CHAPTER 10 APPROACHING THE DAY OF JUDGMENT: RECENT DEVELOPMENTS IN TAKE-OR-PAY LITIGATION

• Jurisdiction: United States

Natural Gas Marketing
(May 1987)
CHAPTER 10
APPROACHING THE DAY OF JUDGMENT: RECENT DEVELOPMENTS IN TAKE-OR-PAY LITIGATION^*
Paul E. Strohl
Johnson & SwanSon
Dallas, Texas

TABLE OF CONTENTS

SYNOPSIS

I. INTRODUCTION

II. THE NATURE AND PURPOSES OF TAKE-OR-PAY PROVISIONS

A. NATURE

B. PURPOSES

III. RECOVERY ON TAKE-OR-PAY CLAIMS

A. THEORIES OF RECOVERY

1. Anticipatory Repudiation

2. Drainage

3. Tortious Breach of Contract

4. Antitrust

5. RICO

6. Miscellaneous Claims

B. COMMON PIPELINE DEFENSES

1. Commercial Impracticability and Frustration of Purpose

2. Force Majeure

3. Take-or-Pay Provisions as Penalties

4. Unconscionability

5. Miscellaneous Contractual Defenses

6. Illegality Under the NGPA

7. FERC Primary Jurisdiction

8. Conservation Regulations

a. Waste

b. Ratable Taking

c. Analysis

IV. REMEDIES

A. DAMAGES

B. INJUNCTIVE RELIEF

C. RESCISSION OF PRIOR CONTRACT AMENDMENTS

V. SOME OBSERVATIONS ON ARBITRATION

A. THE DECISION TO ARBITRATE

1. Advantages

a. Expertise

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b. Speed

c. Expense

2. Disadvantages

a. Discretion

b. Absence of Appeals

c. Absence of Procedural Safeguards

B. AVOIDING ARBITRATION

C. ARBITRATING THE DISPUTE

1. Reach an Agreement on Ground Rules

2. Select the Arbitrators Carefully

3. Organize Your Presentation

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I. INTRODUCTION

For many years, policymakers and the courts paid little attention to take-or-pay provisions in natural gas sales contracts. During the era of federal wellhead price controls, there was no shortage of demand for natural gas. Instead, the central problem facing the natural gas industry was security of supply. Pipelines and producers could enter into long-term contracts, confident that government regulation limited their market risk. Insufficient takes were rare in this economic environment, and could easily be made up in subsequent years.

Significant developments in the early 1980's dispelled these feelings of complacency. The prices of fuel oil and other energy sources which compete with natural gas for the industrial market plunged sharply and caused customers to swing off gas pipeline systems. Meanwhile, overall industrial demand shrank during the recession of 1981-1982 and the subsequent restructuring of American heavy industry. However, contract price provisions continued to track federal price ceilings in excess of market-clearing levels even though the Federal Energy Regulatory Commission ("FERC") issued new rules designed to permit pipeline customers to benefit from lower natural gas prices. Natural gas was thus transformed from a regulated service into a free-market

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commodity, and competition became a fact of life rather than a vague threat. See generally, Notice of Inquiry, FERC Doc. No. RM85-1-000, 50 Fed. Reg. 114 (Jan. 2, 1985); Order No. 380, Elimination of Variable Costs from Certain Natural Gas Pipeline Minimum Commodity Bill Provisions, Docket No. RM83-71-000, Regulations Preambles 1982-1985 Fed. Energy Reg. Comm'n Rep. (CCH) par. 30,571 (May 25, 1984); Order No. 436, Regulation of Natural Gas Pipelines After Partial Wellhead Decontrol, Docket No. RM 85-1-000, Regulations Preambles 1982-1985 Fed. Energy Reg. Comm'n Rep. (CCH) par. 30,665 (October 9, 1985).

The sharp downward spike in the demand for natural gas late in 1981 destroyed the economic basis for natural gas contracts which had been entered into during the late 1970's and early 1980's. Pipelines, having entered into long-term purchase contracts at above-market prices, faced tens of millions of dollars in take-or-pay liabilities, with no assurance that deficiencies could be made up in subsequent contract years.¹ While pipelines sought excuses from performance, producers, under heavy pressure from creditors and investors because of falling prices, demanded enforcement of take-or-pay provisions. In a

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market driven by surplus rather than scarcity, the take-or-pay provision moved into the forefront of the continuing debate over energy policy.

The debate in the courts has been the most heated; however, until quite recently, there had been few judicial decisions specifically addressing the enforceability of take-or-pay provisions in natural gas contracts. Reasons for this are not difficult to find. As noted above, market conditions prior to the early 1980's made take-or-pay litigation unnecessary. Moreover, the modern rules of civil procedure encourage protracted courtroom battles and slow development of precedent across several years in novel controversies. When trial follows several years of discovery, and when ensuing appeals span an additional year or more, a lawyer frequently has little more than his own speculation to offer clients in the interim. Only within the past year have judicial decisions started to trickle in.

