Claim Based on Covenant to Market Gas to Move Forward in Texas Class Action

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.

For many landowners in Pennsylvania, the receipt of the monthly royalty statement is an ongoing source of frustration and anger. In addition to excessive and unreasonable deductions for post-production costs, landowners are now questioning whether the driller is really making a good faith and legitimate effort to sell the gas at the highest and best price. Royalty statements showing that gas is being sold at $1.15 per MCF (1,000 cubic feet) or even less are becoming more and more common. These prices are well below the reported national averages. Even more troubling is the variance in price between different producers in the same county or township. How can ABC Drilling sell its gas for $2.50 per MCF while XYZ Drilling, who is operating a well pad only several miles away from ABC Drilling, sell its gas for only $1.09 per MCF? Does the landowner have any recourse against XYZ Drilling? Possibly. A recent decision by the Fifth Circuit Court of Appeals suggests that drillers have an implied duty and obligation to obtain the highest and best price when selling gas.

Before discussing the particulars of this case, a brief primer on implied covenants is warranted. For almost 120 years, Pennsylvania courts have recognized that the conduct of a driller may be governed by certain implied obligations that are not expressly stated in the parties’ lease. In order to promote fairness and “fill in the gaps”, courts will imply certain obligations on the lessee-driller to ensure the interests and rights of the landowner are adequately protected. One of these “implied” obligations is the covenant to actually market and sell the gas.[1]

The marketing covenant requires a lessee to use due diligence to market the gas and to obtain the best possible price. The implied duty to market is an obligation imposed upon a lessee to make a “diligent” effort to market the gas in order that the lessor may realize a return on his royalty interest.” See, Davis v. Cooper, 837 P.2d 218, 222 (Colo. App. 1992). The covenant implies that if gas is discovered in paying quantities, the well will be operated so as to secure actual production royalties. The covenant requires the lessee to “begin marketing the product within reasonable time” after completion of the well. See, McVicker v. Horn, Robinson & Nathan, 322 P.2d 410 (Okla.1958). In addition to this “timing” component, the covenant also contains a “price” component. When marketing the gas, the driller has an obligation to find and secure the “best current price reasonably available.” See, Union Pacific Res. v. Hankins, 111 S.W.3d 69 (Tex. 2003). As one court observed, the “price” component of the covenant “serves to protect a lessor from the lessee’s self-dealing or negligence.” See, Yzaguirre v. KCS Res. Inc., 53 S.W.3d 368 (Tex. 2001). Under this prong of the marketing covenant, the task for the court is to “determine the price a reasonably prudent operator would have received at the wellhead.” See, Bowden v. Phillips Petroleum, 247 S.W.3d 690 (Tex. 2008).

The marketing covenant was first recognized by the Pennsylvania Supreme Court in Iams v. Carnegie Natural Gas Co., 45 A. 54 (Pa. 1899). In Iams, the lessee successfully drilled a producing well but neglected to market the gas. The lessor brought suit claiming that the lessee had breached the lease by failing to actually market and sell the gas. On appeal, the Pennsylvania Supreme Court affirmed the jury’s award in favor of the lessor. The Iams court upheld the trial court’s instruction to the jury which essentially stated that the lessee, upon producing gas in paying quantities, was under a continuing duty to market the gas and “operate for the common good of both parties.” Iams, 45 A. at 55. By adopting and approving this instruction, the Supreme Court recognized an implied obligation to market and sell gas discovered on the leasehold.

In light of widespread landowner concerns over post-production costs and royalty pricing, the scope of this implied covenant may be expanding. As illustrated by the recent decision in Seeligson, et al. v. Devon Energy Production Company, No. 17-10320 (United States Court of Appeals, Fifth Circuit – October 16, 2018), an express marketing clause in an oil and gas lease may trigger the same obligation and duty to obtain the highest and best price for the produced gas products. This represents a potentially significant expansion of the marketing covenant and may provide landowners with another valuable tool to challenge questionable royalty pricing.

In Devon, the plaintiffs sought to certify a class action comprising of royalty owners who had their royalty payments reduced by the lessee, Devon Energy Production Company (DEPCO). DEPCO operated several thousand horizontal wells in the Barnett Shale region in East Texas. These wells were serviced by a network of pipelines known as the Bridgeport Gathering System (the Bridgeport System). The Bridgeport System collected gas from the DEPCO wells and transported the gas to a processing plant known as Bridgeport Gas Processing Plant (the Bridgeport Plant). At the Bridgeport Plant, the “wet” gas was processed into natural gas liquids (NGLs) and dry residue gas. Both the Bridgeport System and the Bridgeport Plant were owned and operated by Devon Gas Services (DGS), an affiliate of DEPCO.

