CHAPTER 7 ROYALTY CLAUSES: WHAT IS EVERYONE FIGHTING ABOUT (AND HOW DO I AVOID IT)?

• Jurisdiction: United States

Drafting and Negotiating the Modern Oil and Gas Lease
(May 2018)
CHAPTER 7
ROYALTY CLAUSES: WHAT IS EVERYONE FIGHTING ABOUT (AND HOW DO I AVOID IT)?
Matthew J. Salzman ¹
Stinson Leonard Street LLP
Kansas City, MO ²
Aaron K. Friess
Stinson Leonard Street LLP
Bismarck, ND

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MATTHEW J. SALZMAN is a partner in the Kansas City, Missouri office of Stinson Leonard Street and is co-chair of the Oil & Gas Practice Group. He represents clients in oil and gas consulting and litigation in various matters such as lease formation, compliance, and termination; AMI and joint development agreements and disputes; JIB and operator/non-operator issues; surface use and right-of-way agreements and disputes; and surface damage, trespass, nuisance, and oilfield service disputes. Matt has represented clients in five antitrust oil and gas class actions, and over a dozen royalty interest owner class actions involving well over a billion dollars of underpaid royalty claims. He does appellate work and recently took the lead in getting the U.S. Supreme Court to grant certiorari in a royalty class action resulting in a favorable decision on a removal issue. Matt has assisted clients on oil and gas matters in several states, including Texas, Colorado, New Mexico, Arizona, Nevada, Kansas, Oklahoma, Missouri, North Dakota, Montana, and Arkansas.

AARON FRIESS is an attorney in Stinson Leonard Street's Oil & Gas Practice Group, based in Bismarck, North Dakota. He is licensed in North Dakota and New Mexico and his practice encompasses all facets of energy law, including transactions, litigation, and regulatory practice before administrative agencies. Aaron is a member of the Rocky Mountain Mineral Law Foundation and has written and presented on oil and gas topics at multiple special institutes hosted by the Foundation. He is also a past recipient of the David P. Phillips Scholarship, the Foundation's highest award for academic excellence. Aaron is also a member of the Landman's Association of North Dakota and the New Mexico Landman's Association.

Table of Contents

The Oil and Gas Production Process

Royalty Clauses

"Market Value" and "Proceeds" Leases

"Net Proceeds" and "Gross Proceeds" Leases (and the Workback Method)

Interpreting Royalty Clauses

The Implied Covenant or Duty to Market

"At the Well," "Marketable Product," and "At the Market"

Examples of Case Law Affecting the Meaning of Royalty Clauses

Volume Issue

Conclusion

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Mineral ownership has its benefits. One such benefit involves the right to develop the mineral estate. Should the interest yield minerals, the owner may do with them as she will--using them if she desires and selling the portion she does not. Should the owner be disinclined to develop her own mineral estate, she may convey the development right to another who will--with a geologically-dependent degree of enthusiasm--develop the minerals on her behalf. This conveyance of the development right occurs by the oil and gas lease. As partial consideration for the oil and gas lease, the lessor receives a royalty, or a certain percentage of the hydrocarbons produced from the lessor's lands, without the lessor paying the costs of production.

In 2000, Professor Pierce put his finger on the pressure point between lessors and lessees with a hypothesis that he dubbed the "royalty value theorem." This theorem holds that "when compensation under a contract is based upon a set percentage of the value of something, there will be a tendency by each party to either minimize or maximize the value."³ The royalty under the oil and gas lease is the preeminent example of this theorem at work. Obviously, only 100% of the production exists, and the royalty clause in the lease states the lessor is entitled to a certain portion or percentage (e.g., one-eighth (1/8^th ) or 12.5%) of that production. Consequently, oil and gas royalties have been a consistent source of litigation for over a century, with no signs of letting up.

This Paper provides an overview of the process of oil and gas production for context of negotiating, drafting, interpreting, and applying royalty clauses. Next, this Paper explores different types of typical royalty clauses including "market value," "proceeds," "net proceeds," and "gross proceeds" clauses. After reviewing certain judicial interpretive approaches that apply to oil and gas leases, this Paper explores the implied covenants and duty to market, and each of the three primary approaches adopted by producing states, namely, the "at the well" approach, the "marketable product" approach, and what this Paper calls the "at the market" approach. Because royalty calculation and payment exist as creatures of state law, this Paper will explore recent cases from various producing states that illustrate, inter alia, how the same language in a royalty clause may have different meaning and widely different economic implications in different states. Finally, the Paper will address an often unstated issue that is implicitly part of almost every royalty underpayment claim.

