CHAPTER 7 JUDICIAL INTERPRETATIONS OF ROYALTY OBLIGATIONS AND THE RESULTING DRAFTING LESSONS
| Jurisdiction | United States |
(Dec 2008)
JUDICIAL INTERPRETATIONS OF ROYALTY OBLIGATIONS AND THE RESULTING DRAFTING LESSONS
Professor of Law
Director, Business and Transactional Law Center
Washburn University School of Law
Topeka, Kansas
David E. Pierce is a professor at Washburn University School of Law in Topeka, Kansas where he teaches Oil & Gas Law, Advanced Oil & Gas Law, Contracts, Property, Transactional Drafting, and Business Associations. He is also the Director of the Law School's Business and Transactional Law Center. Prior to entering law teaching Professor Pierce was an in-house oil and gas attorney for Shell Oil Company in Houston, Texas and before that he engaged in the private practice of law in Neodesha, Kansas. He has also worked Of Counsel with the Tulsa-based law firm of Gable & Gotwals and with the Kansas City-based law firm of Shughart Thomson & Kilroy. Professor Pierce has a B.A. from Pittsburg State University, a J.D. from Washburn University School of Law, and a Masters of Law (LL.M.-Energy Law) from the University of Utah College of Law. Professor Pierce is the author of the Kansas Oil and Gas Handbook, a co-author of Cases and Materials on Oil and Gas Law, a revision and upkeep co-author of Kuntz on the Law of Oil and Gas, a co-author of Hemingway Oil and Gas Law and Taxation, and an editor of the Oil and Gas Reporter.
A Drafting Lesson from the Supreme Court of Appeals of West Virginia:
[L]anguage in an oil and gas lease that is intended to allocate between the lessor and lessee the costs of marketing the product and transporting it to the point of sale must expressly provide that the lessor [:] [1] shall bear some part of the costs incurred between the wellhead and the point of sale, [2] identify with particularity the specific deductions the lessee intends to take from the lessor's royalty (usually 1/8), and [3] indicate the method of calculating the amount to be deducted from the royalty for such post-production costs.1
I. INTRODUCTION
Today the practicing oil and gas bar enjoys the mixed blessings of many judicial views on the meaning of many royalty clause variations found in oil and gas leases and lease assignments. The law has become Balkanized, often varying markedly from state-to-state, depending upon the approach a court takes to the interpretation of the instrument at issue. This article addresses the issue at three levels: (1) identifying, and explaining, the varying approaches states have taken to defining royalty obligations; (2) analyzing the interpretive jurisprudence that is being employed by
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these courts; and (3) describing the lessons these decisions offer for drafting royalty provisions in future oil and gas leases and assignments creating overriding royalties.
II. ANALYSIS OF STATE LAW REGARDING THE ROYALTY OBLIGATION
To effectively compare and contrast state law defining the royalty obligation, it is useful to prepare a grid that lists various issues to analyze. These issues are the ones the reported cases deem significant, and which are often determinative of the outcome in calculating the royalty that is due. The grid is derived from analysis of the judicial opinions addressing royalty issues. In those instances where a statute has played a major role in a court's opinion, the statute is noted under the appropriate issue on the grid. In order to make a rough visual comparison of state royalty law, I have prepared a chart that summarizes the observations and conclusions of my analysis. The analysis of the royalty law of individual states is found in Appendix A to this article. The discussions that follow provide the foundation for the issues evaluated in the "State Royalty Law Analysis Chart" that is also found at Appendix A.
