SELF OR AFFILIATE GAS PROCESSING: HOWELL v. TEXACO, INC.
| Jurisdiction | United States |
Eugene Kuntz Chair in Oil, Gas & Natural Resources
The University of Oklahoma College of Law
[Page 331]
I. Introduction
On Pearl Harbor Day, 2004, the Oklahoma Supreme Court handed down a long-awaited decision, Howell v. Texaco, Inc.1 This case is important for at least four reasons. First, the case concerns the processing of wet gas--a common practice. Wet gas is natural gas that is saturated with natural gas liquids (NGLs). These NGLs are extracted at gas processing facilities and marketed separately from the remaining dry (i.e., residue) gas. Second, the wet gas at issue was both produced and processed by Texaco, as lessee and as processor. Producers often sell wet gas to a processing affiliate or directly engage in processing activities. Yet, there is surprisingly little case law that expressly addresses how affiliate transactions or lessee self-dealing should be treated for royalty-valuation purposes. Third, Howell illustrates several important and current royalty-valuation issues. Finally, Howell was essentially a unanimous decision. While Justice Opala dissented, he did so only by stating that he would not have granted certiorari to review the interlocutory order to certify the matter to the court.2
II. Facts and Claims
Unlike many recent royalty-valuation suits, Howell was not a class action. Rather, a group of named plaintiffs, lessor-royalty-owners, sued Texaco, the lessee, and its processing division, alleging underpayment of royalty, fraud, and breach of fiduciary duty.
Although some of the wet gas at issue was produced from wells that were subject to statutory field-wide unitization orders, the appeal did not concern those wells. Rather, the breach-of-fiduciary-duty issue concerned some leases that were subject to voluntary communitization agreements and wells that were not communitized. Thus, the fiduciary-duty issue was
[Page 332]
limited to whether lessees owed lessors a fiduciary duty arising from the lessor-lessee relationship or a voluntary-communitization relationship.
Texaco transferred the wet gas to its processing division for recovery of NGLs. The processing division processed the wet gas and then sold the residue gas and extracted NGLs to third parties. The royalty payments relevant to this appeal were due on "market value or proceeds at the prevailing market rate at the mouth of the well or at the well (market value leases),"3 but the royalty clauses were not fully set forth in the opinion.
The facts state that "Texaco's production division and Texaco's gas plant division entered into an intra-company 'contract' for the sale of the gas covered by the plaintiffs' leases at the wellhead. After the gas was processed, Texaco sold the residue gas and the natural gas liquids to third parties."4 For most of the relevant time period, "Texaco computed the plaintiffs' royalty payments on prices established by the intra-company contract."
Although the opinion is unclear on this matter, the so-called intra-company contract was not an actual affiliate contract of sale for the specific gas at issue. In reality, the royalty payments were determined by reference to percentage-of-proceeds (POP) contracts for the sale of unprocessed wet gas between the Texaco gas-processing division and unaffiliated producers. Thus, the intra-company contract, although apparently called a "contract" was merely a memorandum between divisions of the same entity that was used to describe how Texaco was valuing the gas for royalty purposes.
In the gas industry, wet gas is commonly sold on a POP basis to processing plants. Under the particular POP contracts in Howell, unaffiliated third-party producers were paid a percentage of the proceeds from the resale of the residue gas and NGLs after processing by the Texaco
[Page 333]
processing division.5 An expert witness for Texaco opined that the POP prices were representative of the market value of the gas.6
Accordingly, Texaco paid royalty to the plaintiff-lessors as if the gas at issue had been sold on the same basis as third-party producers had sold gas to the Texaco processing division. Thus, whether one regards this case as an affiliate transaction or more accurately as lessee self-dealing7 makes little, if any, difference. In case of the former, the affiliate transaction would be carefully scrutinized.8 In case of the latter, the lessee's work-back calculations for determining upstream value would be carefully scrutinized.9 This is underscored by the court's holding, which expressly uses the term "intra-company contract."10
The lessors alleged that paying royalty on the basis of the intra-company contract failed to compensate them for "market value," which they argued should be determined by the first arm's-length sale of the gas. The lessors further asserted that "[i]n calculating the royalty payments, Texaco did not measure, did not account for, and did not pay royalty on scrubber oil or drip condensate,"11 but Texaco asserted that the values of these products were nevertheless reflected in the POP contracts used by Texaco to calculate royalty. In addition, lessors alleged that check stubs that Texaco sent royalty owners failed to disclose Texaco's valuation
[Page 334]
methodology and failed to reveal deductions for certain marketing costs and profit margins.
