CHAPTER 1 ROYALTY INTERESTS IN THE UNITED STATES: NOT CUT FROM THE SAME CLOTH
| Jurisdiction | United States |
(Apr 1993)
ROYALTY INTERESTS IN THE UNITED STATES: NOT CUT FROM THE SAME CLOTH
Texas Tech University School of Law
Lubbock, Texas
1.01 — Introduction
If you ask any lawyer familiar with oil and gas law what a royalty is, the response will be reasonably uniform whether the lawyer is located in Colorado, Texas, Kansas, Louisiana, Oklahoma or New Mexico. Most lawyers agree with the basic definition given of a royalty interest by Williams & Meyers. They define a royalty as:
(1) The landowner's share of production, free of expenses of production.
(2) A share of production, free of expenses of production...1
Thus we know that a royalty interest is not a cost-bearing or profit-sharing interest. We also know that it is solely a share of production and does not include any of the remaining constituent elements of a mineral estate. The royalty interest therefore would not be a possessory estate and would likewise not have any easement to use or occupy the surface.
But when you take a closer look at many of the underlying issues which affect royalty interests, you will not find universal agreement among the states. In fact you will find an amazing diversity of opinion on several basic issues relating to defining, measuring and valuing royalty interests. In this paper we will explore a number of those areas where there is a split of authority especially where the differences relate to the valuation of the royalty interest.2
1.02 — The Nature of the Royalty Interest
A — The Stand Alone Royalty Interest
The royalty interest is a constituent or component part of the mineral estate.3 As stated above, the owner of a royalty interest has a right to a fractional share of
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production free of any exploration and production costs.4 A royalty owner does not possess any of the other constituent elements of a mineral interest including the right to explore and/or develop, the executive power to lease or the right to receive bonus or delay rental payments.5 The duration of a royalty interest may be limited to any of the common law estates in land, and in addition may be limited by use of the so-called defeasible term interest which measures the interest by a fixed term for years, followed by an indefinite period usually requiring the continuation of production.6
While the above statements are generally correct, even in the basic definition of a royalty interest there is a divergence of views. For example, most states clearly allow the owner of the mineral estate to segregate the royalty interest and transfer it to another party in fee simple absolute. Yet in Kansas the attempted transfer of a perpetual royalty interest has been found to violate the Rule Against Perpetuities.7 The problem began in Miller v. Sooy,8 where in court in dictum opined that an attempt to transfer a royalty interest that would affect future leases for an indefinite period would violate the Rule.9 But it
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was Lathrop v. Eyestone,10 that firmly entrenched the Rule as a bar to the transfer of a perpetual royalty interest. In Lathrop, the lessor purported to transfer a fractional share of royalty under an existing lease and a fractional share of royalty and bonus under any future leases. The lessor, however, retained the executive power. The plaintiff acquired the lessor's interest and after the extant lease expired brought a quiet title action seeking to terminate the grantee's interest as a violation of the Rule. The court based its holding on the proposition that a royalty interest does not vest until it is created by a lease. Thus the transfer of a present possessory mineral estate is perfectly valid since it vests immediately and Kansas courts will construe an ambiguous instrument so as to create a valid mineral interest rather than an invalid royalty interest.11 While Lathrop has been questioned, it has never been overruled and it would be a foolhardy lawyer who drafted a royalty deed that was not of a limited duration in Kansas.12 With the possible exceptions of California13 and Colorado,14 however, the Kansas adoption of the Rule has been appropriately ignored.15 In fact, in
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several states where the issue has arisen since the Lathrop decision, the courts have rejected its application to the transfer of a royalty interest.16
Another area of divergence that arises when a stand alone royalty interest is created affects the duty owned that royalty owner by the owner of the executive power to lease.17 For example, an early Louisiana case, Gardner v. Boagni,18 found that there was no duty owed at all between the executive and non-executive except that duty which was expressly created by a written instrument. This position, however, was reversed with the adoption of Article 109 of the Mineral Code in 1975 which required the executive owner to act in good faith and as a reasonably prudent operator. Thus the Mineral Code imposed both a subjective and objective standard of care on the executive owner.
