CHAPTER 10 THE TAKING PRODUCTION IN KIND PROVISIONS OF AAPL FORM 610

• Jurisdiction: United States

Joint Operations and the New AAPL Form 610-2015 Model Form Operating Agreement
(Nov 2016)
CHAPTER 10
THE TAKING PRODUCTION IN KIND PROVISIONS OF AAPL FORM 610
Jamie L. Jost
Jost Energy Law, P.C., Founder and Managing Shareholder ¹
Denver, CO

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JAMIE L. JOST is the Founder and Managing Shareholder of Jost Energy Law, P.C. where she focuses primarily on matters relating to exploration, development and production of oil and gas, as well as local, state, and federal permitting and regulatory issues in the Rocky Mountain Region. In addition, she assists clients with legislative and policy strategy planning, land and mineral due diligence, acquisition and divestiture matters, land contracts (including leases, easements, rights-of-way, surface use and access agreements, and subsurface and pore space easements), industrial siting permitting, air and water issues, and eminent domain matters. Jamie practices in front of the Colorado Oil & Gas Conservation Commission, the Wyoming Oil & Gas Conservation Commission, the New Mexico Oil Conservation Division, the Interior Board of Land Appeals, and federal and state courts, on various energy issues, including oil and gas royalty litigation, subsurface trespass matters, and surface use issues. She also currently serves as General Counsel to the Colorado Oil & Gas Association and assists national and international oil and gas operators on a daily basis to ensure that their exploration, development, and operations continue to progress efficiently and economically. Prior to founding Jost Energy Law, P.C., Jamie was a shareholder at a premier Denver based energy law firm where she served as Chair of the Oil and Gas Commission Practice Group. Jamie also enjoyed an in-house counsel role at Suncor Energy (U.S.A.) Inc. where she served as Corporate Legal Counsel and was primarily responsible for legal issues for Suncor's pipeline affiliate's land, title, litigation and permitting matters. Specifically, Jamie worked closely with the business team on the expansion of its existing pipeline system and managed the easement acquisition, permitting, and eminent domain proceedings for the expansion project. She also advised Suncor's Terminal and Distribution Group, Retail Group, and Human Resources Group on various matters. Jamie has served as a trustee for the Rocky Mountain Mineral Law Foundation and has co-authored several oil and gas related articles for the RMMLF. She has co-chaired a Special Institute on midstream operations, and is a member of the Special Institute Committee. She is an active member of the Denver Association of Petroleum Landmen and the Colorado Bar Association's Natural Resources Sections. She is a member of the Colorado Bar Association, Wyoming Bar Association, New Mexico Bar Association, the U.S. District Court of Colorado, the U.S. District Court of Wyoming, and the 10th Circuit Court of Appeals. Jamie received her J.D. from the University of Wyoming in 2002 and her undergraduate degree, cum laude, in Environmental Science and Industrial Hygiene from Indiana State University in 1998. In addition to her legal career, Jamie is also a past member of the Board of Directors for Ronald McDonald House Charities, Inc. and Colfax Community Network, a member of the Cystic Fibrosis Foundation's 2012 class of Colorado's Finest Young Professionals, a recipient of the Denver Business Journal's inaugural 2014 Top Women in Energy, 5280 Magazine's Top Lawyer award for Natural Resources in 2015 and 2016, and has received the "Rising Star designation by Colorado Superlawyers for 2011, 2012, 2013, 2014, and 2015.

THE TAKING PRODUCTION IN KIND PROVISIONS OF AAPL FORM 610

I. Introduction

At first blush, marketing the production from properties subject to the American Association of Petroleum Landmen's ("AAPL") Form 610 Model Form Operating Agreement ("Model Form JOA") is very straightforward because all four versions of the Model Form JOA require that each party "take in kind and separately dispose of its proportionate share of all Oil and Gas produced from the Contract Area." However, that is not always what happens, particularly as to gas production. If a party fails to take its proportionate share of oil and gas in kind, all four versions of the Model Form JOA give the operator "the right, subject to revocation at will by the party owning it, but not the obligation, to purchase such Oil and/or Gas or sell it to others" for the account of the non-taking party. Although not addressed in all versions of the Model Form JOA, if the operator does not exercise this right, then an imbalance occurs among the parties. This article will summarize and comment on the taking in kind provision found in each of the Model Form JOAs, including the 2015 minor revisions to the Model Form JOA, address issues that arise when imbalances occur and how courts have resolved those issues, review the AAPL and Rocky Mountain Mineral Law Foundation's forms of gas balancing agreements, discuss the operator's options if a party fails to take in kind, and make an alternative proposal for addressing the failure to take gas in kind.² Because of the relative higher value and ease in handling oil as compared to gas,³ the issues surrounding the failure to take in kind usually

