CHAPTER 3 THE IMPLIED MARKETING COVENANT IN OIL AND GAS LEASES: SOME NEEDED CHANGES FOR THE 80's

JurisdictionUnited States
Implied Covenants
(Nov 1986)

CHAPTER 3
THE IMPLIED MARKETING COVENANT IN OIL AND GAS LEASES: SOME NEEDED CHANGES FOR THE 80's

Bruce M. Kramer * & Chris Pearson **
Texas Tech University School of Law
Lubbock, Texas

I. INTRODUCTION

In recent years the demand for natural gas has resembled the trek of an amusement park roller coaster—lots of ups and downs. In the mid to late 1970's the nation experienced an energy shortage upon which President Carter declared the "moral equivalent of war."1 In an attempt to combat the shortages Congress passed the Natural Gas Policy Act of 1978 (NGPA).2 At the heart of the NGPA is a pricing structure which places a significant burden on producers in the form of costly (in both time and money) administrative requirements.3 The normal market place incentive to seek higher maximum prices under various NGPA formulae is diluted by the tremendous bureaucratic and administrative transaction costs.4 The lessee is therefore "encouraged" by the high transaction costs to accept the first classification for his wells and

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gas products. This complacency is exacerbated by the recent decrease in demand for natural gas.5

Following a period of governmental policies aimed at stimulating drilling and production in the mid to late 1970's producers of natural gas experienced a prolonged downturn in demand which has continued to date.6 In 1984 it was estimated that the surplus of natural gas in the United States has now reached seven trillion cubic feet per year. This surplus represented about thirty percent of the nation's productive capacity.7 The forecast for 1986 reflects a deliverability surplus in excess of four trillion cubic feet.8 A natural effect of this current glut is that an increasing number of wells are being shut-in.9 On those wells not shut-in, producers find that they are often unable to market the permitted levels of production.10 In either situation, shut-in or marketing of only a percentage of production, lessors are unlikely to receive the royalty payments they expect. It is probable that the above-described scenario will precipitate an increase in litigation predicated on the lessee's duty to market natural gas which has been discovered on the leasehold.11 This article, anticipating such an increase, attempts to review the lessee's obligation under the implied covenant to market.

II. THE APPLICATION OF THE IMPLIED COVENANT TO MARKET

Development of Implied Covenants Generally

One of the most distinctive features of oil and gas leases is the almost total absence in the ordinary type of lease of express

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clauses protecting the royalty interest of the lessor. It is doubtful if any other character of legal instrument can be found in which one of the parties has so much potentially at stake with so little express contractual protection.12

As noted in the above passage, oil and gas lease forms have traditionally not contained provisions which set out the duties a lessee owes his lessor. Thus, a lease will generally be silent as to the lessee's duty to, among other things, drill offset wells, develop the leasehold, protect against drainage, or market the minerals discovered on the leasehold.13 In the absence of such provisions, however, courts have been willing to find implied covenants which require the lessee to perform such duties or suffer the consequences of breach.14

Implied covenants in oil and gas leases originated at the turn of the century.15 In 1905, the landmark case of Brewster v. Lanyon Zinc Co.16 was decided. In Brewster the Eighth Circuit stated that where a lease contains no express provisions regarding the lessee's duty to develop the lease, it does not follow that the decision as to how to develop the lease is left solely to the lessee. Rather, the lessee's duty to develop "arises from the language of the contract when considered in its entirety...."17

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The Brewster rationale is based on the court's interpretation of the intent of the parties.18 Over the years, however, courts have implied covenants on other grounds,19 including public policy20 and general principles of equity.21

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Historical Development of the Marketing Covenant22

One of the recognized but little discussed implied covenants relates to the lessee's duty to market the product discovered on the leasehold. The marketing covenant applies equally to oil and gas; however, as a practical matter, it is rarely applied to the production of oil.23 As with most implied covenants, the marketing covenant arises even though under most conditions or circumstances both the lessor and lessee share a common interest in marketing the minerals discovered. However, where circumstances occur which make the marketing of the product detrimental to the lessee's best interest, disputes will arise.24 It is because of these

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potentially conflicting situations that the implied covenant to market was developed.

