CHAPTER 7 JOINT OPERATING AGREEMENTS AMONG PRODUCTION OWNERS - THE TAKING PRODUCTION IN KIND PROVISIONS OF AAPL FORM 610

• Jurisdiction: United States

Oil and Gas Agreements: Midstream and Marketing
(Feb 2011)
CHAPTER 7
JOINT OPERATING AGREEMENTS AMONG PRODUCTION OWNERS - THE TAKING PRODUCTION IN KIND PROVISIONS OF AAPL FORM 610
Gregory R. Danielson ^*
Davis, Graham & Stubbs, LLP
Denver, Colorado
Judith M. Matlock
Davis Graham & Stubbs LLP
Jamie L. Jost
Beatty & Wozniak LLP

GREGORY R. DANIELSON received his undergraduate degree from the University of Colorado in 1979 and obtained his J.D. in 1983 from the University of Denver. Since graduation, Greg has represented oil and gas companies in a variety of matters including business transactions, title examination and bankruptcy law. Greg is currently a partner in the law firm of Davis Graham & Stubbs LLP. Greg is an active participant with the Rocky Mountain Mineral Law Foundation. He has served as a member of the Board of Trustees and the Executive Committee. Greg chaired the 2002 Special Institute on the Regulation and Development of Coalbed Methane and the 2004 Special Institute on the Development of Unconventional Gas. Greg has been a lecturer and author for various industry groups. His published papers include: "Title Examination of State and Federal Lands," Mineral Title Examination III, Paper No. 4 (Rocky Mt. Min. L. Fdn., 1992); "Liability Associated with Federal Record Title Leasehold Rights," 32 Public Land Resources L. Dig. 283 (1995); "Due Diligence for the Purchase of Pipeline Systems," Institute on Rights of Way, Paper No. 14 (Rocky Mt. Min. L. Fdn., 1998); and "Lease Maintenance and the Development of Coalbed Methane," 46 Rocky Mt. Min. L. Inst. 5-1 (2000); "The Perfect Oil and Gas Lease: Why Bother!" 50 Rocky Mt. Min. L. Inst. 19-1 (2004) and "An Industry Perspective on Coalbed Natural Gas (Methane) Units," Federal Onshore Pooling & Unitization, Paper No. 20A (Rocky Mt. Min. L. Fdn., 2006) and "Evaluating the Purchase and Sale Agreement in Light of Potential Royalty and Tax Claims," Private Oil and Gas Royalties, Paper No. 12 (Rocky Mt. Min. L. Fdn. 2008). Greg is a member of the Colorado Bar Association (Chair, Natural Resources and Energy Law Section, 2003-2004), American Bar Association, American Association of Professional Landmen and the Denver Association of Petroleum Landmen.

I. Introduction

At first blush, marketing the production from properties subject to the American Association of Petroleum Landmen's ("AAPL") Form 610 Model Form Operating Agreement ("Model Form JOA") is very straightforward because all four versions of the Model Form JOA require that each party "take in kind and separately dispose of its proportionate share of all Oil and Gas produced from the Contract Area." However, that is not always what happens, particularly as to gas production. If a party fails to take its proportionate share of oil and gas in kind, all four versions of the Model Form JOA give the operator "the right, subject to revocation at will by the party owning it, but not the obligation, to purchase such Oil and/or Gas or sell it to others" for the account of the non-taking party. Although not addressed in all versions of the Model Form JOA, if the operator does not exercise this right, then an imbalance occurs among the parties. This article will summarize and comment on the taking in kind provision found in each of the Model Form JOAs, address issues that arise when imbalances occur and how courts have resolved those issues, review the AAPL and Rocky Mountain Mineral Law Foundation's forms of gas balancing agreements, discuss the operator's options if a party fails to take in kind, and make an alternative proposal for addressing the failure to take gas in kind.¹ Because of the relative higher value and ease in handling oil as compared to gas,² the issues surrounding the

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failure to take in kind usually arise in the natural gas context and, therefore, this paper will discuss the failure to take in kind in that context.³

II. The AAPL Model Form JOA - Taking Production in Kind Provisions

There have been four versions of the Model Form JOA: 1956, 1972, 1982 and 1989. The taking production in kind provisions of each are similar in many respects, particularly for the first three versions. The 1989 provision differs most notably in the operator's standard of care if it exercises its right to purchase or sell the share of production of the non-taking parties. Given the overall similarities in the four versions of the Model Form JOA and the common misperception that the operator has the duty to market the production of non-taking parties, often very little thought is given to this provision of the Model Form JOA and the decision as to which version of the Model Form JOA to use does not typically turn on the taking production in kind provision. However, this does not mean that there are not significant consequences in the area of marketing of production associated with which version of the Model Form JOA is selected.

