CHAPTER 2 HANDLING AND MARKETING PRODUCTION: NOW THAT WE ARE PRODUCING IT, WHAT DO WE DO WITH IT?

• Jurisdiction: United States

Oil and Gas Agreements: The Production and Marketing Phase
(May 2005)
CHAPTER 2
HANDLING AND MARKETING PRODUCTION: NOW THAT WE ARE PRODUCING IT, WHAT DO WE DO WITH IT?
Thomas C. Jepperson
Julie A. Wray
Questar Corporation
Salt Lake City, Utah
THOMAS C. JEPPERSON

Thomas C. Jepperson presently serves as Division Counsel for Questar Corporation, an integrated natural gas company with operations in the Rocky Mountain and Mid-Continent Regions. Mr. Jepperson manages the legal department and is responsible for environmental, health and safety compliance for the upstream and mid-stream operations of Questar. Mr. Jepperson began his career in natural resources law as a law clerk with the U.S. Department of the Interior. Prior to joining Questar in 1988, Mr. Jepperson was a shareholder of the law firm Nielsen & Senior, P.C., of Salt Lake City, Utah where his practice focused on oil, gas, and mining law. Mr. Jepperson previously has served in various capacities for the Rocky Mountain Mineral Law Foundation, including trustee, Mineral Law Newsletter reporter, and committee member. Mr. Jepperson is active in various oil and gas trade associations and served as past chair of the legal committee of the former Rocky Mountain Oil and Gas Association. He is a member of the Utah State Bar and the American Bar Association. Mr. Jepperson recently authored "Royalties on Processed Gas," Private Oil & Gas Royalties (RMMLI 2003); and coauthored "The 'Marketable Location' Rule and Energy Policy Considerations," 24 Journal of Land, Resources, & Environmental Law 323 (2004). Mr. Jepperson received his B.A. degree in 1978 from Brigham Young University, graduating summa cum laude and his J.D. degree in 1981 from the same institution, graduating cum laude.

JULIE A. WRAY

Julie A. Wray currently holds the position of Senior Counsel for Questar Corporation located in Salt Lake City, Utah. While at Questar, Ms. Wray has been responsible for various legal matters involving the company's oil and gas exploration, production and midstream activities in the Rockies and Midcontinent regions, with current primary legal responsibility for the company's marketing and hedging activities. Ms. Wray also advises the corporate human resources department regarding labor and employment issues. Prior to joining Questar, Ms. Wray served a judicial clerkship for Chief Justice Christine M. Durham of the Utah Supreme Court. Ms. Wray received her B.S. in Political Science from the University of Utah and her J.D. from the University of Utah School of Law in 1995, where she served as a staff member on the Utah Law Review and was a quarterfinalist in the Roger J. Traynor Moot Court Competition. She also received Richard L. Dewsnup Fellowship and graduated Order of the Coif. She is currently a member of the Utah State Bar and the American Bar Association.

I. Introduction.

"Gas marketing is the area where the entrepreneurial spirit will flourish in the years to come." ¹

Professor David E. Pierce made the above observation back in 1990 while predicting that the future trend for oil and gas producers would involve seeking out and capturing new markets as the gas marketing infrastructure developed. The gas marketing infrastructure has indeed developed substantially since the early 1990s, and is far different than what was originally envisioned at the inception of interstate pipeline open access in 1985. ² Unlike the early years of gas production, the gas marketing environment no longer involves a contract with a single "pipeline purchaser" of all the gas produced at the wellhead, with the pipeline allocating the purchase proceeds to each owner in proportion to their working interest. ³ Today producers have a myriad of options for selling their gas ranging from wellhead sales to marketing or gathering companies to moving gas downstream for sales at the mainline interconnects and market hubs, or even direct sales to an ultimate end user. Yet, standard industry forms governing joint operations and the disposition of leasehold production have not been updated to reflect the changes in the current marketing environment.

