Federal District Court In Pennsylvania Allows Royalty Claim To Move Forward
Robert J. Burnett is a director and chair of Houston Harbaugh’s Oil and Gas practice. To learn more about our work with landowners and royalty owners, visit our Oil and Gas Law practice page.
As the Marcellus Shale development enters its fifteenth year, drillers are becoming more creative and aggressive in their effort to avoid express lease language that was drafted to prohibit or restrict the deduction of post-production costs. Many landowners sought to insulate their royalties from such deductions by negotiating royalty clauses which either expressly or implicitly designated the royalty valuation point as being at the point-of-sale, as opposed to the well-head. The effect of this subtle yet critical distinction was to preclude application of the so-called “net back” method. Under this method, drillers may deduct costs incurred between the well-head and the downstream point-of-sale. Conversely, when the point-of-sale is designated as the royalty valuation point, drillers are, in theory, prohibited from deducting those intervening costs. This is typically accomplished by drafting a royalty clause which states that the royalty will be paid on the “price paid” to the driller or the “proceeds received” by the driller. In Chambers v. Chesapeake Appalachia, LLC, the Middle District of Pennsylvania recently ruled that the driller breached a similar royalty clause by selling gas to an affiliate at an artificially low price.
The landowners in Chambers owned several hundred acres in Wyoming County, Pennsylvania. In 2007, they entered into identical oil and gas leases with Magnum Land Services (the “2007 Lease”). The royalty clause in the 2007 Lease provided as follows:
“…pay to the Lessor as royalty for the oil, gas, and/or coalbed methane gas marketed and used off the premises and produced from each well drilled thereon, the sum of one-eighth (1/8) of the price paid to Lessee per thousand cubic feet of such oil, gas, and/or coalbed methane gas so marketed and used. Payment of royalty for oil, gas, and/or coalbed methane gas marketed during any calendar month to be on or about the 60th day after receipt of such funds by the Lessee.”
Magnum subsequently assigned the 2007 Lease to Chesapeake Appalachia, LLC (“Chesapeake”) and Equinor USA Onshore Properties (“Equinor”). Thereafter, portions of the leasehold were pooled into the Woolen North Unit and the landowners began to receive royalties from the Unit wells. The landowners were alarmed by the depressed commodity prices referenced in their royalty statements and notified Chesapeake and Equinor of their concerns. These concerns went unanswered and the landowners commenced a lawsuit in January 2018. The landowners interposed a rather novel theory with respect to their royalty claim against Equinor. They argued that the royalty clause required Equinor to sell and market the gas downstream from the well-head. In essence, the landowners suggested that the 2007 Lease imposed an express, non-delegatable duty to market gas. As support for this proposition, the landowners relied on the phrase “so marketed and used” in royalty clause. This language, they argued, created an express obligation on Equinor to move and sell the gas downstream and calculate the royalty based on that downstream sale. Because Equinor “sold” the gas at the well-head to an affiliate (i.e., Equinor Natural Gas or “ENG”), the landowners argued that Equinor was not actually marketing the gas to downstream locations. And because the 2007 Lease did not expressly authorize or contemplate an affiliate performing such downstream marketing, the landowners argued that the well-head transaction between Equinor and ENG was improper and in direct contravention of this alleged duty to market. To add insult to injury, the landowners further alleged that Equinor breached the royalty clause because the royalty itself was not calculated on the “price paid” to Equinor – it was instead based on a published index price unilaterally selected by Equinor and ENG. Since the index price was artificial and not reflective of a true sale or the actual “price paid”, the landowners contended that their royalties were improperly calculated.
