CHAPTER 5 COMMON CONTRACTUAL, PROPERTY, AND SECURITY ISSUES ASSOCIATED WITH PRODUCTION AND MARKETING AGREEMENTS

• Jurisdiction: United States

Oil and Gas Agreements: The Production and Marketing Phase
(May 2005)
CHAPTER 5
COMMON CONTRACTUAL, PROPERTY, AND SECURITY ISSUES ASSOCIATED WITH PRODUCTION AND MARKETING AGREEMENTS
David E. Pierce
Professor of Law
Washburn University School of Law
Topeka, Kansas
DAVID E. PIERCE

David E. Pierce is a professor at Washburn University School of Law in Topeka, Kansas where he teaches Contracts I & II, Oil & Gas Law, Advanced Oil & Gas Law, and Hazardous Waste Regulation. Prior to entering law teaching Professor Pierce was an in-house oil and gas attorney for Shell Oil Company in Houston, Texas and before that he engaged in the private practice of law in Kansas.

Professor Pierce earned a B.A. from Kansas State College of Pittsburg, a J.D. from Washburn University School of Law, and a Masters of Law (LL.M.%sb%sEnergy Law) from the University of Utah College of Law.

Professor Pierce has written extensively on contracts and oil and gas law topics. He is the author of the Kansas Oil and Gas Handbook, a co-author of Cases and Materials on Oil and Gas Law, a revision and upkeep co-author of Kuntz on the Law of Oil and Gas, and an editor of the Oil and Gas Reporter.

TABLE OF CONTENTS

I. SURVEY OF THE CONTRACTS AND PROPERTY RIGHTS

A. The Development Phase

B. The Production Phase: Progression from Real Property to Personal Property

1. Oil and Gas Lease

2. Pooling Agreements

3. Unit Agreements

4. Operating Agreements

C. The Marketing Phase: Sale or Service?

1. Division Orders

2. Other Sales Contracts

3. Other Service Contracts

II. THE ROLE OF THE UNIFORM COMMERCIAL CODE IN MARKETING

A. Sale of "Goods" and Article 2

1. "Sale" vs. "Service"

2. "Mirror Image" and "Battle of the Forms"

B. "Security" for the Sale or Service

1. Letters of Credit and Article 5

2. Security Interests and Article 9

III. THE IMPACT OF REGULATION ON MARKETING

A. The Regulatory History of Oil

B. The Regulatory History of Gas

C. Affiliate Transactions

IV. CONCLUSION

V. POWER POINT HANDOUTS

I. SURVEY OF THE CONTRACTS AND PROPERTY RIGHTS

A. The Development Phase

The development, production, and marketing of oil and gas are accomplished through a series of commonly encountered contracts that create myriad property interests and contractual relationships. During the exploration and development phase the primary focus is on identifying property rights in the oil and gas mineral estate and ensuring the necessary rights are brought under the developer's control through an oil and gas lease. Pooling agreements and unitization agreements may impact the underlying ownership in a pooled or unitized area. Multiple owners of leasehold interests may enter into operating agreements to coordinate development of leased land. New property interests may be created in the leasehold estate through assignments. Development rights in oil and gas leases may change hands through assignment or farmout agreements. Division orders may further define the rights of the parties to their interests in production. The one common attribute of all these agreements, in the development context, is they seek to define the development rights--the oil and gas property interests--of each party involved in the development process.

The major non-ownership relationship at the development phase is the drilling contract. The drilling contract is designed to allocate the risks of exploring for oil and gas between the drilling contractor and the developer. The developer frequently leverages the financial risks of exploration and development by sharing them with other investors, typically through an operating agreement. Once a producing well has been completed, the parties move from the development phase to the production phase.

B. The Production Phase: Progression from Real Property to Personal Property

As we move from the development phase to production and marketing, the focus shifts from ownership of development rights (real property) to ownership of the extracted oil and gas (personal property). This transformation from real to personal property is a major prelude to many of the issues producers face at the marketing phase of the process. Careful study of the foundational documents (oil and gas lease, pooling agreements and orders, unitization agreements and orders) often reveal the precise moment when the "real" becomes the "personal."

