CHAPTER 10 THE TAKE-OR-PAY WARS: A CAUTIONARY ANALYSIS FOR THE FUTURE
| Jurisdiction | United States |
(Sep 1991)
THE TAKE-OR-PAY WARS: A CAUTIONARY ANALYSIS FOR THE FUTURE
Holliman, Langholz, Runnels & Dorwart, P.C.
Tulsa, Oklahoma
"Those who cannot remember the past are condemned to repeat it."1
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"Experience enables you to recognize a mistake when you make it again."2
The first generation of take-or-pay battles — those between the producers and the pipelines — is ebbing.3 While major pieces of producer-pipeline litigation remain in the courts4 , attention has now turned to two other foci: producer-lessor royalty disputes5 and state severance tax controversies.6 What this paper will attempt to do is to first summarize the take-or-pay wars and then extract lessons one may apply for future gas contracting — hence — the cautionary analysis of the title.
Executive Summary: Do not count on the courts to get you out of a Bad Bargain. They have not in the past7 , and will not in the future. Producers won most take-or-pay disputes8 because the pipelines which drafted most purchase contracts failed to protect themselves, not generally because of great producer draftsmanship. The future may not be so kind. What the past litigation reveals is that the terms of the gas purchase contract are strictly enforced.9
I. Evolution Of The Gas Contract.
In the early stages of the natural gas industry, takes from gas wells were not routinely required10 . The result was that
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productive wells fully capable of commercial production were often incapable of paying expenses because the pipelines could freely restrict purchases. Additionally, productive gas wells had no loan value, because any cash flow was uncertain. The producer had no options. All contracts contained an exclusive dedication clause which prohibited the producer from seeking another market for his gas.
Pipelines desired an ample, if not overabundant, dedication of gas reserves in order to avoid the risk of gas shortages during periods of peak use. Without a take-or-pay clause, the pipeline was under no obligation to purchase gas. The pipeline often chose not to do so. A common result was that the producer would receive no revenue even though the pipeline could freely store its supply of gas within the producer's reservoir. Because the producer had exclusively dedicated his gas to one pipeline, the producer was prevented from selling his gas to a third party purchaser. Having been deprived of revenues from gas sales, the producer was often unable to recover the substantial exploration, drilling, and operational costs associated with the well.
This predicament was resolved by the inclusion of a take-or-pay provision in the gas contract. The provision required the pipeline to purchase the producer's gas. If the pipeline failed to purchase, the pipeline would provide annual minimum revenues to the producer, regardless of whether the market existed to sell the gas at a commercially attractive price.
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During the 1970's, a similar reason arose for producers to be concerned with obtaining a substantial minimum take provision: every pipeline was offering such a provision. With strict price provisions in place, competing pipelines had little unique to offer a producer. Therefore, the strength of a take-or-pay provision, and the concomitant shift of market risk, was a bargaining chip that pipelines used to outbid one another. No producer would execute a gas purchase contract without a take-or-pay provision. To do so would be comparable to buying a car without getting tires; a take-or-pay provision was part of the standard offer and deal11 .
As a result of the differing perceptions of the take-or-pay clause during the 1960's and 1970's, the use of the clause proliferated. Natural gas purchase contracts drafted during the 1960's, 1970's and early 1980's universally contained take-or-pay clauses. During the 1980's, the take-or-pay clause began to become significant to the pipelines. Falling energy prices collided with long-term gas contracts containing fixed and ever escalating prices. The gas market began to rapidly deteriorate. The resale price of gas became less than the purchase price. As a result, there was no market for natural gas at the contract prices. Pipelines realized that it would be unprofitable to perform their gas purchase contracts.
The harsh reality is that in falling markets, someone must lose. This loss has been voluntarily shifted to the pipeline by the use of take-or-pay clauses.12
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II. The Take-or-Pay Clause
...Buyer agrees to purchase and receive from Seller or to pay for if available but not taken, a quantity of gas equal to the sum of the Daily Contract Quantities herein specified...The Daily Contract Quantity shall be the daily rate of production equal to seventy-five percent (75%) of the Delivery Capacity of each well...
