The following article by James Holmes continues his review of the marketable product rule (also called, the marketable condition rule). He likes this installment the most – thus calling it the best installment – because the rule’s rationale not only justifies the rule’s continuation and expansion, but also demonstrates several failings of the Texas approach, which is diametrically opposed to the rule. By carefully studying the rule’s rationale, Texas courts could strengthen the Texas approach and return Texas royalty jurisprudence to the nationally prominent and beneficially seminal position it once held.
“The rationale for holding that a lessee may not charge a lessor for ‘post-production’ expenses appears to be most often predicated on the idea that the lessee not only has a right under an oil and gas lease to produce oil or gas, but he also has a duty, either express, or under an implied covenant, to market the oil or gas produced. The rationale proceeds to hold the duty to market embraces the responsibility to get the oil or gas in marketable condition [note the ‘quality’ component] and actually transport it to market [note the ‘market component].” Wellman v. Energy Res., Inc., 557 S.E.2d 254, 264 (W. Va. 2001)
So, the rule’s rationale presumes that the producer has a “duty” to market oil and gas on the royalty owner’s behalf. But why does the producer bear this duty? Is it fair to make the producer bear this duty? This installment answers these questions.
The Piney Woods Case
Oddly enough, a justification for the marketable product rule does not begin with a study of the laws of Oklahoma, Colorado, Kansas, and West Virginia, or even of federal law on royalty valuation. It does not begin with a juxtapositional analysis of (and a criticism of) the radically different Texas approach. Defending the rule’s rationale best begins with reviewing a federal case, arising from diversity jurisdiction (wherein litigants of different states can proceed in federal court, as neutral turf). This celebrated federal case applies Mississippi law on royalty valuation. The case is Piney Woods Country Life School v. Shell Oil Co., 726 F.2d 225 (5th Cir. 1984), authored by Judge John Minor Wisdom, a great jurist and, above all, a great American citizen.
West Texas Satellite Battery: Northwest Mallet Unit
Piney Woods addresses a collision of royalty rights – between a producer and a royalty owner – and resolves the collision by assessing the economic relationship between these two litigants. The case is not the first authoritative writing to explore the economic relationship between producers and royalty owners; many oil and gas treatise writers, for instance, have studied and described that economic relationship since the 1920s forward. But Piney Woods may be the best exploration of this economic relationship and – despite involving Mississippi law (which doesn’t follow the marketable product rule) – the case lays out the fundamental justification for the marketable product rule. Just as inadvertently, it lays out also the justification for protecting royalty owners with implied covenants under the Texas approach, as Holmes presented the “duty to market” covenant in the Sixth Pillar of Texas royalty law.
Piney Woods’s collision of royalty rights arises from the commonplace legal fight over the distinction between (i) gas sales “on leased premises” (or sales “at the wells”) and (ii) gas sales “off leased premises” (i.e., sales away from points of production). Many old leases require a “proceeds” or “amount realized” royalty price for (i) gas sales on lease, but require a “market value” royalty price for (ii) gas sales off lease.
“Market value” prices frequently exceed “proceeds” prices in royalty valuation. (Holmes explores the distinction between “proceeds”-style leases and “market value”-style leases in the Fifth Pillar; the distinction is very important for the Texas approach (which Mississippi law follows), but much less important for the marketable product rule.) Accordingly, the Piney Woods royalty owner sought the higher “off leased premises” prices – meaning the “market value” measure for royalty valuation. Note, the producer had not received that “market value” measure; it had received the lower “proceeds” measure. Naturally, the producer sought to pay royalties on the lower “on leased premises” prices; namely, the actual “proceeds” prices the producer had received. Also, the producer had entered sales contracts with several buyers (a city, a utility, and an industrial plant) that designated title transfer points at the wells, so that those buyers nominally owned the gas from points of production to points of consumption.
Judge Wisdom, on the Law’s Protections for Royalty Owners
As a break in the action, seemingly the Piney Woods producer should have won the battle. In fact, the producer had won in the trial court. After all, the producer was paying gas royalties based on prices it had actually received. It seemingly would be unfair to force the producer to pay royalties based upon higher “market value” prices, which the producer itself had not received. Further, the producer’s own sales contracts designated “on leased premises” title-transfer points, thus bolstering the producer’s argument that gas sales indeed had occurred on lease.
