CHAPTER 12 Federal Oil and Gas Royalty Liability

• Jurisdiction: United States

Federal & Indian Oil & Gas Royalty Valuation and Management II
(Feb 1998)
CHAPTER 12
Federal Oil and Gas Royalty Liability
Dante L. Zarlengo
Zarlengo & Kimmell, LLC
Kenneth R. Vogel,
Office of Enforcement, Minerals Management Service. ^*
Denver, Colorado

I. Introduction

The question of responsibility for royalty payment has been one of the most hotly fought battles between the Minerals Management Service (MMS), as the lessor's agent for Federal and Indian lands, and the various players in the oil and gas industry. It was one of the principal focuses of the recently enacted Federal Oil and Gas Royalty Simplification Act (RSFA). Yet despite the importance of the question, which can involve difference of millions of dollars to lessors and lessees or their agents, it is an issue that is not often litigated, either before the administrative tribunal or in court. In this paper, we attempt to review some of the existing literature and try to explain where we see how this issue will be treated in the future.

We will look at both the common law and regulatory history, then we will discuss RSFA and attempt to forecast the regulations that may come in the near future to implement it. We walk on ground that has been trod so often, it may seem difficult to say something new, and we are indebted to those who came before us, particularly the excellent work by Marla and Cecelia Williams, who presented papers at the last MMS/RMMLF Special Institute in 1992¹ .

In simple terms we examine whether you may be liable because:

1. You enter into an agreement to pay royalties.

2. You are assigned and you assume the responsibilities to develop and to pay royalties.

3. You agree to pay royalty on behalf of the owner or operator of a property.

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4. You jointly develop a property on which royalty may be owed.

5. You take production from a property on which royalty may be owed.

Our agenda for this paper and discussion is broad, it includes the following topics for each of the legal regimes mentioned in the previous paragraph:

A. Lease Instruments and Assignments

B. Agency and its effects

C. Co-lessees

1. Joint and Several Liability

2. Takes vs. Entitlements

D. Payment Responsibility

II. Who may be liable — a common law perspective

The oil and gas business has among the most complex legal ownership relations of any business in the United States. The typical relationship between the landowner and the operators of oil and gas properties is an oil and gas lease. While such a lease has many characteristics in common with other leasehold arrangements, several courts in the major oil producing states have distinguished oil and gas leases from other leases.² Thus, while one might be informed by

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property law as it applies to leaseholds, there are enough differences that straight application of landlord-tenant law may occasionally lead to an inappropriate result.

Part of the reason for this is the plethora of sub-lease and cross-lease relationships that exist in a typical oil and gas development. The surface ownership patterns do not correspond to the geography and the geology of the oil or gas reservoir(s) under the surface. Often a lessee will, as part of the financing and risk spreading in an oil and gas development, transfer parts of the lease to other parties. These arrangements go by such terms as Farm-in, Farm-out³ , working interest, overriding royalty, record title, etc. Often there are multiple parties with each of these ownership interests.⁴ It is important to remember that most of the lease covenants, including, for our purposes the covenant to pay rent and royalty, are covenants which "touch and concern the land" and therefore run with the assignment.⁵

Another complication may arise when the oil or gas reservoir underlies more than one lease. When this occurs, states may regulate the spacing of wells and the owners will combine through Unit, Pooling and Communitization Agreements. As many lessors may be affected by the combinations, the relationship between the person(s) with the power to develop and market production from the agreement and the lessors thereof may be attenuated. For instance, all production may be marketed by the operator, who is a lessee of only one lease. There may be no contractual relation between the operator and lessor B, and there may be no proceeds to the lessee of lessor B for the lessee to pay royalty out of.

