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“Royalty-Valuation Disputes Under the Marketable Product Rule: Its Summary, Its Rationale, and Its Mechanics.” First Installment.

On Behalf of | Mar 10, 2022 | Firm News

Read this article if any of the following applies:

  1. You liked James Holmes’s article on “Royalty Valuation Disputes in Texas Oil and Gas Leases” and want to read more about that.
  2. You are in the oil and gas industry and need to know about the most common type of litigation for your industry.
  3. You wish to know more about upstream and midstream revenue accounting.
  4. You like to study the evolution of state common law, and you are curious about how forces – e.g., judges, class actions, politics, businesspeople – can shape that law.

The following article by James Holmes follows and compliments his popular three installments on “Royalty-Valuation Disputes in Texas Oil and Gas Leases, and Post-Production Deductions Against Royalties: A Royalty Pirate Looks at 50.” The article presents the marketable product rule (also called, the marketable condition rule) – which stands in stark contrast to the Texas approach to royalty-valuation disputes.  The marketable product rule remains the law for Oklahoma, Colorado, Kansas, and West Virginia, but sadly faces pressures in each of those States to transform into something like the Texas approach.  Holmes believes the marketable product rule, one of the oldest principles of American royalty law, provides a far-superior means for resolving royalty disputes than the approach of his home State (Texas).  This installment presents a summary of the rule.

Most oil and gas-producing states, whether they expressly acknowledge it or not, follow the Texas approach to royalty-valuation disputes.  Whereas the Texas approach generally burdens royalty owners with post-production deductions, the marketable product rule followed by Oklahoma, Colorado, Kansas, and West Virginia – and Uncle Sam! (see below) – generally shields royalty owners from bearing post-production deductions (i.e., the costs of gathering, treating, processing and transporting oil and gas) in their royalties.  However, the rule allows producers (lessees) to take deductions against royalties in two scenarios.  Understanding the rule’s two exceptions helps to explain the rule itself.

First, if the lessee (a) sells “marketable products” (viz., commercially usable products derived from raw oil or gas production), and (b) such sales take place where willing sellers and buyers commonly conduct such sales (i.e., at a “market”), then royalties are paid on prices there and not on higher prices downstream of the sales point.  (The (a) and the (b) in the foregoing sentence establish, respectively, the quality component and the location component in the marketable product rule, which are explored below.  See, e.g., Wellman v. Energy Res., Inc., 557 S.E.2d 254, 264 (W. Va. 2001) (“[T]he duty to market embraces the responsibility to get the oil or gas in marketable condition [quality component] and actually transport it to market [location component].” (emphasis added)).)  Thus, royalties bear deductions arising past this described point of sale – because, under the rule, royalty valuations do not arise from higher downstream prices.  This is the “point of sale (at a market)” scenario.  It is an exception to – more accurately, a curtailment of – the marketable product rule.

Second, the lease may expressly and with specificity allow the lessee to take deductions against royalties – and the lessee must actually incur the costs underlying those deductions (and cannot “make up” fictitious costs), and such costs must be reasonable.  This is the “lease permission” scenario.  It shows the rule’s diametric opposition to the Texas approach: in Texas, producers may take post-production deductions against royalties unless leases say they cannot do so, whereas in States following the marketable product rule, producers may not take such deductions against royalties unless leases say they can do so.

Of course, in order to avoid the rule’s results, producers will seek to maximize the two exceptions when they can.  Whether the “lease permission” scenario exists is easily recognized, but not easily determined.  The parties will agree that lease language attempts to allow producers to take post-production deductions, as an exception to the rule.  The parties will not agree whether the lease language is sufficient to do so: royalty owners will argue the language lacks specificity or burdens them with “unreasonable” or fictitious deductions.  Producers, on the other hand, will defend the lease language.

