CHAPTER 12 GAS MARKETING BY CO-OWNERS: PROBLEMS OF DISPROPORTIONATE SALES, GAS BALANCING AND ACCOUNTING TO ROYALTY OWNERS

• Jurisdiction: United States

Natural Gas Marketing II
(Apr 1988)
CHAPTER 12
GAS MARKETING BY CO-OWNERS: PROBLEMS OF DISPROPORTIONATE SALES, GAS BALANCING AND ACCOUNTING TO ROYALTY OWNERS^*
Ernest E. Smith
The University of Texas School of Law of Counsel, Hughes & Luce
Austin, Texas

TABLE OF CONTENTS

SYNOPSIS

Page

I. INTRODUCTION

II. GAS MARKETING UNDER THE JOINT OPERATING AGREEMENT

A. RIGHTS OF CO-OWNERS IN THE ABSENCE OF A GAS BALANCING AGREEMENT

1. The Owner Who Fails to Market: The Effect of the Operator's Disposition of Gas from the Contract Area

a. The Operator's Options Under the Model Form Operating Agreements—In General

b. The Operator's Purchase of the Nonoperator's Gas

(1) The Pricing Provisions

(2) The Separate Sales Contract

c. Operator Acting As Agent for the Nonoperator

(1) Problems Involving Prices Under Long-Term Contracts

(2) The Nonoperators' Claims to Take-or-Pay Settlements

(3) The Operator's Obligations in Structuring Take-or-Pay Settlements

(4) Apportionment of the Take-or-Pay Settlement

(5) The Revised Gas Purchase Contract

(6) The Operator's Duty to Obtain the Best Price: The Effect of FERC Order 451 and 500

d. The Operator Who Markets All Current Gas Production for Himself

e. The Advantage to the Operator of Purchasing the Nonoperators' Gas

2. Rights of Marketing Co-owners in the Absence of a Gas Balancing Agreement

[Page 12-ii]

a. Rights of a Nonmarketing Owner Who Enters into a Gas Sales Contract: Gas Balancing Problems

b. The Split-Stream Sale

(1) The Operator's Duty To Maintain Balance

(2) Rights of the Underproduced Parties

B. RIGHTS OF CO-OWNERS UNDER A GAS BALANCING AGREEMENT

1. Latent Drafting Problems

a. The Gas Balancing Agreement's Priority Over the Operating Agreement

b. The Gas Balancing Agreement as the Exclusive Method for Balancing

c. Co-Ordination of Gas Balancing with Take-or-Pay Make-up Clauses

d. MMBtu Pricing and Volumetric Balancing

2. Advantages of the Express Balancing Agreement

C. STATUTORY MODIFICATIONS OF THE RIGHTS AND OBLIGATIONS OF THE OPERATOR AND NONOPERATORS

III. THE RIGHTS OF ROYALTY OWNERS

A. THE IMPLIED COVENANT TO MARKET

1. The Standard for Breach

2. The Effect of Self Dealing: Sales to a Wholly Owned Subsidiary

B. THE EFFECT OF A SPLIT STREAM CONNECTION ON THE RIGHTS OF ROYALTY OWNERS

1. The "Weighted Average" and "Tract Allocation" Methods of Adjusting the Rights of Royalty Owners

2. The Texas Problem

3. Conflicts Between the Oil and Gas Lease and the Operating Agreement

C. THE ROYALTY OWNERS' RIGHT TO SHARE IN PROCEEDS FROM SETTLEMENTS WITH PIPELINE PURCHASERS

IV. CONCLUSION

FOOTNOTES 39

———————

[Page 12-1]

I. INTRODUCTION

Gas marketing decisions rarely affect only the two parties who are involved in negotiating the terms of the gas sales contract. In most instances the seller is one of several companies or individuals who have contributed working interests to the gas well unit and have entered into a formal operating agreement governing their rights and obligations with respect to the gas production. The operating agreement, if typical, specifically authorizes each co-owner to separately market its proportionate share of gas production. Sales of production in precise proportion to ownership rarely occur, however. The well operator may be selling gas while the nonoperating co-owners are either unable to obtain contracts or unwilling to market their shares of gas at current prices. Even if all co-owners have entered into gas sales contracts, disproportionate takes are likely to occur if there is more than one purchaser.

In all such instances the rights to gas may come into question. Nonmarketing parties may assert that the operator was selling gas on their behalf and is obligated to account for their proportionate share of the sale price or value of the production. The operator or other parties selling gas may respond that the co-owners' rights to gas are simply out of balance, that some co-owners are overproduced and others are underproduced, and that their rights should be adjusted through a cash or in-kind balancing in the future.