In response, Equinor filed a motion to dismiss. Equinor asserted that the landowners’ claim was without merit for two reasons: i) nothing in the 2007 Lease prohibited Equinor from selling the gas to an affiliate at the well-head and ii) Equinor had no express or implied duty to market the gas. With respect to the marketing claim, Equinor pointed out that paragraph 20 in the 2007 Lease specifically disclaimed any implied duty to market: “It is mutually agreed that this instrument contains and expresses all of the agreements and understandings of the parties in regard to the subject matter thereof, and no implied covenant, agreement or obligation shall be read into this agreement or imposed upon the parties or either of them.” While Equinor acknowledged that Pennsylvania law does recognize an implied covenant to market gas, this marketing obligation was negated by the language set forth in paragraph 20. Since Equinor had no implied obligation to move the gas downstream, Equinor further argued that the landowners’ claim could only survive if there was a clear and express marketing obligation set forth in the 2007 Lease. According to Equinor, the language relied upon by the landowners (i.e., “so marketed and used”) created no express marketing duty or obligation: “The phrase ‘marketed and used off the premises’ dates back to very old lease forms to simply clarify that royalty would be owed on gas only if the lessee was able to extract some value from it by selling it or taking it off the lease for processing. It was not intended to impose any marketing duty.”
“More specifically, the phrase ‘marketed and used off the premises’ is intended to distinguish between (a) gas sold, (b) gas used off the premises, and (c) gas used on the premises-as only the first two are royalty bearing.”
“Thus, the phrase ‘marketed and used off the premises’ can be read only to describe the quantum of gas on which royalty is owed – it has nothing to do with value or any implied duty to market”
Since the 2007 Lease contained no express obligation requiring Equinor to move the gas to downstream points of sale, Equinor argued that the well-head transaction was authorized and that utilization of the purported index price was consistent with the parties’ royalty clause. In short, Equinor suggested that by allowing the landowners’ royalty claim to move forward, the court would erode and confuse the century-old distinction between implied and express covenants in oil and gas leases.
The District Court disagreed and entered an order on January 14, 2019 dismissing Equinor’s motion. The District Court opined that the term “marketed” in the royalty clause suggested that the parties intended that the lessee (i.e., Equinor) and not an affiliate would actually sell the gas downstream. This, in turn, imposed on Equinor “a duty to reduce the gas to marketable form and sell it at a price higher than it would command at the well-head…” Under this interpretation, the purported well-head transaction between Equinor and ENG was invalid. In essence, the District Court adopted the landowners’ novel theory by concluding that the mere use of the term “marketed” created an affirmative duty on Equinor to move and sell the gas downstream.
By equating the term “marketed” with an express obligation to market the gas, the District Court may have altered the trajectory of Pennsylvania oil and gas law. Prior to Chambers, landowners who had leases with a disclaimer clause (i.e., paragraph 20) could not assert a breach of the implied marketing covenant when challenging affiliate sales or index-based pricing. Chambers may have changed this. Pennsylvania courts, at least in the Middle District, may now impose an express marketing obligation on drillers if the underlying royalty clause conditions the production royalty on all gas “marketed and used” from the leased premises. Under Chambers, this express marketing obligation requires the driller to actually move the gas downstream and calculate the production royalty on the downstream sale, as opposed to a purported well-head sale to an affiliate. When coupled with the “price paid” language in the royalty clause, this express marketing covenant will erode the dubious applicability of the “net back” method to such leases once and for all. As such, Chambers is a favorable decision for landowners. Landowners and drillers alike should closely monitor the Chambers litigation. Readers should be cautioned that the recent ruling by the District Court was only a preliminary procedural matter and was not a final decision on the merits. The landowners will now have to marshal evidence demonstrating that the index-based sales price used by Equinor was, and is, below market and that Equinor underpaid their royalties. Nonetheless, the recent Chambers decision illustrates the continued importance and viability of the marketing covenant and perhaps reflects a growing willingness on the courts to expand and enlarge the protective sphere of that covenant.  The landowners’ complaint alleged that Chesapeake and Equinor breached two distinct clauses in the 2007 Lease: the pooling clause and the royalty clause. This article addresses only the royalty-related claims.  The Complaint alleged that ENG “actually markets and sells the gas to end users at significantly higher prices…”