Tenth Circuit Rules That Obligation to Pay Royalty on Fuel Gas Depends on Lease Language

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.

The processing of natural gas and natural gas liquids requires a constant and reliable energy source. Critical operations such as compression, dehydration and fractionation cannot be conducted unless the driller has “fuel” to power the underlying equipment and machinery. At some well pad sites, the driller will divert a portion of the raw gas stream produced by a well to these operations and then use the raw gas as the power source. Alternatively, a driller may contract for such processing services with a third-party provider and allow the third-party provider to “use” the raw gas as fuel. In either scenario, the gas is never sold or marketed and is instead consumed as fuel during the operations. Is the driller obligated to pay a royalty to the landowner on the volume of raw gas diverted as fuel? A recent decision by the U.S. Court of Appeals for the Tenth Circuit observed that a royalty may be due depending on the precise language in the parties’ oil and gas lease.

In Anderson Living Trust, et al. v. Energen Resources Corporation (United States Court of Appeals, Tenth Circuit – No. 16-2124, January 9, 2018), several family trusts (the “Trusts”) filed suit against the driller, Energen Resources Corporation (“Energen”), alleging that Energen breached the parties’ respective leases by failing to pay a production royalty on the diverted “fuel” gas. Energen had entered into contracts with third-parties to provide compression and processing services. Instead of paying the third-party providers for these services in cash, Energen simply allowed the providers to use the Trusts’ raw gas as a form of in-kind compensation (the “Fuel Gas”). The Trusts objected, claiming that Energen was obligated under the various leases to calculate and pay a royalty on all gas produced from the leasehold. Since the Fuel Gas was produced, but not actually sold, the Trusts argued that a royalty was nonetheless due on that volume of raw gas. The Trusts’ further claimed that the “free use” clauses in the leases were inapplicable because those clauses allowed Energen to use gas for fuel only if the operations were physically located on the leased premises. Here, the gathering system and processing plant were located miles away. Energen defended on the grounds that no royalty was due on the Fuel Gas volume because the “free use” clauses in two of the leases expressly authorized Energen to use the gas as fuel. The precise location where the gas was consumed as fuel was immaterial, according to Energen, so long as the gas was used “in furtherance of lease operations.” The United States District Court for New Mexico agreed with Energen and dismissed the Trusts’ Fuel Gas royalty claim on summary judgment. The Trusts appealed to the Tenth Circuit.

The issue on appeal was interplay between two common lease clauses: the royalty clause and the “free use” clause. By way of background, a “free use” clause is a provision in an oil/gas lease which gives the lessee the right to use gas produced from the leasehold. When a lease authorizes the driller to use raw gas to operate the leasehold, it is generally recognized “that the gas used for these purposes should be excluded [from] the calculation of the lessor’s royalty.” See, 2 W.L. Summers, The Law of Oil and Gas §33:12 at 160 (3d ed. 2008). This right is not unlimited. Typically, unless the clause provides otherwise, the particular operations fueled by the raw gas must be actually located on the leased premises or be in close proximity so as to support leasehold operations. See, Tidewater Associated Oil Co. v. Clemens, 123 S.W.2d 780 (Tex. App. 1938) (the clause “limits the lessee’s free use of the residue gas to that produced from the land, and to that used for operations thereon”); Bice v. Petro Hunt LLC, 768 N.W.2d 496 (N.M. 2009) (tank batteries located off leased premises were held to be a permissible use because “the residue gas is used in furtherance of overall lease operations”). As with many oil/gas lease disputes, the precise scope and application of any “free use” clause is often dependent on the exact language set forth in the parties’ lease.

Given this analytical framework, the Tenth Circuit reviewed each of the subject leases separately. With respect to the Anderson Trust lease, the panel observed that the express terms of the “free use” clause did not require the operations to be physically located on the leasehold. The clause stated that “[T]he lessee shall have the right to use free of costs, gas, oil and water found on said land for its operations thereon…” The Anderson Trust argued that the phrase “operations thereon” implied that such operations must occur on the leasehold. The Tenth Circuit disagreed and remarkably concluded that the phrase was not a limitation on where the use of the gas may occur but rather a “limitation on the purpose for which the gas may be used.” In other words, so long as the gas was used in furtherance of leasehold operations, Energen was permitted to use such gas as fuel. The precise gas location of the equipment or machinery being fueled was irrelevant. Accordingly, the Tenth Circuit held that the Anderson Trust was not entitled to a royalty on the fuel gas volume.

Unlike the Anderson Trust lease, the Neely-Robertson Trust lease did not contain a “free use” clause. Given the absence of any such clause, the Tenth Circuit instead closely scrutinized the language in the underlying royalty clause. Since the royalty clause expressly obligated Energen to pay a royalty on all gas “produced from the lands”, the Tenth Circuit opined that fuel gas could not be excluded from the royalty calculation:

“[T]he royalty provision is explicit: royalty is owed on all oil and gas produced from the leased lands. In other words, royalty is to be paid on all gas emerging from the wellhead of each well…”

In light of this language, and the undisputed fact that the fuel gas was part of the gas stream “produced” from the leasehold, Energen was required to calculate a royalty on the fuel gas volume.  However, in a rather unusual and peculiar use of circular reasoning, the Tenth Circuit also allowed Energen to deduct the fuel gas as a post-production cost:

“[I]n calculating that value, Energen may deduct the value of the fuel consumed as a post-production cost, but it must also pay royalty on the wellhead value…”

Thus, although the Neely-Robertson Trust prevailed on its royalty claim, the victory was somewhat hollow because Energen could deduct that same fuel volume as a post-production cost. The author submits this was an exercise of form over substance.

Finally, the “free use” clause in the Tatum Trust lease provided that Energen “shall have free use of oil, gas and water from said land, for all operations hereunder.” The Tenth Circuit’s analysis focused on the phrase “all operations hereunder.” Unlike the Anderson Trust lease, which used the term “thereon” to qualify the term “operations”, the Tatum Trust’s lease use of the term “hereunder” was found compelling by the Court. The Tenth Circuit opined that the term “hereunder” referred back to the underlying lease and the language set forth in the granting clause. This meant that only those operations contemplated by the original granting clause in the Tatum Trust lease were eligible to be fueled by the Trust’s gas. Since the granting clause only authorized Energen to conduct operations on the leasehold itself, the Tenth Circuit concluded that the scope of the “free use” clause was also limited to the leasehold:

“[T]hus, the operations called for by the lease are those occurring on the leased premises. As a result, the plain language of the “free use” clause in this lease suggests only gas used on the leased premises is free of royalty. Fuel gas used off the leased premises is not a free use”

The Tenth Circuit concluded that its interpretation of the “free use” clause was consistent with the lease’s royalty clause. The royalty clause obligated Energen to pay a royalty on “all gas produced from well on the leased premises…and sold or used off the leased premises.” Since the gas used by the third-party providers was clearly “used off the leased premises”, the panel held that both the “free use” clause and the royalty clause required by Energen to calculate and pay a royalty on the fuel gas volume.

The issue of whether a driller must pay a royalty on fuel gas has not yet been addressed by the Pennsylvania courts. This issue is likely to emerge in 2018 as another source of tension between Pennsylvania landowners and drillers as the practice of using leasehold gas for fuel becomes more prevalent. Many leases in Pennsylvania do not have a “free use” clause or, if they do, the clause might be inconsistent with the royalty clause. Landowners should carefully review their leases and regularly monitor their royalty statements for any indications of reduced gas volume due to fuel usage. The driller may not be authorized to divert the raw gas stream without paying a royalty on the same.