July 27, 2015 Practice Points

TX High Court Rules for Producer in Natural-Gas-Compression Case

The court focused on the contract language in finding that a pipeline operator could not deduct compression costs from its payments to the producer, and was not entitled to a five-year extension of their agreement.

By Christina A. Denmark – July 27, 2015

On June 12, 2015, the Texas Supreme Court ruled for the producer of natural gas in the compression-cost case of Kachina Pipeline Co., Inc. v. Michael D. LillisIt focused on the contract language in finding that a pipeline operator could not deduct compression costs from its payments to the producer, and was not entitled to a five-year extension of their agreement.

Kachina Pipeline Co., a natural-gas transporter, owns and operates a natural-gas gathering system and pipeline.  It entered into gas-purchase agreements in 2001 and 2005 with Michael Lillis, a natural-gas producer, to purchase his gas and transport it for resale. To successfully deliver gas, a producer must have sufficient pressure to overcome the working pressure in the gathering system. As such, the 2005 agreement provided that “neither party hereto shall be obligated to compress any gas” and, “[i]f Buyer installs compression to effect delivery of Seller’s gas, Buyer will deduct from proceeds payable to Seller hereunder a value equal to Buyer’s actual costs to install, repair, maintain and operate compression plus 20% of such costs to cover management, overhead and administration.”

At the time of the 2005 agreement, Kachina had a compression station, the Barker station, in place, but added compression equipment in 2007 to enhance operations. The agreement was set to expire on May 2010, when it would then continue month-to-month, but also provided that “Upon termination or cancellation of agreement, prior to Seller selling gas to a third party,” Kachina had the option to “continue the purchase of gas under the terms of agreement with such adjustments in the price hereunder as may be required to yield the same economic benefit to Seller, as would be derived from the proposed third party offer.” 

In 2008, Lillis entered into a separate purchase agreement and constructed his own pipeline. Around that time, he objected to the compression fees that Kachina had been deducting. Lillis then sued for (1) breach of contract for deducting the costs of compression, and (2) fraud alleging that Kachina had represented that it would release him from the 2005 agreement. Kachina counterclaimed for breach of contract, claiming that Lillis failed to notify it of the third-party offer, and sought a declaratory judgment that Kachina had exercised its option to extend the agreement for another five-year term.

The trial court granted summary judgment for Kachina, declaring that the 2005 agreement allowed Kachina to deduct the compression costs, and gave Kachina the option to extend the agreement for another five years. The court of appeals reversed, holding that the agreement prohibited the deductions and the five-year extension.

The Texas Supreme Court found that the 2005 agreement allowed Kachina to deduct only the costs of compression installed during the term of the agreement if required to overcome the working pressure in Kachina’s system. The compression-cost language (1) did not apply to pre-existing compression or any compression; (2) provided “only compression installed for the purpose of overcoming Kachina’s working pressure is installed to ‘effect delivery’”; and (3) applied only to delivery and not re-delivery. The Barker compression station and the compression added in 2007 were completed to increase the amount of gas gathered and transported, not to address underpressurization, and therefore the 2005 agreement prohibited the deductions.

Importantly, the court disagreed with the court of appeals that compression occurring on Kachina’s side of delivery point cannot “effect delivery.” The 2005 agreement allowed for a decrease in the working pressure to effect delivery, but did not address the compression’s location.

The court did reject Kachina’s argument that Lillis acquiesced to the marketing fees because Kachina had been deducting compression costs since at least 2003. The earlier deductions took place under the 2001 contract and not the current agreement and the language in the two contracts was different. “Both Lillis’s acquiescence and his testimony are evidence of subjective intent that we cannot consider to contradict the provision’s unambiguous legal meaning.”

Finally, the court found that the option right was not a right to a five-year extension, but only the right to continue to purchase gas under the agreement’s terms on a month-to-month basis. The agreement’s provision allowed adjustments for price based on a third-party offer, not other terms such as a five-year extension.

In line with its previous decisions, the Texas Supreme Court focused on the express terms of the contract. As such, natural-gas transporters and producers should carefully draft their gas-purchase agreements to ensure that the contract language protects their interests.

Keywords: energy litigation, Texas Supreme Court, gas purchase agreements, natural gas, compression fees, Kachina, Lillis

 

Christina A. Denmark is with Steptoe & Johnson PLLC in Houston, Texas.


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