SOME REALLY BASIC CONTRACTS LAW

In law school we learn quite a few things that I think everyone should be taught in high school.  One of those things is that the heading of a contract, or the heading of a clause in a contract, does not control what the contract or the clause actually says.  For example, I’ve seen plenty of documents that say they’re wills, but when you read through them, they actually set up trusts.  While the will still has to go through probate, it’s going to create a trust in the end.

APPLIED TO OIL AND GAS LEASES

Most oil and gas companies will give a name to their document that roughly describes what it actually is.  A lease is usually just a lease, a modification is usually just a modification, etc.

But when it comes to the clauses in a lease, it’s a different story.  The heading will always tell you the main point to that clause.  Except when it doesn’t.  But the devil is in the details.

THE POST-PRODUCTION COSTS CLAUSE

For example, for decades there has been a post-production costs clause in almost every gas lease. It gave the producer the right to deduct some of their costs from the royalty. Those costs included things like transporting the gas through a pipeline, dehydration, compression, cleaning up the gas, and separating the different types of gasses for marketing, to name a few.

WEST VIRGINIA LAW ABOUT POST-PRODUCTION COSTS

Here in West Virginia a couple years ago there was a big, high profile case (Tawney v. Columbia Natural Resources) about royalties and post-production costs that went to the West Virginia Supreme Court.  The Court sided with the royalty owners and said that post-production costs could not be passed on to the royalty owner unless they were specifically spelled out in the lease.  It got a lot of press because it was a $404 million dollar settlement (which was negotiated down to $380 million.)

MARKET ENHANCEMENT IS BORN

Everybody heard about the Tawney case.  Royalty owners got wise and started asking for no post-production costs or deductions.  Oil and gas companies didn’t like that.

So instead of putting a Post-production Costs clause in their leases, they put in a Market Enhancement clause.  Their landmen could point to their lease and say, “we don’t include a post-production costs clause.”

While it was true, it was also a blatant lie.

WHAT MARKET ENHANCEMENT REALLY IS

The Market Enhancement clause was nothing more than the old Post-production Cost language, changed around a bit, with an emphasis on how the costs being deducted actually increased the value of the gas.  If you parsed the old language and the new language, there was almost no difference.

When someone called the landmen on it, the landmen would respond, “those costs actually increase the amount of royalty you get because they increase the value of the gas.”

POST PRODUCTION COSTS REDUCE YOUR ROYALTY

While that statement is (possibly) true, you have to remember that everything the producer does increases the value of the gas.  Building a pad, drilling the well, flaring the well, even the title work increase the value of the gas because if none of those things happen, the gas will have literally no value.  That’s the argument that the landmen are making, and it’s just wrong.  You will get more royalty when no post-production costs are deducted from it.  A post by John McFarland from Oil and Gas Lawyer Blog does an excellent job of explaining how.  It’s a long post, but I highly recommend you take the time to read it.

HOW TO POLICE THE OIL AND GAS COMPANY

It’s nearly impossible for you to ever be sure that the oil and gas company is only deducting those costs that are increasing the value of the gas.  You can’t even be sure they are deducting only what they say they are deducting.  Unless you audit them, you just have to take them at their word.  I can think of three ways of checking up on them.

First, you can audit their books.  This requires that you go to their office and spend time figuring out their record keeping system.  Because you probably don’t know much about oil and gas accounting systems, you’ll need to hire an expert to go with you.  In short, you’ll need to time and money to audit them.

Second, you can check the WV DEP’s web site for the oil and gas company’s reported production.  But if you want current numbers you’re going to have to wait a while because the oil and gas company only has to report once a year, by the 31st day of March.  And wait a little longer because the DEP takes a while to post those numbers to the internet.  Note, also, that the most recent numbers are going to be at least four months old.

Third, you can go out to the well site and check the gauges.  This is the simplest and most reliable method.  But it really only works to get the total production from the well.  That’s why the lease needs to say that royalties will be calculated based on the total production from the well, with no deductions.  It’s simple and you don’t have to rely on anyone else to get or give you information.  Of course, for all you out-of-state mineral owners this is not really an option.

The takeaway here is that you really need to read everything that’s in a lease.  You can’t skim the headings and know for sure what you’re signing.

And always get no post-production costs.