CHAPTER 7 POST PRODUCTION COSTS
| Jurisdiction | United States |
(2001)
POST PRODUCTION COSTS
Davis, Graham & Stubbs LLP
Denver, Colorado
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THE RESTRUCTURING OF THE GAS INDUSTRY —CREATING THE FACTUAL BACKGROUND FOR CURRENT ROYALTY LITIGATION
Historical structure under the Natural Gas Act of 1938
The structure of the natural gas industry regulated by the NGA was simple. The producers would sell their natural gas in the production area to the interstate pipelines at Commission-determined just and reasonable rates. The pipelines would transport their purchased gas and their own production to the city gate for sale to local distribution companies (LDC'S) at Commission-determined just and reasonable rates which recovered both the pipelines' cost of gas and cost of transmission. In addition, the pipelines would sell gas to end users in nonjurisdictional sales with an appropriate allocation of costs to the nonjurisdictional services. [Footnote omitted.] Producer sales to LDC's or end users in the production area, with the pipeline providing only the transportation, were rare. FERC in Order No. 636, III F.E.R.C. Stats. & Regs. [Regs. Preambles] ¶ 30,939 at 30,395 (1992).
Generally, the same pipeline which transported gas off the lease was the purchaser of the gas. Exceptions, see for example, Kretni Development Co. v. Consolidated Oil Corporation, 74 F.2d 497 (10th Cir. 1934); Sternberger v. Marathon Oil Company, 894 P.2d 788 (Kan. 1995), reh'g denied May 4, 1995.
Restructuring of the pipeline segment of the gas industry
FERC Order No. 636 issued April 1992 required interstate pipelines to unbundle their merchant (i.e., sales) service from their transportation service and to make any sales in the production area only. In other words, pipeline sales to LDC's and other end users were required to take place before the gas was transported in the pipeline's jurisdictional interstate pipeline facilities. As a result of this requirement, interstate pipelines no longer own any of the gas which they transport. Because of this limitation on where they could sell, many interstate pipelines simply got out of the business of being merchants at all.
Interstate pipelines spun down or spun off gathering segments of their systems
FERC required interstate pipelines to unbundle (separate) their services into their component parts (gathering, processing, storage and transportation) and to provide those services on a stand alone basis. However, FERC continued to assert jurisdiction over these interstate pipeline unbundled services including "gathering" which was a non-jurisdictional activity only when performed by companies other than interstate pipelines. In order to avoid regulation of certain interstate pipeline services, interstate pipelines began to "spin down" to affiliates or "spin off" to third parties (i.e. transfer) facilities and the new owners sought FERC orders declaring those facilities to be nonjurisdictional gathering facilities. With FERC's
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jurisdictional link — ownership by an interstate pipeline — gone, many of these formerly regulated facilities were determined by FERC to be exempt gathering facilities in the hands of the new owners. See Arkla I, 67 FERC ¶61,257 at 61,872; Conoco v. F.E.R.C., 90 F.3d 536 (D.C. Cir. 1996).
Court decisions forced FERC to modify its test of what constitutes gathering under the NGA
FERC was forced by the courts to modify its test for determining what constitutes a gathering facility so that more and more facilities which would have been classified as jurisdictional "transportation" systems under prior tests were found to be gathering systems under the modified tests. See EP Operating Company, 876 F.2d 46 (5th Cir. 1989); Amerada Hess Corporation, 52 FERC ¶61,268, pg. 61,987 (Sept. 17, 1990).
Result of restructuring in the last decade
As a result of these changes in the federal regulation of interstate pipelines the simple structure of the natural gas industry that originally existed has changed. Today (i) producers often transport their gas production off the lease to downstream sales points rather than selling in the production area; (ii) interstate pipelines are not the primary purchasers of gas from producers; (iii) many former interstate pipeline facilities are now owned by pipeline affiliates or third parties and are now considered to be or have been declared by FERC to be exempt gathering facilities under section 1(b) of the NGA; and (iv) more pipelines qualify as NGA exempt gathering facilities than at any previous time in history.
Royalty litigation resulting from restructuring
Royalty owner viewpoint — specific royalty clauses, the implied covenant to market or, in Wyoming, sections 304 and 305 of the Wyoming Royalty Payment Act, require lessees to transport gas downstream at no cost to the royalty owner. How far downstream? Deductions for systems which are classified as gathering under the NGA are currently the most disputed deduction but royalty owners may not stop there.