1. Oil and Gas Lease

Depending upon the applicable state law, the lessor/mineral interest owner either owns the oil and gas beneath their land "in place," ¹ FN1 or they own the exclusive right to go onto the property to drill and try and capture the oil and gas and reduce it to possession. ² FN2 Regardless of the mineral owner's rights, the royalty clause of the oil and gas lease typically defines the respective rights of the lessor and lessee in produced oil and produced gas. Consider the operation of the following royalty clause:

3. The royalties to be paid by Lessee are as follows: On oil, one-eighth of that produced and saved from said land, the same to be delivered at the wells or to the credit of Lessor into the pipe line to which the wells may be connected. Lessee shall have the option to purchase any royalty oil in its possession, paying the market price therefor prevailing for the field where produced on the date of purchase. On gas, including casinghead gas, condensate or other gaseous substances, produced from said land and sold or used off the premises or for the extraction of gasoline or other products therefrom, the market value at the well of one-eighth of the gas so sold or used, provided that on gas sold at the wells the royalty shall be one-eighth of the amount realized from such sale.... ³ FN3

Under this clause production of oil will result in the lessor and lessee each owning a share of the oil. This means that often a separate contract will be required to acquire oil from the lessee, and from the lessor. If a third-party purchaser is involved (someone other than the lessee), they will typically have at least a division order contract with the owners of the oil (lessors and lessee) authorizing the purchaser to take possession of the oil and, in return, pay a stated sum of money for the oil. In the sample clause if the lessee elects to purchase the lessor's oil, instead of delivering the oil to the lessor, or to lessor's credit with a third-party purchaser, the lessee will typically document its election through a division order with the lessor.

When the production concerns gas, ⁴ FN4 the relationship between the lessor and lessee is fundamentally different. Because the lessor owns none of the gas being produced, ⁵ FN5 they have nothing to sell or transfer to the lessee, or to a third party. Their gas royalty rights in such a case are to be paid a sum of money in accordance with the covenants expressed in the royalty clause: in our example, an amount of money measured either by the ""market value" or the "amount realized" depending upon whether the gas is "sold at the wells" (amount realized) or "sold or used off the premises" (market value). ⁶ FN6

2. Pooling Agreements

In some situations a pooling agreement, entered into by the affected lessors and lessees, may seek to state a single basis for calculating royalty from all leases contributing acreage to the pooled area. Pooling agreements should be contrasted with "declarations" of pooling. The declaration of pooling is merely evidence the lessee is exercising authority to pool, granted by a pooling clause in an oil and gas lease. The declaration will not alter the basis for calculating royalty under the oil and gas lease because it is merely the lessee's unilateral exercise of authority to pool granted by the terms of the oil and gas lease.

However, if the lease lacks a pooling clause, or the pooling authority granted by the lease is too narrow, the lessee may seek additional pooling authority directly from the lessor through a pooling agreement. The terms of the pooling agreement must then be analyzed to determine whether the basis for determining royalty provided for in the underlying oil and gas leases has been changed. The pooling agreement may also contain details regarding the marketing of pooled production.

3. Unit Agreements

When a field wide unit is formed, the lessors and lessees enter into a Unit Agreement; the lessees will also enter into a separate Unit Operating Agreement. Because the lessors are a party to the Unit Agreement, there is the potential the royalty provisions of their oil and gas leases can be altered. Many unitization projects use some version, or adaptation, of the American Petroleum Institute's Model Form of Unit Agreement. ⁷ FN7 The effect of the Unit Agreement on the lessors' lease rights is addressed in the following provisions of the Unit Agreement:

1.3 Unitized Substances are all oil, gas, gaseous substances, sulphur contained in gas, condensate, distillate, and all associated and constituent liquid or liquefiable hydrocarbons other than Outside Substances within or produced from the Unitized Formation.

....

3.1 Oil and Gas Rights Unitized. All Oil and Gas Rights of Royalty Owners in and to the lands described in Exhibit A, and all Oil and Gas Rights of Working Interest Owners in and to said lands, are hereby unitized insofar as the respective Oil and Gas Rights pertain to the Unitized Formation, so that Unit Operations may be conducted with respect to the Unitized Formation as if the Unit Area had been included in a single lease executed by all Royalty Owners, as lessors, in favor of all Working Interest Owners, as lessees, and as if the lease contained all of the provisions of this agreement.

....

3.3 Amendment of Leases and Other Agreements. The provisions of the various leases, agreements, division and transfer orders, or other instruments pertaining to the respective Tracts or the production therefrom are amended to the extent necessary to make them conform to the...