A federal district court in Ohio recently upheld the constitutionality of Ohio’s forced pooling statute (R.C. § 1509.28) in Kerns v. Chesapeake Exploration, LLC, et al., N.D. Ohio No. 5:18 CV 389 (June 13, 2018). R.C. § 1509.28 establishes the procedure for owners to combine contiguous acreage and interests to efficiently and effectively develop the oil and gas resources underlying that land. Additionally, the statute grants the chief of the division of oil and gas resources management the authority to compel landowners unwilling to lease their land to join in drilling operations. The constitutional challenge in Kerns involved the same group of landowners whose writ of mandamus was rejected by the Ohio Supreme Court in January. Following their unsuccessful challenge at the Ohio Supreme Court, the landowners alleged that R.C. § 1509.28 violated their constitutional rights under the Fifth and Fourteenth Amendments by authorizing an impermissible taking of their property. In rejecting the constitutional challenge, the federal district court relied on previous decisions from the United States Supreme Court holding that the statute was a legitimate exercise of Ohio’s police powers to protect correlative rights and reduce waste. In deeming R.C. § 1509.28 constitutional, Ohio courts join the well-settled national consensus that unitization procedures do not constitute an impermissible taking of property.
The Ohio Supreme Court recently rejected a constitutional challenge to Ohio’s forced pooling statute in State ex rel. Kerns v. Simmers, Slip Opinion No. 2018-Ohio-256. A group of landowners (the “Landowners”) sought a writ of mandamus compelling the Chief of the Ohio Department of Natural Resources (ODNR) to commence appropriation proceedings to compensate landowners with interests included in an oil and gas drilling unit through a unitization order. The Landowners alleged that the Chief’s order issued pursuant to R.C. 1509.28 was “unlawful or unreasonable” and constituted an unconstitutional taking of their property without compensation. Under R.C. 1509.36, the Landowners appealed the Chief’s order to the Ohio Oil and Gas Commission (the “Commission”). The Commission, concluding that it lacked jurisdiction to determine the constitutionality of the order, dismissed the appeal. Instead of appealing the Commission’s decision to the Franklin County Court of Common Pleas within 30 days as permitted by R.C. 1509.37, the Landowners filed a petition for a writ of mandamus to the Ohio Supreme Court.
The Ohio Supreme Court denied the writ and dismissed the Landowners’ case, reasoning that the Landowners failed to utilize the adequate legal remedy available. To be entitled to a writ of mandamus, the Landowners needed to show (1) that they had a clear legal right to appropriation proceedings, (2) that the ODNR had a clear legal duty to commence the proceedings, and (3) that the Landowners had no plain and adequate legal remedy. Under R.C. 1509.37, the Landowners could have appealed the Commission’s decision to the Franklin County Court of Common Pleas to determine the constitutionality of the unitization statute. In denying the writ, the court determined that the Landowners had a complete, beneficial and speedy remedy at law by way of an appeal to the Franklin County Court of Common Pleas as provided in R.C. Chapter 1509 and should have pursued their appeal there. While dismissing this challenge on procedural grounds, it appears inevitable that the Ohio Supreme Court will ultimately have to determine the constitutionality of Ohio’s forced pooling statute.
The Supreme Court of Ohio recently ruled in Alford v. Collins-McGregor Operating Company, Slip Opinion No. 2018-Ohio-8, that Ohio does not recognize an implied covenant to further explore, separate and apart from the implied covenant of reasonable development. Under Ohio law, the implied covenant of reasonable development requires a lessee to drill and operate such number of wells as would be reasonably necessary to develop the leasehold premises in a proven formation. While other jurisdictions recognize a separate implied covenant of further exploration, which requires a lessee to additionally explore potentially productive formations that are yet to be proven, the Supreme Court of Ohio refused to impose such requirement on lessees.
The Alford oil and gas lease was held by production and did not disclaim the application of any implied covenants. The lessee drilled one shallow well pursuant to the lease, which had produced in paying quantities ever since. The lessee never drilled any additional wells or sought production from any additional depths. Because the lessee declined to explore deeper depths, the Plaintiff landowners alleged that the lessee breached the implied covenant of reasonable development and the implied covenant to explore further, and sought a partial forfeiture of the lease as to deeper formations.
