In Kachina Pipeline Company, Inc. v. Lillis, No. 13-0596, the Supreme Court of Texas interpreted a natural gas-purchase contract and held that a producer was not required to share in the costs of compression, even though that compression helped yield a higher re-sale price. Whether this decision narrowly reflects the language of one specific contract or represents a sea change is yet to be determined.

Factual Background

Kachina Pipeline Company, Inc. (“Kachina”) operates a natural gas gathering system, as well as a gas pipeline.  Kachina utilized its pipeline to transport gas it purchased to Davis Gas Processing’s Plant (“Davis Plant”) where it was re-sold.  Michael Lillis (“Lillis”) was one of the producers who sold natural gas to Kachina, dating back to 2001.

In 2003, Kachina installed the “Barker Central Compression Station” (“Compression Station”) on its pipeline, which allowed it to resell the gas in the pipeline at its high-pressure inlet, increasing its re-sale value to Davis.  In 2005, Kachina (the Buyer) and Lillis (the Seller) entered into a new Gas Purchase Agreement (“Agreement”).  Under the Agreement, Lillis would transfer his gas into Kachina’s gathering system to be transported through the pipeline to the Davis Plant.  In exchange, Kachina would pay Lillis a percentage of the re-sale price it obtained from Davis. The Agreement had an initial five (5) year term, and was scheduled to expire in May 2010.  After the expiration of the initial term, the Agreement continued on a month-to-month basis, and could be cancelled by either party after thirty (30) days notice.  The Agreement also included a provision allowing Kachina to “continue the purchase of gas under the terms of this Agreement” if Lillis attempted to cancel the Agreement and sell to a third-party, provided Kachina would match the price terms offered by the third-party.

Procedural History

In 2008, Lillis contracted to sell his gas directly to Davis, and constructed his own pipeline to the Davis Plant.  Lillis then brought suit against Kachina, alleging that compression costs had been improperly deducted in breach of the Agreement.  Kachina counterclaimed, arguing that Lillis breached the Agreement by failing to notify it of Davis’ third-party offer, as well as a declaratory judgment allowing it to both:  1) take compression deductions under the Agreement;  and 2) exercise a renewal of Agreement until May 2015.  Both parties filed motions for summary judgment.  The trial court denied Lillis’ motion and granted Kachina’s motions.

Lillis appealed the judgment to the Third Court of Appeals in Austin, which reversed both declarations, and held that the Agreement did not allow Kachina to deduct compression costs, and that the Agreement was not extended until May 2015.  In a 6-3 decision, the Supreme Court of Texas agreed with the Third Court of Appeals on both issues, with Justice Brown writing the majority opinion.  Chief Justice Hecht, joined by Justice Green and Justice Devine, dissented.

Does the Compression Contract Require Payment?

Kachina asserted that the Agreement allows for deductions for “any compression that aids in the final delivery to Davis of gas bought from Lillis.”  Id. at *7.  Conversely, Lillis asserted that the Agreement allows for deductions for compression that Kachina installed only after Lillis fails to deliver gas that can be transported through the pipeline.  Under Lillis’ interpretation, Kachina would be required to show:  “1) that Lillis was unable to deliver gas against Kachina’s working pressure, and (2) the compression equipment was installed after the Agreement’s execution.”  Id. at *7-8.  That interpretation would exclude deductions related to the Compression Station, which was installed in 2003, two years prior to the Agreement.  The specific provision on pressure read as follows:

Pressure:  Seller shall deliver the gas deliverable hereunder, at the above[-]described delivery point at a pressure sufficient to enter Buyer’s pipeline against the working pressure maintained therein from time to time.  Seller will regulate its[] pressures so as to not exceed the maximum allowed operating pressure (MAOP) as set from time to time by Buyer for deliveries into Buyer’s gas pipeline.  However, it is expressly understood and agreed that neither party hereto shall be obligated to compress any gas under the terms of this Agreement and if the well is no longer capable of delivering gas against the working pressures maintained at the delivery point and neither party elects to install a compressor, then Buyer shall, upon request from Seller, release such well and the gas produced therefrom from the terms and provisions of this Agreement.  If 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.

(emphasis by Court).  The Court noted that the Agreement put the burden of maintaining sufficient well pressure (to overcome the working pressure in the pipeline) on Lillis.  If Lillis’ wells failed to do so, then the Agreement provided Kachina with two options:  “[i]t may do nothing, in which case the well will be released from the Agreement.  Or it may elect to install compression so that the well can overcome the working pressure.”  Id. at *11.  If Kachina elected the latter, the Agreement provided it was entitled to deduct compression costs.

Based on this framework, the Court viewed the ability to deduct costs for compression as entirely contingent, arising “only if [Kachina] installs compression to effect delivery.”  Id. at *11-12.  As a result, Justice Brown held that it could not apply to pre-existing compression, as the provision utilized the word “installation.”  That word choice would not make any sense if the parties intended Kachina to charge Lillis for pre-existing compression.  The opinion also held that “only compression installed for the purpose of overcoming Kachina’s working pressure is installed to ‘effect delivery.’”  Id. at 12.  The Court reasoned that “if a well’s natural pressure is sufficient to overcome the working pressure at the delivery point, added compression can hardly be said to bring about delivery that would occur without it.”  Id. at *12-13.

Kachina argued that the Compression Station, though pre-existing, “effects delivery” by “lowering suction” which reduced upstream pressure and aided the flow of gas into the pipeline.  Chief Justice Hecht also echoed this point in his dissent.  The Court found this position unavailing, noting that, while this compression may aid in delivery, it does not “effect delivery.”  Id. at *15

Kachina also alleged, and the dissent agreed, that Lillis would have been unable to deliver the gas to the pipeline without the compression.  The Court disagreed, distinguishing between the “high-pressure” sales made possible by the Compression Station, and Davis’ ability to take low-pressure gas (albeit for a lower resale price).

The Court, however, did make sure to clarify that the location of the pressure was not determinative on the question of whether compression can “effect delivery,” as compression can reduce upstream pressure as well as downstream pressure.  This point stood in contrast to the Court of Appeals, and was urged by two pipeline industry amicus briefs.  In closing, the majority noted that while downstream compression of gas “was both common and critical to efficient transportation,” the industry custom of producers willingness to share in those costs could not overcome the unambiguous meaning of the Agreement.  Id. at *19.

In his dissent, Justice Hecht argued that the summary judgment evidence conclusively established that Kachina’s compression was necessary to effect the delivery of Lillis’ gas, noting that appellee’s counsel conceded that, without any compression in the Kachina pipeline, Lillis’ gas could not enter the delivery system.  Moreover, he rejected the majority opinion’s temporal distinction based on the word “installation,” asserting that it makes little sense for Lillis to stop paying for compression (as under the parties’ previous agreement) only to resume paying for it when it became necessary under the 2005 Agreement.  In closing, the dissent stated:  “Today’s lesson is that producers’ agreements to share in compression costs are common and critical and will be enforced unless a court can think of a way to avoid them, regardless of the evidence.”  Id. at *28.

Did the Compression Contract Extend the Contract?

The Court also addressed the extension of the Agreement.  Kachina asserted that its right to “continue the purchase of gas under the terms of this Agreement” afforded it the right to extend the Agreement by another five (5) years, because the five-year initial period was a “term.”  The Court rejected this argument, noting that the extension merely allowed Kachina to “continue to purchase gas,” and that the Agreement explicitly became month to month as of May 2010.  In his dissent, Justice Hecht joined this portion of the opinion.