The Oil and Gas Addendum

The development and processing of raw natural gas requires a constant and reliable energy source. Critical operations such as compression, separation, dehydration and fractionation cannot be conducted unless the driller has “fuel” to power and operate the underlying equipment and machinery. At some well pad sites, the driller will divert a portion of the raw gas stream produced by a well to these operations and then use the raw gas stream as a power source. Is the driller obligated to pay a royalty to the landowner on the volume of raw gas diverted as fuel? Reflecting a growing trend across the country, a recent decision by the Federal District Court in Oklahoma concluded that the driller owed a royalty on the volume of gas diverted for fuel usage.

In Reirdon v. Cimarex Energy Company (United States District Court for the Eastern District of Oklahoma, March 21, 2019), the plaintiff filed suit alleging that Cimarex Energy Company (“Cimarex”) breached the parties’ 1953 oil and gas lease (the “1953 Lease”) by failing to pay a production royalty on the diverted “fuel” gas. At issue were six (6) natural gas wells located in south-central Oklahoma (the “Subject Wells”). A wholly-owned subsidiary of Cimarex sold the gas produced from the Subject Wells to Madill Gas Processing (“Madill”) and then delivered the gas to Madill at or near Madill’s “North Madill Compressor Station” located in Marshall County, Oklahoma. A portion of the gas stream was used by the subsidiary to power compressors which helped to move the gas through the pipeline gathering system. Madill also used a portion of the gas stream to power machinery and equipment at Madill’s gas processing plant, including compressors, an amine treater and generators. None of the compressors, generators or other machinery were located on the property subject to the 1953 Lease. Rather, all of these operations occurred downstream and off of the leased premises.

The plaintiffs argued that the royalty clause in the 1953 Lease obligated Cimarex to pay a royalty on all volumes of gas “used or sold off the premises.” Since all the fuel usage occurred “off the premises”, the plaintiffs argued that they were entitled to a royalty on that volume of gas. Cimarex defended the suit on the grounds that no royalty was due on that volume because the “free use” clause in the 1953 Lease expressly authorized Cimarex to use the gas as fuel. In January 2018, Cimarex moved for summary judgment given the language set forth in the “free use” clause.

The issue in Reirdon was the interplay between two common lease clauses: the royalty clause the “free use” clause. By way of background, a “free use” clause is a provision in an oil/gas lease which gives the lessee the right to use gas produced from the leasehold. When a lease authorizes the driller to use raw gas to operate the leasehold, it is generally recognized “that the gas used for these purposes should be excluded [from[ the calculation of the lessor’s royalty.” See, 2 W.L. Summers, The Law of Oil and Gas §33:12 at 160 (3d ed. 2008). This right is not unlimited. Typically, unless the clause provides otherwise, the particular operations fueled by the raw gas must be actually located on the leased premises or be in close proximity so as to support the leasehold operations. See, Tidewater Associated Oil Co. v. Clemens, 123 S.W.2d 780 (Tex.App. 1938)(the clause “limits the lessee’s free use of the residue gas to that produced from the land, and to that used for operations thereon”); Bice v. Petro Hunt LLC, 768 N.W.2d 496 (N.M. 2009)(tank batteries located off leased premises were held to be a permissible use because “the residue gas is used in furtherance of overall lease operations”); Conoco Phillips Co. v. Lyons, 299 P.3d 844 (N.M. 2012) (“[L]essees are entitled to the free use of both plant and field fuel so long as it was used in the operation of the lease”). As with many oil/gas lease disputes, the precise scope and application of any “free use” clause is often dependent on the exact language set forth in the parties’ lease.

The “free use” clause in the 1953 Lease provided that Cimarex had the “right to use, free of cost, gas, oil and water produced on said land for its operations thereunder…” Cimarex argued that this clause created an exception to the general obligation to pay a royalty on all gas “used or sold” off the premises. Under Cimarex’s interpretation of the 1953 Lease, no royalty was owed on gas “used” off the premises so long as said gas was used in conjunction with the development of the leased premises. In other words, if the fuel gas usage benefited the leasehold in any way (i.e., by powering compressors or other equipment that moved the gas downstream, etc.), Cimarex argued that such usage fell within the sphere of the “free use” clause and no royalty was owed on that volume of gas. Cimarex’s interpreted the phrase “operations thereunder” very broadly: the precise location of the fuel usage was immaterial so long as the usage itself benefited the leasehold.

The District Court rejected Cimarex’s broad and expansive view of the “free gas” clause. In support of its decision, the District Court cited other recent cases that have narrowly construed similar “free use” clauses. See, Chieftain Royalty Company v. Apache, (District Ctr. of Caddo County, Oklahoma – January 24, 2019)(“…[A]pache is required to pay royalty on this gas pursuant to the express terms of the leases whether Apache uses the gas itself or allows a midstream company to use it.”); Pummill v. Hancock Exploration, LLC, 419 P.3d 1268 (January 5, 2018)(driller owed royalty on fuel gas used off the leasehold). Given this trend, the District Court opined that:

“…a harmonized reading of the royalty clause and the free gas clause require Defendants to pay royalty on gas from Plaintiff’s wells used – whether used by Defendants, or by a midstream gas gathering and/or processing company – off the lease as fuel or otherwise in gas gathering systems…and that the ‘free use’ clause applies to gas [used] on the leased premises only.”

The issue of whether a driller must pay a royalty on fuel gas has not yet been addressed by the Pennsylvania courts. This issue is likely to emerge in 2019 as another source of tension between Pennsylvania landowners and drillers as the practice of using leasehold gas for fuel becomes more prevalent and widespread throughout the Marcellus Shale region. In the meantime, landowners should carefully review their leases and the specific language in the underlying royalty clause. If the clause conditions payment of a royalty on all gas “produced” or “used” from the leasehold, a colorable argument could be made that the driller may owe a royalty on any gas diverted for fuel usage downstream from the well meter. This obligation, however, could be limited or negated if the lease contains a “free use” clause. In any event, all landowners should be aware of this fuel gas issue and should regularly review their lease and their corresponding royalty statements.