Affirming the Fourth Appellate District’s decision, the Ohio Supreme Court held that the implied covenant of reasonable development sufficiently protects the landowner’s interest in the exploration of deep formations. The court discussed that the implied covenant of reasonable development requires the lessee to act as a reasonably prudent operator would in developing an oil and gas lease. It requires the lessee to take into account the interests of both the lessor and lessee and to consider all of the circumstances relevant to the exploration and development of the land, including the associated risks, costs and profit. Conversely, the court observed that the implied covenant of further exploration only focuses on a small subset of factors relevant to the overall development of a lease, namely the lessor’s interest in obtaining additional compensation, and ignores the profit motive of a reasonably prudent operator.
The court held that the comprehensive scope of the implied covenant of reasonable development subsumes the implied covenant to further explore. The implied covenant of reasonable development is well suited to address the landowner’s interests in the further exploration of deeper formations because it takes into consideration all of the factors relevant to the exploration and development of a leased property. The court noted that it would be “unhelpful at best” to recognize a separate implied covenant to explore further, but expressed no opinion whether a prudent operator has a duty to develop deep rights under the implied covenant of reasonable development.
Pennsylvania House Bill No. 1401, which would create a severance tax and significantly change oil and gas royalty payments, recently failed to pass an important legislative hurdle.
The bill imposes a 3.2% severance tax, or drilling tax, on unconventional natural gas extraction. This tax would be in addition to the Act 13 impact fees already levied upon natural gas producers. According to drafters of the bill, the severance tax and the impact fees would equal approximately 5% of the value of natural gas sold in Pennsylvania. Additionally, the bill would alter the required minimum royalty payment under and oil and gas leases so that the lessor would not receive less than 12.5% of the gross proceeds received by the lessee on production under the lease. Under the terms of the bill, a deduction or allocation of costs, expenses or other adjustments could not be deducted from the gross proceeds before calculating the amount of royalty due to the lessor. This provision would severely limit, and at times eliminate, an operator’s ability to deduct pro-rata post-production costs from royalty payments.
Late Tuesday night, supporters of House Bill No. 1401 failed to acquire the necessary votes to push the bill to the House floor so that debate on the legislation could resume. The motion, which required 101 votes to succeed, instead received 100 votes in favor. The bill has been subject to numerous amendments which has stalled its progress.
Although this represents a setback for the bill, it is possible that further legislative action may be taken to pass it. At this point, however, it now appears that passage will be more difficult.
On November 13, 2017, the Pennsylvania Environmental Hearing Board issued its second opinion analyzing Article I, Section 27 of the Pennsylvania Constitution, commonly known as the Environmental Rights Amendment, in light of the Pennsylvania Supreme Court’s June 20, 2017 decision in Pennsylvania Environmental Defense Foundation v. Commonwealth (PEDF). In Friends of Lackawanna v. DEP and Keystone Sanitary Landfill, EHB Dkt. No. 2015-063-L (November 10, 2017) the EHB applied the principles set out in PEDF and upheld a landfill permit renewal.
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On October 14, 2017, the DEP published notices of availability for a trio of draft Technical Guidance Documents (TGD) in the Pennsylvania Bulletin. Each of these TGDs proposes policy departures from current practices in both the form and substance of the respective TGD. Two of them, Policy for the Development and Publication of Technical Guidance and Policy for the Development and Review of Regulations, are significantly less detailed than their predecessor TGDs. For instance, the draft TGDs omit internal procedural steps and checkpoints involved in the DEP’s promulgation of new technical guidance documents and regulations. The revisions, if finalized, will affect those regulated and public entities who routinely participate in the DEP’s TGD and regulatory development process.
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On June 20, 2017, Babst Calland released its seventh annual energy industry report entitled The 2017 Babst Calland Report – Upstream, Midstream and Downstream: Resurgence of the Appalachian Shale Industry; Legal and Regulatory Perspective for Producers and Midstream Operators. This annual review of shale gas development activity acknowledges the continuing evolution of this industry in the face of economic, regulatory, legal and local government challenges. To request a copy of the Report, contact info@babstcalland.com.
In this Report, Babst Calland attorneys provide perspective on issues, challenges, opportunities and recent developments in the Appalachian Basin and beyond relevant to producers and operators.
