CHAPTER 6 INTERPRETING THE ROYALTY OBLIGATION: THE ROLE OF THE IMPLIED COVENANT TO MARKET
| Jurisdiction | United States |
(Sept 2003)
INTERPRETING THE ROYALTY OBLIGATION: THE ROLE OF THE IMPLIED COVENANT TO MARKET
Southern Methodist University
Dallas, Texas
John S. Lowe
George W. Hutchison Professor of Energy Law
Southern Methodist University
Dallas, TX 75275-0116
Tel.: 214-768-2595
Fax: 214-768-4330
I. Introduction
II. The Timing "Leg" of the Implied Covenant to Market
A. The Lessee's Obligation to Find a Market
B. The Meaning of "Market Value"
C. Royalty on Take-or-Pay Benefits
D. Costs Deductible in Calculating Royalty
1. The Capture-and-Hold Rule
2. The Marketable-Product Rule
III. The Pricing "Leg" of the Implied Covenant to Market
A. The Duty Not to Act in Bad Faith
B. An Affirmative Duty to Market
IV. Current Implied-Covenant-to-Market Issues
A. When Does the Marketing Covenant Arise?
B. How is the Duty Defined?
C. What Does It Take to Modify or Disclaim the Implied Duty?
D. The Effect of Transactions with Affiliated Entities
V. The Implied-in-Fact/Implied-in-Law Distinction
VI. The Significance of the Implied-in-Fact/Implied-in-Law Distinction
VII. Conclusion
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I. Introduction
There is more to the royalty obligation than the language of the royalty clause. Leases include implied, as well as express, provisions that historically have played an important role in defining the royalty obligation.
Implied covenants are unwritten promises by one of the parties to a contract. Covenants by implication have been recognized in a variety of contracts,1 but they are particularly troublesome in oil and gas law, where there have been thousands of reported cases discussing implied covenants in oil and gas transactions, mostly involving disputes between lessors and
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lessees under leases.2 Because implied obligations by their very nature are less specific than express obligations, they provide a fallow ground for litigation.
Lease implied covenants arise from the ongoing relationship of the lessor and lessee. The oil and gas lessee has the exclusive cost-bearing right to explore and develop the leased property. The lessor has a cost-free interest in production or revenues or value, but has given the lessee the exclusive right to drill or produce. Because the typical oil and gas lease makes the lessor's royalty—the major compensation for grant of the lease—dependent upon the quantity and quality of the lessee's actions on the property, the courts have been quick to conclude that the lessee has the obligation to perform certain unstated obligations.3
Initially, the inquiry of many courts when considering implied covenants was the subjective good faith of the lessee. Today, however, the standard of the implied covenants is generally
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stated to be an objective standard, that of a "reasonably prudent operator":
"[Some cases hold that] the question of what is reasonable ... where there is no specific stipulation on the subject, is committed to the judgment of the lessee, whose determination, if made honestly and in good faith, is conclusive, much as is the decision of an engineer under a construction contract which expressly makes him the final arbiter of all questions relating to the amount and character of the work done, its conformity to the contract, and the price to be paid.
* * *
With great deference to the able courts which have adopted this view, we think it is not sound.... The object of the operations being to obtain a benefit or profit for both lessor and lessee, it seems obvious, in the absence of some stipulation to that effect, that neither is made the arbiter of the extent to which or the diligence with which the operations shall proceed, and that both are bound by the standard of what is reasonable.
* * *
Whether or not in any particular instance such diligence is exercised depends upon a variety of circumstances.... Whatever, in the circumstances, would be reasonably expected of operators of ordinary prudence, having regard to the interests of both lessor and lessee, is what is required."4
The marketing covenant - our focus in this Special Institute - was the logical result of the reasonably-prudent-operator syllogism: the reasonably prudent operator, having taken the risks of drilling successfully, will seek to make a profit by marketing, which will benefit both the lessee and the lessor. Another way to understand the covenant is to realize that "without marketing the lessor will not realize any benefit from the lease."5
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Many commentators have written excellent papers over the years discussing how the authors thought the marketing covenant ought to work.6 In this paper, I will try to refrain from commentary, so that I can focus on how the covenant has evolved over the years and the issues that lawyers and courts dealing with it must confront today.
