cost in the pipeline, if any, otherwise free of cost at the mouth of the well…”

In 2004, the Engler entered into an oil and gas lease with Quicksilver Resources, Inc. (“Quicksilver”). Quicksilver subsequently drilled thirty-four (34) wells on the 645 acre parcel. The thirty-four (34) wells were connected to a comprehensive gathering system via number of pipelines, which collected and compressed the raw gas and then moved it to third-party transportation pipelines located off the leased premises. From there, the gas was sold to buyers at various downstream locations. Both the gathering system and the transportation pipelines were owned by non-affiliated third-parties. Those operators charged Quicksilver a fee to move, compress and process the gas. Quicksilver, however, did not deduct those costs from Engler’s non-participating royalty.

In 2016, Bluestone Natural Resources II, LLC (“Bluestone”) acquired the underlying lease and became the operator of the thirty-four (34) wells. Unlike Quicksilver, Bluestone valued Engler’s non-participating royalty at the point where the raw gas entered the pipeline attached to the gathering system. As a result, Bluestone deducted a proportional share of all gathering, compression and processing costs incurred by Bluestone downstream from that location. Engler experienced an immediate and substantial reduction in royalty payments. Engler brought suit claiming a material breach of the 1986 Deed.

Engler argued that the 1986 Deed’s reference to “in the pipeline” meant the pipeline where the gas is necessarily sold and not the gathering system. Here, the gas was marketed and sold miles away on the transportation pipeline. As such, Engler contended that no costs incurred prior to the transportation pipeline could be legally deducted (i.e., gathering, compression or processing costs). Engler’s argument was three-fold. First, Engler argued that a gathering system is not technically a single pipeline and therefore the language in the 1986 Deed must be referring to a different pipeline. In other words, a gathering system is a network of pipelines and cannot be used to identify a precise delivery point. Second, the language in the 1986 Deed itself prioritized delivery “in the pipeline” over delivery “at the mouth of the well” by using the specific term “otherwise”. Under Engler’s interpretation, the term “pipeline” must be a pipeline located downstream of the well-pad because if no “pipeline” existed, the default language in the 1986 Deed identified the “mouth of the well” as the valuation point. Engler argued that these two valuation locations (i.e., “in the pipeline” vs. “mouth of the well”) had to be different or the language itself would be rendered duplicative and superfluous. Engler pointed out that the interconnect with the gathering system and the “mouth of the well” location were essentially the same location. Since the language had to mean something, Engler argued that the phrase “in the pipeline” could not be the delivery point into the gathering system. Finally, Engler presented expert testimony that in the mid-1980’s, when the 1986 Deed was drafted, the term “pipeline” in oil and gas leases typically referred to the place where title to the gas passed from the producer /driller to the buyer. Given this industry custom and practice, the expert opined that the phrase “in the pipeline” should be construed to mean the location where title to the gas actually passes to the buyer. Here, that did not occur until the gas reached the transportation pipeline. Consequently, the expert opined that no costs incurred prior to this location could be deducted under the 1986 Deed.

The trial court agreed with Engler and granted Engler’s motion for summary judgment. The trial court opined that costs incurred by Bluestone prior to delivery into the transportation pipeline could not be deducted from Engler’s royalty. Costs incurred moving the gas on and about the transportation pipeline, however, could be deducted by Bluestone. Nonetheless, the trial court awarded Engler damages in the amount of $88,849, representing the improper gathering, compression and processing costs deducted between April 2016 and March 2019. Bluestone appealed to the Court of Appeals for the Second District of Texas.

The Court of Appeals reversed and rendered judgment in favor of Bluestone. The Court of Appeals opined that the 2019 decision of the Texas Supreme Court in Burlington Resources Oil & Gas v. Texas Crude Energy was controlling and that, per Burlington, the phrase “in the pipeline” denotes a royalty valuation point at the well-head. In essence, the Court of Appeals viewed the Burlington Resources decision as establishing a binding and mandatory rule of law which automatically equates “in the pipeline” language with “at the well-head.” The import of this broad application was, and is, significant. Royalty clauses which value the royalty “at the well-head” necessarily authorize and allow the deduction of all costs incurred between the well-head and the downstream point-of-sale. In other words, the Court of Appeals treated the “in the pipeline” language as setting the royalty valuation point at the well-head. As such, the Court of Appeals concluded that Engler’s royalty was subject to all post-production costs incurred after delivery into the gathering system (i.e., gathering, compression, processing and transportation costs).

In July 2020, Engler filed an appeal with the Texas Supreme Court. In a much anticipated decision, the Texas Supreme Court issued an opinion on February 4, 2022 affirming the Court of Appeal’s ruling. The opinion, however, rejected the Court of Appeal’s effort to adopt a universal rule that automatically equates the “in the pipeline” language with a royalty valuation point at the well-head:

“To the contrary, we explained [in Burlington] that the “decisive factor in each [contract-construction] case is the language chosen by the parties to express their agreement.” Just as in Burlington Resources, our analysis here turns not on an immutable construct but on the parties’ chosen language “

Although the Texas Supreme Court declined to adopt a universal rule, this author believes that drillers will now nonetheless argue that the phrase “in the pipeline” must always refer to the gathering system interconnect and not the pipeline where the gas is actually sold. This is unfortunate and incorrect. And the impact on landowner royalties will be significant. Under the flawed logic and rationale of the Texas Supreme Court, drillers can arguably deduct all costs incurred downstream from the meter at the gathering system interconnect, which typically is located at or near the well-head. This means the cost to move and gather the gas from the well-head to the off-site processing facility and then to further move the gas to the interstate transportation pipelines, along with all compression and dehydration costs incurred between those two points, can be deducted. Regrettably, this is not what the parties intended when they agreed to value the royalty “free of cost in the pipeline.” As such, Pennsylvania courts should reject the logic and rationale of the Texas Supreme Court and instead focus on the actual intent of the parties.