The Oil and Gas Addendum

Many Pennsylvania oil and gas leases have what is commonly known as a “market enhancement” royalty clause. These clauses typically prohibit the deduction of any post-production costs that are incurred transforming the raw gas into a marketable product. Once gas is in marketable form, these clauses generally allow the driller to deduct further costs only if those costs actually enhance the value of the gas. Moreover, the enhancement costs must actually result in the driller obtaining a “better” price for the 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 enhancement cost resulted in a better sales price for that volume of gas. This makes sense. Incurring costs and receiving a “worse” price makes no sense. Despite this clear language, drillers often deduct all post-production costs regardless of whether the gas is marketable and regardless of whether the downstream costs actually enhanced the value of the gas.

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, gas is rarely sold at the well head as there is generally no competitive 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.

Drillers further suggest that simply moving gas further away from the well head always increases value. They contend and suggest that better prices are always available the further away you move the gas.  This is not factually or legally accurate.  Remote and distant sales do not always result in a better “net” sales price, or even a better “gross” sales price. Not surprisingly, the purported costs associated with gathering and moving the gas are often the largest deduction in the landowner’s monthly royalty statement.  Landowners should not be required to bear these movement costs unless the costs clearly result in better pricing, taking all costs into account.

Each week, the United States Energy Information Administration publishes a “Natural Gas Weekly Update” on its website. It provides a general snapshot of current natural gas issues and includes “spot pricing” information. While many gas sales are not based on “spot” prices, the weekly bulletin highlights different “spot” prices in diverse markets throughout the country.  Many Pennsylvania royalty owners are familiar with price differentials when they compare the commodity pricing reported in their royalty statements to widely published indices, such as the Henry Hub or the Tennessee Gas Pipeline.

During the record cold-snap this past winter that significantly impacted Texas, natural gas was a very expensive commodity in some markets in that region. But if the mere act of moving gas enhances its value, one would have expected Pennsylvania drillers to have moved as much Marcellus Shale gas as possible to distant markets (i.e., Texas) at that time because, as the drillers’ narrative goes, the value of gas is always and automatically enhanced by simply moving it further away. This did not happen.  The robust market in Texas and the Midwest should have also resulted in Pennsylvania landowners seeing higher commodity prices in their royalty statements. This also did not happen. Why? Because merely moving gas further away does not always enhance value or automatically result in “better” pricing.  It is simply a myth.  Likewise, the hypothesis that moving gas further away from the well head suggested that Texas drillers would have obtained better prices for their gas by moving it to Pennsylvania, versus selling it locally. Market realities clearly show that hypothesis was inaccurate.

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 driller 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 that must be incurred in order to actually sell the gas.  As such, they should not be deductible.  See, Mittelstraedt 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, supra. (“[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, drillers 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. 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.