The following article by James Holmes concludes his review of the marketable product rule (also called, the marketable condition rule). This installment demonstrates that the rule better protects royalty owners than the Texas approach, and the rule consistently demands royalty pricing on commercially usable products sold in vibrant markets, despite a variety of marketing circumstances.
Holmes has given many speeches to royalty owners and their representatives that start with this competition: “The Texas World vs. The Oklahoma World.” He contrasts the many differences between the Texas approach and the marketable product rule, of which Oklahoma is the most prominent historical follower. Then, without telling the audience which State has which position, Holmes asks them which sounds more protective for royalty owners: (1) “the producer must market the oil and gas production with due diligence and obtain the best price reasonably possible,” or (2) “the producer has the responsibility to get the oil or gas in marketable condition and actually transport it to market.” (He is first quoting from a case showing the Texas approach and, second, from a West Virginia case on the rule.) By show of hands, the audience votes for the first quotation – they can’t resist the sound of “obtain the best price reasonable possible.” They believe this quotation (arising from Texas’s “duty to market”) sounds more protective for their rights than the marketable product rule (the second quotation). They couldn’t be more wrong.
The Marketable Product Rule’s Objectivity, and the Texas Approach’s Subjectivity.
Even beyond the fact that Texas implies the “duty to market” (the first quotation) only in “proceeds”-style leases and the marketable product rule applies to any kind of lease, the rule surpasses the Texas approach for protectiveness in many ways. The concepts of “due diligence,” “best price,” and “reasonable possibility” in the Texas approach become highly subjective in the hands of expert witnesses and judges in litigation. What constitutes a “best price” or “due diligence” in one transaction does not dictate what must be a “best price” or “due diligence” in another transaction. A producer’s selling sour casinghead gas at 4-8 GPM (a measure of the gas’s liquid content) in one area having multiple plants (i.e., buyers) on certain sales prices and terms does not set a standard for all producers selling similar gas in other areas, especially in areas lacking numerous plants. The producer’s sales prices and terms don’t easily create binding and broad standards for the “best price” or “due diligence” under Texas’s “duty to market.”
Moreover, even if royalty owners prevail in trial courts, appellate courts often view findings on the “duty to market” very critically against the royalty owner, and in favor of the producer. With the Texas approach, the problems of subjectivity and vicissitudes continue into the appeal. This happens because any legal standards depending on the concept of “reasonableness” – which expressly permeates the “duty to market” – invite subjectivity into legal analysis and appellate review. Cf. Kellam v. SWN Prod. Co., No. 5:20-CV-85, 2021 U.S. Dist. LEXIS 195308 at *27-*28, 2021 WL 4621067 (N.D.W. Va. Sept. 13, 2021) (“Stating in a lease that deductions will be ‘reasonable’ does not describe any particular mathematical process nor objective limitation. Instead, it forces prospective lessors to rely on the lessee’s conclusory representation that the calculation will be ‘reasonable’ without giving the prospective lessor an opportunity to evaluate for himself or herself whether the lessee’s methods are ‘reasonable.’”).
East Texas LACT: Hawkins Field Unit
Holmes believes, and case law bears out, that a producer’s “responsibility to get the oil or gas in marketable condition and actually transport it to market” (i.e., the marketable product rule) provides substantially greater protections for the royalty owner. The rule utilizes more objectivity than the “duty to market” in the Texas approach: “marketability” and “a market” objectively mean commercially usable oil and gas products that are sold at locations in which sellers and buyers routinely interact.
The rule is reasonable about these objective concepts. The commercially usable products may be upstream products rather than downstream products: for instance, stabilized crude oil that can enter a refinery is a usable product. The producer doesn’t have to transform that oil (i.e., refine it) into vehicular gasoline or diesel – which are clearly commercially usable products – before calculating royalties due under the marketable product rule. Likewise, although Mont Belvieu, Texas is the largest and most active American market for natural gas liquids, many smaller “markets” (which satisfy the rule) exist at plant tailgates and liquids-trading centers. Producers, accordingly, can sell liquids at one of these smaller markets and then calculate royalties due under the marketable product rule.
The Marketable Product Rule’s Features Are Consistent Under Fire.
Importantly, the marketable product rule does not limit a producer’s marketing duty to bearing only those costs necessary to bring oil and gas out of the ground, as does the Texas approach. In States like Texas, once oil and gas are out of the ground, then the producer and the royalty owner both bear costs, unless the lease specifically states otherwise. Thus, the producer usually takes full post-production deductions against royalties.
The marketable product rule, on the other hand, makes the producer bear those costs necessary to bring oil and gas out of the ground, as well as (i) those costs to move the oil and gas to a market and, ultimately, (ii) those costs necessary to render marketable products at such market. (Costs (ii) often arise from minimal processing, treating and stabilizing of raw production, making it suitable for pipeline movement. With liquids-rich gas, further processing to render natural gas liquids and residue gas becomes necessary.) Merely transporting un-usable oil and gas production to a market is insufficient; the producer must have rendered the production into recognizable, commercially usable products at that market. See Wellman v. Energy Res., Inc., 557 S.E.2d 254, 263 (W. Va. 2001); Tawney v. Columbia Nat’l Res., 633 S.E.2d 22, 27 (W. Va. 2006) (both embracing the commentary of Robert Donley that a producer must run oil and gas production “to a common carrier” (which accepts commercially usable products) and must pay royalties on “the sale price received [there]” (citing Robert Donley, The Law of Coal, Oil and Gas in West Virginia and Virginia, § 104 (1951)); see also W.W. McDonald Land Co. v. EQT Prod. Co., 983 F. Supp. 2d 790, 800 & 801 (S.D.W. Va. 2013) (holding that “[a]t the TCO line [a common carrier pipeline], gas is commoditized and bought and sold by third parties,” “[t]he TCO line is therefore a market,” and “the duty [is] to get the gas to market, not to a point of sale”); Rogers v. Westerman Farm Co., 29 P.3d 887, 892 (Colo. 2001) (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”).
