CHAPTER 3 FROM EXTRACTION TO ENDUSE: THE LEGAL BACKGROUND
| Jurisdiction | United States |
(Sept 2003)
FROM EXTRACTION TO ENDUSE: THE LEGAL BACKGROUND
Washburn University School of Law
Topeka, Kansas
Page
I. THE OIL AND GAS LEASE AND THE USE OF ROYALTY
II. THE INHERENT CONFLICT BETWEEN ROYALTY OWNER AND LESSEE
A. Maximizing Royalty
B. The Royalty Value Theorem
III. THE ROYALTY VALUE THEOREM IN PRACTICE: THE BASIC ISSUES
A. The Linear Enhancement of Production Value
B. Defining the Scope of the Oil and Gas Lease Relationship
C. Impact of Regulatory Change
D. Impact of Changing Marketing Patterns
E. Determining the Base Royalty
1. Royalty on Oil
2. Royalty on Gas
F. Post-Extraction Investments: Activities Beyond the Wellhead
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SYNOPSIS
IV. RELATIONSHIPS BEYOND THE OIL AND GAS LEASE
A. Production Contracts
1. Pooling Agreements
2. Unit Agreements
3. Operating Agreements & Gas Balancing Agreements
B. Marketing Contracts
1. Sales Agreements
2. Gathering/Transportation Agreements
3. Treatment Agreements
4. Processing Agreements
5. Marketing Agreements
C. Division Orders
V. JUDICIAL AND LEGISLATIVE INTERVENTION INTO THE OIL & GAS RELATIONSHIP
A. Indirect Judicial Intervention: Interpretation and Implied Covenants
B. Direct Legislative Intervention: Defining the Lease Relationship by Statute
C. Application of Oil & Gas Lease Jurisprudence to Non-participating Royalty and Overriding Royalty
VI. CONCLUSIONS
APPENDIX A
A Concise History of Federal Natural Gas Regulation
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I. THE OIL AND GAS LEASE AND THE USE OF ROYALTY
The oil and gas lease is an American invention designed to give the lessee an exclusive option to develop leased land.1 In the event development is undertaken, and is successful, the lessor will be entitled to a "royalty."2 However, the term "royalty" does not describe what the lessor is entitled to in the event of production. The term merely indicates the lessor will be compensated in some fashion because development has been successful. For example, if oil is produced, the lessor's "royalty" may be a fractional share of the oil that is produced and saved.3 In early oil and gas leases,
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the lessor's compensation for gas was a stated sum per completed gas well.4 The precise terms of the lease,5 and the facts surrounding the production and sale of oil and gas,6 will define the "royalty" that is due.
In addition to the oil and gas lease, there are other oil and gas relationships that entitle a party to a "royalty." For example, the right to receive a royalty can be conveyed directly from the owner of the minerals. 7 This is called a "nonparticipating royalty interest" and could look like the following conveyance:
ROYALTY DEED
A conveys to B the right to receive one-half of the royalty provided for in any oil and gas lease covering the following land:
Section 3, Township 11 South, Range 15 East of the 6th Principal Meridian in Shawnee County, Kansas.
An immediate issue is to what extent will the terms of the underlying oil and gas lease impact the calculation of B's royalty interest? The issue is even more difficult in the following type of
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nonparticipating royalty:
ROYALTY DEED
A conveys to B 1/16th of all the oil, gas, and other minerals produced from the following land:
Section 3, Township 11 South, Range 15 East of the 6th
Principal Meridian in Shawnee County, Kansas.
Depending upon the timing of the conveyance, the grantee (B) may, or may not, have a relationship with the oil and gas lessee. The calculation of what B is due in the event of production becomes difficult because the language contained in the Royalty Deed is often no more revealing than in the above examples.8
Royalty calculation issues also arise when the oil and gas lessee conveys the right to receive
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a noncost-bearing ("cost-free") share of production payable out of the working interest owner's share of production: an "overriding" royalty.9 An overriding royalty may provide:
ASSIGNMENT
A assigns to B the right to receive 1/16th of all the oil, gas, and other minerals produced under the Fred Farmer to A Oil and Gas Lease dated 1 May 2002, covering the following land:
Section 3, Township 11 South, Range 15 East of the 6th
Principal Meridian in Shawnee County, Kansas.
