CHAPTER 6 LITIGATION OF OIL AND GAS ROYALTY ACCOUNTING ISSUES
| Jurisdiction | United States |
(May 1996)
LITIGATION OF OIL AND GAS ROYALTY ACCOUNTING ISSUES
Weinman Cohen & Niebrugge
Denver, Colorado
Eric A. Beltzer 2
McGloin, Davenport, Severson & Snow, P.C.,
Denver, Colorado
TABLE OF CONTENTS
I. Royalty Owner's Claims to Royalty on Take-or-Pay Payments
A. Klein v. Arkoma Production Company
B. Roye Realty & Dev., Inc. v. Watson
C. Grabow v. Santa Fe International Corp
D. Harvey E. Yates Co. v. Powel
E. Hurd Enters., Ltd. v. Bruni
F. Samedan Oil Corp
G. Tracy v. Wagner & Brown
II. Royalty on Tax Reimbursements
A. Enron Oil & Gas Co. v. Utah Department of Natural Resources
B. 3300 Corp. v. Marx
III. Royalty on "Scrubber Oil"
IV. Deductibility of Costs for Royalty Valuation Purposes
A. Garman v. Conoco
B. Ferrer v. Amoco
C. ARCO v. Smallwood, et al
D. Sternberger v. Marathon Oil Co
E. Mittelstaedt v. Santa Fe Minerals, Inc
F. TXO Production Corp. v. Commissioners of Land Office
G. Roberts Ranch, et al v. Exxon Corporation
H. Texaco Inc
I. Xeno, Inc
J. Hanley v. Santa Fe Minerals Inc
K. Heritage v. Nations Bank
V. Posted Price Litigation
VI. Royalty Owners Participation in Marketing Fees or Profits
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In the last few years, royalty owners have escalated their efforts to cause oil and gas operators to pay royalties tied to the total of benefits received by the operator that are derived from the oil and gas produced from the royalty owners' property. In the past, operators have frequently exercised unquestioned latitude in determining the basis on which royalty is calculated and paid, often taking for themselves significant deductions for items such as gathering, compression, processing, dehydration, and transportation generally on the basis that the "market value at the well," would permit such deductions. In those leases where "proceeds of sale" is the basis of royalty settlement, they have elected to exclude from those proceeds income derived from take-or-pay settlements with gas purchasers, marketing fees taken by the lessee or its affiliates, and other income tied to its sale of the resources. Royalty owners, meanwhile, place their emphasis on a strict or liberal (as the case may require) reading of the lease royalty provisions and overlay that with the implied covenant to market and the traditional concept that royalties are to be "cost free."
The disputes have escalated. Even more aggressive royalty owners are claiming a right to participate in downstream entrepreneurial activities which arguably reflect or are based upon the value of the commodity produced from the royalty owner's land. Based on this, royalty owners have made claims for participation in take or pay settlements, marketing fees received by the lessee or its affiliates, and tax reimbursements recovered by the lessee under gas purchase contracts. Royalty owners have made such claims while asserting a right of cost free delivery of gas to even distant markets.
On the one hand, it appears established that the lessee bears the duty to market under the implied covenant to market imposed upon prudent operators under oil and gas leases. The benefit of this duty to market has been extended to overriding royalty interest owners. Under the previous decisions, the duty to market was traditionally fulfilled when the product reached a marketable form. On the other hand, it appears the
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duty to market does not extend to activities that may enhance the value of the commodity. Given the divergent view of the parties on this issue, it is safe to presume that any entrepreneurial activities of the operator or its downstream affiliates based on the delivery of oil and gas to a market will be scrutinized by ever more aggressive royalty owners. If income is made downstream, royalty owners may claim a share as theirs. Related to this question is the widely used industry practice of oil royalty payments based on a local posted price. If market value is the basis of royalty settlement under the terms of the lease, then royalty owners have asserted that royalty payments tied to a stated price which would not necessarily be reflective of the market value are improper.
The financial consequences of these issues are potentially significant leading to a motivated population of royalty owners and abundant litigation. Class action and multi-party lawsuits have resulted. In the case summaries that follow we attempt to provide a written thumbnail sketch of decisions and pending cases related to the royalty accounting issues about which we are aware, without advocating any particular position. Our goal is to inform only, and to let the readers draw their own conclusions. A note of caution with respect to pending cases: we offer no opinion as to the legal merit of any party's position taken in pending litigation or to the accuracy of any facts alleged. We only briefly characterize these proceedings.