In general, the oil and gas industry has rebounded during the past year through efficiency measures, consolidation and a resurgence of business opportunities related to shale gas development and its impact on upstream, midstream and downstream industries. As a result, many new opportunities and approaches to regulation, asset optimization and infrastructure are underway. Increased spending during the past year has led to a significantly higher rig count in the Appalachian Basin enabling growth in the domestic production of oil and gas as other shale plays across the country experience reductions.
The shale gas industry continues to provide the tri-state region with significant economic opportunities through employment and related revenue from the development of well sites, building of pipelines necessary to transport gas to market, and new downstream opportunities being created for manufacturing industries due to the volume of natural gas and natural gas liquids produced in the Appalachian Basin. Shell’s progress from a year ago to construct an ethane cracker plant in Beaver County, Pennsylvania represents just one example of the expanding downstream market for natural gas. Many other manufacturing firms are expected to enter the region and establish businesses drawn by the energy and raw materials associated with natural gas and natural gas liquids from the Marcellus and Utica shales.
The Report also highlights changes that have occurred during the past year in the political landscape that are expected to affect the energy industry. The Trump administration is signaling a fundamental shift in the energy policies established by the Obama administration. New executive orders and policies have been issued that promise to lead to more pipeline development, reduced federal oversight of the oil and gas industry and increased access to oil and natural gas reserves.
Joseph K. Reinhart, shareholder and co-chair of Babst Calland’s Energy and Natural Resources Group, said, “This Report provides perspective on the challenges and opportunities of a resurging shale gas industry in the Appalachian Basin, including: the divergence of federal and state policy that creates more uncertainty for industry; increased special interest opposition groups on new issues and forums despite their lack of success in the courts; and the expansion from drilling to midstream development and now to downstream manufacturing that demonstrates the emergence of a more diverse energy economy.”
The 74-page Report contains six sections, highlighted below, each addressing key challenges for oil and gas producers and midstream operators.
- Business Issues: Adapting to the New Price Environment as natural gas producers continue to focus on reducing costs and improving efficiencies. Recently, the number of natural gas producers in the Appalachian Basin has contracted through select merger and acquisition activity. With efficiency of operations in mind, natural gas producers continue to focus on consolidating their activities geographically. The oil and gas industry faced significant financial stress over the past year, and 2016 will go down as one of the more dramatic years in the United States’ oil and gas history. In the 2016 calendar year, primarily due to low commodity prices, 70 North American oil and gas exploration and production companies filed for bankruptcy protection.
- State and Federal Governments Remain Active in a Changing Regulatory Landscape as developments in the state environmental standards for enforcement, air, water and waste management in Pennsylvania, West Virginia and Ohio, as well as anticipated initiatives from non-governmental organizations (NGOs), will continue to have an effect on production and midstream operations. Separately, the impact of the Trump administration on various federal regulatory initiatives from the Obama era promises to be significant. President Donald Trump’s March 28, 2017 Executive Order was directed towards the development of the country’s natural resources. The order, among other things, requires agencies to review regulations that may burden the development or use of domestic energy resources.
- Pipeline Safety Legislative and Regulatory Developments Continue to Shape the Industry through the U.S. Department of Transportation’s Pipeline and Hazardous Materials Safety Administration’s (PHMSA) pipeline safety program. It is unlikely that there will be a dramatic shift in PHMSA’s enforcement policy in 2017. “Protecting our Infrastructure of Pipelines and Enhancing Safety Act of 2016” (PIPES Act) was signed into law last year with a provision allowing PHMSA to issue emergency orders if an unsafe condition or practice constitutes, or is causing, an imminent hazard. These emergency orders can impose industry-wide operational restrictions, prohibitions, or safety measures without a prior hearing.
- Litigation Trends including a number of alleged nuisance claims continue to travel through West Virginia, Ohio and Pennsylvania courts. Materials discussing alleged health effects from unconventional natural gas development continue to be disseminated at a record pace by industry opposition groups. A casual review of the material could lead to the erroneous conclusion that air emissions have not been tested; this is not, however, the case. The air quality data collected by a variety of objective parties using established monitoring and testing protocols around shale development in northeastern U.S. over the last six years demonstrate that shale operations are safe.
