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TX Supreme Court Decision in Compression Cost Case Focuses on Express Contract Language

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On June 12, 2015, the Texas Supreme Court issued its decision in a compression cost case impacting the natural gas production industry in the case of Kachina Pipeline Co., Inc. v. Michael D. LillisIt focused closely on the contract language finding that a natural gas transporter could not deduct compression costs and was not entitled to a five year extension based on the terms of their agreement.

I. Factual and Procedural Background

Kachina Pipeline Co. (“Kachina”), a natural gas transporter, owns and operates a natural gas gathering system and pipeline.   It entered into Gas Purchase Agreements in 2001 and 2005 (“the Agreement”) with Michael Lillis (“Lillis”), a natural gas producer, to purchase his gas and transport it for resale.  In order for a producer to successfully deliver gas, it must have sufficient pressure to overcome the working pressure in the gathering system.  As such, the Agreement addressed the parties’ rights and responsibilities providing 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 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 in May 2010 where it would then continue month-to-month.  It, however, provided “Upon termination or cancellation of Agreement, prior to Seller selling gas to a third party,” Kachina has 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 Kachina had been deducting. He then sued for (1) breach of contract for deducting the costs of compression and (2) fraud asserting that Kachina represented it would release him from the Agreement.  Kachina counterclaimed asserting Lillis breached the contract by failing to notify it of the third-party offer and sought declaratory judgment, including a declaration that it exercised its option to extend the Agreement for another five-year term.

The trial court granted summary judgment for Kachina declaring that the Agreement entitled Kachina to deduct the costs of compression and gave Kachina the option to extend the agreement for an additional five-year term.  The court of appeals reversed holding the agreement unambiguously allowed neither the disputed deductions, nor a five-year extension. 

II. Holding
A. Deduction Language

The Texas Supreme Court affirmed the court of appeals’ judgment reiterating several contract law principles, including (1) in construing a contract, the four corners rule applies and the contract must be examined as whole to ascertain the parties true intent and (2) extrinsic evidence can only be used if a contract is ambiguous. 

Applying these rules, the Court found that the Agreement provision unambiguously 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 Agreement language was clear in that (1) the compression cost language 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.’”  Id. at p. 8; and (3) it applied only to delivery and not re-delivery.  The Barker compression station and compression added in 2007 were completed in order to increase the amount of gas gathered and transported, not deal with underpressurization, and therefore the Agreement language did not allow Kachina to make deductions.

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

Finally, the Court did not agree with Kachina’s interpretation that Lillis acquiesced to the marketing fees because Kachina had been deducting compression costs as part of the marketing fees 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 were 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.”  Id. at p. 13. 

B. Option Right

The Court also found that the option right granted was not a right to a five year extension, 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 any other terms, including a new five-year term.  Therefore, the trial court’s declaration that Kachina was entitled to a five-year extension is inconsistent with the Agreement’s express language and the court of appeals correctly reversed it.  

III. Conclusion

In line with its previous decisions, the Texas Supreme Court focused closely on express contract language.  As such, natural gas transporters and producers should carefully negotiate and word Gas Purchase Agreements to ensure that the contract language in itself protects their interests.

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