The ultimate goal and purpose of the royalty clause in an oil and gas lease is to define clearly the parties' respective rights and obligations so. Throughout this Paper, there are several suggestions to assist lessors and lessees understand the obligations in their existing leases, as well as drafting or negotiating suggestions aimed at helping parties enter predictable and enforceable oil and gas leases. Ultimately, we hope this Paper assists those who read and use it stay out of litigation, thereby minimizing the risk that they appear in the next Foundation proceeding addressing royalty payment litigation.

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The Oil and Gas Production Process

In many important ways, modern petroleum development bears a shocking resemblance to Colonel Drake's activities in rural Pennsylvania. Certainly, modern rigs make hole faster than the three feet per day at which Drake's rig bored into the Earth.⁴ But, the fundamental aspects remain the same: drilling into the Earth and releasing oil and gas previously trapped in strata. As the oil and gas come to the surface, they must be captured and eventually transported to market.

Oil. When oil exits in the wellbore, it is ordinarily run into tanks on the lease. Once the tanks fill, the oil is loaded into trucks and taken to a Lease Access Custody Transfer ("LACT") station, where the oil is emptied out of the trucks and into holding tanks, and is ultimately loaded into a crude oil pipeline. This pipeline will carry the oil to a refinery, where it will be "cracked" and refined into usable petroleum products. Sometimes, the operator will have the wells connected to an oil gathering system, in which a pipeline connected to the well will carry the oil off the lease and to a LACT facility. In either event, the oil makes its way from the mouth of the well, off the lease, into a pipeline, and off to the refinery in relatively short order. This much has not changed in many years. In certain instances in which oil production outstrips pipeline capacity, oil may be loaded on trains and shipped by rail, as was recently done with some of the production from the Williston Basin in North Dakota and Montana.

Determining ownership of the oil should be a straightforward matter of contractual interpretation. The party that removes the oil from the tank batteries will have a contract with the lease operator. This transfer does not customarily effectuate a transfer of ownership--rather, the party transporting the oil off the lease is typically a bailor, charged with delivering the lessee's oil to either a pipeline or to the refinery, depending on the lease's proximity to a refinery. Like the transporter, the pipeline company typically takes custody, but not ownership, of the oil. The oil is shipped on the pipeline using capacity owned by either the pipeline operator or the intervening midstream company. In either case, the refinery does not customarily take ownership of the produced oil until it is run out of the pipeline and into the refinery's tanks. For situations involving an oil gathering system, the process works in a similar manner. The gathering system typically takes custody, but not ownership, of the oil. Thus, the lessee generally retains ownership of the oil from the time it leaves the wellhead until it is sold at the refinery.

Critical differences between oil and gas help explain the lack of litigation surrounding oil royalties and the deluge of litigation surrounding gas royalties. Oil does not undergo the same level of treatment after it leaves the lease. Once it leaves the wellbore, the oil is run through a gas-oil separator, the unsurprising purpose of which is to separate the dissolved gas out of the oil. From there, the oil is run into tank batteries, and eventually leaves the lease for transportation to the refinery--either by pipeline, railcar, or truck. In any event, the oil arrives at the refinery in basically the same condition it left the wellbore. Any impurities such as sulfur will be removed as the oil is processed at the refinery. So, the oil's value at the refinery generally reflects the wellhead value increased only by transportation, but not transformation.

Gas. The majority of the gas produced in this country historically has been marketed at the

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well. The federal government began regulating the natural gas market in 1938 with the passage of the Natural Gas Act, and this regulation later included a regulated price for the marketing or sale of the gas at the wellhead.⁵ Interstate pipeline companies often owned gathering systems and laid pipelines to the production company's wells. They contracted to purchase the gas at or near the wellhead as it entered their pipelines.

Following the deregulation of this wellhead market in the early 1990s, several interstate pipeline companies divested themselves of the gathering pipeline systems and new...