The basic principles underlying the implied covenant to market were elucidated in 1899 by the Pennsylvania Supreme Court in Iams v. Carnegie Natural Gas.25 The case also is illustrative of the early marketing covenant cases which dealt not with a fractional royalty but with a flat rate sum to be paid if gas was found and marketed. The basic problems that have confronted all courts dealing with the marketing covenant are reflected in Iams. For example, the court had to determine the standard of conduct to govern the lessee's activities under the lease.26 It concluded that once the marketing duty was triggered by the finding of gas in sufficient quantities "[t]he tenant [lessee] was then under an obligation to operate for the common good of both parties."27

The Iams court also impliedly discussed the allocation of the burden of proof on the issue of proving a violation of the marketing covenant. In this case the plaintiff/lessor presented evidence of the defendant/ lessee's failure to market the gas which had been found in quantities sufficient to justify marketing. The burden of presenting evidence then shifted to the lessee to "show some good reason for not having done so."28 In this case the jury did not accept the lessee's rebuttal testimony and held for the lessor.29

The parameters of the implied covenant were developed more fully in Howerton v. Kansas Natural Gas Co.30 As with Iams, the court was dealing with a fixed sum royalty for gas. However, there was no express covenant to market the gas if sufficient quantities were found.31 The court nonetheless found that an implied covenant to market existed based on the implied intent of the parties in agreeing to the lease with a royalty provision. The marketing covenant springs forth from the nature of the leasehold transaction whereby the lessor's major benefits only arise upon the marketing of any discovered mineral.32 The court

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did not discuss the relevant standard to judge the lessee's conduct because there was a total absence of any effort to market the discovered gas.

The court also differed from lams in the remedy given to the lessor. Although the case involved a fixed sum royalty, the court concluded that there was no adequate remedy at law.33 Treating the implied covenant as both a condition and a covenant, the court upheld a decree of forfeiture terminating the leasehold estate.34

By 1931 the Texas Supreme Court had accepted as a well-established fact the implied covenant to market in the context of an oil and gas lease.35 The marketing covenant was derived from and considered an essential part of the development covenant, as neither the lessor or lessee gained any advantage from the discovery of hydrocarbons unless those substances were marketed.36 The covenant to market in the oil and gas lease transaction had its foundation in the earlier hard-rock mineral cases which implied a covenant to market minerals such as coal or sulfur.37 The implied covenant to market was soon recognized in most oil producing jurisdictions throughout the United States.38

The Prima Facie Case

The minimum elements that a lessor must prove to state a cause of action for breach of the implied covenant to market are:

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1. Discovery of hydrocarbons on the premises;

2. Failure to market the discovered hydrocarbons;

3. Ability to market the hydrocarbons if the lessee's actions complied with the relevant standard of conduct, and;

4. Damages proximately caused by the lessee's failure to act in the prescribed manner.39

Once these requirements have been met, a remedy is available.40

The initial requirement that hydrocarbons be discovered on the premises is axiomatic. Clearly one must have a product to market before a duty to market will arise. However, as in lams and Howerton, a factual issue may arise as to whether the hydrocarbons have been discovered in "sufficient quantities".41

The second element required to establish a cause of action for breach of the marketing duty requires the lessor to prove that a market exists. Markets only exist if there is a willing buyer as well as a willing seller.42

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Thus, notwithstanding the fact that commercial quantities of oil and gas have been discovered, there is no breach of the marketing covenant unless it is shown that an actual market existed.43 It is clear, however, that the lessee must undertake diligent efforts to secure a buyer if none are readily available.44 Often it is apparent that the lessee has done little if anything regarding the marketing of the gas.

Although rarely discussed, the rules allocating the burden of proof and burden of going forward in the context of the marketing duty are very important.45 In Craig v. Champlin Petroleum Co. the allocation of the burden to the lessor to prove the existence of a market for the gas was undoubtedly a critical factor in the Tenth Circuit's reversal of the trial court's finding that a market existed.46 In one recent case, a federal district court held that...

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