At issue in the Devon litigation was the 2005 Gas Purchase and Processing Agreement (the GPPA) between DEPCO and DGS. Under the terms of the GPPA, DEPCO allegedly sold “wet” gas from the wells to DGS: i) at the wellhead and ii) for a purchase price of 82.5% of the “published industry index value of the residue gas.” According to the plaintiffs, the GPPA was nothing more than a shame transaction. The plaintiffs alleged that DEPCO never sold the gas at the wellhead and DGS never transferred funds to DEPCO. Instead, the gas was simply transported to the Bridgeport Plant where DGS “charged” DEPCO a processing fee of 17.5%. The plaintiffs contended that this processing fee was then passed on to the royalty owners when DEPCO automatically reduced the purported wellhead price by 17.5%. The plaintiffs argued that DEPCO’s practice of unilaterally reducing the wellhead price by 17.5% breached the implied duty to obtain the highest and best price for the produced gas products. As a result of this manufactured and artificial wellhead price, all class plaintiffs received lower royalty payments.

In determining whether a class action was appropriate, the District Court for the Northern District of Texas had to decide whether the express marketing clause in the class leases precluded application of any implied marketing covenant. It is well-settled that implied covenants, such as the marketing covenant, only apply if the parties’ oil and gas lease is silent on that particular topic. See, Aye v. Philadelphia Co., 44 A. 555 (Pa. 1899) (“Where the parties have expressly agreed on what shall be done, there is no room for the implication of anything not so stipulated for”); Harris v. Ohio Oil Co., 48 N.E. 502 (Ohio 1897) (“The implied covenant arises only when the lease is silent on the subject”). In Devon, DEPCO argued that some of the class leases expressly addressed the marketing of gas and therefore no class-wide claim based on a breach of the implied covenant could be advanced. As such, DEPCO argued that the class action could not be certified. The marketing clause in some of the class leases provided as follows:

“Lessee covenants and agrees to use reasonable diligence to produce, utilize, or market the minerals capable of being produced from said wells, but in the exercise of such diligence, lessee shall not be obligated to install or furnish facilities other than the well facilities and ordinary lease facilities of flow lines, separator, and lease tank, and shall not be required to settle labor trouble or to market gas upon terms unacceptable to lessee.”

The District Court held that the duty imposed by the express marketing clause (i.e., the duty to use “reasonable diligence”) was identical to the implied duty to act as a “reasonably prudent operator” when marketing the gas. This, in turn, meant that the express marketing clause also required DEPCO to “obtain the best current price reasonably available.” On appeal, the Fifth Circuit affirmed this aspect of the District Court’s order and observed that “[D]EPCO owed all class members the same duty, under either the express marketing clause or the implied duty to market.” In essence, the Fifth Circuit held that the mere existence of an express marketing clause in some of the class leases did not preclude certification of a class-wide claim based on the implied covenant because both imposed the same obligation on DEPCO: to obtain the highest and best price for the gas.

It is important to note that the Fifth Circuit did not enter judgment in favor of the class plaintiffs. The panel merely concluded that DEPCO owed the same obligation to all class plaintiffs regardless if the underlying lease contained an express marketing clause. The class plaintiffs will still have to prove a breach of this covenant in order to prevail.

Nonetheless, the Devon ruling is significant to the extent it clarifies that the driller’s duty to market gas – whether express or implied – carries with it an affirmative duty to obtain the highest and best price for the gas. In the past, drillers often argued that an express marketing clause in an oil and gas lease only obligated the driller to actually sell the gas with “due diligence”. In other words, drillers argued that the clause only addressed when the gas must be sold but did not cover or implicate how the gas was sold or the sufficiency of the price obtained. Devon may have changed this. Now, landowners can argue that such clauses also obligate the driller to sell gas at the highest price reasonably available. Landowners experiencing unreasonably low pricing may now be able to challenge such pricing by asserting a breach of the marketing covenant and such challenges may not be limited or precluded by any express marketing language in the parties’ lease.

[1] Pennsylvania currently recognizes three implied covenants in oil and gas leases: i) an implied covenant to reasonably develop the leasehold, ii) an implied covenant to protect the leasehold reservoir from drainage due to adjoining operations and iii) an implied covenant to market the gas.