The most common manner of payment occurs through the use of division orders⁶ , which

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are contracts that specify the proportion of the proceeds that are to go to each party⁷ . While these instruments may specify a different percentage than found in the conveyances (lease or assignment), they do not modify the conveyance. Therefore, if a division order specifies that an owner of a 1/8 royalty interest is to receive 10.25 per cent of the proceeds, the royalty owner may sue the person who received excessive payments to collect the difference between 12.5% and 10.25%,⁸ however he may not sue the purchaser.⁹

A. Lease Instruments and Assignments

When a lessor grants an oil and gas lease to the lessee, it usually contains a royalty clause wherein the lessee agrees to pay to the lessor a certain percentage of the production, either in value or in volume. This contracts creates privity of contract and of estate between the parties. If the lessee's interest is assigned in whole to another person¹⁰ , the relationship between the lessor and the new lessee is still grounded in both privity of contract and privity of estate. As the lease specifically required the payment of royalty, the record title owner and its assigns are liable for the payment of royalty. Absent express lease provisions or a discharge by the lessor to the contrary, the original lessee remains liable even for royalty debts accruing after the period of ownership, as the parties remain in privity of contract.¹¹

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If the lessee assigns less than his full interest in the lease, whether it is called an assignment or partial assignment, it may have the effect of creating a sub-lease.¹² Generally if the division is of a specific geographic or geologic portion, the effect is to create a partial assignment and not a sublease, although as with most other aspects of oil and gas law, there are splits among the jurisdictions.

If the jurisdiction applies common law real property principles, the sub-lessee would not have a duty to perform the covenants of the lease in the absence of express agreement, since there is no privity of estate between him and the lessor. In those jurisdictions, the lessor's suit would be against the lessee (or the assignee of the remainder interest — the record title). Unfortunately, the lessee is usually out of possession and has little or no authority over the sub-lessee, who has the sole power to control development, to market and therefore to pay royalty. Thus, the overwhelming majority of cases hold the sub-lessee to be liable, even though were common law real property principles to apply, the sub-lessee would not be liable.¹³

B. Agency and its effects

Often a lessee will enter into a number of arrangements with other parties who may assist in the development of the property, the marketing of production and the payment of royalties. Each of these arrangements, based on contract, may result in the assumption of liability by the other party. For example, a lessee may enter into an arrangement whereby another person operates the lease, or certain parts of the lease, on behalf of the lessee. This arrangement is usually documented by an operating agreement (or in the case of unitized production by a unit operating agreement). The agreement may provide that certain responsibilities are assumed by the operator. Among those responsibilities may be the development of the lease, the marketing of production, and the payment of royalties. The question before us is whether, O, a person who operates a lease through an operating agreement may thereby become liable for the payment of royalties.

First, it is plain that the lessor does not have a claim on the operator through privity of contract or privity of estate. There are no contractual or property relations between the lessor and operator. The only contracts are between the lessee and the operator (the operating agreement) and the lessee and lessor (the lease). However that does not end the inquiry. The operator may

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become liable to the lessor either through applications of agency principles or through application of the doctrine of third party beneficiary. In addition, it is possible that the operator becomes liable through the application of statutory or regulatory law.

Similarly a person, M, may market or purchase production from the lease and agree, as a condition of the contract of sale, to pay royalty to the lessor. Once again P is not liable due to its privity of contract with lessor, but may become liable due to application of agency or third party beneficiary law.

Finally, P may simply have agreed to act as the payor for the lessee and to complete the paperwork and do the accounting associated with the payment of royalties to the lessor. Again there is no privity of contract or estate between P and the lessor, but P may have become liable under agency or third-party beneficiary principles.

1. Agency

An agent is not ordinarily bound by the obligations of the contract between its principal (lessee) and a third party (lessor). Even if the contract is made by the agent, acting within the scope of its authority for a disclosed principal, the principal alone is normally the only person liable thereon. Even if the agent received money to pay to the lessor from the lessee, the agent does not become liable to the lessor thereby.¹⁴

To make an agent liable to a third person, the agent must somehow have warranted his authority to enter into a contract without the principals...