Nonetheless, allowing the producer to win the battle not only would have made bad law – it would have been patently unfair to the royalty owner. Judge Wisdom, in the appeal from the trial court, surveyed Mississippi, Texas and Oklahoma law on royalties and on sales of goods (note: oil and gas taken from the ground are “goods” under the law). He observed the law’s recurring objective of protecting a party whose rights are beholden to sales whenever that party lacks power or control over those sales. Here, the royalty owner had no power or control over (or involvement in) the producer’s sales contracts with the buyers.
Judge Wisdom observed also the royalty owner’s expectation, at the time of entering the lease, for some circumstances when “proceeds”-style royalties would be paid, and for some other circumstances when “market value”-style royalties would be paid. Surely the parties at the time of leasing expected that either type of royalties could occur – and not that one party (the producer) always could bring about one circumstance to the exclusion of the other.
Looking past the nominal passage of title ownership, Judge Wisdom concluded that the producer controlled the gas from points of production to downstream markets, which were close to points of consumption (e.g., burning the gas to make electricity). The producer itself processed the gas and paid for pipeline transportation; the nominal buyers had done neither. Also, the sales prices did not arise from field activity – that is, the fictitious sales at the wells. Rather, the sales prices arose from the downstream markets where the buyers effectively took control of the gas, and where the producer relinquished such control. Therefore, Judge Wisdom concluded that gas sales were occurring “off leased premises” at the downstream markets, thus entitling the royalty owner to higher “market value”-style royalties – even though the producer had not received those “market value” prices.
Hon. John Minor Wisdom
Piney Woods repeatedly holds that royalty law must protect the party in an economic relationship that lacks control and power, especially in a long-term relationship. The party lacking control and power, especially as to royalty valuation, is the royalty owner. See Piney Woods, 726 F.2d at 236 (“The payment of royalties is controlled by lessees, and lessors have no ready means of ascertaining current market value other than to take lessees’ word for it.”); cf. 3 Eugene Kuntz, Law of Oil and Gas § 40.4, at 332 (rev. ed. 1989) (emphasizing royalty law’s protection for royalty owners lacking control over sales: “If, however, the lessee is a corporate affiliate of the purchaser and that sale is not at an arm’s length, the sale price will not be accepted as representing the market price or market value. Nor will sales on a market which is dominated by a few producers and purchasers establish an acceptable market price of gas.”).
The Piney Woods royalty owner, as with virtually all royalty owners, had no involvement in its producer’s sales contracts, was not a party to those contracts, and had no influence over them. The royalty owner could not designate an on-lease or off-lease title-transfer point in the contracts; it was entirely beholden to the producer’s and buyers’ designation. The law would not force the royalty owner to accept the such title-transfer point designation – which caused the royalty owner to receive lower royalties. See Piney Woods, 726 F.2d at 236 (“But the simple passage of title does not control whether the gas was ‘sold at the well’ within the meaning of the leases. In the leases, ‘at the well’ refers to both location and quality . . . . To interpret the leases otherwise would place the lessors at the mercy of the lessee. The lessors had no say in [lessee’s] choice of where to put the passage of title.”), cited with approval by Leggett v. EQT Prod. Co., 800 S.E.2d 850, 864-65 (W. Va. 2017).
The Justification in Piney Woods for the Marketable Product Rule
Returning to the marketable product rule, how does the lesson of Piney Woods inform the rule, and justify it? As mentioned in the first installment, the best way to learn the rule is to study its exceptions, especially the “point of sale (at a market)” scenario. That scenario could create an exception that swallows the rule, thus transforming the rule into something akin to the Texas approach.
Ideally, this situation occurs (called “situation (1)”): royalty law recognizes that points of sale exist only when producers transfer marketable oil or gas to buyers, at markets involving many buyers and sellers of what is transferred. But what if situation (2) happens?: courts allow for points of sale whenever producers transfer unprocessed and contaminated oil or gas to a single buyer, at a remote location, where no other buyer is present? Royalty owners have no control over the point of sale, the market, or the sales location in situations (1) or (2). They are entirely beholden to their producers to market oil and gas, including where to sell and in what condition.