A. The Duty to Take in Kind. In all four versions of the Model Form JOA, the taking production in kind provision starts out with the mandate that each party is to take in kind and separately dispose of its share of production. Article VI.G., Option No. 2, of the 1989 version of the Model Form JOA expresses this mandate as follows:

Each party shall take in kind or separately dispose of its proportionate share of all Oil and Gas produced from the Contract Area, exclusive of production which may be used in development and producing operations and in preparing and treating Oil and Gas for marketing purposes and production unavoidably lost. Any extra expenditure incurred in the taking in kind or separate disposition by any party of its proportionate share of the production shall be borne by such party. Any party taking its share of production in kind shall be required to pay for only its proportionate share of such part of Operator's surface facilities which it uses.

Each party shall execute such division orders and contracts as may be necessary for the sale of its interest in production from the Contract Area, and, except as provided in Article VII.B., shall be entitled to receive payment directly from the purchaser thereof for its share of all production.⁴

Before 1948, a joint operating agreement might have provided that the operator would have the duty to market all of the production for the joint account or at least all of the natural gas production. In 1948, the Internal Revenue Service issued I.T. 3930, C.B. 1948-2, 126, which

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addressed whether a joint operating agreement among coowners of oil and gas properties creates an association taxable as a corporation for Federal income tax purposes. This ruling has been described as follows:

I.T. 3930 and I.T. 3948, supra, are applicable in the determination of whether a joint operating agreement among coowners of oil and gas properties creates an association taxable as a corporation for Federal income tax purposes. In general, I.T. 3930 provides that if the parties to such an agreement do not have a joint profit objective, the agreement does not create an association. Thus, if under the terms of the agreement the joint objective of the parties is limited to the acquisition, development, and operation of oil or gas properties, but the sale or other disposition of the share of production of each coowner constitutes the individual activity of the coowner, rather than the joint activity of the group, under these rulings [I.T. 3930 and I.T. 3948, C.B. 1949-1, 151], it is not considered to have a joint profit objective and does not constitute an association. On the other hand, if the joint operating agreement provides that the operator or other person in his representative capacity shall have irrevocable authority to sell the production on behalf of the coowners, the sale of production will be a joint activity and the organizations will be considered an association taxable as a corporation.⁵

Today, the conclusions of I.T. 3930 can be found in C.F.R. § 1.761-2 which provides that if the conditions set forth in that section are met, an unincorporated organization may be excluded from the application of all or a part of the provisions of subchapter K of chapter 1 of the Code.⁶ Subsection (a)(3) of § 1.761-2 provides:

Operating agreements. Where the participants in the joint production, extraction, or use of property:

(i) Own the property as coowners, either in fee or under lease or other form of contract granting exclusive operating rights, and

(ii) Reserve the right separately to take in kind or dispose of their shares of any property produced, extracted, or used, and

(iii) Do not jointly sell services or the property produced or extracted, although each separate participant may delegate authority to sell his share of the property produced or extracted for the time being for his account, but not for a period of time in excess of the minimum needs of the industry, and in no event for more than 1 year, then

such group may be excluded from the application of the provisions of subchapter K under the rules set forth in paragraph (b) of this section. . . .⁷ In addition, except as provided in paragraph (d)(2)(i) of this section, this paragraph (a)(3) does not apply to any

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unincorporated organization that produces natural gas under a joint operating agreement, unless all members of the unincorporated organization comply with paragraph (d) [Rules for gas producers that produce natural gas under joint operating agreements] of this section.

Thus, care must be taken not to inadvertently modify the provisions of the Model Form JOA that require each party to take in kind or separately dispose of its proportionate share of production, and limit the operator's right to sell the production of a party who fails to take in kind to only such reasonable periods of time as are consistent with the minimum needs of the industry under the particular circumstances, but in no event for a period in excess of one...