The Oil and Gas Addendum

Let’s assume that you own 125 acres in Tioga County.  In 2017, you negotiate a new oil and gas lease with XYZ Drilling.  During the negotiations, you insist on a “gross royalty” which prohibits the deduction of post-production costs.  The landman for XYZ Drilling assures you that the proposed royalty clause will prohibit deductions.  He suggests the following royalty clause:  “15% of the gross proceeds received from the sale of gas sold at the well…”  Based on his representations, you sign the lease.  Three years later you receive your first royalty statement.  Your excitement is soon replaced with shock and anger.  The royalty is reduced by significant deductions for gathering, compression and processing.  You call XYZ Drilling and they simply say that deductions are permissible because the “at the well” language automatically negates the “gross royalty” component and therefore authorizes all deductions.  You are frustrated and confused – how can this be possible?  A recent decision by the Pennsylvania Superior Court suggests that XYZ Drilling’s interpretation of the royalty clause is incorrect and that the deductions may not, in fact, be authorized.

At issue in Dressler Family, LP v. PennEnergy Resources, LLC, 276 A.3d 729 (Pa Super. Ct 2022) was a 2007 oil and gas lease concerning acreage located in Connoquenessing and Lancaster Townships in Butler County (the “2007 Lease”).  The royalty clause in the 2007 Lease provided as follows: 

Lessee covenants and agrees to pay Lessor as a royalty for the native gas from each and every well drilled on said premises producing native gas, an amount equal to one-eighth (1/8) of the gross proceeds received from the sale of the same at the prevailing price for gas sold at the well, for all native gas saved and marketed from the said premises, payable monthly.

From January 2012 through December 2015, the operator, R.E. Gas Development (“Rex”), issued monthly royalty statements to Dressler LP (“Dressler”) averaging approximately $35,000 for hydrocarbons produced from the Leased Premises.  In May 2015, Rex informed Dressler that it was retroactively going to collect, through offsets from future royalties, certain electric and processing costs Rex incurred prior to April 2014.  In addition to these costs, Rex had been deducting other post-production costs as well.  The deductions reduced Dressler’s net royalty from an average of $35,000 per month to approximately $7,800 per month.  In June 2017, Dressler filed suit against Rex alleging a breach of the 2007 Lease.

Dressler’s claim was two-fold:  i) there was no express provision in the 2007 Lease that authorized or permitted the deduction of any costs, and ii) the term “gross proceeds” meant that the royalty was to be based on the gross sales price received by Rex, without any deductions or adjustments.  Dressler further argued that although the royalty clause in the 2007 Lease referred to “gas sold at the well”, no gas was ever sold at the well so this qualification was irrelevant and immaterial to the royalty calculation.  In July 2020, Dressler filed a motion for summary judgment and requested that the trial court enter judgment in its favor on the deduction issue.

In October 2020, Rex’s successor, PennEnergy Resources, LLC (“PennEnergy”), filed a cross-motion for summary judgment. PennEnergy argued that the interpretation of the 2007 Lease was controlled by the Pennsylvania Supreme Court’s 2010 decision in Kilmer v. Elexco Land Services, 990 A.2d1147(Pa2010).  Under Kilmer, Penn argued, drillers can utilize the “net back method” when calculating royalties, which allows the deduction of post-production costs incurred between the well-head and the downstream sales.  PennEnergy urged the trial court to adopt a broad and sweeping application of Kilmer, essentially arguing that Kilmer allowed drillers to “net back” (and thus deduct) post-production costs regardless of the actual language in the parties’ lease.  PennEnergy justified this expansive reading of Kilmer on the notion that “post-production costs add significant value [to the gas]…by enabling the gas to be sold for a higher price….”  PennEnergy further argued that under Kilmer, the “at the well” language in the 2007 Lease automatically negated the “gross proceeds” clause.

