The Oil and Gas Addendum

Deducting fuel costs from landowner royalties continues to be an ongoing and widespread practice. Not only are landowners denied a royalty on the fuel gas volume, but they are also having that same “cost” deducted from their production royalty. This practice of deducing fuel costs must be closely monitored by all landowners.

Let’s assume you signed an oil and gas lease with XYZ Drilling back in 2015. The 2015 Lease provides for a royalty of 17% but values the royalty at the well-head. Your lease allows XYZ Drilling to “use” a portion of the raw gas recovered to “fuel” well-pad operations. XYZ Drilling eventually builds a well-pad on your farm. Shortly thereafter you began to receive royalty payments. You are troubled by the amount of deductions. XYZ Drilling also routinely deducts fuel costs from your royalty. You contact XYZ Drilling to get an explanation. They inform you that the fuel deduction represents that volume of gas consumed at your well-pad, as well at a neighboring pad four (4) miles away. You are frustrated and confused – how can XYZ Drilling deduct fuel costs from your royalty?

The processing of natural gas requires a constant and reliable energy source. Critical operations such as compression, dehydration and fractionation cannot be conducted unless the driller has fuel to power 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 as the power source. Alternatively, a driller may contract for such processing services with a third-party provider and allow the third-party provider to “ use” the raw gas as fuel. In either scenario, the gas is never sold or marketed and is instead consumed as fuel during the processing operations. Is the driller obligated to pay a royalty to the landowner on the volume of raw gas diverted as fuel? Can deducting fuel costs be characterized as an enhancement of the raw gas?

These answers often depend on the precise language in the underlying oil/gas lease. A recent decision by the Texas Court of Appeals in San Antonio, however, ignored critical language in the parties’ lease and erroneously concluded that the practice of deducting fuel costs was authorized.

In Enervest Operating, LLC v. Mayfield, (Court of Appeals – San Antonio, No. 04-21-00337), the landowner (“Mayfield”) filed suit against the driller, Enervest Operating, LLC (“Enervest”), alleging that Enervest breached the parties’ oil and gas lease by failing to pay a production royalty on the diverted fuel gas. Mayfield alleged that Enervest was using a portion of the raw gas produced from the leasehold to power equipment and other facilities located off the property (“Fuel Gas”). No royalty was calculated or paid on this Fuel Gas volume. Instead, Enervest actually deducted that volume as a post-production costs from Mayfield’s royalty.

Mayfield filed suit alleging that Enervest’s practice of deducting fuel costs was a material breach of the parties’ Lease. Mayfield argued that the “free use” clause in the parties’ Lease was inapplicable because that clause allowed Enervest to use gas for fuel only if the operations were physically located on the leasehold. Here, the gathering system and processing facility were located miles away.  Enervest defended on the grounds that no royalty was due on the Fuel Gas volume because the Lease actually authorized the deduction of downstream post-production costs. Since the purported Fuel Gas volume was used to power equipment and operations which allegedly enhanced the value of the residue gas, Enervest argued that the Fuel Gas volume was essentially a post-production cost that could be legitimately deducted from Mayfield’s royalty.

The issue in Enervest was the interplay between two common lease clauses: the royalty clause and 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 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”). See also, Bluestone Natural Resources II, LLC v. Randle, 620 S.W.3^rd 380 (Texas 2021) (“[W]hen a [free use] clause is present in a lease, free-use gas is excluded when calculating the lessor’s royalty on production. The right to freely use gas is often limited to the leased premises…”). 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.

Here, the underlying royalty clause provided as follows:

The royalties to be paid by lessee are … on gas, including casinghead gas and all gaseous substances, produced from said land and sold or used off the premises or in the manufacture of gasoline or other product therefrom, the market value at the mouth of the well of one-eighth of the gas so sold or used, provided that on gas sold at the wells the royalty shall be one-eighth of the amount realized from such sale[.]

The “free use” clause was consistent with the royalty clause, stating that the lessee had free use of gas produced from the leasehold so long as the gas was “used” in connection with operations conducted or performed on the leasehold:

[Free Use Clause] Lessee shall have free use of oil, gas, coal and water from said land, except water from Lessors’ wells, for all drilling operations hereunder, and the royalty shall be computed after deducting any so used.