By far, the most widely-used form governing joint operations is the Form 610 Joint Operating Agreement promulgated by the American Association of Petroleum Landmen ("AAPL Form 610" or "Model Form"). The AAPL Form 610 was first published in 1956, with three subsequent revisions completed in 1977, 1982 and 1989. Despite the changes in the gas marketing environment, no other revision to this integral document governing the rights and responsibilities of parties to joint operations has been made for over fifteen years. The basic right of each participant under the Model Form to take its share in kind and separately market such share is still the industry practice. However, the rights and responsibilities of the parties when one party does not take its share in kind need attention. Provisions which may have been adequate when marketing decisions were fairly simple and straightforward are no longer sufficient given the complexities of the current gas market. The parties need to recognize and address the problems inherent in today's marketing environment when the operator undertakes to market the production belonging to a non-operator or, if it fails to do so, the consequences and resolutions of disproportionate takes and sales.

This paper examines the rights and obligations of the parties concerning the handling and disposition of production under the joint operating agreement ("JOA"), focusing primarily on the production of natural gas and the language of each of the four editions of the Model Form. ⁴ The first section explores the right of each participant to take its proportionate share of production in kind and the operator's right to purchase or market such production if a non-operator fails to do so. Focusing on the express language of the Model Form, this paper discusses the potential pitfalls where an operator does undertake to purchase or market the non-operator's gas. The last part of this section offers various solutions, with the preferred solution to execute a separate marketing letter agreement.

This paper then addresses disproportionate gas takes (or sales) under the Model Form as a result of a party's failure to take in kind (or the operator's failure to purchase or market such gas production). How such producer imbalances are handled and resolved under the Model Form depends on judicial interpretation of the parties' rights under the applicable operating agreement and/or the terms of any gas balancing agreement.

Finally, this paper explores lease considerations arising from the producer's marketing of production and how royalty owners may be impacted, as when a lessee is not marketing its proportionate share of the gas, or when gas from a unit well is being sold under different contracts for different prices.

II. Handling and Marketing Production under the Joint Operating Agreement.

Before 1948, it was not uncommon for operating agreements to provide for the operator to market all the production-especially the marketing of gas which in earlier times was considered to have little value. ⁵ After 1948, however, the right for each participant to take its share of production in kind and market it separately became necessary to avoid the joint operation being treated as a corporation for tax purposes. In Income Tax Ruling (I.T.) 3930, the Internal Revenue Service (IRS) ruled that a typical oil and gas operating agreement did not create a taxable association because the corporate characteristic of a joint profit was lacking. ⁶ The IRS concluded that because the parties to the agreement did not jointly market the produced oil or gas, the joint operation itself could not realize profits. If, however, a joint operating agreement provided for one party to sell the production and distribute the sale proceeds to the other parties, then reasoned the IRS, an association was created. ⁷ Therefore, due to potential adverse tax consequences, all subsequent joint operating agreements provided that each party could take its share of gas in kind.

Even without the tax motivation, as the value of gas began to increase with the development of the pipeline infrastructure, owners had an additional economic incentive to take their share of gas in kind to look for better markets for their gas. ⁸ Professor Pierce contends that given the availability of new gas marketing opportunities in the current environment, it is doubtful that lessees with a competitive edge would turn over marketing activities to a well operator even if the tax motivation were removed. ⁹ However, given the complexities of gas marketing, many non-operators prefer the operator to be in charge of marketing all the production, including (i) working interest owners which have difficulty marketing small quantities on favorable terms, (ii) unsophisticated owners that lack marketing expertise, or (iii) those owners that, for one reason or another, lack interest in gas marketing. ¹⁰

The specific take-in-kind provision of the 1982 Model Form (with slight variations in the other three editions) provides as follows:

Each party shall take in kind or separately dispose 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. ¹¹

In 1956, when the first Model Form was published, all parties to the operating agreement often would take their share pursuant to this provision and join in...