CHAPTER 2 GAS MARKETING ROYALTY ISSUES IN THE 1990s
| Jurisdiction | United States |
(Apr 1993)
GAS MARKETING ROYALTY ISSUES IN THE 1990s*
Hall, Estill, Hardwick, Gable, Golden & Nelson, P.C.
Tulsa, Oklahoma
TABLE OF CONTENTS
Page
§ 2.01 FERC Order 636—Culmination of a Changed Gas Market
§ 2.02 Gas Contracts Today
[1] Spot Market Contracts
[2] Term Contracts
[a] Warranty Premium Priced Contracts
[b] Term Contracts—Reservation Charge
[c] Term Contracts—Liquidated Damage Provisions
§ 2.03 Some Issues To Be Considered
§ 2.04 The Royalty Clause
[1] Proceeds Clause
[a] Sale Made At The Well
[b] Sale Made Off Lease—Deduction Of Post-Production Costs
[2] Market Price Or Market Value Clause
[a] Minority View
[b] The "Minority Rule" Today—Does It Still Apply?
[c] Majority View
[i] Proof Of Market Value: Comparability
[ii] Work-back Method
[d] Statutory Conversion of Market Value Leases to Proceeds Leases
[3] Two-Pronged Clauses
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§ 2.05 The Marketing Covenant
[1] Marketing At Best Price
[2] Lessee's Obligation Is Not Fiduciary
[3] The "Stand-Alone" Rule
§ 2.06 Relationship Between The Marketing Covenant And Warranty And Other Non-Source Specific Contracts.
[1] The Cases
[2] Some Conclusions
§ 2.07 Current Methods of Calculating Royalties For Off-Lease, Direct Sales
[1] Tracing Or Source Method
[2] Pooling Method
[3] Market Price Method
§ 2.08 Analysis Of Producer Direct Marketing Issues
[1] Lessee Has No Duty To Seek A Premium Market
[a] Market Value Leases
[b] Proceeds Leases
[2] Proceeds Leases—Tracing Method Issues
[a] Spot Sales As Discharging The Marketing Covenant
[b] Selection Of Wells To Satisfy Premium Price Contracts
[3] Proceeds Leases—Pooling Method Issues
[4] Proceeds Leases—Market Price Method Issues
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[5] Analysis Under Market Value Leases
[a] Market Value Today
[b] Neither Tracing Nor Pooling Methods Are Appropriate
§ 2.09 Other Significant Issues
[1] Reservation Fees
[2] Liquidated Damages
[a] Receipt of Liquidated Damages
[b] Payment of Liquidated Damages
[3] Pipeline Imbalance Penalties
[4] Producer/Pipeline Imbalances
[a] Positive Producer/Pipeline Imbalances
[b] Negative Producer/Pipeline Imbalances
[c] Tracing Or Market Value Method for Imbalances
[5] Gas Produced And Stored
[6] Gas For Gas Exchanges
§ 2.10 Marketing Affiliates
[1] Description Of Marketing Affiliates Activities
[2] Discussion Of Case Law
[3] Principles Drawn From Case Law
[a] Primary Focus Must Be On The Marketing Covenant
[b] No Per Se Breach Of Covenant
[c] Transactions With Affiliates Will Be Upheld If Formalities Observed
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[4] Unincorporated Divisions As Marketers
[5] Use Of Marketing Affiliates
§ 2.11 Royalty on Take-Or-Pay Payments And Gas Contract Settlements
[1] Overview
[2] Diamond Shamrock
[3] Pennzoil
[4] Bruni I
[5] Bruni II
[6] Mandell
[7] Frey
[8] Roye Realty
[9] Klein
[10] MMS Policy
Appendix—Examples of Royalty Clauses
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§ 2.01 FERC Order 636 — Culmination of a Changed Gas Market
This paper is not about FERC Order 636.1 Since the Federal Energy Regulatory Commission ("FERC") issued that Order on April 8,
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1992, the profession has not lacked for papers by qualified authors exploring that Order and its implications in detail.2 Rather, this paper examines a number of the royalty issues arising as a result of the restructured gas market which has evolved over the past ten years and as to which FERC Order 636 merely represents its culmination.
Beginning in the 1930's and continuing until the mid-1980's, as this nation's vast network of interstate pipelines developed, the regulation of these pipelines under the Natural Gas Act3 almost insured that gas would flow to market in a relatively organized and unimaginative fashion. Pipelines contracted with producers to purchase gas, transported the gas through the lines which they had built and resold it, sometimes to industrials and other end-users in direct sales, but most often to local distribution companies ("LDC's") who further distributed the gas to industrial, commercial and residential customers.
