CHAPTER 10 PRIVATE LANDOWNER ROYALTIES ON OIL — THEORY AND REALITY
| Jurisdiction | United States |
(Sept 2003)
PRIVATE LANDOWNER ROYALTIES ON OIL — THEORY AND REALITY
Hall, Estill, Hardwick, Gable, Golden & Nelson, P.C.
Tulsa, Oklahoma
TABLE OF CONTENTS
§ 10.1 Introduction
§ 10.2 Royalties on Oil - Fundamentally Different Than on Gas
§ 10.3 Posted Price Litigation
§ 10.4 Factors Bearing On Royalty Outcomes
§ 10.5 The Crude Oil Royalty Clause
[1] Variations
[2] The In-Kind Clause
[3] In-Value Clauses
§ 10.6 The Division Order
[1] The Historical Instrument
[2] Division Orders Under Attack
[3] The Impotent Division Order - No Longer A Contract of Sale
[4] Life Without Contract of Sale Division Order - Do We Truly Want To Go There?
[5] The Statutory Division Order
[6] Producer-Operator Division Orders
§ 10.7 The Implied Duty to Market
[1] General
[2] Applicability To Royalty Oil
[3] The Jurisprudential Bases For Implied Covenants
[4] The Application of Implied-in-Fact Principles to the Duty to Market Royalty Oil
[5] Other Attributes of the Duty to Market
[6] Standard of Performance: Prudent Operator or Fiduciary
§ 10.8 Applicability of the Uniform Commercial Code
§ 10.9 Costs Chargeable Against the Royalty Owner
[1] The Context
[2] A Closer Look: Sometimes Words Mean What They Say; Sometimes They Mean What The Court Believes The Parties "Really" Meant
[3] The Statutory Amendment: The Legislature May Rewrite Your Contract
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SYNOPSIS
§ 10.10 Affiliate Transactions
[1] Context and Background
[2] Consequences of Veil Piercing- Why Do We Care?
Appendix- Examples of Royalty Clauses
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§ 10.1 Introduction
This paper explores the matter of royalties and royalty payments on oil due under so- called private landowner oil and gas leases. This is meant to exclude the payment and accounting for royalty on oil under federal and Indian leases and under leases issued by states and state agencies. What distinguishes private landowner royalties, whether on oil or gas, is that they are in the first instance a matter of contract governed by the provisions of the royalty clause in the oil and gas lease. Royalties on federal and Indian leases have much less to do with the terms of the royalty clause and much more to do with implementing regulations.1 Royalties on leases issued by states and state agencies are somewhat in the middle, often containing explicit language on the valuation of and accounting for royalty. But many, if not most states, have exercised their rule-making authority to promulgate rules and regulations governing royalty accounting and product valuation so as to distinguish state and state agency leases from private landowner leases sufficiently that much of the analysis applicable to private landowner leases fails when applied to the state lease arena - many of the answers to royalty valuation problems are to be found in regulations and not as a matter of, at least in the first instance, contract construction.
§ 10.2 Royalties on Oil - Fundamentally Different Than on Gas
The first thing we notice about royalty on oil are significant fundamental differences from royalties on gas. This manifests itself by the paucity of articles and papers dealing with oil royalties compared with the plethora of papers and published articles dealing with gas royalties. The past decade reveals only three papers dealing with oil royalties.2 Even these three papers were an outgrowth of the so-called posted price litigation, an issue which has now largely been settled. This, of course, suggests there are many more problems and, as a consequence, much more litigation over gas royalties than oil. This is due in large part to a couple of things. First, the fundamental difference under the typical oil royalty and gas royalty clause as pertains to the lessor's ownership rights in the product. The second is the fundamental difference in the very nature of the product. Oil is liquid and more or less easily stored on-lease or in the field and thus susceptible to periodic as opposed to continuous marketing. In contrast, gas, by its very nature, cannot be stored on-lease or in the field but requires a series of pipes from wellhead to end user
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(or to regional underground storage reservoirs) in order for a gas well to even produce. The infrastructure required for gas marketing is much more pervasive and capital intensive than for oil. Overlaying this requirement for gas marketing is the fundamental change in the regulatory environment pertaining to gas pipelines which has transformed pipelines from their pre-1980's role of gas merchants3 which contracted with producers to purchase gas, transported the gas through the lines which they had built and resold it, sometimes to industrial and other end users but most often to local distribution companies ("LDCs") who further distributed the gas to industrial, commercial and residential customers.4 These pipelines were predominantly interstate pipelines regulated by the Federal Energy Regulatory Commission ("FERC") and its predecessor, the Federal Power Commission ("FPC") under the Natural Gas Act.5 Most frequently these pipelines purchased gas at or near the well and, as a part of their bundled service, provided gathering and compression and often dehydration.
