Historic Cold May Provide Window Into “Market Enhancement” Under Gas Leases
Many landowners in Pennsylvania signed oil and gas leases with “market enhancement” clauses. These clauses typically contain language that prohibits a driller from deducting post-production costs unless the driller can demonstrate that the purported costs “enhanced the value” of the gas and enabled the driller to receive a better price for the gas. Despite the general prohibition in these clauses, many royalty owners have discovered that post-production costs are always deducted from their royalties, with no demonstration that any value enhancement actually occurred. This is not what landowners were told when they originally signed the lease.
When drillers are asked for an explanation about how post-production costs such as “gathering” and “transportation” enhance the value of the gas stream, royalty owners are told that these movement costs allow the driller to “access” more diverse downstream markets and therefore obtain better pricing. The underlying theory is that the simple act of moving the gas to a remote market is, in fact, an enhancement. The drillers concede and acknowledge that the gathering and transportation costs do not change or alter the molecular structure or condition of the gas – the enhancement is purely an economic metric based on simply moving the gas further away. The recent record cold that plagued much of the mid-west may test the veracity of this explanation.
Natural Gas Intelligence reported on February 16, 2021, that the NGI Spot Gas National Average increased from $21.315 to $86.745. The publication stated that mid-day spot prices at Oneok Gas Transmission in Oklahoma were reported to average $918.625 per MMBTU and that mid-day spot pricing at the Houston Ship Channel had increased $238.835 to $400.00. Regardless of the numbers, record cold and the competition for gas between power generators and residential customers has made for a soaring gas market in the center of the country.
One would expect that every driller in the Marcellus region will be doing everything they can do to move as much of their gas to Texas, Oklahoma, and surrounding midwestern states in order to participate in this producer-friendly market. Demand is simply exceeding the available supply of gas. As a result, gas prices are soaring. Landowners with “Market Enhancement” clauses should carefully scrutinize the commodity pricing in their upcoming royalty statements and examine whether their gas was actually moved to these high-price spot markets to get better pricing. If the driller did not move gas into these soaring markets, the landowner should demand an explanation from the driller. Moreover, the landowner should question and challenge why the same “transportation” and “gathering” charges appear in their royalty statement despite the apparent failure to realize and access these midwestern markets. If the linchpin is “better” pricing, how can drillers credibly argue that the cost of moving gas to a lower-priced market is a legitimate enhancement cost? The authors suspect that most landowners will not see any change in their royalty statements in the next quarter- they will see the same deductions and the same flat pricing. This will certainly undercut and undermine the driller enhancement theory and should warrant greater scrutiny of their pricing and marketing practices.