As with the nonparticipating royalty interest, a major issue is how the overriding royalty will be calculated and whether B's royalty rights will be governed by the same royalty calculation jurisprudence that defines the rights of the lessor/landowner and lessee/producer.
II. THE INHERENT CONFLICT BETWEEN ROYALTY OWNER AND LESSEE
A. Maximizing Royalty
Once the oil and gas lease is executed, there are only two ways the lessor can increase their revenue under the lease: (1) an increase in the volume of oil and gas produced; and (2) an increase in the value of that which is produced.10 As I have noted previously: "The situs of the lessor's volume- and value-enhancing efforts is often a courthouse."11 The lessor has traditionally addressed
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volume issues relying upon an implied covenant to protect against drainage and to further explore and develop the leased lands.12 Value issues typically focus on the meaning of the royalty clause which, in turn, trigger the Royalty Value Theorem.
B. The Royalty Value Theorem
I first posited the royalty value theorem at the Foundation's "Federal and Indian Oil & Gas Royalty Valuation & Management III" special institute where I stated:
When compensation under a contract is based upon a set percentage of the value of something, there will be a tendency by each party to either minimize or maximize the value.13
This is also the foundation for why there will never be peace—under the oil and gas lease.14 To the extent there is room for interpretation, argument, or a new theory, there will be an incentive to challenge the other party's view of what is required under the lease. If an argument can be made for a fraction of "X+" instead of the fraction of "X" that is being paid, litigation will ensue when the "+" is worth the effort. The "+" is often pursued when the potential value of the argument can be magnified through the class action procedural device.
However, the "+" at issue in the value-driven royalty context is fundamentally different from the "+" at issue in volume-driven cases. For example, when the issue concerns the lessee's failure to further develop, the test is whether a "prudent operator" would conduct further development. The prudent operator would only conduct further development if the costs of development will likely be recovered, plus a reasonable profit, from the "new" production. The "+" is the new profit that will be obtained from new production. In the value context, there is no new profit or value, but merely a reallocation of existing value and profit based upon a new entitlement theory. Courts are merely deciding how the finite pie will be re-cut. If the lessor is held to be entitled to downstream values,
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and the lessee has been paying royalty based on upstream "at the well" values, the lessor's slice will get bigger and the lessee's slice will get correspondingly smaller. The analysis will be similar when the issue is whether royalty must be paid on downstream investments to obtain downstream values.15
III. THE ROYALTY VALUE THEOREM IN PRACTICE: THE BASIC ISSUES
A. The Linear Enhancement of Production Value
As a general proposition, as oil or gas moves downstream from the wellhead it increases in value. This increase in value is comprised of two components: (1) investments made in the production either by the lessee providing a facility or service or purchasing the service from others;16 and (2) the increased value of the production in a particular form at a particular location. For example, the lessee may spend 500/Mcf17 in gathering and compression costs to transport gas from the wellhead to an interstate pipeline. If we assume the gas has a wellhead value of $ 1.00/Mcf, and a value at the point where the gathering system enters the interstate pipeline of $1.55/Mcf, the total enhanced value is comprised of the 500 in additional investment plus 50 in additional value. As the gas moves further downstream from the wellhead it is typically subject to additional value-increasing investment until it is sold to the purchaser that consumes the gas.
When the phenomenon of linear enhancement of production value is combined with the royalty value theorem, the lessor/lessee battle lines become clear: lessees will seek to value production for royalty purposes as close to the point of extraction as possible while lessors will seek to value production as far downstream from the point of extraction as possible. If a downstream value is used to calculate royalty, lessees will seek to deduct the investment value (the 500/Mcf in the prior example) of the gas before applying the royally fraction.18 Lessors will seek to have their
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royalty calculated on the total downstream value (the $1.55/Mcf in the prior example) without deduction of any investment value. The judicial resolution of these issues will be discussed hi subsequent papers by Professors Kramer, Lowe, and Boomgaarden.
B. Defining the Scope of the Oil and Gas Lease Relationship
One of the foundational issues in addressing royalty obligations is defining the scope of the oil and gas lease relationship. The basic question is: when does the oil and gas lease cease to govern oil or gas that has been extracted from the ground? Since the oil and gas lease is the source of the lessor's royalty rights, it will be to their benefit to keep extracted oil and gas subject to the lease terms as long as possible. This provides the lessor with a contract-based argument for downstream values by...
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