CHAPTER 6 NATURAL GAS WELLHEAD AGREEMENTS
| Jurisdiction | United States |
(Apr 1988)
NATURAL GAS WELLHEAD AGREEMENTS
Davis, Graham & Stubbs
Denver, Colorado
Drew A. Reimer
Home Petroleum Corporation *
Denver, Colorado
TABLE OF CONTENTS
Page
I. INTRODUCTION
A. Coverage—Wellhead Sales Agreements
B. Approach
C. Negotiating Environment
1. The Present and Future Market for Gas
2. Interstate vs. Intrastate Purchasers
3. Take-or-Pay Settlements and Order 451 Negotiations
4. Move Towards a Commodity Market
5. Proliferation of Purchasers
II. COMMITMENT, TERM AND DELIVERY CONDITIONS; MODIFICATION OF EXISTING, TRADITIONAL CONTRACTS
A. The Traditional Approach
1. Economic and Regulatory Conditions
2. Purchaser-Financed Facilities; Broad, Long-Term Commitment
B. Contracts for New Wells in the Current Environment
1. Changed Economic and Regulatory Conditions
2. Remote Delivery Point
3. Flexibility in Commitment
4. Third-Party Gathering
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C. Modification of Existing "Traditional" Contracts
1. Replacement Contract
2. Temporary Release
3. Excess Gas Arrangements
III. PRICE
A. Overview
B. Specific Types of Price Provisions
1. Redetermination and Renegotiation
2. Commodity Parity
3. Favored Nations
4. Net-Back Pricing
5. Price Nomination
6. Market-Out
IV. QUANTITY
A. Overview
B. The Traditional Approach—Long-Term Contracts
1. The Early Years
(a) Ratable Takes
(b) Reserve-Based Takes
2. The Era of "Deliverability-Based" Take-or-Pay Clauses
C. Current Issues and Problems—Generally
1. Existing Take-or-Pay Contracts
2. New Contracts—New Approaches
(a) Take-or-Cancel
(b) Best Efforts
(c) Stated Volume
(d) Requirements Based
D. The Future—Quantity Provisions Obsolete?
V. OTHER CONTRACT TERMS AND CURRENT ISSUES
A. Excess Royalty Clause
1. Background
2. Recent Developments in Gas Valuation Issues
3. Order 451 Problems
B. Force Majeure Clause
C. Payment—Proceeds Distribution
D. "Regulatory Out" Clauses
E. 451 Disclaimer
F. Quality Specifications
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NATURAL GAS WELLHEAD AGREEMENTS
I. INTRODUCTION
A. Coverage — Wellhead Sales Agreements
This paper covers wellhead sales agreements. There was a day when the term "wellhead sale" would have called to mind a rather distinct sales arrangement, but that is no longer true. Today the term "wellhead sale" covers a broad spectrum of diverse arrangements where the only common factor is that title to the gas is transferred to a middle marketer.
Today, it is easier to describe what a "wellhead sale" is not, rather than what it is. As the name suggests, a "wellhead sale" occurs at or near the well; thus, sales at the processing plant, sales through brokers (who do not take title) and sales by middle marketers are not specifically covered. However, not all sales that occur at the well are considered "wellhead sales." Sales through brokers and sales to end users (direct sales) might occur "at the wellhead," but these require very distinct contractual arrangements and are covered by separate papers at this Institute. Also, as explained in Section II, today's "wellhead" sale sometimes requires the producer to gather the gas and deliver it to some point remote from the well, but this is just a minor contractual variation (although not a minor economic variation) from a traditional wellhead sale, and so is covered in this paper. Finally, we note that our focus is primarily on "gas well" gas sales as opposed to "oil well" or "casinghead" gas sales. While most of the principles we discuss apply in some respect to "casinghead" gas sales, the latter often involve some processing arrangement or other special considerations that we do not address.
Our discussion necessarily covers both traditional "contract" or "system supply" sales and "off system" or "spot" sales (where these are not end-user contracts). Although the extremes of these two types of sales—the twenty-year contract on the one hand and the thirty-day sale on the other—are quite different, most contracts today fall into a middle ground, adopting features of both extremes. Many individual contracts, in fact, provide for both a system and a spot sale, and nearly every wellhead sale will involve some consideration of the issues we discuss. Of course, drafting a thirty-day spot sale contract involves fewer complications than drafting a long-term sale, and many of the provisions and strategies discussed herein would be irrelevant to such a short-term sale. But as the commitment becomes longer, the points we discuss will become more pertinent.