In April 2021, the Court of Common Pleas of Butler County granted PennEnergy’s motion and entered judgment in favor of PennEnergy.  In so ruling, the trial court concluded that the “at the well” language in the royalty clause was clear and unambiguous and, therefore, deductions were authorized.  The trial court, however, acknowledged that the royalty clause contained contradictory terms:

“[I]t may first appear that the phrasing in Section 2(b) of the Lease causes a contradiction because the term “gross proceeds” means an amount without deductions for costs, whereas “at the well” contemplates deductions.  However, upon close review of the language utilized, the royalty provision of the Lease is subject only to one reasonable construction.  The prevailing price for gas sold at the well must be determined first, and then that full amount, without any further deductions, is the amount used to calculate the 1/8^th portion paid to the Lessor as a royalty”

The trial court then reasoned that since no gas was ever sold at the well, PennEnergy was required to ascertain the market value at the well by utilizing the “net-back method” sanctioned by Kilmer.  In other words, PennEnergy could deduct costs incurred between the actual downstream point-of-sale and the well-head to arrive at a fictional well-head price:

“[T]hus, it is necessary to make adjustments to the sales price of the gas by deducting post-production costs to establish the prevailing price for gas sold at the well.”

Since the 2007 Lease itself did not expressly authorize or permit any deductions or the use of the “net back method”, Dressler filed an appeal to the Pennsylvania Superior Court.  In a much anticipated decision, the Pennsylvania Superior Court reversed the trial court on April 29, 2022.

First and foremost, the Superior Court disagreed with the trial court’s conclusion that the royalty clause was clear and unambiguous.  The panel opined that because no gas was, in fact, sold at the well, this created a latent ambiguity in the royalty clause.[1]  In addition, the panel noted that the reference to “gross proceeds” in the royalty clause was at odds with the meaning typically ascribed to the “at the well” language by the gas industry. In other words, the term “gross proceeds” suggests no deductions are authorized while the “at the well” language encourages deductions under the “net back method” espoused by the Kilmer decision.  These two terms, the panel observed, have “very opposite meaning”. As such, the panel ruled that the trial court erred when it ignored this ambiguity and simply concluded that the “at the well” language controlled.  The Superior Court therefore reversed the entry of summary judgment and remanded the matter to “determine the proper meaning” of the royalty clause:

“[W]e note that on remand, the trial court may consider, inter alia, whether it should apply the accepted meanings, in the oil and gas industry of ‘gross proceeds’ and ‘at the well’; the contractual intent of the original lease parties who executed the Lease in 2007; whether gas was ever sold at the wellhead under this Lease; the subsequent conduct or course of performance of [the prior lessee] in not deducting post-production costs for eight years from 2007 to 2015; and any other factors advocated by the parties…”

The author submits that the Superior Court’s decision was correct and is consistent with other jurisdictions that have confronted similar royalty clauses. As the Texas Supreme Court once observed, “there is an inherent, irreconcilable conflict between ‘gross proceed’ and ‘at the wellhead’ in arriving at the value of gas”, See, Judice v. Mewbourne Oil Co., 939 S.W.2d 133 (Tex. 1996).  The Texas Supreme Court has further observed that such a conflict renders the royalty clause ambiguous. See, Bluestone Natural Resources v. Walker Murray, 620 S.W. 3d 380 (Tex. 2021)(“…..the joinder of the terms ‘gross proceeds’ and ‘at the wellhead’ gives rise to an inherent conflict that renders a royalty clause ambiguous”).  When the royalty is to be based on the ‘gross proceeds’ or the ‘amount realized’, the purported “net back method” is inapplicable and no deductions are typically authorized or permitted. See, Burlington Resources v. Texas Crude Energy, 573 S.W. 3d 198 (Tex. 2019) (under a proceeds clause, the landowner is granted “the right to a percentage of the sale proceeds with no adjustment for post-production costs”); See also, Chesapeake Exploration LLC v. Hyder, 483 S.W.3d 870 (Tex. 2016)(noting that under a proceeds lease, “the price-received basis for payment in the lease is sufficient itself to excuse the lessors from bearing post-production costs”); Warren v. Chesapeake Exploration, 759 S.W.3d 690 (Tex. 2008)(stating that an “amount realized” clause, standing alone, will create a royalty interest free from post-production costs).  Recognizing the critical difference between a ‘gross proceeds’ clause and a ‘at the well’ clause, the Dressler panel correctly ruled that such terms are inconsistent and contradictory when set forth in the same royalty clause.  This is good news for Pennsylvania landowners.

[1] A latent ambiguity is created by extrinsic or collateral circumstances. If a latent ambiguity is present, parol evidence is admissible to ascertain the intent of the parties.