Colorado Gas Royalty Law: the Intersection of Implied Covenants and Class Treatment
| Publication year | 2014 |
| Pages | 57 |
Articles
Natural Resource and Environmental Law—Natural Resources and Energy Law
Colorado Gas Royalty Law: The Intersection of Implied Covenants and Class Treatment
By Barry C. Bartel
Natural Resource and Environmental Law articles are sponsored by the CBA Environmental Law, Water Law, and Natural Resources and Energy Law Sections. The Sections publish articles of interest on local and international topics.
Coordinating Editors
Kevin Klnnear, Boulder, Porzak Browning & Bushong LLP (water)—(303) 443-6800, kkinnear@pbblaw.com; Melanie Granberg, Denver, Gablehouse Granberg, LLC (environmental)—(303) 572-0050, mgranberg@gcgllc.com; Joel Benson, Denver, Davis Graham & Stubbs LLP (natural resources and energy)—(303) 892-7470, joel.benson@dgslaw.com
In 2013, the Tenth Circuit Court of Appeals vacated certification of two classes of royalty owners in cases from Oklahoma and Kansas. Together with these jurisdictions, Colorado has adopted the "marketable product rule" as an implied obligation in oil and gas leases. Litigation over the intersection of this rule with class certification standards will determine the extent to which implied covenants create common issues for class treatment.
Contracts are a cornerstone of business relationships. Oil and gas leases are contracts defining the rights and obligations for exploration and production of natural resources. The express terms of a lease define the obligations of the parties. However, where leases do not address rights and obligations expressly, some courts impose certain implied obligations. Where express contract terms create different obligations in a group of parties, courts are not likely to treat those parties as a class with common issues to litigate. However, when similar obligations are implied in a group of contracts, those obligations may be used to define a class of litigants under Rule 23. Recent cases have begun to define the limits where covenants implied in oil and gas leases intersect with requirements for common issues necessary for class treatment.
Implied Covenants
Courts address implied covenants in different ways.[1] Colorado law implies certain obligations in oil and gas leases when the express provisions do not adequately fulfill the purposes of the lease.[2] In Davis v. Cramer, the Colorado Supreme Court acknowledged that "most commentators divide the implied covenants into four categories: exploration, development, production (including marketing), and protection against drainage."[3] The Colorado Supreme Court had previously recognized implied obligations to drill; to develop; to operate diligently and prudently; and to protect against drainage, where "[e]mbodied in the covenant to operate diligently and prudently is the implied covenant to market."[4]
Failure to fulfill an implied obligation in an oil and gas lease can lead to cancellation of the lease.[5] For example, failure to market gas within a reasonable time after completion of a well can lead to cancellation.[6] That is what happened on remand in Davis v. Cramer. There, a well capable of producing in paying quantities was completed in 1972 and a pipeline was built less than three-quarters of a mile from the well in 1975, but the well was not connected to the pipeline and the product was not marketed until 1978.[7] The court of appeals affirmed the trial court's judgment terminating the lease for failure to market the gas within a reasonable time after completion of the well.[8]
Failure to market the product within a reasonable time can lead to cancellation of the underlying oil and gas lease. As the law has developed, courts in several states have defined obligations of marketing in cases for breach of the lease alleging that royalty has been underpaid.
The Marketable Product Rule
Colorado is one of several states that has adopted what is referred to as the "marketable product rule" for payment of royalties on production of natural gas.[9] This is one form of implied covenant. The Colorado Supreme Court articulated the obligation in Rogers v. Westerman Farm Co.[10] There, gas was produced from some 200 wells and sold at the well or at the interstate pipeline,[11] so the issue was not a failure to market and potential cancellation. Rather, the case involved the proper allocation of costs between the parties.
Specifically, the Court addressed whether the express terms in the oil and gas leases were sufficiently clear, or whether an implied obligation would determine the proper allocation of the costs of gathering, compressing, and dehydrating the gas before it entered the interstate pipeline.[12] The Court concluded that, "[a]bsent express lease provisions addressing allocation of costs, the lessee's duty to market requires that the lessee bear the expenses incurred in obtaining a marketable product."[13]
In determining whether express lease provisions addressed allocation of costs, the Court considered leases with four provisions for royalty payment that it had not previously interpreted.[14] All four of the lease types at issue contained some common language contemplating that royalties are to be computed "at the well" or "at the mouth of the well."[15]
The Court explained that:
[d]espite the differing language in each of the four types of leases, and despite the arguments raised that the "at the well" and "at the mouth of the well" language provides for the allocation of costs, we conclude that all of the leases are, in fact, silent with respect to the allocation of costs.[16]
Thus, the Court concluded that "the expense of getting the product to a marketable condition and location are borne by the lessee."[17]
The Rule in Other States
Colorado is not alone in adopting a marketable product rule. Three years earlier in Oklahoma, its Supreme Court articulated a marketable product rule in response to a certified question from the federal district court asking whether a lessee is entitled to deduct a proportional share of transportation, compression, dehydration, and blending costs when the lease obligates the lessee to pay "3/16th of the gross proceeds received for the gas sold."[18] In this case, the Oklahoma Court held that:
a royalty interest may bear post-production costs of transporting, blending, compression, and dehydration, when the costs are reasonable, when actual royalty revenues increase in proportion to the costs assessed against the royalty interest, when the costs are associated with transforming an already marketable product into an enhanced product, and when the lessee meets its burden of showing these facts.[19]
Likewise, the Kansas Supreme Court stated its law to be that:
[a]bsent a contract providing to the contrary, a nonworking interest owner is not obligated to bear any share of production expense, such as compressing, transporting, and processing, undertaken to transform gas into a marketable product.[20]
However, the Court also specified that, "[o]nce a marketable product is obtained, reasonable costs incurred to transport or enhance the value of the marketable gas may be charged against nonworking interest owners."[21]
The Kansas Court's statement of the rule highlights a unique aspect of the Colorado rule. In the Kansas case, although the gas was marketable at the well, there was no market at the well, so "the lessor must bear a proportionate share of the reasonable cost of transporting the marketable gas to its point of sale."[22] In Colorado, the marketable product rule articulated in Rogers requires that "the expense of getting the product to a marketable condition and location are borne by the lessee,"[23] where "the determination of whether a market exists is an issue of fact to be decided by a jury. . "[24]
The Intersection of Implied Covenants and Class Treatment
Colorado and Federal Rule of Civil Procedure 23 provide a mechanism for actions on behalf of groups of plaintiffs where...
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