But that is alright. Royalty law protects them for their lack of control and power. Royalty law’s propensity to protect the party lacking power and control in an economic relationship – best articulated in Piney Woods – demands that the producer pay royalties as though situation (1) occurred. The producer must pay on prices for marketable products (quality component) at recognized markets (location component).
The marketable product rule provides a superior framework for protecting the royalty owner, as royalty law historically directed courts to do, and as best explained by Judge Wisdom in Piney Woods. The Texas approach purports to protect the royalty owner with the “duty to market” (which applies only to “proceeds”-style leases, as Holmes discusses in the Sixth Pillar); however, the marketable product rule provides the protection more consistently and with less subjectivity and vicissitudes in application. The third installment on the rule’s mechanics will demonstrate why the rule involves less subjectivity and vicissitudes than the Texas approach.
The Marketable Product Rule, Under Assault
Sadly, royalty owners in Oklahoma, Colorado, Kansas, and West Virginia are facing the producers’ efforts (in courtrooms, and potentially in state legislatures) to transform the marketable product rule into something like the Texas approach. See, e.g., Fawcett v. Oil Producers, Inc., 352 P.3d 1032, 1042 (Kan. 2015) (frustrating a royalty-owner class action as follows: “We hold 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 beyond that geographical point to post-sale expenses. In other words, the duty to make gas marketable is satisfied when the operator delivers the gas to the purchaser in a condition acceptable to the purchaser in a good faith transaction.” (citation omitted)). These States may transform into the Land of Oz, telling the royalty owner what Texas says: “Yes, Dorothy, the low sales prices for this contaminated and dangerous hydrocarbon sludge can become and should be the basis for your royalty payments.”
The same dynamic that deteriorated Texas royalty law, which Holmes explained in the Second Pillar, is at play in these States. Class action lawyers are burdening the oil and gas industry with class-action lawsuits over royalty-valuation disputes and post-production deductions. Representing people they’ve never met or will meet (called “Classes of Plaintiffs”), these class action lawyers seek to force oil and gas companies to pay millions in damages and attorneys’ fees over royalty-valuation disputes and post-production deductions – with a large share of those winnings going into the lawyers’ pockets.
If he looked as hard as he could, Holmes would not be able to find a group of lawyers more adept at (a) spoiling substantive law (like royalty law) with greedy usage and (b) under-serving their clients (the “Classes of Plaintiffs”) than class action lawyers. A procedural disallowance of class formations – so that royalty owners would have to seek court relief individually, with their selected legal counsel to protect their interests – would ameliorate the deterioration of the marketable product rule and would thereby preserve the rule’s protectiveness in Oklahoma, Colorado, Kansas, and West Virginia. A disallowance of class formations may even allow the rule to spread to other States, so that American royalty owners more broadly could experience the rule’s protectiveness.
A sagacious federal judge, who was applying West Virginia law in a royalty case, recently observed how the marketable product rule protects his State’s citizens:
“First, many of these leases are entered into with unsophisticated individuals [i.e., royalty owners] who lack the expertise and experience to understand the terms of the lease. Second, with no clear statement as to methodology, the lessee [i.e., the producer] could sell to a related company and thereby control the amount of post-production costs, yet make a large profit downstream. Third, the lessee can include indirect costs that are unrelated to the true post-production costs. It must be emphasized that it is the lessee that controls the information. Most lessors are ill-equipped to conduct an audit of the lessee’s numbers, even if they were allowed to do so.” Kellam v. SWN Prod. Co., No. 5:20-CV-85, 2021 U.S. Dist. LEXIS 195308 at *32-*33, 2021 WL 4621067 (N.D.W. Va. Sept. 13, 2021) (emphasis added).
The judge strongly encouraged the West Virginia Supreme Court (a state court) to keep the marketable product rule in place, for the protection of royalty owners.
The rule’s ultimate justification is the protection of the royalty owner, who lacks power and control over the producer’s marketing of oil and gas and, consequently, who depends entirely on the producer’s marketing decisions. Piney Woods provides one of the best articulations for protecting the royalty owner, a proper objective for any state’s royalty law.
The Texas approach attempts to protect the royalty owner with the “duty to market” in “proceeds”-style leases and with the “market value” concept in “market value”-style leases. However, the rule is much more protective of royalty owners and much less susceptible to subjectivity and vicissitudes – in the hands of the courts – than the Texas approach. In the next and final installment, Holmes demonstrates why.