The Oil and Gas Addendum

The processing of natural gas and natural gas liquids 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? The answer often depends on the precise language in the underlying oil/gas lease. A recent decision by the Federal District Court in Houston, however, ignored critical language in the parties’ lease and erroneously concluded that no royalty was owed on the fuel gas volume.

In Carl/White Trust, et al. v. Hillcorp Energy Company, (Southern District of Texas, No. 4:21-CV-02133), the Carl/White Trust (the “Trust”) filed suit against the driller, Hillcorp Energy Company. (“Hillcorp”), alleging that Hillcorp breached the parties’ oil and gas lease by failing to pay a production royalty on the diverted fuel gas. The Trust alleged that Hillcorp 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. The Trust argued that Hillcorp was obligated under the Lease to calculate and pay a royalty on all gas produced from the leasehold. Since Fuel Gas was produced, but not actually sold, the Trust argued that a royalty was nonetheless due on that volume. The Trust further claimed that the “free use” clause in the parties’ Lease was inapplicable because that clause allowed Hillcorp 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. Hillcorp 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 enhanced the value of the residue gas, Hillcorp argued that the Fuel Gas volume was essentially a post-production cost that could be legitimately deducted from the net royalty. Instead of deducting the Fuel Gas volume as a “cost”, Hillcorp simply excluded that volume from the royalty calculation. The United States District Court for the Southern District of Texas agreed with this novel theory and dismissed the Trust’s Complaint.

The issue in Carl 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.3rd 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:

[Gas Royalty Clause] The royalties to be paid by Lessee are: . . . (b) on gas, including casinghead gas or other gaseous substance, 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 well of one-eighth of the gas so sold or used . . .

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, wood and water from said land, except water from Lessors’ wells, for all operations hereunder, and the royalty on oil, gas and coal shall be computed after deducting any so used.

Given this language, the Trust 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, the Trust 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 Hillcorp was using the Fuel Gas volume to power equipment and operations downstream from the leasehold, the Trust contended that a royalty must be paid on that volume pursuant to the royalty clause.

The District Court, however, erroneously concluded that no royalty was due on the Fuel Gas volume because Hillcorp could, theoretically, deduct that same volume as a purported “cost” under the royalty clause. The District Court rationalized that since the Fuel Gas was used in furtherance of downstream processing operations which benefited the Trust, 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. It is respectfully submitted that the District Court’s rationale and reasoning was, and is, flawed and misguided.

The District Court observed that the royalty clause in the underlying lease set the royalty valuation point “at the wellhead”. Given this language, the District Court further observed that when “the location for measuring value is at the wellhead, the work-back method permits an estimation of wellhead value by …subtracting post-production costs incurred between the well and the point-of-sale.” While this is an accurate description of the so-called work-back accounting method[1], the District Court’s reliance on this concept was misplaced. The District Court 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 work-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 District Court 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 Carl decision is troubling news for landowners. The District Court inexplicitly expanded the dubious work-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. Nor does it apply to each and every oil and gas lease. Regrettably, the District Court in Carl used the work-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 work-back method. Fortunately, the Carl 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 courts. This issue is likely to emerge in 2022 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. In the meantime, landowners should carefully review their leases and the specific language in the underlying royalty clause. If the clause conditions payment of a royalty on all gas

“produced” or “used” from the leasehold, a colorable argument could be made that the driller may owe a royalty on any gas diverted for fuel usage downstream from the well meter. This obligation, however, could be limited or negated if the lease contains a “free use” clause. In any event, all landowners should be aware of this fuel gas issue and should regularly review their lease and their corresponding royalty statements.

[1] The work-back or 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 author does not believe that this is a valid assumption.