The Oil and Gas Addendum

Let’s assume you own 115 acres in Greene County, Pennsylvania.  In 2017, you signed an oil and gas lease with ABC Exploration, Inc.  During the negotiations, you agreed that only those post-production costs that actually “enhanced” the value of the raw gas could be deducted from your royalty.  In 2019, you received your first royalty statements from ABC Exploration.   You noticed that the deductions for “gathering” amounted to approximately $0.40 per unit.  The commodity prices in your 2019 royalty statements range from $2.00 per unit to $2.50 per unit.  Now, several years later, the commodity price is $6.00 per MCF. You are pleased and encouraged by this. But yet, the gathering charge reported in your statement remains the same at roughly $0.40 per unit.  Is this static, rcurring charge actually enhancing the value of your gas? Are you getting a better price of gas that your royalty calculation is based on? And why is this gathering charge the same rate month after month while the gas price goes up and down?  As discussed below, many landowners in Pennsylvania are currently experiencing this same phenomenon and are asking these same troubling questions.

Many post-production activities that result in royalty deductions are based on volumetric costs. For example, gas producers typically have long-term gas gathering contracts with pipeline companies. These gas gathering contracts require the gas producer to pay a fixed fee in order to move daily volumes of gas through the gathering system. So, whether the eventual sales price of that gas is $2.00 per unit or $6.00 per unit, the charge to move the gas is based on the volume that was actually moved. In other words, the cost incurred to move that gas is not dependent on the final sales price. The gas producer is paying that same volumetric fee regardless of where the gas is eventually sold and at what sales price.

But, if the post-production costs are not really dependent on the price of the gas, then one has to wonder how those same costs actually “enhance” the value of the gas, as drillers always claim. This is particularly significant for landowners like the one in our example above who have “market enhancement” clauses that only authorize deductions if those costs enhance the value of the gas and result in a better price.

A frequent narrative asserted by drillers is that gas is 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, the volumes of gas that drillers need to sell are rarely sold at the well head as there is generally no competitive market at that location for the volumes that drillers have produced and must sell.  Most shale gas is sold on the interstate pipeline network where there is sufficient demand for the volumes of gas that drillers produce.  Given the lack of any true marketplace at the well head, a strong 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.  

Returning to our example above, let’s assume ABC Exploration has signed a gas gathering contract that allows it to move gas on the Red Gathering System. The Red Gathering System eventually connects with the Big Interstate Pipeline, which is the true marketplace for the gas produced in your area of Greene County. ABC Exploration has no other means to access the Big Interstate Pipeline- all of your gas must move through the Red Gathering System in order to reach the marketplace on the Big Interstate Pipeline. As per the gas gathering contract, ABC Exploration is charged $.40 per unit for that access. When gas was selling for $2.00 per unit just a few years ago, that gathering charge would result in a “net” royalty of approximately $1.60 per unit. According to the drillers’ logic, the $.40 per unit gathering charge enhanced the value of the gas by that amount -even though the royalty was calculated on a price that did not include the $.40 per unit of allegedly enhanced value.

But, consider the same example but with gas now selling for $6.00 per unit because of war in eastern Europe and other geopolitical factors. ABC Exploration is moving the same gas, through the same gathering pipeline (i.e. the Red Gathering System) and paying the same volumetric charge of $.40 per unit for that access.  The deduction of that gathering charge would result in the royalty being calculated on a “net” amount of $5.60 per unit. According to the ABC Exploration’s logic, the $.40 per unit gathering charge also enhanced the value of the gas by that same amount, even though the royalty is calculated on the “net” price of $5.60 per unit that does not include the alleged $.40 per unit of “value enhancing” gathering costs. How is that possible?