This paper will summarize the most important of these decisions. It begins with a general discussion of the nature and purposes of take-or-pay provisions. After summarizing the legal theories used to justify recovery on take-or-pay claims, and the most common defenses to those claims, the paper discusses the remedies that may be available for breach of take-or-pay provisions, and concludes with some observations on arbitration as an alternative to the litigation of take-or-pay disputes.²

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II. THE NATURE AND PURPOSES OF TAKE-OR-PAY PROVISIONS

A. NATURE

The take-or-pay provision of a natural gas contract requires the purchaser³ to buy (i.e., take) a specified quantity of natural gas, or, in the alternative, to pay for that quantity if it is not taken. Ordinarily, the purchaser must take a specified percentage of the amount of gas that wells subject to the contract can produce during a given year. However, the obligation may also be stated in terms of the total reserves estimated by the parties to be recoverable from the lands subject to the contract. If the specified quantity of natural gas is paid for but not taken during the applicable contract year, the purchaser will usually be permitted to take the gas in a subsequent contract year either at no cost, or upon payment of any price increase between the time payment was made and the time the seller actually delivered the gas. See generally, H. WILLIAMS & C. MEYERS, OIL AND GAS LAW §724.5 (1986); Johnson,

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Natural Gas Sales Contracts, 34 INST. ON OIL & GAS L. & TAX'N 83 (1983) (hereinafter Johnson); Howell, Natural Gas Purchase Contracts, 5 ROCKY MTN. MIN. L. INST. 221, 253-63 (1960). Thus, the take-or-pay provision makes the gas sales contract an alternative contract which permits the buyer to perform by either taking or paying for the specified quantity of gas. E.g., Int'l Mineral & Chem. Corp. v. Llano, Inc., 770 F.2d 879 (10th Cir. 1985), cert. denied, ________ U.S. _______, 106 S. Ct. 1196 (1986) (hereinafter International Mineral); PGC Pipeline Co. v. Louisiana Intrastate Gas Co., 791 F.2d 338 (5th Cir. 1986) (hereinafter PGC Pipeline); Superior Oil Co. v. Transco Energy Co., 616 F. Supp. 98 (W.D. La. 1985).

B. PURPOSES

Take-or-pay provisions serve several commercial purposes. First, they give the seller the assurance of cash flow necessary to compensate him for the risk of exploring and drilling for natural gas. Second, they allocate the risk of a falling market to the pipeline. Third, they encourage purchasers to take gas so that producers may comply with their obligations to royalty owners under implied leasehold covenants to market production. Fourth, the take-or-pay clauses afford a producer some protection against drainage of gas underlying his land to the tracts of adjoining producers. See generally, Universal Resources Corp. v. Panhandle E. Pipeline Co., No. CA3-85-0723-R (N.D. Tex. Apr. 1, 1986), affirmed, 813 F.2d 77 (5th Cir. 1987) (motion for

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rehearing pending) (hereinafter Universal Resources);⁴ Medina, McKenzie & Daniel, Take or Litigate: Enforcing the Plain Meaning of the Take-or-Pay Clause in Natural Gas Contracts, 40 ARK. L. REV. 185, 188, 190 (1987) (hereinafter Take or Litigate); Johnson, supra, at 111.

Take-or-pay provisions also help pipelines. Specifically, such provisions give pipelines a hedge against changed market conditions, permitting them to limit their purchase obligation to a specified percentage of the amount that the wells dedicated to the contract are capable of producing. As a result, pipelines have the flexibility to meet fluctuations in demand due to economic conditions or seasonal factors. The take-or-pay provision may also serve to allocate the risk of failure of supply to the producer. See generally, Universal Resources, supra; Johnson, id.; Pierce, Natural Gas Regulation, Deregulation, and Contracts, 68 VA. L. REV. 63, 78-79 (1982).

III. RECOVERY ON TAKE-OR-PAY CLAIMS

A. THEORIES OF RECOVERY

A purchaser who fails to take gas from a seller as prescribed by a natural gas sales contract may be liable to the seller under a number of theories, depending upon the terms of the contract and the nature of the relationship between buyer and seller. The most straightforward of these theories is that of breach of contract, and it is this theory which will be

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emphasized.⁵ However, the existence of other causes of action deserve at least a brief mention.

1. Anticipatory Repudiation.

A producer may sue for anticipatory repudiation of the contract if his purchaser has taken any action or made any statement demonstrating a clear determination not to continue performance. UCC §2-610 clearly authorizes suit for anticipatory breach of contract where there has been "an overt communication of intention or an action which renders performance impossible or demonstrates a clear determination not to continue with performance." UCC §2-610, Comment 1. The aggrieved seller may obtain any remedy to which he is entitled under the other...