II. The Timing "Leg" of the Implied Covenant to Market
A. The Lessee's Obligation to Find a Market
Initially, the implied covenant to market arose from disputes over the timing of marketing.
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From early in the history of the oil and gas industry, courts held that a lessee is under an implied obligation to market within a reasonable time, which they translated to an obligation to use due diligence to market the products produced.
Early courts applied the implied covenant to market to impose an obligation on lessees to act with diligence on or near the lease to respond to or locate available markets, not to create them.7 Thus, for example, while cases applied the covenant to market to require a lessee to install a booster on the lease to force gas into a pipeline8 or to build a plant on or near the lease to permit carbon dioxide production,9 others held that there is no implied obligation to construct a long-distance pipeline to make it possible to get gas to market.10
How much time is reasonable for the lessee to find a market will depend upon the facts and circumstances. But a "reasonable time" may be a long time. In Gain V. Pan-American Petroleum Corporation,11 a gas well was shut in for three-and-a-half years, from 1956 until 1960, while the lessee sought better contract terms. The court held that the lessee had not breached the covenant to market because the lessee had used due diligence in negotiating to obtain a satisfactory market.12 In Bristol V. Colorado Oil & Gas Corp.13 applying Oklahoma law, the court held a delay of nearly eight years before marketing was reasonable because the gas was impure and there was no pipeline available.
The presence of a shut-in royalty clause in the lease may also lengthen the time a court
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ultimately determines is reasonable to find a market.14 If the parties have agreed to a lease that includes a shut-in royalty provision, logic suggests that the parties anticipate that marketing may not occur promptly, and payment and acceptance of shut-in royalty clearly is a factor in courts' determinations of the reasonableness of marketing delays.15 The presence of a shut-in royalty clause will not obviate the implied covenant to market, however, for the purpose of the shut-in royalty clause is to protect the lessee against loss of the lease for failure of production where marketing is not possible or advisable, not to relieve the lessee of the duty to market.16
The lessee's prudence is judged as of the time the lessee made its decisions. Thus, in Robbins v. Chevron U.S.A., Inc.,17 the Kansas Supreme Court held that a lessee had not breached the implied covenant to market as a matter of law by shutting in wells capable of producing gas in paying quantities for two years during the pendency of a gas contract dispute. Chevron had entered into contract amendments in 1978 that called for prices that were higher than market prices in the mid-1980s. Chevron then refused to amend the contract to take lower prices and shut in the wells when the purchaser, KGS, refused to honor the contract. Chevron's lessors argued that Chevron had acted imprudently.18 The Kansas court reversed a summary judgment for the lessors, stating that:
"Chevron's conduct must be judged upon what an experienced operator of reasonable prudence would have done under the facts existing at the time. The wisdom of hindsight cannot be utilized in making such determination."19
When a lessor establishes a breach of the timing leg of the covenant to market, many cases grant lease forfeiture or cancellation as a remedy. In Colorado, it appears that forfeiture is the
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pereferred remedy.20 In Kansas, forfeiture is available if damages are an inadequate remedy.21 Generally, however, notice and an opportunity to correct the breach are prerequisites. For example, in James Energy Co. v. HCG Energy Corp., the Oklahoma Supreme Court refused to quiet title in lessors who failed to make a demand that a lessee produce and market gas before they sued for cancellation. The court reasoned that the duty to produce and market is an implied covenant, and that an action to cancel an oil and gas lease is an action in equity, so that the lessee must be given notice and a reasonable time to comply22 before a court may order cancellation unless there are circumstances under which the giving of notice would be a vain and useless thing23 Other courts may award damages equal to the amount of royalty the lessor would have received had production been marketed if evidence establishes with reasonable certainty the quantity of oil or gas that would have been produced,24 though theoretically the better measure would ordinarily be the interest that could have been earned on the royalty had marketing occurred at a reasonable time.25
B. The Meaning of "Market Value"
In a later generation of litigation, the implied covenant to market within a reasonable time shielded some lessees from liability. In the 1960s and 70s, when a combination of market forces and government regulation caused new gas...
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