The Oil and Gas Addendum

For many landowners in Pennsylvania, the receipt of the monthly royalty statement is an ongoing source of frustration and anger. In addition to excessive and unreasonable deductions for post-production costs, landowners are now questioning whether the driller is really making a good faith and legitimate effort to sell the gas at the highest and best price. Royalty statements showing that gas is being sold at $1.15 per MCF (1,000 cubic feet) or even less are becoming more and more common. These prices are well below the reported national averages. Does the landowner have any recourse against a driller who is selling gas below market? Possibly. A recent decision by the United States District Court in Harrisburg suggests that the implied covenant to market gas may be implicated by questionable or artificial royalty pricing.

Before discussing the particulars of this case, a brief primer on implied covenants is warranted. For almost 120 years, Pennsylvania courts have recognized that the conduct of a driller may be governed by certain implied obligations that are not expressly stated in the parties’ lease. In order to promote fairness and “fill in the gaps”, courts will imply certain obligations on the lessee-driller to ensure the interests and rights of the landowner are adequately protected. One of these “implied” obligations is the covenant to actually market and sell the gas.[1] The marketing covenant requires a lessee to use due diligence to market the gas and to obtain the best possible price. The implied duty to market is an obligation imposed upon a lessee to make a “diligent” effort to market the gas in order that the lessor may realize a return on his royalty interest." See, Davis v. Cooper, 837 P.2d 218, 222 (Colo. App. 1992). The covenant implies that if gas is discovered in paying quantities, the well will be operated so as to secure actual production royalties. The covenant requires the lessee to “begin marketing the product within reasonable time” after completion of the well. See, McVicker v. Horn, Robinson & Nathan, 322 P.2d 410 (Okla.1958). In addition to this “timing” component, the covenant also contains a “price” component. When marketing the gas, the driller has an obligation to find and secure the “best current price reasonably available." See, Union Pacific Res. v. Hankins, 111 S.W.3d 69 (Tex. 2003). As one court observed, the “price” component of the covenant “serves to protect a lessor from the lessee’s self-dealing or negligence." See, Yzaguirre v. KCS Res. Inc., 53 S.W.3d 368 (Tex. 2001).

The marketing covenant was first recognized by the Pennsylvania Supreme Court in lams v. Carnegie Natural Gas Co., 45 A. 54 (Pa. 1899). In Iams, the lessee successfully drilled a producing well but neglected to market the gas. The lessor brought suit claiming that the lessee had breached the lease by failing to actually market and sell the gas. On appeal, the Pennsylvania Supreme Court affirmed the jury’s award in favor of the lessor. The lams court upheld the trial court’s instruction to the jury which essentially stated that the lessee, upon producing gas in paying quantities, was under a continuing duty to market the gas and “operate for the common good of both parties." Iams, 45 A. at 55. By adopting and approving this instruction, the Supreme Court recognized an implied obligation to market and sell gas discovered on the leasehold. As illustrated by the recent decision in Canfield v. Statoil USA, et seq. (No. 3:16-0085, Middle District of Pennsylvania, June 12, 2017), the marketing covenant is apparently alive and well in Pennsylvania 118 years later.

In Canfield, the landowner argued that the lessee, Statoil USA Onshore Properties LLC (SOP), breached the lease and the implied covenant by improperly calculating her royalty based on an “index” price as opposed to an actual sales price. Ms. Canfield further argued that the purported sale of gas at the wellhead between SOP and its affiliate, Statoil Natural Gas LLC (SNG), was invalid because it was not an “arms-length” transaction. In her complaint filed on January 15, 2016, Ms. Canfield asserted that SOP breached not only the express royalty clause set forth in her 2008 Lease, but also the implied covenant to market gas. In this latter claim, Ms. Canfield alleged that SOP “had an obligation to use reasonable best efforts to market the gas to achieve the best price available.” Because SOP sold the gas to an affiliate based on an unrelated index price, Ms. Canfield claimed that SOP was not achieving the “best price available.”

The royalty clause in the original 2008 Lease provided as follows:

Lessee … shall pay the Lessor on gas, including casinghead gas and other gaseous substances, produced and sold from the premises fifteen percent (15%) of the amount realized from the sale of gas at the well. “The amount realized from the sale of the well” shall mean the amount realized from the sale of the gas after deducting gathering, transportation, compression, fuel, line loss, and any other post-production costs and/or expenses incurred for the gas whether provided by a third party, Lessee or by a wholly owned subsidiary of Lessee. Lessee is authorized by Lessor to provide gathering, transportation, compression, fuel, and other services for Lessor’s gas either on its own or through one or more wholly owned subsidiaries of Lessee and to deduct from the royalty to be paid to the Lessor the costs and/or expenses of providing such services including, without limitation, line-loss.