B. Approach
A previous paper has addressed gas contracts in general terms and has covered the basic functions and principles of the
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various types of gas sales agreements. The purpose of this paper is to (i) discuss in some depth the key provisions which are at the heart of the wellhead sale contract, (ii) provide some guidance as to what can be expected in negotiations, (iii) give some practical suggestions on drafting, and (iv) discuss the impact of certain legal and regulatory developments on wellhead gas contracts. We do not address certain standard provisions that are not likely to be the subject of negotiation or that involve little drafting complexity.1 In Sections II through IV we look at the key provisions of the wellhead contract that define its essential economic function: Commitment, Term, Delivery Conditions, Price and Quantity. The issues we discuss are generally relevant to formulation of new contracts for the sale of new gas and modification of existing contracts. However, in Section III-C we address specifically the three types of modification arrangements that are likely to arise. Section V then addresses other contract provisions that are of particular relevance today because of legal or regulatory developments. Annex 1 contains example price and quantity provisions supplementing those that appear in the text.
We start, however, with several disclaimers:
First, it is impossible to completely survey the myriad variations of contract provisions in an undertaking such as this. In this paper we discuss the basic principles and attempt to give representative examples both in the text and in Annex 1, but many alternatives exist. We recommend other sources for a more comprehensive collection of forms.2
Second, there can be no "model" gas contract since every gas contract is a product of a multitude of unique economic, geographic, bargaining, production and regulatory factors. Therefore, we give examples of the various key provisions in the text and do not attempt to create a model form of contract.
Third, in preparing this paper, we engaged in numerous conversations with pipeline companies and producers, but these
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people comprised a small fraction of the industry, and many people that we talked to would only speak in generalities because of a concern over the confidential nature of their gas marketing strategy. We attempted to obtain input from a variety of such industry participants located in various geographic regions of the country. But we must emphasize that the rapid changes the industry is undergoing are generating a great deal of creativity. Ideas abound. We are certain that many arrangements, strategies and provisions are being encountered of which we are unaware.
Fourth, although we talked to pipeline companies and attempted to relate their views and strategies, the authors' personal experiences, at least in recent years, have generally been representing producers. Thus, although we represent and warrant that our treatment is absolutely unbiased, our comments may reflect a lesser understanding of the purchaser's perspective than the producer's.
C. Negotiating Environment
The gas contract negotiator must have a good understanding of the regulatory and market factors that affect buyers, sellers, transporters, brokers, distributors and consumers of natural gas. Previous papers at this Institute have described these forces in some detail. Below, in summary fashion, we attempt to relate these factors to the process of negotiating wellhead sales agreements.
1. The Present and Future Market for Gas
Virtually everyone connected with the oil and gas industry is aware of the low demand for, and high supply of, the product, but few consider the ramifications of the inevitable change in these circumstances. Reflecting on current circumstances will help little in today's negotiations, but understanding how the circumstances arose can help one predict what circumstances are likely to develop in the future. Negotiating with an eye to the future can help one at least minimize future problems and may even give one an advantage down the road.
The sources of current market problems were explained in previous papers.3 Today there are forces acting which
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promise a reversal of these trends.4 The regulatory distortions that have existed are being somewhat lessened via FERC Orders 436, 500 and 451. At the same time, drilling for new gas has subsided, while world oil prices have firmed at nearly twice their 1986 low. This combination of events should lead to a balancing of supply and demand forces, followed by some level of gas shortage and price increase.
Thus, one should not assume that all the negotiating cards are in the hands of the purchasers. Time will surely change the current dynamics of the industry. The party that best predicts the time and nature of the changes, and adjusts contract terms to take advantage of expected changes, will profit from such foresight. We point out several circumstances where we think foresight is warranted. Our purpose, of course, is merely to expand the negotiator's perspective so that he or she can take advantage of the opportunities that may present themselves in specific circumstances.
2. Interstate vs. Intrastate Purchasers
Intrastate purchasers...
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