A. Substances Covered by the Particular Clause
The royalty clause should clearly identify the substances that are subject to a royalty obligation. If oil and gas are going to be treated differently for royalty purposes, then all permutations of "oil" and "gas" should be identified either with the oil royalty clause or the gas royalty clause, or by creating a separate royalty provision for the substance. For example, some leases expressly address "condensate"2 by referencing it either in the oil clause, the gas clause, or a separate condensate clause. Some leases are silent as to which clause, oil or gas, applies to condensate. In those cases it is left to the parties, and the courts, to determine whether the "oil" clause, "gas" clause, or even an "other minerals" clause should apply to the substance.3
Similar problems arise with substances such as helium, hydrogen, carbon dioxide, sulphur, and any other substance within the production stream that becomes valuable. These substances typically become valuable only after extensive processing of the production stream to isolate the substance so it can be separately marketed. The royalty dispute arises when a separate value can be readily identified with the substance. This is best illustrated by the 25-year saga known simply as the "Helium Cases."4
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Drafting Suggestion #1
The approach to drafting in this area will depend, in part, on whether the royalty is to be fully determined before the production, in whatever form, leaves the leased premises,5 or whether it is to be determined at some point downstream of the leased premises. The lessee will generally prefer to determine the royalty obligation, as to the oil, gas, and any constituent substances, as far upstream as possible. The lessee's goal is to obtain title to the substances before they are transformed into higher value substances such as natural gas liquids obtained following gas processing. The lessor will generally prefer to determine the royalty obligation as far downstream as possible so it can share in the value of constituent products that are created from the gas stream before the royalty is determined.
Regardless of which party you represent, the royalty clause should clearly indicate whether the lessor's royalty will, or will not, include values associated with constituent products that are created downstream from the wellhead or leased premises. Often this issue will be determined by specifying the location where the royalty determination will be made, but the substances issue requires further specification to ensure whether the location will also trigger royalty on substances that require more involved manufacturing processes, such as processing to isolate natural gas liquids, helium, or other substances.
As with the "other minerals" problem in deed construction, if there are particular substances of interest, or that have caused problems in the past, mention them by name. For example: "oil and gas, to include any helium, hydrogen, and carbon dioxide that is produced as part of the gas stream."
Another matter that must be addressed, particularly if the royalty obligation is to be determined downstream from the leased premises, is whether the lessee has any sort of obligation to pursue downstream processing to isolate a substance. This will influence whether the lessee can safely sell the production stream, and trigger a royalty, at some point in the production process before processing. The goal is to provide an express covenant on the marketing obligation issue instead of leaving it to the implied covenant process. Absent an express clause, the litigation issue would be: since the lessee has an obligation to pay royalty on downstream products manufactured from the gas stream, does the lessee have an implied obligation to pursue such downstream processing opportunities so as to generate the authorized royalty on products?
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B. Share of Production or Contractual Obligation to Pay Money?
Another issue is whether the royalty clause should provide for royalty based upon an actual share of the extracted substance, or instead provide that all the production is owned by the lessee with the lessor entitled to payment of a sum of money as a contract right.
Consider the language of the following royalty clause:
The royalties to be paid by lessee are: (a) on oil, and other liquid hydrocarbons saved at the well, one-eighth of that produced and saved from said land, same to be delivered free of cost at the wells or to the credit of lessor in the pipe line to which the wells may be connected; (b) on gas, including casinghead gas and all gaseous substances, produced from said land and sold or used off the premises or in the manufacture of gasoline or other products therefrom, the market value at the mouth of the well of one-eighth of the gas so sold or used, provided that on gas sold at the wells the royalty shall be one-eighth of the amount realized from such sale.
Under this clause the lessor owns one-eighth of the oil produced.6 All of the gas produced belongs to the lessee; the lessor is a creditor of the lessee pursuant to the lessee's obligation to pay a sum of money equal to either one eighth of the "market value" or the "amount realized."7 One of the benefits of eliminating the in-kind royalty is there would be no need for a division order from the
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lessor.8 The lessor can also avoid potential environmental liabilities by divorcing itself from the extracted oil.9 On balance, I have concluded that the lessor should structure the lease so all their royalty is in the form of an intangible property right instead of an interest in tangible personal property. This approach also allows for a single unified basis for royalty compensation whether the substance is oil, gas, something in-between, or a substance derived from the oil or gas.
Drafting Suggestion #2
To the extent possible, the royalty clause should use the same bases for calculating royalty regardless of the physical attributes of the royalty-generating substance. Today there is typically no good reason to provide for an in-kind...
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