CHAPTER 4 INTERPRETING THE ROYALTY OBLIGATION BY LOOKING AT THE EXPRESS LANGUAGE: WHAT A NOVEL IDEA?

• Jurisdiction: United States

PRIVATE OIL & GAS ROYALTIES
(Sept 2003)
CHAPTER 4
INTERPRETING THE ROYALTY OBLIGATION BY LOOKING AT THE EXPRESS LANGUAGE: WHAT A NOVEL IDEA?
Bruce M. Kramer
Maddox Professor of Law Texas Tech University School of Law
Lubbock, Texas

I INTRODUCTION

It is indeed a daunting task to wax eloquent about a subject matter where one's peers and mentors have felled many a tree beforehand.¹ But my role is somewhat more limited than attempting to develop a grand, unifying theme for dealing with royalty interests. My role is to give a brief historical perspective on the express language that has been used in the royalty clauses. Royalty clauses are not uniform. I have spent a good deal of time in the past 5-10 years reviewing the language in literally thousands of oil and gas leases and assignments of oil and gas leases. While the overall structure of the basic royalty clause has remained unchanged over the past 50 years, the language used to describe either the delivery or payment obligation varies substantially. It is my hope to discuss and analyze some of the important terms that are found in many royalty clauses. As Professor Anderson and I have noted, this parsing of language approach may lead to substantial differences in interpretation between states and sometimes within a single state.² To contrast with this parsing approach, several courts apply the extrinsic approach whereby factors not gleaned from the language of the instrument are used to determine the parties' intent. Professor Merrill and to a certain extent Professor Anderson are exponents of this approach.³ Nonetheless, I believe that where the parties have articulated their intent through express language, the court's principal role, in the absence of fraud, duress or mutual mistake, is to enforce the agreement as written. One of the root causes of the disparate treatment of royalty clauses in the past two decades has been the change of external circumstances regarding the production and marketing of both oil and natural gas that does not mesh with the language used by the parties in instruments that may be decades old. But without an understanding of why and how

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certain royalty clause language became widespread, our attempts to resolve our current problems are likely to be haphazard at best.

II THE HISTORICAL ANTECEDENTS

Some of the earliest oil and gas leases did not reserve to the mineral owner what we now call a royalty interest. Instead a type of shared profits agreement using a 50% sharing arrangement was utilized.⁴ Nonetheless within a few years it became commonplace for the owner of the mineral estate to reserve a smaller fraction, typically 178^th , of all of the oil collected.⁵ The origin of the 178^th fraction, however, as the norm is clouded in history. The earliest leases reported show a royalty share of as much as 173^rd of the oil produced.⁶ Yet many of the earliest cases provide for a 1/8 in kind royalty for oil and a cash payment for gas wells.⁷ One of the earliest printed oil and gas lease forms first distributed around 1870 provided for the "usual royalty of one-eighth of the oil produced", but no payments for gas.⁸ By 1880, however, the flat rate royalty clause for gas begins to appear in printed form leases.⁹ By the turn of the 20^th century there were few reported cases that described the shared profits arrangement rather than the typical royalty arrangement.¹⁰ No explanation has ever been proffered for the demise of the shared profits agreement, but as with the no-term lease, it disappeared from the oil and gas scene in a reasonably short period of time.

By the decade of the 1910s, the leading oil and gas treatise identified the following seven methods currently in vogue for the fixing of the rents or royalties in a mining or oil and gas lease:

(1) a fixed sum; or an (2) annual or other periodical sum; or (3) a royalty on the amount of the minerals or oil mined or produced, payable at fixed intervals or times; or (4) a royalty, not, however, less in the aggregate than a specified sum each year; or (5) a royalty accompanied by a covenant to mine a certain minimum amount or pay a certain sum thereon; or (6) in case of a gas lease, to bore so many wells and pay so much a well, or forfeit a certain sum per well for a failure to bore the required number; or (7) in case of an oil lease, to pay a certain percentage of the oil taken out of the premises.¹¹

Thus, it was established early on that gas production was to be treated separately from oil production and that the traditional reservation of a fractional share of production was not the only remuneration received by the lessor.¹²