Given this language, Mayfield acknowledged that the volume of gas used or consumed on the leasehold can be excluded from royalty calculation. Conversely, if gas is used off the leasehold, Mayfield argued that such gas falls outside the parameters of the “free use” clause and triggers a royalty obligation under the royalty clause (i.e., royalty is owed on all gas “produced from said land and sold or used off the premises…”). Since Enervest was using the Fuel Gas volume to power equipment and operations downstream from the leasehold, Mayfield contended that a royalty must be paid on that volume pursuant to the royalty clause.

The Court of Appeals, however, erroneously concluded that no royalty was due on the Fuel Gas volume because Enervest could deduct that same volume as a purported “cost” under the royalty clause. The Court of Appeals rationalized that since the Fuel Gas was used in furtherance of downstream processing operations which allegedly benefited Mayfield, the volume of Fuel Gas should simply be treated as a post-production cost and therefore deducted from the production royalty. This rationale wrongly assumes that all post-production costs automatically enhance the value of the gas stream. See, The Net-Back Method Does Not Result in Better Pricing to Justify Deductions Under Market Enhancement Clauses (October 16, 2021). It is respectfully submitted that the Court of Appeals’ rationale and reasoning was, and is, flawed and misguided.

The Court of Appeals observed that the royalty clause in the underlying lease set the royalty valuation point “at the mouth of the well”. Given this language, the Court of Appeals further observed that when the location for measuring value is at the wellhead, the “sales price must be adjusted to properly calculate the royalty payment.” This “adjustment” is performed via the so-called net-back method and “is made by subtracting the costs of bringing the product to market [the post-production costs] from the sales price obtained at the market.” While this is an accurate description of the net-back accounting method[1], the Court of Appeals’ reliance on this concept was misplaced. The Court of Appeals erred when it failed to recognize that while the “at the well” language may affect the amount of royalty to be paid (i.e., the net royalty due after deducting costs), it does not control or define whether a royalty is, in fact, due and owing on a certain volume of gas. In other words, the “at the well” language and the corresponding application of the net-back method only comes into play when calculating the royalty on a fixed and known volume of gas – it is not a yardstick or metric that identifies or limits the volume of gas upon which a royalty is due and owing. The Court of Appeals failed to appreciate this distinction and compounded this error when it essentially ignored the geographic limitation expressly set forth in the “free use” clause.

In sum, the Enervest decision is troubling news for landowners. The Court of Appeals inexplicitly expanded the dubious net-back method beyond its original and sole purpose: to estimate a well-head value of gas when the underlying lease designates the well-head as the royalty valuation point. It is essentially an accounting mechanism and nothing more. See, Why Is The Driller Deducting Post-Production Costs My Lease Doesn’t Allow? Kilmer v. Elexco Land Services: A Decade Later (June 15, 2020). Nor does it apply to each and every oil and gas lease. Regrettably, the Court of Appeals in Enervest used the net-back method to determine and limit what volume of gas was actually subject to a royalty- that essentially re-wrote the parties’ oil/gas lease. This represents a radical and dangerous expansion of the net-back method. Fortunately, the Enervest decision is not binding or controlling here in Pennsylvania.  

The issue of whether a driller must pay a royalty on fuel gas has not yet been addressed by the Pennsylvania Supreme Court. Nor have Pennsylvania courts addressed whether the practice of deducting fuel costs is consistent with the purported net-back method. These issues are likely to emerge in 2023 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.

[1] The net-back method is based on the assumption that “[o]il and gas production is less valuable at the wellhead because any arms-length purchaser will assume that it will have to incur the costs to remove impurities from the production and transport it from the wellhead…”  See, Randle, 620 S.W.3d at 388.  The Pennsylvania Supreme Court authorized use of the net-back method in Kilmer v. Elexco Land Services, 990 A.2d 1147 (Pa. 2010).  The Kilmer panel theorized that the driller “must work backwards from the value-added price received at the point of sale by deducting the companies’ cost of turning the gas into a marketable commodity.”  Kilmer, 990 A.2d at 1154.  The author does not believe that these are valid assumptions.