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The Market Enhancement Clause – Be Careful How You Word It

By Paul R. Yagelski, Esquire

Does a market enhancement clause require the producer to show that its deductions resulted in a net increase in the value of the oil and/or gas or other products produced from the leased premises in order that post-production costs may be deducted?

In Tennant v. Range Res.-Appalachia, LLC, 2021 U.S. Dist. LEXIS 17940 (W.D. Pa. September 21, 2021), Plaintiffs James S. Tennant and Sara J. Tennant (the “Tennants”) and John W. McIlvaine and Alica L. McIlvaine (the “McIlvaines”) claimed that Defendant Range Resources-Appalachia, LLC breached certain oil and gas leases between the parties by failing to demonstrate that post-production costs deducted from their royalty payments resulted in a net increase in the value of gas produced under those leases.

The Tennants owned the oil and gas underlying 99.15625 acres in Washington County, Pennsylvania.  The McIlvaines owned the oil and gas underlying two parcels of property in Washington County: a 22.6487 acre parcel and a 29.98 acre parcel.  On September 10, 2013, Plaintiffs entered into identical oil and gas leases with Defendant covering the Tennant property, the McIlvaine 22 acre property and the McIlvaine 29 acre property (collectively, “the Leases”).  The Leases contained a royalty clause pursuant to which Defendant agreed to pay Plaintiffs “[f]or gas and other hydrocarbons produced with gas . . . as royalty for the gas, saved and sold from the Leased Premises, eighteen percent (18%) of the net amount realized by [Range] for the sale and delivery of such gas.”  The royalty clause authorized the deduction of Plaintiffs’ pro-rata share of certain specified post-production costs.

Each Lease contained an Addendum specifying that, in the event of any inconsistency between the terms and conditions in the Lease and those in the Addendum, “the provisions of the Addendum shall prevail and supersede the inconsistent provisions of the main body of this [L]ease.”  The Addendum contained the following royalty clause which addressed the applicability of post-production costs to royalty payments:

The royalties payable to Lessor hereunder shall never be charged with any part of the costs and expenses for exploration, drilling, development, production, storage, processing, compressing, marketing or transportation to the point of sale of the production from the leased premises, except that Lessor’s royalty shall bear its proportionate share of any severance, ad valorem, windfall profits or other excise taxes attributable to the production of oil and/or gas from the leased premises; provided, however, that any expense incurred by Lessee for the purpose of enhancing the value of the oil and/or gas or other products produced from the leased premises, or any property pooled therewith, to receive a better price and any deductions from price or volumes for processing, compressing, marketing or transportation by a purchaser of the production from the leased premises may be deducted from the Lessors’ share of production so long as such deductions are based upon the Lessee’s actual cost of such enhancements or charges.  These deductions shall only be charged to the Lessor if they result in a net increase in the value of the oil and/or gas or other products produced from the leased premises, or any property pooled therewith.  It is the intent to ensure that the Lessors receive a price that is not less than, or more than, the price received by Lessee including all enhancements received by Lessee less any charges and deductions made by a purchaser.

Defendant placed the Tennant property and the McIlvaine properties into certain drilling units.  Based on the production from those drilling units, Defendant made royalty payments to Plaintiffs.  Defendant provided Plaintiffs with royalty statements accompanying the payments, which showed the deductions of certain post-production costs for transportation, gathering, processing, firm capacity and purchased fuel.  Plaintiffs, however, claimed that the royalty statements did not contain any “identification, demonstration or proof that any of the assessed ‘deductions’ resulted in a ‘net increase’ in the value” of the gas to substantiate the deductions.  Plaintiffs claimed that Defendant breached its contractual obligations under the Leases by deducting post-production costs without demonstrating that said costs resulted in a net increase in the value of the produced hydrocarbons.  Consequently, Plaintiffs alleged that Defendant’s deductions of post-production costs were improper and unauthorized by the Addendum and damaged Plaintiffs.  Plaintiffs’ deposition testimony confirmed that their breach of contract claim was premised on Defendants’ alleged duty to demonstrate to them that post-production costs deducted from their royalty payments resulted in a net increase in the value of the gas produced and that Defendant failed to show the same.

In deposition testimony, Plaintiff, John McIlvaine, conceded that there were no words in the Addendum that said that Defendant must prove that the post-production costs reflected in the royalty payments resulted in a net increase of the value of the gas produced under the Leases.  When asked whether there was anything in the words of the Lease that required Defendant to show him a net increase on any particular form or royalty statement or anywhere, Plaintiff McIlvaine responded, “[n]ot to my knowledge.”  Defendant McIlvaine admitted that there are “no expressed words” in the Lease that put the burden on the Defendant to demonstrate to Plaintiffs that it enhanced the value of the gas, but suggested, “It’s implied.”  Finally, Defendant McIlvaine testified that he did not have any evidence that the post-production costs deducted from the royalty payments did not result in a net increase in the value of the gas produced under the Leases.  Mr. and Mrs. Tennant likewise testified that they did not have any such evidence.

