As we approach the 20th anniversary of the Marcellus Shale play, one issue remains constant: the ongoing debate over the deduction of post-production costs. Landowners all across Pennsylvania have spent countless hours negotiating royalty clauses that they believed prohibited or, in some cases, limited such deductions. Despite those efforts, drillers keep deducting post-production costs regardless of the actual language in the parties’ oil and gas lease. See, Federal District Court Injects Confusion into Definition of Gross Royalty Under Pennsylvania Law (June 2021).
For example, let’s assume you own 150 acres in Butler County. In 2020, you negotiate a new oil and gas lease with ABC Drilling. Your goal was to negotiate a cost-free royalty. ABC Drilling pushed back on your language but agreed to limit deductions to certain enumerated costs. The landman from ABC Drilling inserts language into the addendum that says only “transportation, compression and dehydration costs” may be deducted. He assures you that only the costs incurred moving the gas on the interstate pipeline network will be deducted. You reluctantly agree and sign the lease. Last week you receive your first royalty statement. The statement shows deductions for “gathering” and “fuel”. This must be a mistake. You call ABC Drilling. They inform you that there is no mistake: the costs to gather and collect the raw gas falls within the transportation deduction authorized by the lease. You politely explain to the ABC Drilling representative that only costs incurred on the interstate pipeline network should be deducted and that “gathering” costs are incurred prior to those interstate pipelines. ABC Drilling ignores your plea and continues to deduct gathering costs from your royalty. You are shocked, angry and confused. Are gathering costs separate and distinct from transportation costs? Does one necessarily include the other? And how can ABC Drilling unilaterally re-write your lease and expand the scope of permissible deductions? See, Texas Supreme Court Issues Troubling Decision in Royalty Dispute (March 2022). A recent decision from the Ohio Court of Appeals addressed the thorny question of whether gathering and transportation costs should be considered one in the same for deduction purposes.
At issue in EAP Ohio LLC v. Sunnydale Farms LLC, et al. (24-CA-0974 Seventh Appellate District, September 11, 2024) were thirteen (13) oil and gas leases that were executed in 2008 and 2009 in Carroll County, Ohio (the “2008 Leases”). The 2008 Leases contained an identical royalty clause which provided as follows:
To pay the Lessor, as royalty for the gas marketed and used off the premises and produced from each well drilled thereon, the sum of one-eighth (1/8) of such gas so marketed and used at the price paid to the Lessee per thousand cubic feet, measured in accordance with Boyles Law for the measurement of gas at varying pressures, on the basis for 10 ounces 14.73 pounds atmospheric pressure at a standard base temperature of 60 degree Fahrenheit without allowance for temperature and barometric variations less any changes for transportation, compression and/or dehydration to deliver the gas for sale. Payment of royalty for gas marketed during any calendar month to be on or about the 30th day after receipt of such funds by Lessee.
EAP Ohio LLC (“EAP”) acquired the 2008 Leases, drilled several shale wells and thereafter paid royalties to the Plaintiffs pursuant to the 2008 Leases. Despite the limitations set forth in the royalty clause, the royalty statements issued by EAP contained multiple “deduct codes” identifying specific post-production costs being charged against the Plaintiffs’ royalty. These “deduct codes” included: compression, dehydration, processing, treating, transportation, fuel and gathering.
In July 2021, the Plaintiffs filed suit alleging a breach of the 2008 Leases. The Plaintiffs averred that the 2008 Leases only authorized three types of deductions: transportation, compression and dehydration. No more, no less. The Plaintiffs argued that the purported “gathering” costs were improper and unauthorized since gathering and transportation are separate and distinct post-production activities. According to the Plaintiffs, the costs incurred to collect the raw gas and move it though the gathering system to the central processing facility could not be deducted as a separate cost. The Plaintiffs argued that the mere movement of gas through any pipeline did not automatically authorize the deduction of that cost. On the contrary, the reference to the transportation in the 2008 Leases referred to a specific mid-stream operation that was different from gathering. Transportation, the Plaintiffs argued, arises out of the movement of gas on the interstate pipeline network, which is an entirely separate and distinct pipeline system than the local gathering pipeline. The Plaintiffs’ theory urged the court to recognize gathering and transportation as separate and distinct costs that are unique to specific pipeline networks and operations.
In addition, even if the gathering costs could be considered a form of transportation, the Plaintiffs nonetheless argued that such costs could not be deducted because they were not incurred “to deliver the gas for the sale.” The Plaintiffs contended that the gathering costs were incurred while moving the gas to the processing plant, not to the eventual point-of-sale. Conversely, the movement of the gas through the interstate pipeline network was delivering the “gas” for sale as most, if not all, gas sales occur on the interstate pipeline network. See, Kansas Court Rules That Gas Is Not Marketable Until It Reaches Interstate Pipeline (August 2020). As such, since there were no buyers or sales points on the gathering pipeline itself, the Plaintiffs argued that the alleged gathering costs were not incurred for the purpose of delivering the gas “for sale”. The deduction code for the gathering costs was therefore improper and a material breach of the 2008 Leases.