Many jurisdictions have adopted an "utmost fair dealing" standard.19 But defining what is utmost fair
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dealing under any particular factual situation has proved to be elusive. While it is generally conceded to be an intermediate standard of care, lying somewhere between good faith and fiduciary, the parameters of the standard have never been carefully laid out. In fact, some courts refer to the standard as one of utmost good faith and fair dealing, combining both an objective and subjective test, although never fully explaining the differences between the two.20 Other courts have used the standard "utmost fair dealing and diligence."21
Yet other courts have found higher duties owed by the executive. In Hollister Co. v. Cal-L Exploration Corp.,22 the court analogized the relationship between the executive and non-executive as similar to that of a trustee and beneficiary. That immediately raises the spectre of imposing a fiduciary obligation on the owner of the executive right. In fact, such language was used in Manges v. Guerra,23 although later Texas courts eschewed finding a fiduciary relationship.24 Thus, even within a single state there has been difficulty in agreeing on the basic issue of what is the relationship between a stand alone royalty interest owner and the owner of the executive power.
B — The Landowner's or Leasehold Royalty
The landowner's royalty is the percentage of production retained by the lessor who has granted the privilege to explore and produce to the lessee. The royalty has been firmly entrenched in the oil and gas business since its inception. For example, while it was labelled a rental a
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copy of the Drake lease retained for the benefit of the lessor, "one-eighth of all oil as collected from the springs in barrels."25 This is an example of a royalty clause requiring the lessee to make an "in kind" payment of the oil. Neither the lessor nor the lessee have the option to make payment except in kind.26
There is no standard royalty clause. There are substantial variations in length, coverage and types depending on the state or region in which the lease is executed. The following examples are not meant to be representative but to suggest the various general types of clauses that can be found. Royalty clauses have historically differed regarding the production of oil versus the production of gas. This can be traced to the earlier view of natural gas as a waste product and the difficulties in above ground storage of gas. It is also true that royalty clauses are more varied when it comes to gas than when it comes to oil.
1. Oil Royalty Clauses
Lessee shall pay royalties to Lessor as follows: (a) one-eighth (1/8th) of the Oil produced and saved from said land to be delivered at the wells or to the credit of Lessor into the pipeline to which the well may be connected: Lessee may, at any time or times, purchase any royalty oil, paying the market value in the field on the day it is run to the storage tanks or pipeline.27
The above provision requires payment in kind either at the well or in the pipeline. It does, however, favor the lessee by giving the lessee the power, but not the duty, to take the royalty oil and pay the prevailing market value on the day the oil is run to the storage tanks.
A royalty clause which is more favorable to the lessor is as follows:
(a) on oil, one-eighth (1/8) of that produced from said land the same to be delivered free of cost to Lessor into the nearest available pipeline to which the oil produced from this lease may be delivered...28
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This clause makes it clear that the expense of delivering the oil to the pipeline is borne solely by the lessee. In addition, the obligation is to deliver it to the nearest available pipeline. Finally, the lessee is not authorized to take the lessor's royalty oil and pay for it.
The principal variations in oil royalty clauses relate to the fraction of royalty reserved, whether it must be taken in kind, if it is not taken in kind is the royalty owner to receive the market price or market value of the oil, the expenses which may be deducted from the royalty and how it is to be measured, sampled and/or adjusted. Obviously, the lengthier the oil royalty clause the more you can deal with the above variables. While earlier leases were silent on treatment or transportation issues, most leases today specify a point of delivery as either a storage tank or the nearest common carrier pipeline, so that expenses incurred prior to the point of delivery are solely borne by the lessee.
2. Gas Royalty Clauses
Unlike oil royalty clauses, gas royalty clauses have normally been longer and more complex. After the initial period in which a flat fee per well or no royalty at all was standard, gas royalty clauses have gradually evolved into drafter's nightmares. The options are typically more numerous and the products...
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