Plaintiffs filed a Partial Motion for Summary Judgment and supporting brief, arguing that Defendant’s liability was clear.  Defendant had deducted post-production costs without showing – or being able to demonstrate – that the deductions were authorized under the Addendum.  Plaintiffs repeatedly asserted that the Defendant had not demonstrated that various post-production costs were proper under the Addendum.

Defendant argued in its own Motion for Summary Judgment that it had no duty to demonstrate that post-production costs reflected in Plaintiffs’ royalties resulted in a “net-increase” in the value of gas produced under the Leases because no such contractual duty existed.  Accordingly, Defendant contended that Plaintiffs’ breach of contract claim failed as a matter of law.

In addressing the parties’ claims, the court went immediately to the plain language of the Addendum.  The Court stated that the case was a case about contract interpretation, and  Pennsylvania’s Supreme Court has recognized that an oil and gas lease “is in the nature of a contract and is controlled by principles of contract law.”  T.W. Phillips Gas & Oil Co., v. Jedlicka, 42 A.3d 261, 267 (Pa. 2012).  Accordingly, the Leases had to be construed in accordance with the terms of the agreements as manifestly expressed, and the accepted plain meaning of the language used, rather than the silent intentions of the contracting parties, determined the construction to be given the agreement.  Hall v. C.N.X. Gas Co., 137 A.3d 597, 601 (Pa. Super. Ct. 2016).

In reviewing the language of the Addendum, the District Court found that the language of the Addendum was clear and unambiguous; it did not impose upon Defendant a duty to demonstrate that post-production costs deducted from Plaintiffs’ royalty payments resulted in a net increase in the value of the gas produced under the Leases.  There was simply nothing in the plain language of the Addendum that imposed such an obligation.  Defendant McIlvaine, who was a lawyer and negotiated the Leases on behalf of Plaintiffs, acknowledged that there were no words in the Addendum that said that Defendant must prove that post-production costs reflected in the royalty payments resulted in a net increase in the value of the gas produced under the Leases.  To underscore this point, Defendant McIlvaine also responded in his deposition testimony, “[n]ot to my knowledge” when asked whether there was anything in the words of the Lease that required the Defendant to show him a net increase on any particular form or royalty statement or anywhere.

Given that the plain and unambiguous language of the Addendum did not impose on Defendant a duty to demonstrate that the post-production costs deducted from Plaintiffs’ royalty payments resulted in a net increase in the value of the gas produced under the Leases, the Court found that it was impossible for Range to have breached the Leases.  Consequently, the Court held that Plaintiffs could not establish their breach of contract claim as pled in their Complaint.  The Court found that Plaintiffs’ breach of contract claim failed as a matter of law and entered summary judgment in favor of Range.

The outcome in Tennant may have been different if the Leases had contained a phrase or words that said Defendant had the obligation to demonstrate that its costs resulted in a net increase in the value of the leased hydrocarbons; however, the Leases did not contain such language.

In addition to the breach of contract claim, Plaintiffs contended that there was an implied duty or obligation for the Defendant to demonstrate or substantiate deductions for post-production costs; however, this contention was undercut by the fact that the breach of contract claim in Plaintiffs’ complaint was not premised on a breach of any alleged implied duty.  Whether or not there is such implied duty in Pennsylvania, the Court found that such a breach of implied duty had not been put in Plaintiffs’ complaint.

If an owner of oil and gas is seriously considering accepting a market enhancement clause in an addendum, the language has to be carefully examined.  If the owner of the oil and gas wishes to have a provision in the addendum to the effect that the producer has to demonstrate or substantiate that the deductions for post-production costs enhanced the value of the gas before the deductions can be taken, such language should be inserted in the clause.  Otherwise, if the oil and gas owner believes that there has been a breach of the market enhancement clause in that deductions for post-production costs were taken that should not have been taken, the owner is left to a breach of contract action in which the allegations would be, inter alia, to the effect that the producer breached the contract as the deductions did not enhance the value of the gas such that they should not have been deducted from the royalty payment paid to the owner of the oil and gas.  The owner of the oil and gas would then have to demonstrate through discovery that the deductions did not enhance the value of the gas.

If you have an oil and gas lease that needs to be reviewed, contact us online or call (412) 338-1124.