News

Landowners and Royalty Owners: Beware Of The Market Enhancement Clause

December 16, 2019

By Paul R. Yagelski, Esq.

The oil and gas company through its landman has offered you an oil and gas lease.  The landman tells you that the lease is a gross lease, meaning that your royalty would be based on the proceeds received from the sale of your gas without any post-production cost deductions. To support his statement, the landman points to an addendum to the lease you are offered and a clause therein, entitled, “Market Enhancement Clause.”  The landman indicates that this clause prevents any deductions and makes the lease a gross lease.  If this is the representation that is made to you, this is false!  A market enhancement clause does allow for deductions.

A typical market enhancement clause reads as follows:

Market Enhancement Clause.  It is agreed between the lessor and lessee that, notwithstanding any language contained in the lease to the contrary, all royalties or other proceeds accruing to the lessor under this lease or by state law shall be without deduction, directly or indirectly, for the cost of producing, gathering, storing, separating, treating, dehydrating, compressing, processing, transporting, and marketing the oil, gas and other products produced hereunder, to transform the product into marketable form; however, any such cost which would result in enhancing the value of the marketable oil, gas or other products to receive a better price may be proportionately deducted from lessor’s share of production so long as they are based on lessee’s actual cost of such enhancements.  However, in no event shall lessor receive a price per unit that is less than the price per unit received by lessee.

A plain reading of this paragraph indicates that certain costs are deductible.  Specifically, as the language of the clause indicates, “any such cost which would result in enhancing the value of the marketable oil, gas or other products to receive a better price may be proportionately deducted from lessor’s share of production so long as they are based on lessee’s actual cost of such enhancements.”

Accordingly, if there is a market enhancement clause contained in your lease or addendum, it does not mean that your royalty will be a gross royalty.  It does not mean that there will not be any deductions from your royalty.  Rather, under a market enhancement clause, certain deductions may be taken, but what are these deductions?  First, what cannot or should not be deducted?

A plain reading of the market enhancement clause should indicate that any post-production costs to the point that the gas becomes marketable should not be deducted from your royalty.  This interpretation of the market enhancement clause should be readily obvious from a plain reading of the clause’s language.  The problem that may arise, however, is that the oil and gas company, your lessee, may not interpret the clause this way.  Some oil and gas companies may interpret the market enhancement clause as allowing for the deduction of all post-production costs, as they will argue that all post-production costs enhance the value of the gas.  Accordingly, these oil and gas companies may deduct post-production costs from your royalty both prior to the point that the gas becomes marketable and thereafter.  Based upon the plain language of the market enhancement clause, post-production costs incurred prior to the point that the gas becomes marketable should not be deducted.  Only the post-production costs incurred after the gas becomes marketable, and which enhance the value of the gas such that a better price may be received, should be deducted.

In addition to the plain language of the market enhancement clause, another indication that the interpretation of the clause that only costs incurred after the gas becomes marketable and that enhance the price of the gas is the correct interpretation of the clause is drawn from the language of the lease and addendum taken as a whole.  Specifically, when an addendum is prepared by the oil and gas company, which includes a market enhancement clause, the intent is that this clause will replace the royalty clause in the lease.  The royalty clause in the lease normally allows for the deduction of post-production costs.  Accordingly, to interpret the market enhancement clause as allowing for the deduction of all post-production costs, where the lease already allows for the deduction of post-production costs, does not amend or replace the lease language.  If the market enhancement clause is to be interpreted as allowing for the deduction of all post-production costs, there should be no need to add the market enhancement clause in the addendum as the lease itself provides that post-production costs are deductible.

When you find a market enhancement clause in the oil and gas company’s lease, normally in an addendum prepared by the oil and gas company, the first thing that you need to understand is that the market enhancement clause does allow for the deduction of certain post-production costs.  The market enhancement clause is not a gross royalty clause.  It is not a clause that prevents the deduction of all post-production costs.

The second thing that you need to understand is that your oil and gas company may take the position that all post-production costs are deductible as the oil and gas company may argue that all post-production costs enhance the value of the gas, so a better price may be obtained.  This is not the way the market enhancement clause reads, but this is the way your oil and gas company may interpret the clause.  Accordingly, before you sign a lease, with a market enhancement clause, you should ask the oil and gas company how it interprets this clause.  What post-production costs will be deducted?  Will all post-production costs be deducted?  If not, what costs will be deducted and at what point will these costs be incurred?  If they are incurred after the gas becomes marketable, when or at what point does the oil and gas company consider the gas to be marketable?  If you can, you need to pin this down.  You need to understand when the oil and gas company considers the gas to be marketable, so you will know when the oil and gas company will begin to deduct post-production costs (presumably, these costs will enhance the value of the gas).  In addition, it may be that the point at which the oil and gas company considers the gas to be marketable may not be the correct point.

If you have a market enhancement clause in your lease, when you receive your royalty statement, you need to check to see if any post-production costs have been deducted.  If they have, you need to find out what these costs are (post-production costs may not be specified by type or kind on your royalty statement) and at what point they were incurred.  At what point did the oil and gas company consider the gas to be marketable?  Were the costs incurred before or after the gas was marketable?  If before, the costs should not have been deducted.

Landowners and royalty owners beware of the marketable enhancement clause.  The clause does allow for the deduction of post-production costs.  If post-production costs are deducted, you need to be vigilant as to what post-production costs are being deducted and when they were incurred.  Only those costs that are incurred after the gas is in marketable form and that enhance the value of the marketable oil and gas such that a better price can be received should be deducted.

If you have questions about your royalties or oil and gas lease, contact Paul Yagelski online or at (412) 338-1124.