In response, EAP argued that the granting clause and the royalty clause in the 2008 Leases both authorized the deduction of gathering expenses as another transportation cost. First, EAP argued that the plain meaning of the term “transportation” encompassed the movement of all gas, regardless of the physical location of the pipeline. According to EAP, the collection of gas and moving it through the gathering network was a form of transportation and, therefore, the costs could be deducted simply as another transportation cost. Second, EAP argued that Ohio regulations define a “gas gathering pipeline” as being “a pipeline used to collect and transport raw natural gas. . .” and further define “transportation of gas” as including the “gathering, transmission or distribution of gas by pipeline. . .” See, R.C. § 4905.90 (D) and Ohio Admin Code § 4901:1-16. Given these statutory definitions, EAP argued that Ohio law recognizes that gathering gas is a form of transportation. Third, EAP argued that Paragraph 1 of the 2008 Lease explicitly granted the lessee the right to construct, install and operate pipelines across the surface for the purpose of gathering the raw gas. Because Paragraph 1 deliberately used the term “transport”, EAP argued that the authors of the 2008 Leases intended that term to have a same meaning in the royalty clause. (i.e. transportation includes gathering). Finally, EAP argued that the Plaintiffs’ reading of the “deliver the gas for sale” clause was misplaced. EAP noted that gathering is simply the first stage of the delivery of gas for sale. And EAP further argued that since “compression” and “dehydration” often occur in connection with the gathering of the gas, the use of the term “transportation” in the royalty clause must be referring to any movement of gas. In essence, EAP urged the trial court to reject any physical limitation on the deduction of transportation costs: any cost incurred while moving the gas can be deducted, regardless of where or when it is incurred.
Both parties moved for summary judgment. The trial court, relying on Webster’s Dictionary, observed that the definition of “transportation” is “an act, process or instance of transporting or being transported. . .” And that the term “transport” means “to transfer or convey from one place to another”. Given these definitions, the statutory definitions under Ohio law and the pipeline rights granted in Paragraph 1 of the 2008 Leases, the trial court opined that the 2008 Leases allowed EAP to pay royalties “less any changes for transportation, including transportation associated with gas gathering.” The trial court granted EAP’s motion and entered judgment in its favor. Plaintiffs promptly appealed to the Seventh Appellate District (the “Seventh District”).
The Seventh District reversed. First and foremost, the panel concluded that the trial court erred by relying on the purported statutory definitions set forth in R.C. §4905.90 and Ohio Admin Code § 4901:1-16. These statutory definitions were not expressly adopted or referenced in the 2008 Leases and, therefore, they could not be relied upon as evidence of what the parties intended in the royalty clause. In addition, the panel further concluded that because the terms “gathering” and “transportation” were not defined in the 2008 Leases, the royalty clause itself was ambiguous and the issue could not be resolved at summary judgment.
The panel found two ambiguities that precluded summary judgment. First, the Seventh District observed that gathering typically describes the collection of gas from multiple wells and funneling it into pipelines “from the wellhead meters directly to central processing or delivery facilities. . .” Conversely, transportation involves “the movement of gas through a pipeline’s principal transmission system.” The panel implicitly concluded that gathering and transportation are functionally and geographically distinct operations. And because of this difference, it was unclear, based on the actual language in the royalty clause, what expenses the lessee could deduct as “transportation”. As such, a genuine issue of fact existed which precluded the entry of summary judgment.
The panel also concluded that the proper application and scope of the phrase “to deliver the gas for sale” was unclear and therefore ambiguous. The Seventh District noted that both parties had proffered two different interpretations of this critical phrase. The panel opined that resolution of the competing factual interpretations is the job for the fact-finder at trial:
“Here, the trial court went to great lengths to conclude the lease provisions are unambiguous. While it declared the provisions are not ambiguous, the court nevertheless relied on extrinsic evidence to support its decision in favor of Appellee and the determination that the term transportation in this case includes gathering, as well as fuel used midstream and not just to the point of sale. The trial court reached conclusions of fact. Thus, we find error.”
The Seventh District remanded the matter back to the trial court for further proceedings.
The result is a mixed bag for landowners. The good news is that the overbroad and expansive reading of the royalty clause was rejected. The trial court essentially re-wrote the royalty clause by unilaterally inserting the word “gathering” as another enumerated deduction. That was unreasonable and improper given the objective differences between gas gathering pipelines and interstate transmission pipelines. See, Jupiter Energy Corp. v. FERC, 482 F.3d 293 (5th Cir. 2007) (”[T]he natural gas industry divides a company’s operations into three functions: production, gathering and transportation”); Northern Nat. Gas Div. of Enron v. FERC, 929 F.2d 1261 (8th Cir. 1991) (transportation of natural gas occurs after gathering in completed); TXO Production Corp. v. Commrs Land Office¸ 903 P.2d 259 (1995) (“. . . the gathering process occurs prior to the product being placed into the purchase’s pipeline”). As such, the author questions the need for remand. The 2008 Leases should not be re-written sixteen (16) years later by expanding the scope of the enumerated deductions. The parties’ decision in 2008 to knowingly and deliberately omit the term “gathering” from the enumerated list of authorized deductions should be honored and enforced as written. See, Ohio Supreme Court Declines to Adopt Blanket ‘At the Wellhead’ Rule (Dec. 2016).
