CHAPTER 8 RELATIONSHIP BETWEEN TRANSPORTATION, MARKETING, AND THE ROYALTY CLAUSE

• Jurisdiction: United States

Drafting and Negotiating the Modern Oil and Gas Lease
(May 2018)
CHAPTER 8
RELATIONSHIP BETWEEN TRANSPORTATION, MARKETING, AND THE ROYALTY CLAUSE
John Shepherd
Tina Van Bockern
Holland & Hart
Denver, CO

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JOHN F. SHEPHERD is a partner with Holland & Hart LLP in Denver, Colorado. For nearly 40 years, he has focused on litigation and counseling in the areas of natural resources, oil and gas, and environmental law. He has handled litigation in virtually all aspects of the energy industry, including class actions and other disputes over calculation of royalty. He is listed in The Best Lawyers in America for the areas of Natural Resources Law, Energy Law, and Administrative Law, and in Colorado Super Lawyers for the areas of Energy and Oil and Gas. He is a graduate of Dartmouth College and the University of Denver College of Law.

TINA R. VAN BOCKERN is an associate in Holland & Hart LLP's Environment, Energy, and Natural Resources Practice Group in Denver, CO. Ms. Van Bockern advises oil and gas and mining clients on virtually all aspects of energy development on federal, state, and Tribal lands. She provides strategic counsel at each stage of development, from the environmental reviews necessary for initial approval to compliance with development obligations and royalty reporting and valuation requirements. Ms. Van Bockern also represents natural resource clients in federal and state court litigation and appeals to federal administrative boards.

Oil and gas are often transported hundreds of miles before being sold to third parties, in an effort to reach more diverse and better markets. How royalty is owed on these transactions is not always addressed in the royalty clause, and litigation challenging the deductibility of transportation costs is on the rise. This article will examine the extent to which the law is evolving and provide drafting tips to avoid the commonly litigated issues.

I. Deregulation of Pipelines Leads to Disputes Over Deduction of Postproduction Costs, Including Transportation Costs

Oil and gas was historically sold at the wellhead; therefore, whether and how much transportation costs could be deducted in calculating royalties was not generally a point of concern. When oil and gas was transported to distant markets, the general view was that the costs were shared proportionately between the lessor and the lessee.¹ As a result, early oil and gas lease forms simply did not directly address the ability to deduct transportation costs.

Transportation costs started to become a point of concern once Congress and the Federal Energy Regulatory Commission (FERC), in the 1980s and early 90s, began to deregulate interstate pipelines and wellhead first sales prices through the Natural Gas Policy Act of 1978² and the Natural Gas Wellhead Decontrol Act of 1989,³ respectively.⁴ Before deregulation, lessees typically sold gas to pipeline purchasers at the well, who then served as gas merchants to sell and distribute gas to end-users.⁵ Deregulation removed many constraints limiting how producers could market and sell their production, leading to the development of marketing affiliates and more flexibility in directly selling production to end-users.⁶ Perhaps most significantly, the deregulation allowed lessees to utilize the entire network of gathering and transportation systems to market and sell production nationwide, rather than limiting their sales to pipelines connected to the wells or plants in the field.⁷

Following on the heels of these changes were a series of cases challenging a lessee's ability to deduct transportation costs, as well as other postproduction costs. Three cases in

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particular, Garmon v. Conoco, Inc.,⁸ Sternberger v. Marathon Oil Co.,⁹ and Mittelstaedt v. Santa Fe Minerals, Inc.,¹⁰ led to the development of the "marketable condition" or "first marketable product" rule, which generally limits the lessee's transportation deductions to costs incurred after the product is placed in marketable condition. While a majority of jurisdictions do not follow the marketable condition rule, disputes arising from its application continue to be litigated. The marketable condition rule and claims arising from it will be discussed in detail in sections III. and IV., supra.

Today, oil and gas are transported by pipeline, tanker, barge, and rail from one region of the country to the other, with data showing a significant increase in movement between regions from 1986 to present.¹¹ Indeed, recognizing the importance of transportation in today's market, one court has commented that "[p]roduction is futile without distribution of the product."¹² Yet there still remains the potential for disputes arising from whether and to what extent a lessee may deduct transportation costs, simply because the lease language (perhaps a remnant from older lease forms or careless drafting) does not specifically address the deductibility of transportation costs, or because the marketable condition rule leaves open disputes as to when and where production is marketable. The most common pitfalls arising from unclear lease language and potential litigation arising under the marketable condition rule are discussed next, followed by recommended lease language to avoid potential disputes.