From the point of purchase to the point of sale, the interstate pipeline performed many discrete services. It acquired inventory for sale purchasing gas, it gathered the gas, transported it, stored it and delivered it to the user or LDC. On redelivery, the gas generally was sold at a price which represented the recovery of the cost of all these services. As a result, there was almost no flexibility in the manner in which gas was sold by the producer or purchased by the interstate pipeline's customer. To meet Federal Power Commission (later the FERC) requirements, gas was purchased under long term contracts generally at the wellhead frequently containing "take-or-pay" clauses to protect the producer's investment in its well. Contracts and tariffs between pipelines and LDCs contained "minimum bills" which were intended to protect the pipeline from their take-or-pay exposure. Lemming-like, marketing practices in the intrastate gas market largely mirrored interstate practices.
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Because of gas shortages and user curtailments occurring in the 1970's followed by gas surpluses and producer curtailments of the 1980's, the FERC began moving to change the gas market, first by initiating in mid-1983 several "blanket certificate programs" granting pipelines greater flexibility to transport gas for certain types of end-users, and continued with a series of orders4 designed to put the gas market on a competitive footing and to enable producers and gas customers to contract directly with one another. FERC Order 636 represents the culmination of this process. As a result, producers and customers will now be able to access only those pipeline services which they feel necessary, whether it be gathering, transportation, storage or gas supply.
§ 2.02 Gas Contracts Today
Today, the long term producer as seller — pipeline as purchaser specific dedication contract is a thing of the past. Instead, we find gas being marketed in ways which were unknown ten years ago.5
[1] Spot Market Contracts
Spot market sales are generally of thirty days duration with prices negotiated monthly at levels which represent current market conditions. Such sales may be at the well or may be off-lease, at a point downstream on a gatherer's or transporter's line and may represent gas produced from numerous wells. Dedication of specific wells or reserves will usually be absent. Delivery requirements will vary from firm, fixed quantities to best efforts or interruptible. Gas may be sold under master contracts having a term of a year or more but which require the producer and the purchaser to agree monthly on the volumes to be taken and the prices for those volumes. While in the form of a term contract, these sales contracts are in reality no more than spot sales since thirty days is the limit of each party's obligation.
[2] Term Contracts
Most longer term contracts today fall in the category of those requiring the sale of a specified quantity of gas, usually on a
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daily but sometimes a monthly basis, for a term which may extend from one to five years. Purchasers typically are LDC's and end-users. Three identifiable types will be examined.
[a] Warranty Premium Priced Contracts
These contracts dedicate no specific reserves, but the producer guarantees delivery of the required contract quantities at set prices. Delivery may be at a specific point or points on either a transmission line or out of a transmission line into facilities owned by the purchaser. At the time the contracts are executed, the price will be set at a level currently above market clearing levels and at a premium to the spot price reflecting the value of assured supply to the user and a premium for the burden and risk of supply availability imposed on the producer.
[b] Term Contracts — Reservation Charge
These contracts impose on the seller a maximum delivery obligation but give the buyer flexibility in its purchase volumes. Such contracts provide for a two-part rate, first a reservation fee payable on the maximum quantity available regardless of the quantity nominated by the buyer and second, a commodity charge based upon the volume nominated and taken. The commodity charge may track the spot price and the reservation fee is frequently a percentage of the commodity charge. Thus, the buyer pays for its flexibility and the seller is compensated for its delivery obligation by the reservation charge.
[c] Term Contracts — Liquidated Damage Provisions
These contracts specify a contract quantity which the lessee/seller contemplates delivering and the buyer/user contemplates purchasing. Their unique feature is that they provide for liquidated damages payable by the seller to the buyer if the seller fails to deliver the contract quantities, and conversely, provide for liquidated damages payable by the buyer to the seller if the buyer fails to take the contract quantities. Typically, these liquidated damages are calculated by reference to a stipulated cover price which itself is usually based upon published indices applicable to the month of under-delivery or under-takes.
Liquidated damages payable by an under delivering seller for a given month would be calculated by applying to the under delivered volumes a unit price equal to the amount, if any, by which the cover price or index price exceeds the contract price. Liquidated damages payable by an under taking buyer for a given month would be calculated by applying to the undertaken volumes a unit price equal the amount, if any, by which the contract price exceeds the cover price or index...
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