CHAPTER 9 THE TAKING PRODUCTION IN KIND PROVISIONS OF AAPL FORM 610

• Jurisdiction: United States

Oil & Gas Agreements: Joint Operations
(Dec 2007)
CHAPTER 9
THE TAKING PRODUCTION IN KIND PROVISIONS OF AAPL FORM 610
Judith M. Matlock
Attorney
Davis Graham & Stubbs LLP
Denver, Colorado
Jamie L. Jost
Corporate Legal Counsel
Suncor Energy (U.S.A.), Inc.
Denver, Colorado

JUDITH M. MATLOCK

Judith M. Matlock is a partner in the Energy Group of the Denver law firm of Davis, Graham & Stubbs LLP. She received her Bachelor of Arts degree from the University of Colorado in 1979, graduating magna cum laude. In 1982, she received her Juris Doctor degree from the University of Colorado. She is a member of Phi Beta Kappa, Order of the Coif, and the Denver, Colorado, and American Bar Associations. Since the mid 1980s, her practice has included extensive work involving the transportation, processing and marketing of production giving her a unique perspective on royalty and tax compliance issues involving post-production costs, non-arm's-length transactions (sales, transportation, processing), and accounting system implementation of inconsistent federal, tribal, state and private royalty and production tax requirements. She has negotiated settlements of class action litigation involving private royalties on both conventional and coalbed methane production. She has conducted internal audits for companies to determine their compliance with royalty and tax requirements involving numerous different marketing arrangements. She has also evaluated royalty and tax compliance issues to assist companies in determining the effective net revenue interest and potential liabilities involved in an acquisition. Ms. Matlock also has an extensive background in the more traditional aspects of a natural resources practice. Ms. Matlock has been a member of the Executive Committee of the Rocky Mountain Mineral Law Foundation, served as a trustee of the Foundation, and served as vice chair of the Special Institutes Committee of the Foundation. She has been the program chair for several Foundation Special Institutes and Short Courses including Natural Gas Marketing & Transportation (1991); Practical Natural Gas Marketing Short Course (1993 and 1994); and Negotiating Natural Gas Contracts (1993). She is a frequent lecturer and writer on energy topics including two annual institute papers and 12 special institute papers for the Rocky Mountain Mineral Law Foundation including "The `Duty to Market' Downstream At No Cost To The Lessor (The Alleged Federal `Duty to Market')," Federal and Indian Oil & Gas Royalty Valuation and Management, Paper 2A (Rocky Mt. Min. Law Fdn. 2000); "Post Production Costs," Institute on Natural Gas Transportation & Marketing (Rocky Mt. Min. Law Fdn. 2001); "The Wyoming Class Action Lawsuits" (an update on post-production cost litigation), handout for Independent Petroleum Association of Mountain States, September 2002; and "Royalty Calculation When the Producer/Lessee is Dealing With An Affiliated Entity," Private Oil & Gas Royalties, Paper No. 9 (Rocky Mt. Min. L. Fdn. 2003). She has been listed in Best Lawyers in America - Oil and Gas since 1995 and was selected to the inaugural Lawdragon 500 for her royalty work.

JAMIE L. JOST

Jamie L. Jost presently serves as Corporate Legal Counsel for Suncor Energy (U.S.A.), Inc. Ms. Jost joined Suncor Energy (U.S.A.), Inc. in October 2007 and is responsible for the legal affairs of Suncor's Pipeline Group, Retail Group, and Termination and Distribution Group. Prior to her position with Suncor Energy (U.S.A.), Inc., Ms. Jost was an associate at Davis Graham & Stubbs in its Natural Resources Department. While at Davis Graham & Stubbs, Ms. Jost worked on various issues affecting the oil and gas industry. She represented numerous industry clients in federal and state courts as well as in proceedings with the Colorado Oil and Gas Conversation Commission. Her oil and gas practice also emphasized commercial transactions involving energy and wind projects in the United States and internationally. Ms. Jost began her legal career with the Cheyenne, Wyoming law firm of Dray, Thomson & Dyekman working primarily on renewable energy issues as well as general civil litigation matters. In 2003, Ms. Jost became an associate with the Roswell, New Mexico law firm of Hinkle, Hensley, Shanor & Martin where she focused her practice on oil and gas related matters. While at the Hinkle law firm, Ms. Jost represented clients both in court and in front of federal administrative agencies on oil and gas royalty issues, subsurface trespass issues, and employment related matters.

Ms. Jost received her J.D. from the University of Wyoming in 2002 and her undergraduate degree in Environmental Science from Indiana State University in 1998. Ms. Jost is a member of the bars of Colorado, Wyoming, the United States District Court of Colorado, the United States District Court of Wyoming, and the Tenth Circuit Court of Appeals. She is active in the Rocky Mountain Mineral Law Foundation, the Colorado Bar Association, and the American Bar Association.

Table of Contents

I. Introduction

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

A. The Duty to Take in Kind

B. The Failure to Take in Kind

III. Imbalances Caused By the Failure to Take in Kind

A. Definition of a Producer Imbalance

B. Split-Stream Connections and Other Causes of Producer Imbalances

C. Problems Caused By Producer Imbalances

IV. Resolution of Producer Imbalances - No Gas Balancing Agreement in Place

A. Ownership of Production

B. Balancing in Kind

C. Cash Balancing

V. Resolution of Producer Imbalances - Gas Balancing Agreement in Place

A. Minimum Provisions of a Gas Balancing Agreement

B. Options and Alternatives in the Form Balancing Agreements

C. Disputes Arising Under Gas Balancing Agreements

VI. Payment of Leasehold Burdens and Income Taxes When Producer Imbalances Occur

A. Payment of Leasehold Burdens

1. The Weighted Average Rule

2. The Tract Allocation Rule in General

a. The Tract Allocation Rule/Takes or Sales Basis

b. The Tract Allocation Rule/Entitlements Basis

3. The Federal Rule

B. Payment of Production Taxes

C. Payment of Income Taxes

VII. Operator Rights and Responsibilities

A. No Duty to Market

B. Problems Faced By Operators In Marketing Production For Others

C. The Temporary Marketing Agreement Alternative

VIII. Conclusions

Table comparing the failure to take production in kind provisions of the Model Form JOAs

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 failure to take in kind usually

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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. All four versions of the Model Form JOA taking production in kind provision start 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...