II. After Deregulation, Commonly Used Lease Terms or Ambiguous Royalty Clauses Fail to Provide Ready Answers to Deductibility of Transportation Costs

Disputes regarding if and how much transportation costs are deductible often arise from reliance on commonly used lease terms (such as "at the well" or "proceeds"), which have different meanings in different jurisdictions, or the inclusion of ambiguous or internally inconsistent royalty language.

A. Reliance on Commonly Used Phrases

Part of the issue with commonly used lease terms is that courts in different jurisdictions interpret the terms differently. Therefore, a producer must either make sure to use a lease form that is specific enough, in each jurisdiction, to allow for the deduction of its transportation costs, or draft a royalty clause that will be specific enough for any jurisdiction.

While an "at the well" royalty valuation clause may in many jurisdictions be sufficiently clear to allow for the deduction of transportation costs, in jurisdictions applying the "marketable condition" rule, the term "at the well" may be viewed as ambiguous or unclear on whether a

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lessor must share transportation costs from the well to the point of sale. In addition, not every jurisdiction has addressed the meaning of an "at the well" valuation clause.

The phrase "at the well" has been interpreted in some jurisdictions, such as Kentucky, North Dakota, and Texas, as defining the point of valuation at the wellhead, such that all costs incurred to transport production away from the wellhead are borne proportionately by the lessor and the lessee. For example, the Kentucky Supreme Court in Baker v. Magnum Hunter Production, Inc. clarified that its interpretation of "at the well" "allows for the deduction of post-production costs prior to paying appropriate royalties" and that "'at-the-well' refers to gas in its natural state, before the gas has been processed or transported from the well."¹³ Similarly, the North Dakota Supreme Court in Bice v. Petro-Hunt, L.L.C. found that the phrase "market value at the well" is unambiguous and means that "any costs incurred by the lessee after the gas reaches the wellhead, whether to improve the quality of the gas or to transport it to a market where it may be sold may be deducted before the royalty is calculated."¹⁴

Likewise, the New Mexico Court of Appeals in Creson v. Amoco Production Co. held that under a unit agreement providing for "net proceeds . . . at the well," a royalty interest in production is "usually subject to a proportionate share of costs incurred subsequent to production" and "such post-production costs generally include transportation costs, expenses of treatment such as dehydration, expenses of compressing gas so that it can be delivered into a pipeline, and other costs incurred in adding value to the well-head product."¹⁵ The holding in Creson has been applied in cases involving claims for royalties under "at the well" leases.¹⁶

Other jurisdictions, however, have held that "at the well" is ambiguous or insufficient to authorize deduction of postproduction costs after the wellhead, including costs incurred for transportation. For example, the Colorado Supreme Court in Rogers v. Westerman Farm Co. held that when a lease provides for royalties calculated "at the well" or "at the mouth of the well," "there is no indication as to how such value is to be determined" because "this language does not indicate whether the calculation of market value at the well includes or excludes costs, and does not describe how those costs should be allocated, if at all, between the parties."¹⁷

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Thus, the Rogers court held that "because the lease language fails to even describe either the costs or the allowable deductions, it is silent with respect to all deductions."¹⁸

While not as explicit as the court in Rogers, the Kansas Supreme Court in Gilmore v. Superior Oil Co. likewise found that "at the well" language was insufficient to permit deduction of compression costs incurred on the lease for the purpose of enabling the gas to enter the pipeline on the lease for sale at a downstream location.¹⁹ The court found, despite the "at the well" language, that compression for transportation was necessary for the lessee to satisfy its duty to make the gas marketable.²⁰ But in a more recent decision, the Court in Fawcett v. Oil Producers, Inc. of Kansas explained that "when a lease provides for royalties based on a share of proceeds from the sale of gas at the well, and the gas is sold at the well, the operator's duty to bear the expense of making the gas marketable does not, as a matter of law, extend...