In support of her breach of contract claim, Ms. Canfield interposed a rather novel theory. She argued that the royalty clause required SOP to sell the gas downstream from the wellhead. Under this theory, the purported sale to SNG at the wellhead constituted a material breach of the royalty clause. Because the royalty clause expressly authorized the deduction of certain post-production costs, Ms. Canfield theorized that this implicitly contemplated a downstream point-of-sale. In other words, because the clause clearly identified the wellhead as the royalty valuation point, the inclusion of deduction language strongly suggested that the parties intended the “net-back method” would be used to calculate the royalty.[2] According to Ms. Canfield, selling the gas to SNG at the wellhead frustrated this intention and resulted in an artificial royalty calculation.

In response to Ms. Canfield’s complaint, SOP and SNG filed a Motion to Dismiss raising a number of issues. With respect to the royalty clause, SOP and SNG argued that the 2008 Lease required only that the royalty itself be based on the “amount realized” (i.e. proceeds) from the sale of gas and that the royalty paid to Ms. Canfield was, in fact, based on the amounts SOP “realized” from the SNG sale. As such, no breach occurred. SOP further argued that utilizing an index price did not breach the implied covenant to market gas.

With respect to the breach of contract, the District Court granted the defendants’ Motion and dismissed the contract claim. The District Court noted that it had “carefully reviewed the lease and could not find any language indicating that SOP’s sale to third-parties was required to be downstream.” Ms. Canfield’s novel theory was undermined, in part, by the simple fact that the lease addendum contained a clause that specifically prohibited the lessee from taking any deductions for post-production costs. As such, the District Court opined that SOP was actually required to sell the gas at wellhead in order to comply with both the “at the wellhead” language in the original royalty clause and the “no deduction” clause in the addendum: “[W]here the lessee is selling [gas] at the well, the lessee need not incur post-production costs and, therefore, would not be forced to recover those costs in defiance of the [no deduction] clause.” Since SOP sold the gas at the wellhead to SNG and calculated Ms. Canfield’s royalty based on the “amount realized” from said sale, the District Court concluded that no breach of the royalty clause occurred.

The District Court, however, denied the Motion as to the implied covenant claim and allowed that claim to move forward. In assessing the applicability of the covenant, the District Court made an important distinction between a “proceeds” lease and a “market-value” lease. Because the 2008 Lease calculated Ms. Canfield’s royalty based on the proceeds actually received by the lessee, the “price” component of the marketing covenant was implicated. In a “proceeds” lease such as this, the District Court opined that there is more risk of self-dealing or negligence on the part of the lessee and therefore an inquiry into the adequacy of the purported sale price, as well as the efforts made by the lessee to obtain the “best” price, is warranted. “Market-value” leases, which calculate the royalty on the prevailing and local market price at the time of sale, generally do not implicate the covenant. This is because the critical metric (i.e. the market value) is based on objective criteria that are not subject to manipulation or avoidance by the lessee. See, Yzaguirre v. KCS Rec., 53 S.W.3d at 374 (“[B]ecause a market value lease provides an objective basis for calculating royalties, the lessor does not need the protection of an implied covenant to obtain the highest price reasonably available”).

SOP’s reliance on an index-based price in connection with the inter-affiliate sale to SNG further implicated the covenant. The District Court observed that the mere allegation of an inter-affiliate sale will typically not give rise to an implied covenant claim. Here, the inter-affiliate sale was effectuated by using an index-based price which was unrelated to the instant market conditions. Given this allegation, the District Court opined that the inter-affiliate “sale” warranted further scrutiny. In addition, Ms. Canfield alleged in her complaint that the index used by SOP was changed by SOP in 2013. The District Court found this significant: “[A]t this stage, the court cannot conclude that the original hub price or the changed hub price reflected the best current price reasonably available.” In light of the foregoing, the District Court concluded that Ms. Canfield had stated a viable claim for breach of implied covenant to market.

Landowners and drillers alike should closely monitor the Canfield litigation. Readers should be cautioned that the recent ruling by the District court was only a preliminary procedural matter and was not a decision on the merits. Ms. Canfield will now have to marshal evidence demonstrating and proving that the index-based sales price used by SOP was not the highest and best price available for her gas. Nonetheless, the recent Canfield decision illustrates the continued importance and viability of the marketing covenant.

[1] Pennsylvania currently recognizes three implied covenants in oil and gas leases: i) an implied covenant to reasonably develop the leasehold; ii) an implied covenant to protect the leasehold reservoir from drainage due to adjoining operations and iii) an implied covenant to market the gas.

[2] The net-back method is typically used to calculate the value at the wellhead only if the point-of-sale is downstream from the valuation point. See, Kilmer v. Elexco Land Services, 990 A.2d 1147 (Pa. 2010) (“[T]herefore, to calculate the price of the natural gas at the wellhead … we must work backward from the value-added price received at the point of sale by deducting the companies’ costs of turning the gas into a marketable commodity”).