- Local Government Law and Regulations Continue to Spawn Debate and Legal Challenges which continue to increase throughout the Appalachian Basin. However, the industry has successfully challenged overly-restricted ordinances. In contrast to municipalities that have adopted ordinances that permit reasonable oil and gas development, some local governments continued in 2017 to test their regulatory authority by enacting strict regulations for uses ancillary to well site development. Operators impacted by these regulations likewise continued to push back on these local regulations that severely impede, if not entirely prohibit, development or operation.
- Downstream Opportunities include exciting developments for production and midstream companies with new emerging markets for consumption of natural gas and natural gas liquids, such as power generation, export, and the petrochemical and related manufacturing industries. The U.S. petrochemical industry is undergoing tremendous growth, including the Northeast which is a prime target for more niche markets, and an opportunity to repurpose industrial assets for this regionalized growth.
As market conditions evolve for the oil and gas industry in the Appalachia Basin and throughout the United States, Babst Calland’s multidisciplinary team of energy attorneys continues to stay abreast of the many legal and regulatory challenges currently facing producers and midstream operators.
On May 26, 2017, in a suit styled Leggett v EQT Production Company, the West Virginia Supreme Court of Appeals issued majority and concurring (links to PDFs) opinions finding 4-1 that the use of the language “at the wellhead” in the Flat Rate Royalty Statute allows the use of the “net back” method to calculate royalties, and that the Estate of Tawney v. Columbia Natural Resources, L.L.C. case does not apply or control. Leggett was certified to the West Virginia Supreme Court of Appeals to determine whether the holding in Tawney, which did not allow post-production expense deductions when calculating royalty, applied when royalties are paid on old, flat rate leases converted to a 1/8 royalty by application of West Virginia’s “Flat Rate Royalty Statute.” The statute provides that royalties are to be paid “at the wellhead.” Tawney held that “at the wellhead” language in a lease was ambiguous, and deductions could not be taken unless expressly authorized in the lease in detail as to the type and method of calculation. After initially deciding Tawney applied and refusing to allow deductions under the Flat Rate Royalty Statute, the Leggett majority (with a change in composition post-election) reconsidered the case and reversed itself. The Court held that the rules of contract construction used to decide Tawney did not apply when interpreting a statute. More importantly, the Court seems to be signaling that it is willing to reconsider and possibly reverse Tawney, which could subsequently impact royalty calculations for West Virginia production.
On March 10, 2017, Senate Bill 576 (SB 576) was introduced in the West Virginia Senate to take the place of SB 244, which addressed the oil and natural gas industry’s effort to efficiently develop production of natural resources. Similar to SB 244, SB 576’s stated purpose is “to encourage the efficient and economic development of oil and gas resources[;]” however, it contains a number of provisions that differ from SB 244.
If signed into law, SB 576 would create a new code section, W. Va. Code §37B-1-1, et seq., titled the “Cotenancy and Lease Integration Act,” which, like SB 244, contains both “co-tenancy” and “lease integration” provisions.
SB 576 declares in proposed §37B-1-2 that West Virginia public policy includes both “the maximum recovery of oil and gas” and the “protect[ion] and enforce[ment of] the clear provision of contracts lawfully made.” This section also states that West Virginia public policy is to “safeguard, protect and enforce” both “the rights of surface owners” and “the correlative rights of operators and royalty owners in a pool of oil and gas to the end that each such operator and royalty owner may obtain his or her just and equitable share of production from that pool of oil and gas[.]”
Proposed section §37B-1-4 allows oil and gas production on a piece of property when “two thirds of the ownership interest in the oil and gas mineral property consent to a lawful use [i.e., production] of the mineral property[.]” By contrast, SB 244 only required that a “majority” of ownership interests agree to a “lawful use.”
In addition, SB 576 (like SB 244) states that payment of royalties will be on a pro rata basis, with payments for a mineral owner who cannot be located reserved by the producer. Unlike SB 244, however, SB 576 would specifically allow surface owners to use W. Va. § 55-12A-1, et seq. (the unknown and missing landowners statute), to lay claim to the interests of the absent or missing owners. Finally, and importantly, SB 576 would require that a mineral interest owner who opposes oil or natural gas development be paid royalties (1) “free of post-production expenses” and (2) “equal to his or her fractional share of the average royalty of his or her consenting cotenants[,]” but “in no event may the royalty be less than his or her fractional share of one-eight [12.5%].”
