The Oil and Gas Addendum

A number of oil and gas leases in the Marcellus Shale region allow a driller to deduct post-production costs after the gas is in “marketable” form. These clauses are known as “market enhancement” clauses. Under a typical “market enhancement” clause, the driller generally cannot deduct the cost of dehydrating, compressing, gathering or processing the untreated gas. This is because those costs are incurred transforming the raw, untreated gas into a “marketable” form. In other words, the costs of moving the gas from the well-pad to the downstream plant where it is dehydrated and processed are not deductible under “market enhancement” clauses. Likewise, because the gas is typically only sold on the interstate pipeline network, the costs of moving the gas to that sales location should also not be deductible. As such, landowners with such clauses argue that the gas is simply not marketable until it has been processed, made pipeline ready and is moved to the interstate pipeline network. Drillers, conversely, argue that the raw gas is “marketable” at the well-pad because some of the gas could hypothetically be used at that location for home heating or used to power and fuel well-pad equipment. Drillers further argue that because there is a limited market for the raw gas at the pad, albeit not a true commercial market, all costs incurred downstream from that location are deductible. The Kansas Court of Appeals recently rejected this expansive and unrealistic theory of marketability and held that the gas is not in “marketable” form until it reaches the interstate pipeline market.  While not binding on Pennsylvania courts, this is good news for landowners with “market enhancement” clauses.

At issue in Cooper Clark Foundation v. OXY USA Inc, 469p.3d1266 (Kansas App. 2020)  were two hundred and forty five (245) oil and gas leases (the “Class Leases”) which concerned approximately one hundred and ninety (190) wells (the “Class Wells”) located  in the Hugoton Field in southwest Kansas.  The Hugoton Field is one of the largest natural gas reservoirs in the United States and has been producing natural gas since 1927. There are approximately 11,000 wells in the Hugoton Field and thousands of miles of pipelines which carry the Hugoton Gas to markets outside of Kansas. The plaintiff, Cooper Clark Foundation( “Cooper”), filed a class-action suit in February 2017 alleging that OXY USA Inc (“OXY”) breached the Class Leases by wrongfully deducting processing costs from the landowners’ royalties. Cooper also alleged that OXY breached the Class Leases by failing to pay royalties on certain volumes of natural gas liquids recovered from the Class Wells.

Cooper alleged that most of the Hugoton gas is sold on the interstate pipeline network. A small amount, less than three percent (3%), is used to heat nearby homes (“House Gas”) or used to power well pad equipment and machinery (“Fuel Gas”).  Cooper further alleged that most of the Class Wells ( i.e. 160 out of 190 wells) simply provided no House or Fuel Gas. According to Cooper, nearly ninety seven percent (97%) of the gas produced from the Class Wells was sent downstream to the processing plant operated by the Amoco Production Company in Ulysses, Kansas ( the “Ulysses Plant”).

At the Ulysses Plant, Amoco extracted three components from the raw gas stream: natural gas liquids (“NGLs”), crude helium and residue gas. Amoco charged an in-house processing fee for its services, retaining twenty-five percent (25%) of the NGLs and fifty percent (50%) of the crude helium. It also charged a separate processing fee for the residue gas. After processing, Amoco delivered the three extracted products back to OXY, less the retained volumes. OXY then sold the individual components across the United States. The residue gas, however, was only sold on the interstate pipeline network.

Cooper’s royalty on the residue gas was reduced by the processing costs incurred by OXY at the Ulysses Plant. OXY argued that the gas was “marketable” at the Class Wells because some volumes were diverted as House Gas or Fuel Gas, thereby establishing a market for said gas. OXY further argued that since the gas the “marketable” at the well, the costs associated with moving the gas downstream to the Ulysses Plant and the costs associated with the actual processing were all deductible under Kansas law. Like the “market enhancement” clauses discussed earlier, Kansas law allows a driller to deduct post-production costs such as gathering and processing once the gas is in “marketable” form. According to OXY, because a small fraction of the gas was used for residential heating and powering equipment at or near the pad, all of the gas produced from the Class Wells was in “marketable” form at the pad locations. Therefore, OXY argued that the downstream processing costs incurred at the Ulysses Plant were deductible from Cooper’s royalty. Cooper disputed and contested OXY’s contention that the gas was “marketable” at the Class Wells.

The trial court certified Cooper’s suit as a class action in 2019.  Thereafter, OXY filed an appeal challenging the certification and arguing that certification was improper because, inter alia, the gas was, and is, “marketable” at the Class Wells. The Court of Appeals rejected OXY’s argument and adopted a market-driven definition of “marketability”. The Court of Appeals found compelling that OXY did not sell any gas at the well- residue gas from the Class Wells was only sold on the interstate pipeline network:  “[A]ll Class Gas was bound for the interstate market and wasn’t of a quality suitable for that market until it was processed. So Class Gas was marketable after processing.” Cooper Clark at 1278. From this finding, the Court of Appeals noted that the concept of marketability must be tied to the actual market for the gas. In other words, the gas must be in a condition that renders it suitable for use in the intended market. Here, the intended market for the Class Wells was the only legitimate commercial market for the gas itself: the interstate pipeline network. As such, the Court of Appeals correctly concluded that the small fraction of gas that was used for residential heating or powering well-pad equipment did not establish or prove an actual commercial market for the residue gas.

In the sum, the Court of Appeals held that when gas will be sold in the interstate market, the driller cannot deduct expenses required to make the gas marketable for that interstate market:

“[O]XY didn't sell any Class Gas at the well; it sold all Class Gas downstream in the interstate market . Until Class Gas was processed, it fell below FERC’s minimum-quality standards for transporting gas in interstate pipelines. So Class Gas wasn’t in a condition suitable for its intended market until Amoco delivered the processed components (now up to FERC standards) back to OXY at the plant”

Cooper Clark at 1277

The author submits that the Court of Appeals reached the correct outcome in Cooper Clark Foundation v. OXY USA Inc. Just because some gas from the Class Wells was used for residential heating or powering equipment at the pad does establish the existence of a commercial market at that location. All gas is usable for some purpose the moment the gas leaves the ground. However, the inquiry must focus on the intended market- what is necessary to make the raw gas suitable for sale in that particular market?  As observed by the Cooper court, most gas must be processed before it is pipeline-ready. And because almost all gas in the Marcellus Shale region, like the Hugoton Field, is sold only on the interstate pipeline network, the raw gas is not “marketable” until it is suitable for those pipelines. As such, it is submitted that Marcellus Shale gas is often not in “marketable” form until it is moved downstream, processed and then delivered to the interstate pipeline sales location. Under most “market enhancement” clauses, the costs associated with moving, processing and transporting the gas should not be deductible. If you have a “market enhancement” clause, you should carefully review and monitor your royalty statements for improper or excessive deductions.