Federal Appeals Court Rules That Driller Must Establish Marketability of Each Gas Product Under Market Enhancement Clause
Many Pennsylvania oil and gas leases have what is commonly known as a “market enhancement” royalty clause (“MEC”). These MEC leases typically prohibit the deduction of any post-production costs that are incurred transforming the raw gas into a marketable product. Once gas is in a marketable form, the MEC generally allows the driller to deduct further costs only if those costs actually enhance the value of the gas product. Moreover, the enhancement costs must actually result in the driller obtaining a “better” price for the raw gas. In other words, the driller cannot deduct the cost of dehydrating the raw gas and then moving the gas 165 miles away to a distant buyer unless the final net sales price at that location is better than the price the driller would have received selling the gas locally. The driller must show that the purported enhancement cost resulted in a better sales price for that volume of marketable gas. See, Net-Back Method Does Not Result In Better Pricing To Justify Deductions Under Market Enhancement Clause (October 16, 2021). This makes sense. Incurring costs and receiving a “worse” price makes no sense. The key is that no post-production costs are deductible until the gas product is marketable. Despite this clear language, drillers often deduct all post-production costs regardless of whether the gas is in marketable form and regardless of whether the downstream costs actually enhanced the value of the gas product.
A frequent narrative asserted by drillers is that gas is always marketable at the well head and that all costs incurred downstream from the well head necessarily “enhance the value” of the raw gas. This is not accurate. In the Marcellus Shale region, gas is rarely sold at the well head as there is generally no competitive or consistent market at that location. Most shale gas is sold on the interstate pipeline network. Given the lack of any true marketplace at the well head, an argument can be made that the gas is not marketable until the driller moves that gas to the actual marketplace (i.e., the interstate pipeline network). See, Pummill v. Hancock Exploration, LLC, 414 P.3d 1268 (Okla. Ctr. App. 2018) (gas not in marketable form until it reaches the intended market for that gas); Cooper Clark Foundation v. Oxy USA, Inc., 469 P.3d 1266 (Kansas Ctr. App. 2020) (“[T]he concept of marketability is tied to the market for the gas”). As such, the costs incurred dehydrating and moving the gas from the well head to the interstate pipeline network should not be deductible under a typical MEC. See, Kansas Court Rules That Gas Is Not Marketable Until It Reaches Interstate Pipeline (August 7, 2020). Likewise, the cost of processing the gas and separating the heavier hydrocarbons (i.e., natural gas liquids) from the gas stream should not be deductible until each particular “product” is marketable. A recent decision from the United States Court of Appeals for the Fourth Circuit supports this interpretation of the MEC and undermines the drillers’ argument that marketability automatically exists at the well head. This is good news for landowners.
At issue in Corder, et al. v. Antero Resources Corporation, (United States Court of Appeals for the Fourth Circuit, NO. 21-1715, January 5, 2023) were several oil and gas leases in Harrison County and Doddridge County, West Virginia. Several of the leases contained a market enhancement clause (“MEC”) which provided as follows:
“It is agreed between the Lessor and Lessee that, notwithstanding any language herein to the contrary, all oil, gas or other proceeds accruing to the Lessor under this lease or by state law shall be without deduction, directly or indirectly, for the cost of producing, gathering, storing, separating, treating, dehydrating, compressing, processing, transporting, and marketing the oil, gas and other products produced hereunder to transform the product into marketable form; however, any such costs which result in enhancing the value of the marketable oil, gas or other products to receive a better price may be deducted from Lessor’s share of production so long as they are based on Lessee’s actual cost of such enhancements. However, in no event shall Lessor receive a price that is less than, or more than, the price received by Lessee.”
Antero Resources Corporation (“Antero”) acquired the leases and began to operate several wells on the leaseholds (the “Subject Wells”). Raw gas produced from the Subject Wells was collected and moved via a pipeline gathering system to one of two larger pipelines: i) the ETC Bobcat Pipeline, an interstate pipeline that moved the unprocessed gas to downstream markets or ii) a processing pipeline that moved the unprocessed gas to the Sherwood Gas Processing Plant owned by MarkWest Liberty Midstream (the “Sherwood Plant”). Gas transported to the Sherwood Plant was then processed into natural gas liquids (“NGLs”). The NGLs, known at this stage as “Y-Grade”, were either sold in that form at the Sherwood Plant or sent to MarkWest’s fractionation plant in Pennsylvania. The fractionation plant converted the Y-Grade into other products such as ethane, propane and butane. The separation of the raw gas at the Sherwood Plant also produced residue gas, which was predominantly methane. The processed residue gas was then moved via other pipelines to downstream points-of-sale.