The more interesting and relevant legal disputes revolve around the “point of sale (at a market)” scenario.  Here is where the marketable product rule could transform into something akin to the Texas approach, should courts allow this exception to swallow the rule.  Producers will argue that because a buyer bought the oil and gas production, such production clearly must be “marketable” (thus satisfying the quality component) and must have been sold in a market (thus satisfying the location component).  They make this argument especially when the buyer is unrelated to themselves – that is, the buyer is “arm’s length” and “unaffiliated.”

So, when an unaffiliated buyer buys unprocessed, untreated, low-pressure, remote, and contaminant-ridden oil and gas – at or near its point of production – can the necessarily-depressed sales price serve as a basis for royalty valuation?  Under the Texas approach, the answer is a resounding “yes.”  For instance, courts will look at raw gas at a well site – containing large percentages of carbon-dioxide, hydrogen sulfide, and liquifiable hydrocarbons – and will conclude that because some buyer has bought this gas, the resulting sales prices are an appropriate basis on which to calculate royalty payments.  Under the Texas approach, courts will tell the royalty owner: “Yes, Dorothy, the low sales prices for this contaminated and dangerous hydrocarbon sludge can become and should be the basis for your royalty payments.”

Being suspicious of the Land of Oz and happenings therein, courts following the marketable product rule would conclude that (a) this raw gas is not yet marketable, and (b) the sales location (i.e., in the field, at a well site) is not a true market; therefore, the low sales prices are an inappropriate basis on which to calculate royalty payments.  If courts in jurisdictions following the rule should allow these sales prices to underlie royalty valuations, they would remove the rule’s protective features for royalty owners and would be enforcing law akin to the Texas approach.

Because under the rule “the expense of getting the product to a marketable condition and location are borne by the lessee,” Rogers v. Westerman Farm Co., 29 P.3d 887, 906 (Colo. 2001), an elaboration on marketable quality and on market location is necessary.  This elaboration shows why the raw gas discussed above cannot be of marketable quality, and its sales location cannot be a market.

Compliance with the marketable product rule requires both a quality component – namely, that the gas be commercially usable, requiring little subsequent processing or treatment – and a location component – that is, that the gas be sold in an open commercial market.  Rogers, 29 P.3d at 905 (“In defining whether gas is marketable, there are two factors to consider, condition [i.e., quality] and location.  First, we must look to whether the gas is in a marketable condition, that is, in the physical condition where it is acceptable to be bought and sold in a commercial marketplace.  Second, we must look to location, that is, the commercial marketplace, to determine whether the gas is commercially saleable in the oil and gas marketplace.” (emphasis added)), cited with approval by Leggett v. EQT Prod. Co., 800 S.E.2d 850, 859 n.13 (W. Va. 2017).  Merely selling gas in an unprocessed, unusable form to any willing buyer does not satisfy the marketable product rule.  Moreover, just because the buyer bought the gas – in that condition, at that location – establishes neither marketable quality nor market location.

Marketable quality requires commercial usability.  See, e.g., Rogers, 29 P.3d at 892 (emphasizing that usability is a key feature to marketability: “[t]he lessees argue that the natural gas at issue is almost pure methane and directly usable in its natural state at the well . . . [indeed] directly usable at the well both commercially and domestically, and does not require any processing in order to be used”); Leggett, 800 S.E.2d at 857-58 (commenting on the relationship of “marketability” and “usability” for gas, after it has undergone processing and transportation to market).

Selling unusable oil or gas – for instance, unprocessed and contaminant-ridden gas that cannot travel far on a pipeline without creating mechanical failure or, worse, exploding – does not constitute selling a marketable product.  See, e.g., Naylor Farms, Inc. v. Anadarko OGC Co., No. CIV-08-668-R, 2011 U.S. Dist. LEXIS 151929, 2011 WL 7053794 at *2 (W.D. Okla. Oct. 14, 2011) (“Defendant [lessee] established it nominally ‘sold’ the gas at the well . . . but not that the gas was in a marketable condition or form at the wellhead.  If the gas had been in a marketable form at the well, the processes [that] DCP [an unaffiliated gas buyer] performed would either have been unnecessary and only transportation to a pipeline would have been necessary . . . .”).

