THE DUTY TO MARKET UNDER FEDERAL AND INDIAN LEASES: IT'S ONLY MONEY
| Jurisdiction | United States |
(2000)
THE DUTY TO MARKET UNDER FEDERAL AND INDIAN LEASES: IT'S ONLY MONEY
Maynes, Bradford, Shipps & Sheftel LLP
Durango, Colorado
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April 2000
I. Introduction
Recent amendments to the federal royalty valuation regulations governing federal and Indian oil and gas leases have redoubled debate regarding the scope of a lessee's duty to market.1 These regulatory provisions require lessees to market lease substances for the mutual benefit of the lessor and lessee at no cost to the lessor.2 Specific and separate mention of the duty to market first appeared in 1997 gas valuation regulatory amendments that also renewed recognition of the lessee's duty to place products in marketable condition.3 At that time, the Minerals Management Service ("MMS") stated that the added "duty to market" language was intended to confirm the lessee's responsibility to bear all marketing costs incurred in fulfillment of the implied duty to market lease substances for the mutual benefit of the lessor and lessee and did not impose a new
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or additional marketing burden on lessees.4 The industry, however, rejected MMS' characterization and claimed that the added language imposed a new duty to pay royalties on values established in downstream markets and not obtained from local fields or areas where lease substances were produced and traditionally sold.5
Both MMS' need to mention the duty to market and industry's reaction to its mention reflected dramatic changes in how and where lease products were being sold. These changes, brought on largely by the Federal Energy Regulatory Commission ("FERC"), had opened use of major interstate gas pipelines to parties other than the pipeline companies that owned the facilities and had permitted parties other than the pipeline companies to sell products to downstream markets.6 The merchant role traditionally filled by pipeline companies was largely replaced by newly created marketing affiliates of producers and by brokers who aligned sellers with downstream purchasers. MMS' added "duty to market" language clearly indicated the lessor's view that changes in the marketing environment should not result in lessors having to assume additional costs associated with the sale of lease products or deprive lessors of the full value of their royalty share of production.
Retention of the "duty to market" language in the newly promulgated regulations warrants examination of the sources and scope of lessee's marketing responsibilities. This paper provides a review of the implied duty to market found in general case law, analyzes specific federal and Indian lease terms that support the duty, and evaluates administrative and case decisions addressing that duty. Significantly, in litigation brought by industry associations, a federal district court recently concluded that the 1997 regulations recognizing a separate duty to market are invalid.7 This decision will also be evaluated.
II. General Sources of the Implied Duty to Market
Admittedly, the pending controversy regarding the implied duty to market relates to what,
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if any, marketing costs should be shared by the lessor and lessee in the context of current practices and sales environments; however, the basic notion of a lessee's implied duty to market is not a new concept. Like other implied covenants, the implied duty to market is "one which may reasonably be inferred from the whole agreement and the circumstances attending its execution."8 Though not expressly written in the lease, without the covenant being implied, the obvious intentions of the parties could be defeated. The duty to market is an incremental aspect of the implied covenant requiring a lessee to exercise reasonable diligence in developing and operating the leased premises.9 "Such diligence means the doing of that which an experienced operator of ordinary care and prudence would do in similar circumstances, having due regard for the interests of both lessor and lessee."10 Like other implied covenants, the implied duty to market suffers from vagueness in its basic articulation, and its application turns upon the particular facts and circumstances at issue.11
Early cases regarding the duty to market under private leases generally did not address which particular costs of marketing might be properly assessed against a lessor, but rather dealt with the fundamental question of whether a lessee's failure to market production in given circumstances resulted in a termination or forfeiture of the lease. Given that the very existence of the leases was at stake, it is fair to say that deductions of marketing costs from royalty shares was not within the litigants' contemplation. In analyzing these situations, particularly where specific lease terms did not provide for shut-in royalties, courts were called upon to determine if the lessee's conduct so defeated the underlying intentions of the parties in entering into the lease as to require lease forfeiture and relinquishment of the opportunity to recover drilling costs incurred in finding potentially valuable production.12 The conclusions of courts clearly differed on this issue;
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however, the cases also reveal significant comments regarding a lessor's intentions in granting a lease. For example, in Benedum-Trees Oil Co. v. Davis, the court observed:
In determining whether a condition is to be implied it is important to note that the substantial consideration which moves a grantor to execute a lease for the exploration of his lands for minerals is the hope of profits or royalties if oil or gas is discovered.... Under such circumstances, the requirement is implied that the lessee would develop the property and dispose of the gas off the premises within a reasonable time, although the only result of delay might be the postponement of profits or royalties....
The duty to develop the property and market the mineral upon the discovery of oil or gas in paying quantities is not to be regarded as a mere implied covenant, but in cases like the ones here where practically the whole consideration to the lessors must depend upon the implied undertaking, it is to be treated as a condition subsequent....
The [lessees] may have realized a gain by retaining the leases for speculation. The [lessors] could receive no benefit from them except by marketing gas from the premises....
The term "paying quantities" involves not only the amount of production, but also the ability to market the product at a profit.
A gas well with small production located in a field with pipe line facilities might be in paying quantities, where conversely a well with large production remote from the pipe line connections and from points of consumption would not produce such quantities.
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Production in paying quantities is not shown except where the well in conjunction with those adjacent or in the same field would justify the construction of transportation facilities and a sale to consumers for a sum sufficient to yield a reasonable return over and above the expenses of production and transportation.13
While some early cases reflect a more flexible application of the covenant than that employed in Benedum-Trees, the decisions reviewed by this writer universally confirm a long-recognized implied duty to market. These early decisions indicate that the location of the market that the lessee was required to find or create in order to retain the lease included locations beyond the boundaries of the lease, if no market at the lease existed. Although the cases appropriately assign that marketing responsibility to the lessee, they do not provide definitive answers to questions regarding the respective cost responsibilities of lessees and lessors in the complex setting of downstream markets and affiliated transactions currently confronting federal and Indian lessees and lessors.
The duty to market recognized in the early cases is obviously one that arises only as the result of the discovery of mineral resources, and, to that extent, later cases involving the post-production responsibilities of the lessee may provide guidance in attempting to establish the relative rights of the parties with respect to marketing. Toward that end, the writer has examined cases addressing the lessee's responsibility to place products in marketable condition, where failure to do so would result in no sales of production. To be sure, many of the decisions turn upon the precise lease language at issue — language that arguably supersedes or alters implied duties.14 However, the cases also create a backdrop of accepted viewpoints regarding the post-production responsibilities of the parties. In reviewing the following cases, one must recognize that there may be a distinction between the costs and activities associated with placing products in marketable condition and those required in downstream marketing. Nonetheless, the potential similarity of purpose between the two activities appears to warrant examination of the marketable condition cases.
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Marketable Condition Cases
In El Rios Oils (Canada) Ltd. v. Chase,15 a California appellate court disallowed deductions against royalty, variously characterized by the lessee as charges for "heating and treating" and "operating overhead," attributable to the injection of distillate into crude oil wells. The purpose of the distillate injection had been to thin the thick crude oil to improve pumping. Relying heavily upon the terms of the lease, which permitted deductions from royalty for treating, the court concluded that the activity involved production, not treating. In establishing value, the court adopted a market price equal to the sales price obtained by the lessee without reductions for the cost of distillate supplied by the oil purchaser to the lessee.
In Gilmore v. Superior Oil Co.,16 the...
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