A resolution of the co-owners' rights will depend initially upon an examination of the gas marketing provisions of the operating agreement and the gas balancing agreement, which may be included as an attached exhibit. Either the presence or absence of such an attachment may create problems of interpretation. In neither event, however, is a construction of the operating agreement likely to resolve all issues resulting from gas marketing by different co-owners of a gas well; for there is yet another category of persons whose interests are affected. The royalty owners are entitled to a fraction of the sale price or market value of the gas produced, but have no right to participate in gas marketing decisions. Their rights will be at issue if gas is being produced from the leased premises, but one or more of the lessees is not marketing its proportionate share of the gas or if gas from the unit well is being sold under different contracts for different prices. Their entitlements to royalty and to the method of its calculation depend upon the language of their oil and gas leases. These are unlikely to make provision for delayed sales from a producing well, sales for different prices or rights of an underproduced party to make up in kind or in cash from an overproduced party. The result is an almost inevitable conflict

[Page 12-2]

between the terms of the operating agreement and those of the oil and gas lease.

This paper will attempt to cover two related sets of issues which may arise from gas marketing decisions: First, the problems of adjusting the rights of working interest owners when there have been disproportionate sales or takes of gas, especially when there is no gas balancing agreement, and secondly, the methods of resolving royalty claims when the working interest owners are not marketing their proportionate shares of gas or are selling gas at different prices.

II. GAS MARKETING UNDER THE JOINT OPERATING AGREEMENT

Although the relationship created by an operating agreement is not free from dispute, most courts¹ and commentators² have concluded that the typical joint operation is a joint venture. Each participant stands in a fiduciary relationship with every other participant insofar as the specific enterprise which gave rise to the venture is concerned.³ In practice, of course, the burden of the fiduciary obligation falls most heavily upon the operator, who is the most active participant and whose actions are most likely to effect the other participants.⁴ This obligation may, however, be modified by a variety of factors, such as the location and type of activity engaged in by the operator.⁵ In the case of disputes over gas marketing and gas balancing it is most likely to be affected by the language of the agreement itself, for specific provisions in the operating agreement which set out the rights and duties of the operator and nonoperators will normally prevail over the duty which would otherwise be imposed by the general law of fiduciaries.⁶ Thus an analysis of the co-owners' rights to market gas and to adjust the imbalances resulting from disproportionate sales must necessarly focus upon the language of the operating agreement and its gas marketing provisions.

A. RIGHTS OF CO-OWNERS IN THE ABSENCE OF A GAS BALANCING AGREEMENT

Most operating agreements entered into in the United States are based on the Form 610 — Model Form Operating Agreement promulgated by the American Association of Petroleum Landmen All versions of this model form⁷ provide that each party has the right to "take in kind or separately dispose of its proportionate share" of the gas produced from the Contract Area.⁸ If all parties to the agreement join in a single gas sales contract, disputes among the co-owners are relatively unlikely. Any other arrangement is likely to result in the parties becoming out of balance. If they have not entered into a separate gas balancing agreement, their rights will turn upon the somewhat imprecise language of Article VI.C of the operating agreement.

[Page 12-3]

1. The Owner Who Fails to Market: The Effect of the Operator's Disposition of All Gas Produced from the Contract Area

In some instances the operator enters into an agreement disposing of the entire production from the Contract Area without the joinder of the nonoperators. How should this disposition of the entire production be viewed? Is the operator selling only his own gas and thus creating a right in the nonoperators to insist upon some form of make-up or balancing later? Or is he acting as the nonoperator's agent and marketing their shares of gas? Is the operator buying the nonoperator's gas and re-selling it under a separate contract to the pipeline purchaser? The rights of the nonoperators will vary sharply, depending upon the analysis of the transaction.

a. The Operator's Options Under the Model Form Operating Agreements — In General ⁹

Under the 1977 model form operating agreement the operator may take the gas attributable to the interest of any nonoperator who does not make arrangements for its separate disposition and deliver it for sale to a purchaser. This authorization to sell or market on behalf of a nonoperator is clearly permissive. The operator is not required to make arrangements on behalf of a noncontracting nonoperator,¹⁰ and he has violated no fiduciary duty if he refuses to do so.¹¹ Thus the operator may take all of the current gas production for himself. If he does so, he will be obligated to balance the remainder of production at a later time. Alternatively, the operator may either purchase the gas from the nonoperator and resell it; or he may act as agent and sell the gas on behalf of the nonoperators.

The proper characterization of the operator's sale of the gas production under the 1977 model form...