Antero deducted two types of post-production costs from the landowners’ royalty. The first cost, known as “PRC2”, consisted of expenses associated with the processing, fractionation and transportation of the NGLs. The second cost, known as “TRN3”, represented the costs Antero incurred moving the processed residue gas to downstream markets. Antero claimed that it only deducted these costs if the transportation and movement of said gas enhanced value and resulted in better pricing.
The landowners disputed the deduction of the PRC2 and TRN3 costs and filed suit in December 2017. The suit asserted a number of claims based on a breach of the underlying MEC. Both Antero and the landowners filed cross-motions for summary judgment in May 2021.
Antero argued that since the unprocessed gas was marketable at or near the well head, all costs incurred downstream from this location, including PRC2 and TRN3, were enhancement costs and therefore deductible under the MEC. Antero essentially argued that the phrase “oil, gas and other products produced hereunder” in the MEC referred to the same product: unprocessed gas. Because that “product” was theoretically marketable prior to processing, the cost of moving the raw gas stream to the Sherwood Plant and processing the same was deductible. The district court disagreed and concluded that the MEC itself was ambiguous because it did not identify “the products from which” Antero could deduct costs. As such, the district court entered judgment in favor of the landowners on liability but ruled issues of fact remained as to damages. Antero appealed to the Fourth Circuit.
On appeal, the Fourth Circuit disagreed with the district court and ruled that the MEC was not ambiguous. At first glance, this was not great news for the landowners. However, the Fourth Circuit also rejected Antero’s broad interpretation of the MEC and remanded the matter back to the district court for further proceeding. The logical and rationale espoused by the Fourth Circuit is arguably encouraging for landowners.
The Fourth Circuit focused on the phrase “oil, gas and other products produced hereunder” in the MEC. As noted earlier, Antero argued that the phrase must be read as referring to a single product from the Subject Wells: unprocessed gas. In other words, under Antero’s interpretation, the NGLs were simply another “form” of the unprocessed gas. Since the unprocessed gas was marketable at or near the well head, all costs incurred downstream from this location, including those costs incurred manufacturing the NGLs at the Sherwood Plant, were deductible.
Conversely, the landowners argued that each “product” identified in the clause (i.e., oil, gas and “other products”) must be in a marketable form before any costs associated with that product can be deductible. The landowners asserted that the NGLs were a separate and distinct “other product.” Under the landowners’ logic, since the NGLs did not even exist as a marketable product until the fractionation process was completed in Pennsylvania, none of the NGL processing costs were deductible. In essence, the landowners argued that the costs to process and fractionate the gas were not enhancement costs: they were costs necessary to transform the gas into another marketable product (i.e., the NGLs). Those costs are not deductible under the MEC. The Fourth Circuit agreed with the landowners’ logic and observed that the MEC:
“…is not concerned with when ‘gas’ first reaches a marketable form, but rather when the particular gas product sold does.”
The Fourth Circuit vacated the district court’s ruling and remanded the matter with specific guidelines:
“…the finder of fact will need to determine which products Antero sold during the relevant time frame, when those products became marketable and whether Antero incurred the PRC2 and TRN3 costs before or after that point.”
This author submits that the Fourth Circuit made the right call here. Although vacating the district court’s entry of summary judgment could be viewed as a “loss” for the landowners, the reasoning and rationale adopted by the Fourth Circuit is more important. The Fourth Circuit correctly rejected and repudiated the driller’s narrative that gas is always marketable at the well head. See, Market Enhancement Clauses in Pennsylvania After Dressler Family LP v. PennEnergy Resources, LLC (October 25, 2022). On the contrary, a determination of marketability is fact intensive and is not subject to a “one size fits all” mentality. Although not binding on Pennsylvania courts, the Corder decision provides a logical and persuasive framework for MEC cases here in the Commonwealth.
Oil and gas development can present unique and complex issues that can be intimidating and challenging. At Houston Harbaugh, P.C., our oil and gas practice is dedicated to protecting the interests of landowners and royalty owners. From new lease negotiations to title disputes to royalty litigation, we can help. Whether you have two acres in Washington County or 5,000 acres in Lycoming County, our dedication and commitment remains the same.
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