Most of the gas purchase contracts drafted between 1960 and 1982 contain a take-or-pay clause. The take-or-pay clause require gas purchasers to purchase a minimum volume of natural gas each year (or month in some instances). If the buyer fails to purchase the minimum volume, the buyer must pay for gas as if the buyer had actually accepted the delivery of the required minimum volume; i.e., take the gas, or pay for it anyway.
The minimum volumes were usually tied to one of two characteristics of the well: deliverability of reserves. A take-or-pay clause tied to deliverability traditionally required the pipeline to purchase a certain percentage of the gas the well is physically able to produce. Prior to 1973, average take requirements were mostly based on reserves. After 1973, deliverability became a much more common criterion than reserves for take-or-pay determinations. After the Arab Oil Embargo and through the remainder of the 1970's minimum take requirements reached 90% of deliverability.
The take-or-pay clause allowed the producer to receive certain revenues annually, whether or not a profitable market existed for the producer's gas. As a result, the true effect of the take-or-pay
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clause was to assign the risk of a deteriorating natural gas market to the pipeline. If gas were delivered and accepted, the pipeline paid the producer; if gas was deliverable, but not accepted, the pipeline still had to pay the producer.
If a deficiency payment was made pursuant to a take-or-pay clause, the pipeline would be able to recoup or make up the payment by purchasing excess gas in future periods without further payment. This prerogative is commonly referred to as the right to "make-up" or recoupment. Typically, three rules normally governed recoupment:
1. Recoupment must be by taking gas in excess of the minimum take provision. For example, if the contract required the pipeline to buy 2000 Mcf per day, no recoupment occurred until more than 2000 Mcf per day was purchased.13
2. Recoupment must be made at the price of gas at the time the gas was physically taken into the pipeline. As a result, if prices rose, a lesser volume of gas was recouped for the deficiency payment made.
3. The regulations of the Federal Energy Regulatory Commission required that recoupment in interstate gas purchase contracts be available for at least five years. Actual recoupment in five years was not required; it was the right to recoup that is required. The time period for recoupment may be limited to five years, in which case, if no recoupment is made the producer retains the deficiency payment without liability. Some contracts allowed recoupment for the life of the contract; still others may required that all outstanding deficiency payments be returned to the pipeline at the termination of the contract.
The pipeline industry had historically been rather cavalier toward the inclusion of such a clause; during the 1970's and early 1980's take-or-pay clauses allowed by law were routinely included
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in a gas purchase contract and viewed by the pipelines as insignificant when considered in the overall context of the contract. As the shortage of natural gas increased through the 1970's, the perception of the pipelines that take-or-pay provisions were insignificant increased, and these provisions were offered without reservation.
The producer was not as ambivalent toward the inclusion of a take-or-pay clause in a gas purchase contract. The producer has always regarded the take-or-pay clause as a necessity: a gas well is worthless if no gas is sold.14
"Take-or-pay clauses, however, are more than just bargaining chips in negotiations for new gas reserves. They provide reasonable assurance to the producer of a certain minimum income stream from a well in cases where the producer is asked to make a long-term commitment of its gas to a single buyer. Having dedicated its gas under such a contract, it is of critical importance to the producer to have some assurance of recovering its substantial investment in the wells involved. Indeed, without a guaranteed minimum cash flow, producers are usually unwilling to commit their reserves to a single purchaser on a long-term basis."15
With the coming of the gas surplus in 1982, another radical shift occurred in the industry. Short-term ("spot market") contracts became more and more the standard practice, with long-term contracts, when they were negotiated, containing not a take-or-pay clause, but a "take-or-release" clause.16 Long term contracts, however will some day resume playing a major role in the industry17 and so it behooves us to examine the past while we
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ponder the future.
III. Producer Remedies In Past Litigation
In seeking to enforce contractual rights, producers have invoked a wide range of remedies. However, the prevailing remedy remained a suit to collect past due take-or-pay payments. In calculation of take-or-pay damages, the operation of a take-or-pay clause is straight-forward. If a pipeline failed to take the volume of gas which it...
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