Producer viewpoint — royalties and overriding royalties are usually defined as interests free of the cost of production but this does not include the cost to transport gas off the lease to downstream markets. The segment of the industry which was restructured was the pipeline segment, not the production segment. The production process has not changed. When gas is transported off the lease, value is added because a higher price can be obtained downstream. The lessor should have to pay its pro rata share of the costs incurred to add the value.
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CASE LAW REGARDING TRANSPORTATION DEDUCTIONS
In 1934, the Tenth Circuit, in an appeal from the District of Wyoming involving a Wyoming oil and gas lease, held that the lessor was entitled to royalties based on the value of gas at the inlet of a 90-mile pipeline built by the lessee to get the gas to market, not to royalties on the price of gas at the end of the line. Kretni Development Co. v. Consolidated Oil Corporation, 74 F.2d 497 (10th Cir. 1934). The gas royalty clause in the lease required the lessee to deliver to the credit of the lessors, free of cost at the pipe lines, to which he may connect his wells, one-eighth part of the oil or gas produced and saved from said premises or the proceeds derived from the sale of said one-eighth part of said oil or gas. The Court stated that the cost of transportation might equal or exceed the value of the gas in the field and that the lessee's duty to market "does not extend to the point of providing pipe line facilities ninety miles in length at a large outlay of money with an extending financial hazard due to possible exhaustion of the supply and other frequently encountered factors, in order to reach a market at which the product may be sold." Id. at 499. The holding in Kretni has not been challenged for more than three quarters of a century and has been considered to reflect Wyoming law.
In 1940, Maurice H. Merrill, in the second edition of his treatise entitled The Law Relating to Covenants Implied in Oil and Gas Leases ("Merrill") had the following to say regarding place of sale:
Ordinarily, the product is marketed from the lease, and the lessee's duty is merely to arrange for sale there. [Kretni Dev. Co. v. Consolidated Oil Corp., 74 F.2d 497 (C.C.A. 10th, 1934) [cert. den. 295 U.S. 750, 79 L.Ed. 1694, 55 S.Ct. 829 (1935)]; Scott v. Steinberger, 113 Kan. 67, 213 P. 646 (1923); Rains v. Kentucky Oil Co., 200 Ky. 480, 255 S.W. 121 (1923).] But suppose the lessee carries the product to a distant point for sale, either for his own convenience or because there is no market at the field? He may be under no duty to seek a market elsewhere, [citations omitted] but if he does, upon what basis must he account? There are three possible solutions: 1. He must account for the price received with no allowance for the transportation to market; 2. He must account for the price received, less the reasonable cost of transportation from the lease to the market; 3. He may purchase the product for his own account at the lease, or treat it as though it were so purchased, at a price representing its fair value there, and may keep for himself whatever profit results form the enhanced price at the outlet in excess of transportation cost. For the first, there is no authority, and it seems impossible to conceive of any arguments in its favor. The transportation to the distant point is no part of the legitimate operating expense of the lease. [Voshell v. Indian Territory Ill. Oil Co., 137 Kan. 160, 19 P.2d 456 (1933).] For both the second [citations omitted] and the third [citations omitted] solutions authority is to be found. Upon principle, the second seems preferable. If there is no market value in the field, establishment of a fair value by anything other than value at the point of disposition less the cost of transportation can rest only on speculation. If there is an outlet for other production in the field but none from this particular lease, the difficulty is obviated in part, but there remains the problem of the application of specific prices to a sale which after all is purely hypothetical. The opportunity for siphoning off substantial values actually realized upon the pretext of
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"no local outlet" is apparent. Moreover, as already has been suggested, [citations omitted] sharing in the proceeds is a presupposition of the lease, and this should continue until final disposition of the product.
§86.
Recent decisions of the Supreme Court's in Kansas and Oklahoma (both states where a lessee is required to put gas in marketable condition at no cost to the lessor), are consistent with Merrill. Sternberger v. Marathon Oil Company, 894 P.2d 788 (Kan. 1995), reh'g denied May 4, 1995, involved a situation where the lessee was unable to induce a gas purchaser to connect its wells. In order to market the gas, the lessee built its own lines to...
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