PIOGA Press
This article highlights an excerpt of the recently published 2015 Babst Calland Report – Appalachian Basin Oil and Gas Industry: Rising to the Challenge, Legal and Regulatory Perspective for Producers and Midstream Operators.
With a large number of regulatory and legal issues unresolved for the industry, litigation will remain part of the landscape. Industry will continue to be required to litigate interpretations of statutes and rules by federal and state regulators and environmental groups—with, we hope, favorable outcomes such as in Citizens for Pennsylvania’s Future v. Ultra Resources, Inc. Industry will also continue to face issues related to the validity of leases and royalty payments. Finally, property owner claims of both personal injury and property impact from oil and gas development activities will continue, fueled by claims of groundwater contamination and adverse health effects of shale development.
Federal court refuses to aggregate compressor stations, dismisses Clean Air Act Citizens’ suit alleging violation of new source review
In a highly-anticipated decision, the U.S. District Court for the Middle District of Pennsylvania granted a motion for summary judgment in favor of a Pennsylvania natural gas operator in an air aggregation case filed by a citizens group. The decision was issued on February 23 in Citizens for Pennsylvania’s Future, and is the latest development in the debate over single source determinations. The court agreed with the permitting decisions made by Department of Environmental Protection that the compressor stations at issue were not located on adjacent properties and thus should not be treated as a single source of emissions. The court disagreed with the Citizens for Pennsylvania’s Future’s (PennFuture) argument that the compressor stations were functionally interrelated and, therefore, should be aggregated as a single source. While the court left some room for the consideration of functional relationships in making single source determinations, it determined that such a case would need to have unique facts that are outside the normal configurations of pipelines and compressor stations contemplated by DEP.
Developments in science and in litigation provide opportunities and challenges for defense of water contamination and nuisance claims
The industry continues to be faced with claims from property owners of temporary or permanent drinking well water contamination from drilling and fracturing activities. Groundwater in the Marcellus region frequently contains methane and elevated levels of constituents such as total dissolved solids, barium, strontium, chloride, sodium, iron, manganese and others. In litigation, the property owner plaintiffs are required to prove through expert testimony that the contaminants in their well water were caused by the gas development activities and were not pre-existing natural conditions. As the industry widens the area of pre-drill testing, many of these suits can be avoided or, if filed, easily defended. Additionally, the ability to use isotopic testing to determine the source of methane found in water wells is an added tool at the industry’s disposal to defeat such claims.
Litigation also continues to be filed by property owners claiming loss of use and enjoyment of their properties and diminution of property value due to air emissions, noise and/or dust from gas development activities. Because air emissions are often not conducive to pre- and postsampling, it can be more difficult to show that the present conditions are an increase over baseline. Medical monitoring claims are frequently included in both suits involving alleged water contamination and suits based on alleged air emissions. Many of the medical monitoring claims are abandoned by plaintiffs before trial or are dismissed by the court because plaintiffs cannot come forward with the required expert testimony to prove such claims. Courts have consistently held that in order to prove a claim for medical monitoring all of the below elements must be proven through expert testimony: (1) exposure greater than normal background levels; (2) to a proven hazardous substance; (3) caused by the defendant’s negligence; (4) as a proximate result of the exposure, plaintiff has a significantly increased risk of contracting a serious latent disease; (5) a monitoring procedure exists that makes the early detection of the disease possible; (6) the prescribed monitoring regime is different from that normally recommended in the absence of the exposure; and (7) the prescribed monitoring regime is reasonably necessary according to contemporary scientific principles.
There is a growing proliferation of questionable scientific and medical articles being published attempting to link air emissions to various medical conditions, ranging from commonly occurring respiratory conditions and nosebleeds to birth defects. It will be important for counsel defending these claims to be able to critically analyze these articles through use of reliable and well-qualified experts and preclude the admission of the unreliable science through the use of Daubert motions.
The defense of these suits has also been strengthened by the refusal of courts to allow plaintiffs to bring strict liability claims, finding as a matter of law that unconventional gas drilling is not an ultra-hazardous activity. As a result, plaintiffs are required to prove negligence. Proof that negligent operations resulted in the alleged water contamination or air emissions requires that plaintiffs retain more experts.
Lease busting—attempts to void or renegotiate terms of existing leases
Royalty owners who signed leases for signing bonuses, royalty rates or other terms that are not as favorable as those currently being offered in their area for new leases continue to look for ways to void the leases or the extension or renewal of the leases.
Lease renegotiation by litigation. Many leases obtained during the early cycle of the Marcellus and Utica boom contain renewal or extension clauses giving the lessee the option to extend the primary term, typically five years, for an additional five-year term, upon notice and payment of the same signing bonus as was paid when the lease was initially obtained. Royalty owners who missed the top of the market or have top lease offers claim the renewal option cannot be extended unless they are paid the current market value for signing bonuses and increased royalty rates, in effect renegotiating the terms of the lease. The royalty owners’ attorneys also frequently claim the landman procuring the lease fraudulently induced the royalty owner to sign by misrepresenting the renewal or extension clause, or falsely asserting that the option could not be exercised without renegotiating the financial terms of the lease. So far, the lessees have generally prevailed in the Appalachian Basin because the courts have held the renewal or extension clause is clear and unambiguous, and does not require the renegotiation of terms or the payment of a bonus at current market rates. Nevertheless, these cases require vigorous defense to avoid a negative outcome or undue delay.