SB 576 adds proposed sections §37B-1-5 and -6, which would take the place of the “Joint Development” provision in SB 244. Under proposed §37B-1-5, “[w]here an operator or operators have the right to develop multiple contiguous oil and gas leases, the operator may develop these leases jointly by horizontal drilling unless the development is expressly prohibited by the terms of a lease or agreement.” Importantly, an operator may only disturb the surface of property subject to this provision if it “has a surface use agreement” with the owner(s) of the property that will be disturbed. As with SB 244, under proposed §37B-1-6, royalty payments are based upon “production [that] shall be allocated to each lease in the proportion that the net acreage of each lease bears to the total net acreage of the jointly developed tracts.” As with dissenting owners under proposed §37B-1-4, however, “[i]n the absence of specific agreement to the contrary or where deductions are authorized by statute, the royalty for all royalty owners of the jointly developed acreage who do not have leases containing express pooling and unitization clauses shall not be reduced for post-production expenses incurred by the operator.” This provision, however, is not “intended to impact royalties due for wells drilled prior to the effective date of this chapter.”
While SB 576 keeps the basic goals of SB 244 – development without the approval of all mineral interest owners and development of contiguous property through horizontal drilling – it contains a number of provisions designed to mollify the concerns of surface owner organizations and other property rights groups. The “co-tenancy” provision now requires a 2/3 majority of mineral ownership interests to permit development, and royalty payments to dissenting owners must not take post-production costs into account. The “lease integration” provisions explicitly allow horizontal drilling of contiguous tracts that are each subject to production leases (provided horizontal drilling is not expressly prohibited), but if a production lease does not explicitly permit pooling or unitization, then royalty payments to the owners under that lease cannot be deducted for post-production costs. Important to surface owners is the requirement that a surface use agreement be in place before the surface of any property is disturbed by joint development.
Babst Calland will follow SB 576 during West Virginia’s Legislative Session, which is scheduled to end on April 8, 2017.
On February 10, 2017, Senate Bill 244 (SB 244) was introduced in the West Virginia Senate to address the oil and natural gas industry’s effort to efficiently develop production of natural resources. Sponsored by, among others, Senate President Mitch Carmichael, SB 244’s stated purpose is “encouraging and facilitating the efficient and economic development of oil and gas resources” by addressing two situations common in West Virginia: (1) fractured ownership of mineral interests where less than 100% of the mineral owners can be located, and (2) development through horizontal drilling of contiguous parcels of property that are already under production leases.
SB 244 amends W. Va. Code §37-7-7 by adding subsection (b), the “Co-Tenancy” provision, which states that “a majority of the ownership interest in the mineral property” may “consent to a lawful use of the mineral property[.]” If the majority of the ownership interest agrees to the use, then the use is “permissible” and the non-agreeing ownership interest cannot claim “waste” or “trespass” on the mineral property. In addition, payment of royalties to all ownership interests will be on a pro rata basis to all owners of the mineral property, with payments for an owner who cannot be located reserved by the producer. While intended to address West Virginia’s requirement that 100% of the mineral owners agree on the terms for development of the mineral property, there is no requirement in SB 244 that the minority owners be absent or otherwise not found.
SB 244 also adds subsection (c), the “Joint Development” provision, to §37-7-7. Under this subsection, “[w]here an operator or operators have the right to develop multiple contiguous oil and gas leases separately, the operator may develop these leases jointly by horizontal drilling unless the development is expressly prohibited by the terms of a lease.” Under this language, an operator may development contiguous parcels of property using horizontal drilling unless a lease expressly prohibits such joint development activity. Notably, under this proposed subsection, the “operator’s use of any surface tract overlying the jointly developed leases shall be permissible for that joint development.” Finally, absent an agreement by all affected royalty owners, production shall be allocated to each lease “in the net proportion that the net acreage of each lease bears to the total net acreage of the jointly developed tracts.”
While Legislative leadership and Governor Justice have each articulated strong support for the oil and natural gas industry, SB 244 faces significant resistance from surface owner organizations, which dislike the simple “majority rules” aspect of the Co-Tenancy provision. Likewise, those groups also object to the Joint Development provision as it opens the surface of an affected parcel to development using horizontal drilling, even if the lease for that property was entered long before horizontal drilling became a popular technology in oil and natural gas production.
