CHAPTER 5 STATE NON-UTILITY REGULATION OF NATURAL GAS PRODUCTION, TRANSPORTATION AND MARKETING

• Jurisdiction: United States

Natural Gas Marketing II
(Apr 1988)
CHAPTER 5
STATE NON-UTILITY REGULATION OF NATURAL GAS PRODUCTION, TRANSPORTATION AND MARKETING
Patrick H. Martin
Louisiana State University Law Center
Baton Rouge, Louisiana

Outline

I. Introduction

II. State Conservation Regulation

A. Protection of "Rights of an Essentially Local Character"

B. Waste

C. Correlative Rights

D. Monopsony, Oligopsony

E. The Development of State Ratable Take/Common Purchaser Statutes and Regulations

F. The State of the Natural Gas Market

III. The Supreme Court Decision in Transco

A. Preemption

1. Four Prior Pipeline Take Decisions

2. The Mississippi Order and Decision

3. Transco

B. Dormant Commerce Clause

IV. The Impact of Transco: Current State Regulation

A. Introduction

B. Kansas

C. Oklahoma

1. Ratable Take/Priority Order and the ANR Decision

2. Allowables for Unallocated Wells: The Conoco Decision

3. Conservation Regulation and Take or Pay: The Golsen Decision

4. House Bill 1221 and the Seal Decision

5. The Teel Decision: Conversion by Purchaser with Notice

D. Texas

1. Ratable Take/Priority Orders

2. Conservation Regulation and Take or Pay: The Valero Decision

E. Louisiana

V. The Relation of Order 500

VI. Conclusion

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I. Introduction

The natural gas picture would be incomplete without considering the fact that both the producing states and the consuming states have significant roles in natural gas matters.¹ The focus of my discussion is on the regulation of gas by the producing states. Utility regulation problems that gas distribution companies face out of the decision in Kentucky West Virginia Gas Company v. Pennsylvania Public Utility Commission² are beyond the scope of this paper except to note that it will pose risk and uncertainty at both ends of the pipeline.

Of greatest interest and consequence for producing state regulation is the recent United States Supreme Court decision in Transcontinental Gas Pipe Line Corporation v. State Oil and Gas Board of Mississippi.³ In going over this and the Northwest Central case⁴ now before the Court, I will describe generally the regulation of gas production by the states and what the Transco decision may portend for that regulation.

In Transco, the Supreme Court reaffirmed the 1963 decision in Northern Natural Gas. The court declared invalid Mississippi's Rule 48 requiring pipelines to take ratably from all wells in a common source of supply if the pipeline decides to take from any well. The court found the Mississippi regulation preempted by federal law. Producing states with ratable take statutes and regulations now face some hard decisions. The problems are much more complex and subtle than they appear in the decisions by the Supreme Court of Mississippi and the United States Supreme Court. Because of the incomplete consideration of the problems by the Mississippi Supreme Court, it would be a mistake to believe that the United States Supreme Court decision speaks finally on the full range of problems.

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II. State Conservation Regulation

A. Protection of "Rights of an Essentially Local Character"

Over the past century of oil and gas production, the states in which production takes place have developed comprehensive, integrated programs for properly managing that production in the public interest. The public interest is three-fold: prevention of waste of valuable natural resources; protection of property rights in those resources; and protection of the public from corporations with monopsonistic and oligopsonistic power.