This change in the regulatory environment began in the mid-1980's as a result of a series of orders issued by the FERC.6 The effect of these orders was to unbundle the interstate pipelines' various functions so that today pipelines are chiefly transporters or carriers of natural gas with the functions of purchase, gathering, resale, storage and other discrete services being performed by other entities. This revolution in the regulatory environment and the changes it has wrought has spawned a deluge of litigation chiefly dealing with the issue of post-production cost deductions. In contrast, no regulatory sea-change applicable to crude oil marketing has occurred.
Although not a regulatory change, one economic change which has had an impact on crude oil markets and might be viewed as fostering some litigation is the advent of the trading of crude oil futures on the New York Mercantile Exchange ("NYMEX"). The advent of such public markets raised the issue in some quarters as to whether the posted prices being paid by major crude oil purchasers truly represented market value. This spawned the posted price litigation.
§10.3 Posted Price Litigation
The 1990's saw an explosion of royalty oil litigation sparked by the 1995 so-called "Summit Report." This was a report prepared by Summit Resource Management, Inc. at the request of the General Land Offices of the States of Colorado, New Mexico and Texas.7 The
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Summit Report8 concluded that since 1988 major oil companies had underpaid royalties on crude oil by basing their payment on posted prices. These underpayments were asserted to be 6% for sour crude and 3% for sweet. The basis for the underpayment was that the posted price utilized by most companies was considerably less than the true value received by the companies.9 An explosion of crude oil royalty cases followed in state courts in Texas, Oklahoma and New Mexico.10 Generally the royalty owners asserted causes of action based upon breach of the royalty clause, breach of the implied covenant to market and breach of the duty to act reasonably and in good faith under the Uniform Commercial Code.11
At the same time suits sprung up in state court, numerous suits were also filed in federal court12 raising antitrust claims, among others.13 These suits were consolidated in the U. S. District Court for the Southern District of Texas, Corpus Christi Division, pursuant to the federal court's multi-district litigation powers, and in 1999 these suits were settled pursuant to the court's order certifying classes for these purposes. Unlike gas royalty litigation which continues unabated, the crude oil royalty litigation has largely been settled and disappeared, coincident with the settlement of the federal multi-district litigation.14
§ 10.4 Factors Bearing On Royalty Outcomes
In the crude oil marketing environment, there are a number of factors that bear on the outcome of any particular issue posed. These include the structure of the oil royalty clause and the lessor's resulting ownership rights with respect to produced crude oil, other express stipulations of the royalty clause, such as point of delivery to lessor's account, any specifications as to value or express sharing of post-severance costs, optional rights of the lessee to purchase the lessor's royalty share; the division order, what it stipulates and who holds it - the lessee or the crude oil purchaser; recent legislation defining division orders and limiting their use; relational duties imposed between lessor and lessee such as the implied duty to market, any fiduciary duty or any duty of good faith and fair dealing; post-production cost issues when the oil is trucked or piped to a downstream point of sale or requires treating before delivery to purchaser; and the interposing of affiliates of the lessee in the marketing process. As will be seen, all of these factors can influence the outcome of any particular oil royalty issue. However, the two of greatest importance are the royalty clause and the resulting ownership rights of the lessor in severed crude oil and other express terms of the clause governing crude oil marketing. And the second is the utilization of division orders.
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§ 10.5 The Crude Oil Royalty Clause
[1] Variations
The variations in wording among leases in respect of the crude oil royalty clause are as myriad as the various producers and printing houses who have over the years undertaken to print or publish a particular lease form. A random sample of the various crude oil royalty clauses from various forms is found on...
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