According to the facts, Texaco internal memoranda indicated that, in 1985, Mobil had offered to purchase casinghead gas from Texaco for a higher price than the price reflected in the "intra-company contract."12 Other internal memoranda from the mid-1990s suggested that Texaco was not properly paying royalty and recommended that the "market value of the gas ... be determined by multiplying the monthly wellhead MMBTU's ... by the weighted average sales price ... per MMBTU received by Texaco ... for residue gas at the tailgate of the plant."13 This method would have taken into account the gross gas volumes at the wellhead, but not the possible additional values associated with the fact that the gas was saturated with NGLs, which would often generate a greater net return if extracted and marketed separately, as Texaco did, rather than being sold at the wellhead as part of the wet-gas stream.
Apparently Texaco did not implement the valuation method recommended in its own internal memoranda; however, for a time in 1999-2000, Texaco did pay royalty on the basis of the sales proceeds for residue gas and NGLs14 --apparently less marketing costs plus a profit allowance for processing. Whether this valuation method accounted for the scrubber oil15 and drip condensate16 is not clear from the facts as summarized by the court.
The lessors argued that Texaco's payment methodology breached the royalty clauses, was fraudulent, and violated Texaco's fiduciary duty. The lessors asserted that they should have been paid based upon the first arm's-length transactions, which occurred after processing, including any amounts received for scrubber oil and drip condensate, either without deduction or, alternatively, subject to the deduction of reasonable actual processing costs. In addition, the lessors argued that Texaco committed
[Page 335]
actual and constructive fraud by failing to disclose the details of its royalty calculation on the royalty check stubs--an alleged violation of the Production Revenue Standards Act (PRSA).17
After the trial court granted Texaco's motion for partial summary judgment, the lessors sought a writ of certiorari on their claims of underpayment of royalties, fraud, and breach of fiduciary duty. The Oklahoma Supreme Court granted the writ and then reversed and remanded.
III. Holdings and Analysis
A. No Fiduciary Duty Arising From Voluntary Agreements.
Not surprisingly, the court in Howell holds that leases and related communitization agreements are simple contracts that do not, at least by themselves, create fiduciary relationships.18 In rejecting the lessors' claim, the court refused to hold an operator to a fiduciary standard for communitization agreements even though an operator is held to that standard in the case of regulatory field-wide compulsory unitization orders.19
[Page 336]
B. Actual and Constructive Fraud in the PRSA Context.
The court adds nothing new to the basic law of actual and constructive fraud. Under either theory, plaintiffs must prove detrimental reliance.20 Although the court's discussion of the relationship between the doctrines of actual and constructive fraud and the PRSA is new, the court's analysis of the doctrines is not. Notably, however, after quoting from the check-stub provisions of the PRSA,21 the court stated "[t]he PRSA provisions give the royalty owners a right to be accurately informed of the facts and place a legal duty on the respondents to accurately inform the plaintiffs of the facts on which the royalty payments are based."22 This statement may signal that the court views the PRSA as a remedial statute that should be liberally construed in light of its purpose, which is disclosure to royalty and other interest owners. Because the defendants failed to show compliance with the PRSA in support of their motion of partial summary judgment and because they could not show a lack of detrimental reliance as to all plaintiffs, the fraud issues were remanded for further fact finding.
C. The Meaning of "Market Value."
The most interesting portion of the opinion is the court's discussion of the market-value royalty obligation. The court first defines market value as "the price negotiated by a willing buyer, not obligated to buy, and a willing seller, not obligated to sell, in a free and open market."23 The court lists three established means of determining market value:24 (1) by actual arm's-length sales of the gas at issue, citing Tara Petroleum Corp. v. Hughey;25...
To continue reading
Request your trial