CHAPTER 10 THE OPERATOR'S RIGHTS AND RESPONSIBILITIES IN MARKETING PRODUCTION

• Jurisdiction: United States

Oil and Gas Agreements
(May 1983)
CHAPTER 10
THE OPERATOR'S RIGHTS AND RESPONSIBILITIES IN MARKETING PRODUCTION
William B. Burford
Hinkle, Cox, Eaton, Coffield & Hensley
Midland, Texas

I. INTRODUCTION

It is appropriate that an institute concerned with oil and gas agreements should include a discussion of the rights and obligations of the operator with respect to the marketing of production. Although this paper will focus less on particular aspects of typical agreements used in the oil and gas industry than will many of the papers to be presented here, an understanding of the legal aspects of the role of the primary actor in the movement of the product from the ground to the market is necessary to comprehension of the need for and the ramifications of the agreements that are used.

This paper will examine the existence and extent of the operator's right to market oil and gas attributable to the interests owned by others, as well as the obligation to market production in a particular manner or to market production at all. It will discuss the implementation of marketing and how the nature of property interests and the practicalities of the business dictate or suggest legal consequences with respect to the operator's own interest and the interests of other owners. The ultimate purpose is to present a conception of where the operator stands in the process of marketing.

II. THE OPERATOR'S RIGHT TO MARKET PRODUCTION

An examination of whether the operator of a lease or a well has the right to market production belonging to another must begin with an inspection of the relationships between the operator and other owners of interests.

The relationship between the operator and owners of royalty interests is ordinarily established and governed by an oil and gas lease.¹ Typically a lease provides, with regard to oil, that the lessee must deliver to the lessor or to the lessor's credit in the pipeline to which the well may be connected a particular fraction of the oil produced from the leased premises. The right of the lessee to do anything with the lessor's royalty share is not explicit in this form of lease, and from all appearances in the instrument it might be expected that the lessor will commonly truck or pipe his own oil off the lease.²

In practice, of course, the lessor does not commonly physically take delivery of his royalty oil and see to its delivery to market. The operating lessee, after producing the lessor's royalty share of oil along with its own working interest share, delivers the royalty oil into the same pipeline or tank truck as

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its own oil to be delivered to market. Even in the absence of any agreement specifically authorizing the lessee to market the lessor's oil or authorizing the purchaser to take it, the lessee's right to do so seems to have been seldom questioned, at least in recent years. The reason is not hard to find. The lease clearly contemplates that the lessee will be allowed to produce and to retain and sell a specified portion of the oil as his own. Although the lease further provides that the lessee will deliver a specified portion of the oil produced to or for the lessor, the lessor is under no obligation under the lease to furnish his own facilities for storage or transportation of his share of the oil. The lessee's right to produce and sell its portion of the oil, it has been held, therefore necessarily carries with it the implicit right to market the lessor's oil as well if the lessor has made no separate arrangements.³ Likewise, there is authority that under the language of most leases authorizing delivery of oil to the credit of the lessor, delivering oil to the operator's purchaser to the credit of the royalty owner constitutes sufficient delivery as though it were directly to the owner.⁴ The same result logically follows with respect to the lessee's right to market royalty gas where such gas is deliverable in kind,⁵ though it is relatively unusual for gas royalty to be payable in kind.

The idea that the operator has implicit authority to sell oil for lessors if the lessors do not make other arrangements appears to be fairly well accepted,⁶ but some problems persist. There may be circumstances tending to negate the operator's implied authority, and unless the operator has authority to deliver a royalty owner's share of oil to a particular purchaser, a conversion has taken place, for which the operator and the purchaser may be held liable in damages.⁷ The damages for such a conversion ordinarily would be the market value of the production at the time it should have been delivered to or sold by the royalty owner,⁸ particularly where the operator relied on the usual custom in the industry in proceeding to market the lessor's oil without a specific agreement from the lessor.⁹ Thus, if the operator has marketed the lessor's oil at the highest available price, as may be expected, there is probably no real danger of substantial liability for doing so even if there is no express or implied authority for the lessee to market the oil.

The question of whether the lease operator has the right to market a royalty owner's share of gas production does not commonly arise because of the terms of leases typically used. Unlike the usual provision for delivery of royalty on oil,¹⁰ the typical gas royalty provision calls for the payment to the lessor not of a fractional portion of the product but of the market value¹¹ or the proceeds received from the sale of the gas or the products thereof. Thus, title to the gas produced is in the lessee rather than the lessor, and the lessee is free to market the gas as it chooses. The obligation to the lessor is

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for the payment of funds rather than for the delivery of a portion of production to which the lessor has retained title.

If the question of the right of an operator to market oil or gas production poses any difficulty, it is probably less troublesome when the right of an operator to market oil or gas production attributable to a nonoperating working interest is considered than when the right of a lessee to market royalty production is considered. This is because the rights of working interest owners will ordinarily be governed by a joint operating agreement.¹² Under the form of agreement most commonly in use,¹³ the operator is expressly given the right to dispose of the share of oil production of any owner of production which does not make its own arrangements.¹⁴ This is also usually true with respect to gas production as well, but it is becoming more common for the authority to be limited to oil.¹⁵

III. THE OPERATOR'S OBLIGATION TO MARKET

That there is a covenant implied in all oil and gas leases that the operating lessee will market the production obtained under the lease is agreed by all authorities.¹⁶ The circumstances in which the nature and extent of the duty to market production have been analyzed are numerous. Although it cannot be doubted that the operator has a duty to market oil¹⁷ as well as gas, most cases dealing with the obligation to market production are concerned with gas. The reason evidently is that ordinarily the difficulties encountered in marketing gas are much more pronounced and widespread than the difficulties in marketing oil. An operator will be able to haul oil in trucks if it cannot connect to an oil pipeline and to store oil in tanks until it can be taken to a refinery. Gas, however, because of its nature can ordinarily only be delivered into a pipeline to be taken, after any necessary processing en route, to its ultimate markets. Preparing for delivery of the product to market always consists of more than simply setting tanks on the lease and arranging for trucks to pick up the product for sale. If an operator completes a gas well in an area where there has previously been little gas discovered, it may be many months or years before a purchaser can be found that is willing to make the investment to build a pipeline to the area. It is not difficult to understand why a royalty owner who knows his lessee has completed a good producing gas well wonders why he is not being paid for the production and imagines that the lease operator, for some reason known only to the oil company but undoubtedly for the purpose of holding the lease without paying for it, is not doing as it should to produce and move the product.¹⁸

Given that the operator is under an obligation to market production, the questions that sometimes give rise to controversies revolve around when the implied covenant to market is and is not

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applicable and to what lengths an operator is required to go to locate a market and deliver production. The general rule, not surprisingly, is that an operator must adhere to the "prudent operator" standard. An operator is required to use due or reasonable diligence in marketing and to do whatever an ordinarily prudent operator would do under the circumstances.¹⁹ This standard requires more than simply that the operator act in good faith,²⁰ and whether the actions of the operator, using his best judgment in good faith, were those of a prudent operator so as to give the nonoperating royalty owner as much protection as he might reasonably expect is reviewable by courts. In other words, the lessee's judgment is not conclusive regardless of his good faith.²¹ He must use reasonable diligence. This is not to say that the question of good faith will not be applicable to questions involving the operator's marketing of production. The operator is of course required to deal with owners of nonoperating interests in good faith, and this duty is often more important than the duty to act as a prudent operator.²²

It has been argued that the "prudent operator" standard that is applied to the operator's obligations under all of the implied covenants of oil and gas leases²³ is too stringent for the covenant to market. Those who so argue assert that it is not as likely that the...