It is also unclear how any better price for the royalty owner is received by this gathering charge. Under ABC Exploration’s view of the world, the well head price of the gas today is allegedly $5.60 per unit, which is the $6.00 per unit price received on the Big Interstate Pipeline minus the $.40 per unit gathering charge on the Red Gathering System. ABC Exploration is calculating a royalty based on gas worth $5.60 per unit, after costs have already been deducted. If the royalty is based on the value of the gas at the well head before the alleged value enhancing gas gathering activities, then how do those activities enhance the value of the gas for the royalty owner? If the royalty is based on the value of gas at the well head before gas gathering charges are incurred, and that value is the same thing as the downstream value minus the gathering charges, then why doesn’t ABC Exploration just sell gas at the well head and not incur those charges which do not have any appreciable impact on the value of the gas?

These authors believe that this scheme, whereby gas gathering charges “enhance” value and lead to a “better price” does not pass muster and reveals that, by and large, gas gathering costs do not enhance value or result in better pricing – as explicitly shown by the fact that royalties calculated after such “enhancement” are not even based on the value received after the alleged “enhancement”. In the science world, it is appropriate to view this fixed rate volumetric gathering charge as a “constant” in an experiment. According to the scientific method, in a controlled experiment, the “constant” is something that does not change, while other variables are added to test the hypothesis during the experiment.

Here, the $.40 per unit gathering charge remains the same, while the price of gas fluctuates significantly. That means that the value of the gas is independent of the gas gathering charge and, as a result, that charge cannot be said to enhance the value of the gas or result in a better price. This is because the value of the commodity can, and does, change independently of this fixed charge. Moreover, the cost to access and move the gas through the Red Gathering System is a necessary and required cost of doing business, just as removing the gas from the ground- ABC Exploration cannot sell any gas without moving volumes of gas through the Red Gathering System. When viewed through this lens, it strains credulity to characterize such gathering costs as purported enhancement costs. 

While recent higher commodity prices have hopefully led to increased royalty payments, landowners should continue to pay close attention to post-production cost deductions, particularly those landowners with “market enhancement” royalty clauses. While the ratio of deductions to the overall royalty value may be lower now, that does not mean that it will remain that way and a comparison of deductions now versus just two years ago may reveal that the post-production costs charged against the royalty have little, if anything, to do with the price of the commodity.

The takeaway is this:  Pennsylvania landowners with “market enhancement” clauses should be mindful and wary of any deductions associated with the movement of gas (i.e., gathering or transportation charges).  Unless the gas producer can provide facts and evidence demonstrating that such costs changed or improved the content and quality of the raw gas, an argument can be made that such costs are not really enhancement costs- they are simply necessary costs of doing business that must be incurred in order to actually sell the gas.  As such, they should not be deductible.  See, Mittelstaedt v. Santa Fe Minerals, 954 P.2d 1203 (Okla. 1998) (“…the lessee may not deduct from royalty payments the costs of gathering, transportation, compression, dehydration or blending if those costs are required to create a marketable product…”); Cooper Clark Foundation v. Oxy USA Inc, 469 P.3d 1266 ( Kansas Ctr. App 2020)  (“[W]hen the parties have agreed that the gas will be sold in the interstate market, the gas company cannot deduct expenses required to make the gas marketable for that interstate market”). 

It is submitted that there is a valid and legitimate distinction between a true enhancement cost versus an operational cost.  Unfortunately, gas producers in Pennsylvania routinely ignore this distinction and consider each and every cost an enhancement that can be deducted. Even if the purported cost somehow enhanced the value of the gas, it can only be deducted if that particular cost resulted in the driller getting a better price for the gas.  This means that the sales price at the distant location must be better (i.e., higher) than if the gas was simply sold closer to home with minimal movement costs.  If ABC Exploration could sell its volumes of gas in Greene County for $4.00 per unit with no costs to move gas and decided to sell its volumes of gas in Clarksburg, West Virginia for $4.50 per unit while incurring $.75 per unit in costs, that is not an enhancement or a better price for royalty calculation purposes.

Landowners should carefully review their royalty statements and pay particular attention to the commodity prices reflected in their statements.  If these prices are consistently below nearby index prices but the costs to move the gas remain the same, it is difficult to justify how these movement costs are resulting in better pricing.