Another group of court decisions in Ohio has rejected claims by royalty owners that older lease forms gave lessees too much discretion in determining when the primary term may be extended, thereby creating an unlawful lease in perpetuity. The Ohio Supreme Court has accepted one such case for review, which may result in a change in previously settled case law in Ohio on the validity of commonly used lease language. Defense of these cases requires the filing of motions at the earliest stage to obtain a judicial declaration on the clear and unambiguous terms of the lease to avoid, where possible, costly discovery and litigation. If the court does not dismiss the case or render judgment for lessors at the outset, further defense of the cases can be complicated by the fact the landman who procured the lease may no longer be working for the lessee and/or has no specific recollection of any communications with the royalty owners.
Challenges to held by production leases – duties of diligent development
Royalty owners who have leases held by production by conventional wells envy the financial success of lessors enjoying the fruits of lucrative new lease signing bonuses and increased royalty rates associated with shale development. Their attorneys continue to look for ways to void the leases or force drilling of exploratory or development wells based on claims of breach of the express or implied duty to diligently develop.
Vertical formation and abandonment claims. Courts throughout the Appalachian Basin generally recognize an implied duty to diligently develop in the absence of an express provision in the lease disclaiming implied covenants. The question becomes whether the failure to drill unconventional shale wells on a lease held by conventional production can result in the abandonment of those formations that are not currently producing. These vertical abandonment claims generally have not been successful as the plain and unambiguous terms of the lease do not support a claim of partial abandonment of a lease. An Ohio court has recently rejected such a claim based upon the language of the lease. Operators should nevertheless be wary of attempts by lessors to obtain a judicial declaration that the prudent operator standard requires the development of all formations. Such claims seem to ebb and flow with the commodity price of gas (i.e., they are less viable when the price of gas is low) and are difficult to prove. Nevertheless, it is an area disgruntled royalty owners and their counsel continue to analyze to determine if a lucrative payday awaits.
Dual purpose leases. Similarly, litigation continues over socalled “dual purpose” leases that provide that the lease is held past its primary term by the production of oil or gas, or the use of the premises for the storage of gas or the protection of stored gas in the general vicinity of the lease. Royalty owners who are not receiving any significant payments for leases being held by storage of gas or protection of stored gas have initiated litigation seeking to declare that the dual purpose lease is “divisible” and the formations that are capable of production without disturbing the storage field have been abandoned. Royalty owners are willing to concede that the storage reservoirs and necessary horizontal and vertical protective zones remain subject to the lease, but are seeking to terminate the lease as to the shale bearing formations. So far, the courts in Pennsylvania and Ohio have generally held that the dual purpose leases are plain and unambiguous and clearly state that the leases are held by production “or” storage of gas. In West Virginia, however, a recent ruling in the United States District Court for the Northern District of West Virginia has held otherwise, and is in the process of appeal to the Fourth Circuit Court of Appeals.
Royalty litigation
Litigation continues over the method of computing and paying royalties.
Post-production costs. With the significant decrease in the price of gas, disgruntled royalty owners continue to argue that the post-production cost deductions in their checks are resulting in improper reduction of revenue. They are looking for avenues to avoid or reduce such deductions. Courts in West Virginia have held that a lessee may not deduct post-production costs unless the lease specifically and in detail so states, and have identified the specific post-production costs that may be deducted and how they may be calculated. Nevertheless, questions continue regarding obligations to pay on the volume of gas produced at the wellhead. A recent ruling by the United States District Court for the Southern District of West Virginia held that where the lease calls for payment on the “gas sold” the deduction for lost and unaccounted for gas incurred prior to the point of sale is not a prohibited deduction.
In Pennsylvania, the decision in Kilmer v. Elexco Land Servs., Inc. seemed to settle that the deduction of post-production costs was allowed under most leases, but litigation continues. A March 5 jury verdict in favor of landowners in a class action case challenging the deduction of certain interstate pipeline expenses and marketing fees incurred downstream from the point of sale may encourage additional litigation challenging complicated royalty payment practices. Class action royalty cases also continue to be filed based on claims of fraud, collusion, and other tort claims challenging post-production cost deductions and seeking to narrow the holding in Kilmer.
Royalty on natural gas liquids. The royalty calculation process is even more complicated for production in the wet gas regions. Older leases typically contemplate the calculation of payment of the royalty “at the wellhead,” but the development of the infrastructure and technology to segregate and sell far downstream of the wellhead the components of wet gas has resulted in various practices among producers on how to calculate royalty on natural gas liquids.
Courts do not favor affiliated party transactions. One thing is clear: courts in the Appalachian Basin have been very skeptical of any post-production cost deductions or sales that relate to charges by affiliated marketing or gathering companies. The courts generally have held that affiliated transactions should be ignored as not constituting fair market, arm’s length transactions. The question then becomes, how far down the gathering and transportation value stream must an operator absorb the post-production costs before a court will hold, under the terms of the lease, that the lessor is obligated to share prorata post-production costs. ■
The 2015 Babst Calland Report was compiled and written by the attorneys of Babst Calland’s Energy and Natural Resources Group and provides legal insights into Marcellus and Utica shale issues, challenges and recent developments facing producers and midstream operators in the Appalachian Basin. For more information regarding litigation challenges facing the oil and gas industry, contact Kathy K. Condo at 412-394-5453 or kcondo@babstcalland.com, or Timothy M. Miller at 681-265- 1361 or tmiller@babstcalland.com. A full copy of the report is available by writing to info@babstcalland.com.