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arise in the natural gas context and, therefore, this paper will discuss the failure to take in kind in that context.⁴

II. The AAPL Model Form JOA - Taking Production in Kind Provisions

There have been four versions of the Model Form JOA: 1956, 1972, 1982 and 1989. The taking production in kind provisions of each are similar in many respects, particularly for the first three versions. The 1989 provision differs most notably in the operator's standard of care if it exercises its right to purchase or sell the share of production of the non-taking parties. Given the overall similarities in the four versions of the Model Form JOA and the common misperception that the operator has the duty to market the production of non-taking parties, often very little thought is given to this provision of the Model Form JOA and the decision as to which version of the Model Form JOA to use does not typically turn on the taking production in kind provision. However, this does not mean that there are not significant consequences in the area of marketing of production associated with which version of the Model Form JOA is selected.

A. The Duty to Take in Kind. All four versions of the Model Form JOA taking production in kind provision start out with the mandate that each party is to take in kind and separately dispose of its share of production. Article VI.G., Option No. 2, of the 1989 version of the Model Form JOA expresses this mandate as follows:

Each party shall take in kind or separately dispose of its proportionate share of all Oil and Gas produced from the Contract Area, exclusive of production which may be used in development and producing operations and in preparing and treating oil and Gas for marketing purposes and production unavoidably lost. Any extra expenditure incurred in the taking in kind or separate disposition by any party of its proportionate share of the production shall be borne by such party. Any party taking its share of production in kind shall be required to pay for only its proportionate share of such part of Operator's surface facilities which it uses.

Each party shall execute such division orders and contracts as may be necessary for the sale of its interest in production from the Contract Area, and, except as provided in Article VII.B., shall be entitled to receive payment directly from the purchaser thereof for its share of all production. ⁵

Before 1948, a joint operating agreement might have provided that the operator would have the duty to market all of the production for the joint account or at least all of the natural gas production. In 1948, the Internal Revenue Service issued I.T. 3930, C.B. 1948-2, 126, which addressed whether a joint operating agreement among coowners of oil and gas properties creates

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an association taxable as a corporation for Federal income tax purposes. This ruling has been described as follows:

I.T. 3930 and I.T. 3948, supra, are applicable in the determination of whether a joint operating agreement among coowners of oil and gas properties creates an association taxable as a corporation for Federal income tax purposes. In general, I.T. 3930 provides that if the parties to such an agreement do not have a joint profit objective, the agreement does not create an association. Thus, if under the terms of the agreement the joint objective of the parties is limited to the acquisition, development, and operation of oil or gas properties, but the sale or other disposition of the share of production of each coowner constitutes the individual activity of the coowner, rather than the joint activity of the group, under these rulings [I.T. 3930 and I.T. 3948, C.B. 1949-1, 151], it is not considered to have a joint profit objective and does not constitute an association. On the other hand, if the joint operating agreement provides that the operator or other person in his representative capacity shall have irrevocable authority to sell the production on behalf of the coowners, the sale of production will be a joint activity and the organizations will be considered an association taxable as a corporation. ⁶

The conclusions of I.T. 3930 can be found in C.F.R. ?1.761-2 which provides that if the conditions set forth in that section are met, an unincorporated organization may be excluded from the application of all or a part of the provisions of subchapter K of chapter 1 of the Code.⁷ Subsection (a)(3) of ?1.761-2 provides:

Operating agreements. Where the participants in the joint production, extraction, or use of property:

(i) Own the property as coowners, either in fee or under lease or other form of contract granting exclusive operating rights, and

(ii)

...