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By the mid 1920's, however, it appears that standard oil and gas leases were in wide distribution whose basic structure and organization is still prevalent today. In Richard Leroy Benoit's Cyclopedia of Oil and Gas Forms published in 1926 the author lists 20 different types of oil royalty clauses and an even larger number of gas and/or casinghead gas royalty clauses.¹³ The oil royalty clauses seen in 1926 mirror the type of oil royalty clauses seen in oil and gas leases 50 years later. Several examples of the classic in kind only royalty clause are provided where there are differences as to the point of delivery. Some of the clauses provide:

To deliver to the credit of the lessor, free of cost, in the pipe line to which lessee may connect its wells, the equal one-eighth part of all oil produced and saved from said leased premises;

If oil should be found in paying quantities on said premises, the lessee shall deliver as royalty to said lessor, free of expense, one-eighth part of all the oil saved from that produced, such delivery to be made either into tanks supplied by lessor, with connections by lessor provided, or into any pipe line that may be connected with the wells;

The grantee agrees to deliver to the grantor in gauge tanks on the premises and free of cost, the equal — part of all oil produced and saved from the premises.¹⁴

In addition, there are several clauses providing for either a lessor or lessee option whereby the in kind delivery obligation may be changed in to a payment obligation. Some of these clauses provide:

The lessee shall deliver to the credit of the lessor, as royalty, free of cost, in the pipe lines to which lessee may connect his wells, the equal one-eighth part of all oil produced and saved from the leased premises, or at lessee's option, may pay to the lessor for such one-eighth royalty the market price for oil of like grade and gravity prevailing on the day such oil is run into the pipe line or into storage tanks.

To pay and deliver to the credit of lessor, free of cost, in the pipe line or pipe lines to which lessee may connect its well or wells, the equal one-eighth part of all oil produced and saved from the premises, or at the lessor's election to pay in cash the current market value of lessor's one-eighth interest in said oil.¹⁵

All but one of the 20 oil royalty clauses are one paragraph in length and reasonably short. Some refer to posted market price while others allocate the costs of storage or building a pipe line between the parties. Only one of the model clauses is lengthy and talks about the sale of the royalty oil at the prevailing market price. It also allocates the

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cost of constructing storage facilities on the premises. Interestingly enough this longer royalty clause authorizes the lessee to make a $ .05/barrel charge for storing and/or transporting the oil to the third-party purchaser should the lessee not purchase the royalty oil on its own account.¹⁶

It is evident from the model gas royalty clauses found in the 1920s that it was still acceptable practice to provide for a cash payment for each gas well producing gas.¹⁷ The oil and gas lease used by the Department of the Interior for Indian lands changed from a fixed amount per gas well in 1908 to a fractional royalty payment obligation by 1926.¹⁸ The modern form whereby the gas royalty calculation methodology differs depending on what is done with the gas that is produced does not appear to be widely used early in this decade. The predominant form of payment requirement is a share of the "net proceeds" from the sale of the natural gas, although "prevailing market price" also appears in some of the model clauses.¹⁹ However, the origins of the distinction between gas sold or used off the premises and gas not so sold or used appears to date back to this period of time. An oil and gas lease forms book published by the influential Mid-Continent Oil and Gas Association in 1926 provides five model oil and gas leases all of which provide that where gas is either sold or used off of the premises, fractional royalty payments are owed.²⁰ In several gas royalty clauses from this vintage, the language used makes clear that gas used by the lessee on the premises is royalty free, notwithstanding the fact that the gas has been produced and saved.²¹ These clauses are the precursor to the modem day free use clauses that make it explicit that royalty is not due on gas used on the premises by the lessee.

By the 1930s there was little appreciable difference in the oil royalty clauses that were in widespread use. The model lease form published in a 1935 treatise provides for the standard in kind royalty of 178^th for all "oil produced and saved from the leased premises" or at the lessee's option the payment obligation of 1/8th of the "market price for oil of like grade and gravity prevailing on the day such oil is run into the pipe line, or into storage tanks."²² The gas royalty clause, on the other hand, was beginning to assume the form that became prevalent in the modern oil and gas lease. This same treatise provides several different model oil and gas leases. The first lease provides for a divided royalty obligation depending on the source of the gas and what is done with the gas after production.

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The...