A marketable sales location requires a true market.  A sales location involving only a single potential buyer and, worse, having no “walk up” allowance for other potential buyers (such as in a proprietary pipeline system) does not constitute a true market.  On the other hand, a sales location involving many sellers and buyers that commonly conduct sales over hydrocarbon products does constitute a market.  See, e.g., Naylor Farms, 2011 U.S. Dist. LEXIS 151923, 2011 WL 7053789 at *3 (noting that a “free and open market” for gas could exist only when “there were two or more perspective willing purchasers of raw gas”); Rogers, 29 P.3d at 905 (“A market is a ‘[p]lace of commercial activity in which goods, commodities, securities, services, etc., are bought and sold.’  It is also defined as ‘the region in which any commodity or product can be sold; the geographical or economic extent of commercial demand.’”).

Holmes in his Dallas office

The Federal Government – as royalty owner or as royalty administrator on Federal and Indian Lands – strictly requires that producers comply with the marketable product rule.  See, e.g., Devon Energy Corp. v. Kempthorne, 551 F.3d 1030, 1033 & 1036 (D.C. Cir. 2008) (noting that “[federal] regulations have long interpreted the Mineral Leasing Act to require lessees to put the gas into marketable condition at no cost to the United States – the so-called ‘marketable condition rule’” and holding directly that “the marketable condition rule requires lessees to put gas into marketable condition at no cost to the United States” as royalty owner).  Uncle Sam is no dummy (at least, not as to royalty valuations).  The federal representatives who monitor and audit royalties on Federal and Indian Lands typically are former managers from large oil and gas companies, many of which are currently producing from Federal and Indian Lands.  These former Big Oil managers, turned federal representatives, know what’s what as to royalty valuation – and they don’t tolerate the Texas approach to it.  Rather, they ensure that the Federal Government and Indian Nations get fair and adequate royalties.

Accordingly, federal case law on the rule is enlightening precedent.  States following the rule often look to that federal law for guidance.  A prominent federal jurist, who has become Chief Justice for the United States Supreme Court, explained the rule as follows: “that producers are to place gas in marketable condition at no cost to the [royalty owner] does not contain a geographic limit,” and there is “a meaningful distinction between marketing and merely selling gas.”  Amoco Prod. Co. v. Watson, 410 F.3d 722, 729 (D.C. Cir. 2005) (Roberts, J.) (emphasis added; citations omitted).  Thus, courts ought to look at broad geography in order to find the oil’s or gas’s true market, and a producer’s merely selling oil or gas to a buyer does not equate to “marketing” – which is selling a marketable product at a market.

In conclusion, the marketable product rule is an older, superior approach to royalty-valuation disputes than the Texas approach, which has become decidedly pro-producer (and anti-royalty owner) over the past 30 years.  The rule requires that oil and gas satisfy a quality component (that is, oil and gas must be in “marketable” condition) and that sales activities satisfy a location component (that is, sales points must occur at true “markets”), before a producer can use sales prices as a basis for royalty valuation.  The two exceptions to the rule are the “lease permission” scenario and the “point of sale (at a market)” scenario, and the latter would vanquish the rule entirely unless courts ensure that royalty valuations arise from prices of marketable products (quality) sold at markets (location).

Holmes hopes that Oklahoma, Colorado, Kansas, and West Virginia continue to follow the rule – and that these States protect against encroachments to the rule by the Texas approach.  He is certain that the Federal Government will enforce the rule on Federal and Indian Lands.  (Uncle Sam is smart about royalty valuations and, consequently, wisely uses the rule to shield royalties from deductions.)

In the next installment, Holmes explores the rule’s rationale – which goes to the very heart of the economic relationship between producers and royalty owners.