The Supreme Court upheld programs for the prevention of waste and protection of correlative rights from the first challenges to them. At issue in Ohio Oil Co. v. State of Indiana,⁵ a case decided in 1900, was a state prohibition on the venting of gas. The state had taken enforcement action against the company which was venting gas in order to produce oil because the defendant was injuring back pressure needed to prevent salt water encroachment in a stratum that served nearby cities and plants with gas. The court recognized that the owners of oil and gas rights "could not be absolutely deprived of this right which belongs to them without a taking of private property." But it observed that these were rights held in common, in that a common source of supply was involved, and regulation could be justified as necessary so that one owner did not unduly impair the rights of another owner. Thus the Supreme Court concluded: "In view of the fact that regulations of natural deposits of oil and gas and the right of the owner to take them as an incident of title in fee to the surface of the earth, as said by the supreme court of Indiana, is ultimately but a regulation of real property, and they must hence be treated as relating to the preservation and protection of rights of an essentially local character. Considering this fact and the peculiar situation of the substances, as well as the character of the rights of the surface owners, we cannot say that the statute amounts to a taking of private property, when it is but a regulation by the state of Indiana of a subject which especially comes within its lawful authority."⁶ This rationale remained the basis for the Supreme Court upholding other state regulatory programs. The court recognized the difficult nature of property rights in a common pool and the primacy of the state in adjusting competing claims of parties with rights to take from the common source.

Long ago the courts in all producing states decided that a landowner has the right to the oil and gas beneath the surface or at least the right to produce oil and gas through wells on his property. Whether the state adopted

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the ownership in place theory or the non-ownership theory, the right to produce was and is held to be a valuable property right, one that may be conveyed and protected like any other property right.⁷ To deprive a person of this right without compensation is a taking of that property.

A corollary of the right to produce is the Rule of Capture. Under this principle, the producer may produce from his own property even if the production results in migration or drainage from the adjacent property. The nature of ownership rights in oil and gas is defined not only by the common law of judicial decisions but also by state statutes and regulations made pursuant to statutes.⁸

B. Waste

The Rule of Capture has unfortunate consequences, for it is its own defense. That is, a landowner whose property is being drained must protect his interest by drilling his own well and producing under his right to produce before his neighbor drains away all that is under his surface. Once oil or gas is discovered, each owner in the area has a great incentive to produce as much as possible as fast as possible. The rush results in too many wells and too rapid a dissipation of the natural mechanisms that sustain production. Gas in the reservoir that provides the pressure for production is lost; water flows prematurely into the well bore. Oil or gas will be left underground that could have been produced had proper methods of production been used. Expensive wells will be drilled that are unnecessary, and pollution may well take place from all of the surface activities.

The producing states have a variety of statutes and regulations to prevent waste. As the same time, the regulations seek to protect the property rights of owners of interests in oil and gas and to limit the abuses of monopsony and oligopsony power of purchsers. While I will use subheadings under "Waste" to describe the state regulations initially, it should be observed that the regulations must also achieve the ends sought under the headings of "Correlative Rights" and "Monopsony and Oligopsony."

1. Drilling Practices

The rule of capture leads to the drilling of wells that are unnecessary to drain a reservoir. It leads to excessive rates of production of oil that may

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cause coning, fingering, and premature loss of reservoir energy as gas cap gas or solution gas is depleted. Surface effects may include production in excess of storage and marketing facilities.

Apart from the incentives of the rule of capture, improper practices by operators can cause waste. Incorrect plugging of a well, for example, can lead to migration of oil out of a reservoir to pollute the surface or can lead to communication between formations thus damaging a productive formation. Putting a valuable resource to inferior uses might also be regarded as a wasteful practice that states may regulate.

All state conservation agencies regulate each phase of oil and gas drilling and production. Elaborate technical regulations govern the drilling and completion of wells, including rules on the setting of casing and protecting against fire, rules establishing requirements for drilling fluids and for storm choke or blow-out prevention equipment, and rules governing plugging and abandonment procedures. Inspectors have access to all rigs and monitor that permits have been obtained and regulations are being complied with.

2. Spacing and Allowables

Well spacing is concerned with the location of wells and the density of drilling into a reservoir. Rules or orders of the state conservation agency may limit the proximity of wells to property lines and to other wells. Such regulations have the effect of protecting correlative rights in areas of diverse ownership and of limiting the number of wells that may be drilled into a reservoir in a given area. Well-spacing is done both by state-wide order and by individual field or reservoir rules. Exceptions may be granted on a well-by-well basis. Generally, an exception location may be approved when it is necessary to prevent waste or to prevent inequity or loss of property rights.

A variety of factors will be considered in the setting of allowables. One concern is establishing for oil the maximum efficient rate of recovery...