Babst Calland will follow SB 244 during West Virginia’s Legislative Session, which is scheduled to end on April 8, 2017.
In a recent op-ed published in the Post-Gazette, “Gas Pipelines Represent Prosperity” (Sept. 5 Perspectives), David Spigelmyer and James Kunz of the Marcellus Shale Coalition described the many benefits Read more ›
On July 19, in Herder Spring Hunting Club v. Keller (Case No. 5 MAP 2015), the Pennsylvania Supreme Court ruled in a 5-0 decision to confirm the practice of “title washing” of unseated or unimproved land in Pennsylvania. Prior to January 1, 1948, “title washing” occurred through a tax sale of unseated land from which oil, gas and/or minerals (the “subsurface estate”) had been previously severed. If the subsurface estate had not been separately assessed, the tax sale of the unseated land would extinguish the prior severance and vest the tax sale purchaser with full ownership in the surface and subsurface estates. If the oil and gas had been separately assessed, then the tax sale of the surface would have no effect on the subsurface estate. After January 1, 1948, mineral estates were no longer separately assessed from the surface in Pennsylvania and title washing could no longer occur.
In Herder Spring, the Court held that a 1935 tax sale for unseated land which was subject to an unassessed 1899 subsurface severance conveyed both the surface and subsurface estates. Citing prior case law, the Court reasoned that, under the prior tax sale law, taxes on unseated land were against the land itself rather than any particular owner. The law placed a duty on the owner of a severed interest to notify the taxing authorities. Tax commissioners had no duty to search the deed records to discover severances relating to unimproved lands. Therefore, if the subsurface was never separately assessed, then the property would be assessed and taxed as a whole, and a tax sale thereunder would encompass the entire estate. Additionally, the Court pointed out that owners of the mineral estate had two years to challenge the tax sale or redeem the property, but failed to do so. The Court also rejected the Appellants’ due process and estoppel by deed argument.
The Court limited its holding in Herder Spring to a very narrow subset of cases and noted that its decision would not govern: (i) tax sales for assessments of surface or mineral rights only; (ii) tax sales where severances occurred after the tax assessment; or (iii) situations in which surface owners can meet the adverse possession standard.
Justice Todd filed a concurring opinion agreeing with the majority but for its position on Appellants’ due process claim that notice by publication of the tax sale was inadequate. According to Justice Todd, such claim was waived for purposes of this appeal because it was untimely raised.
After first acquiring an option agreement in 2012 for a 340-acre site, and then purchasing the site in 2014, Shell Chemical Appalachia has officially announced that it will build a multi-billion dollar ethane cracker plant on the site of the former Horsehead zinc smelter in Beaver County, Pennsylvania. The site will consist of the cracker, two units that will convert ethylene into polyethylene pellets, a natural gas-fired power plant, a loading dock, and a wastewater plant. It is estimated that constructing the plant will employ approximately 6,000 workers. Thereafter, the plant will permanently employ about 600 workers. The plant is expected to consume approximately 105,000 barrels of ethane per day and Shell has reportedly secured supplier commitments from at least 10 oil and gas operators in the region. Primary construction on the site is expected to start in approximately 18 months.
According to a report by the Charleston Gazette-Mail, TransCanada will be purchasing Columbia Pipeline Group for $13 billion. TransCanada had previously proposed the Keystone XL pipeline, and owns more than 42,000 miles of pipeline in North America. TransCanada will acquire about 15,000 miles of pipeline, as well as processing and underground storage facilities, through the purchase of Columbia.
StateImpact Pennsylvania reports that Pennsylvania Governor Tom Wolf wants natural gas drillers to pay a 6.5% severance tax on natural gas production, which he estimates will bring in $217.8 million dollars for the 2016/2017 fiscal year, a fraction of the billion dollars he projected last year’s severance tax proposal would generate.
The newest enactment of the proposed severance tax will keep the state’s impact fee, but will offer producers a credit for those fees which would reduce their severance tax payments. That proposal was not included in last year’s unsuccessful attempt to impose a tax of 5 percent plus a separate fee of 4.7 cents per thousand cubic feet of gas each well produces. The proposal has been met with fierce opposition from industry leaders, who state that Governor Wolf is ignoring market realities of low oil and gas prices which have recently forced producers to cut capital expenditures.