I. Royalty Owner's Claims to Royalty on Take-or-Pay Payments.
A. Klein v. Arkoma Production Company.3
Defendants Jones and McCoy were the sole shareholders of Arkoma, a natural gas production company that held leases with Klein and other royalty owners (collectively referred to as "Klein"). Jones and McCoy sold Arkoma to Arkla, an exploration and pipeline company. Klein sued to recover a portion of the sales proceeds claiming that as a royalty owner, he was entitled to one-eighth of the proceeds received in the sale.
Arkoma sold natural gas to Arkla. One of the contracts with Arkla had a take-or-pay provision. Arkla did not take-or-pay for gas as a result of the drop in natural gas prices. Because of this, Arkoma had a claim against Arkla.
As a result of the take-or-pay obligation, Arkla purchased Arkoma for a premium above the reserve value of Arkoma. The contract between Arkoma and Arkla was cancelled and a new contract was entered that resulted in Arkoma receiving less for new
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gas purchases than it would have received under the old contract. As a result, the royalty owners received less.
Klein sued under a variety of theories. The district court dismissed all claims. The Court of Appeals reversed and remanded on the claims of unjust enrichment and breach of the implied covenant to market.4
On remand the parties agreed the unjust enrichment and breach of implied covenant to market claims remained to be tried. After trial, the district court found that Jones and McCoy had not been unjustly enriched and that they had not breached the implied covenant to market.
On the second appeal, the Court of Appeals reversed the district court finding that the district court failed to follow its mandate. The Court of Appeals examined the unjust enrichment claim and the claim of breach of an implied covenant to market. Under both theories, the court found on behalf of Klein.
The unjust enrichment claim was considered first. Noting that under normal circumstances when an express contract exists between the parties, unjust enrichment is not available, the court found two reasons why this rule did not apply to the facts. First, the leases apply a royalty to "market value" of gas produced and sold under the leases. The Court concluded that the leases did not address whether a take-or-pay settlement fits within the definition of "market value." The Court also found that Jones and McCoy, the parties to whom the premium was paid, were not parties to the leases. "For those reasons, [the Court of Appeals] adopted the Harrell rule, ... for the proposition that courts should construe transactions in such a way that the lessee and lessor split all economic benefits from the land."5
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With respect to the implied covenant to market, the Court stated that "[t]he district court erred when it conflated the cause of action for breach of lease obligations with that of breach of the gas purchase contract. The claim for breach of implied covenant to market arises under the lease." The district court had determined that Klein's status as an incidental beneficiary to the gas purchase contract between Arkla and Arkoma meant that the implied covenant to market had no application to revenues which the Court of Appeals determined were a premium paid for the negation of an accrued take-or-pay liability under the gas purchase contract. The Court of Appeals determined that the gas purchase contract was not the source of the implied covenant to market. The duty arose under the lease.6
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Once the duty was established under the lease, the Court's application of the Harrell rule extended to benefits received by the lessee (and Jones and McCoy by virtue of their control of the lessee) by giving the lessor the right to share in the benefits received by the lessee. In regard to the right of the lessor to share in the benefits, the gas purchase contract did nothing more than measure damages. In other words, the lease created the duty, the Harrell rule extended the lessor's rights to benefits received by the lessee under the gas purchase contract and the gas purchase contract measured the damages flowing from the breach of the duty. Under these circumstances, the Eighth Circuit held for Klein.
B. Roye Realty & Dev., Inc. v. Watson.7
In this case, plaintiff royalty owner sued the lessee and the lessee's pipeline purchaser claiming a right to share in take-or-pay settlement proceeds. As part of that right, plaintiff contended it was entitled to see the settlement terms. Defendants resisted. The district court granted summary judgment against the royalty owner. The court of appeals remanded to the trial court to force the lessee and purchaser to provide the settlement agreement and the payment information. The court reasoned that the lessee's implied duty to market required consideration of this information for the purpose of determining the lessee's royalty obligation. The court determined that a...
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