The marketable product rule applies when the parties have a “proceeds”-style royalty clause (also called “amount realized”) or a “market value”-style royalty clause. See Wellman, 557 S.E.2d at 258 & 264 (involving a “proceeds”-style royalty clause); Tawney, 633 S.E.2d at 25, 27 & 29 (addressing “proceeds”-style royalty clauses, “market value”-style royalty clauses, and possibly others); W.W. McDonald Land Co., 983 F. Supp. 2d at 805-09 (addressing “proceeds”-style royalty clauses and “market value”-style royalty clauses); Rogers, 29 P.3d at 897-99 (same).
The marketable product rule does not grow weak when confronted with common lease language like “at the well” or “at the mouth of the well.” E.g., Tawney, 633 S.E.2d at 28 (answering “no” to the question of “whether the ‘at the wellhead’-type language . . . is sufficient to alter [West Virginia’s] generally recognized rule that the lessee must bear all costs of marketing and transporting the product to the point of sale”); Rogers, 29 P.3d at 912 (“After assessing the ‘at the well’ and ‘at the mouth of the well’ language in this case, we conclude that the leases at issue here are silent with respect to the allocation of costs. . . . Because we have determined that the leases are silent with respect to allocation of costs, we look to the implied covenant to market [i.e., the marketable product rule] to determine the proper allocation of costs.”). Language like “at the well” is outcome-determinative in royalty-valuation disputes under the Texas approach, but plays little role under the marketable product rule.
The marketable product rule does not grow weak when a producer concocts an upstream sale – such as a sale to its affiliate – that avoids (a) rendering marketable products, and (b) bringing those products to a market. See W.W. McDonald Land, 983 F. Supp. at 804 (applying the rule when a producer sold gas production to a sister company: “The defendants cannot calculate royalties based on a sale between subsidiaries at the wellhead when the defendants later sell the gas in an open market at a higher price”). The marketable product rule does not grow weak when a producer enters a legitimate upstream sale to true arm’s length buyer, and such sale avoids (a) rendering marketable products and (b) bringing those products to a market. Imperial Colliery Co. v. OXY USA Inc., 912 F.2d 696, 699 & 704 (4th Cir. 1990) (imposing on a producer the duty to pay royalties on a downstream market-value price even when the producer had sold the gas upstream “by the terms of a 1948 gas sale contract” with an arm’s length party).
West Texas Oilfield
More generally as to buyers, the involvement of either an affiliated or unaffiliated buyer does not disrupt the marketable product rule. That is, a producer may sell unusable (or generally unusable) oil or gas to an affiliated buyer (such as the producer’s sister company) at a sales location that is not a true market – and the rule will demand royalty valuation on that oil or gas once (i) it has ultimately become a marketable product and (ii) it has been sold at a market. Likewise, a producer may sell unusable (or generally unusable) oil or gas to an unaffiliated buyer, in a true arm’s length sale, at a sales location that is not a true market – and the rule will demand precisely the same royalty valuation as in the affiliated-sale scenario. And, with the foregoing involvement of an unaffiliated buyer, the producer may have to pay royalties on prices higher than the producer realized for itself. See Imperial Colliery, 912 F.2d at 700 (requiring that a lessee pay royalties in accordance with the lease (on the higher “market value”) and not on the lessee’s actual sales proceeds from an unaffiliated buyer). A federal court applying Oklahoma law demonstrated the foregoing by holding as follows: “While a lessee may hire a third party to perform the processes necessary to make gas marketable such as gathering, dehydration, compression and processing either by paying a fee to such third party, by entering into a [percentage-of-proceeds] contract with such third party or by some other commercial transaction, the lessee may not deduct the costs incurred for such third party’s services from amounts paid the lessor(s) or royalty owner(s) but must compute the royalty interest(s) based upon the amounts paid by the interstate pipeline for the residue gas and NGLs unreduced by any amount or percentage of proceeds paid to the third party.” See Naylor Farms, Inc. v. Anadarko OGC Co., No. CIV-08-0668-R, 2011 U.S. Dist. LEXIS 151921, 2011 WL 7053787, at *3 (W.D. Okla. July 14, 2011) (emphasis added).
Finally, the marketable product rule applies when a producer has engaged in “net back pricing” (also called “work back pricing”). Just as the rule disallows a producer’s expressly taking deductions of post-production costs necessary to render a marketable product at a market, so it disallows a producer’s embedding into a royalty-payment price those very deductions, so that royalty owners receive payments on low per-unit prices – that is, on prices net of deductions. See W.W. McDonald Land, 983 F. Supp. at 804 (holding that West Virginia’s marketable-produce rule disallows “work-back pricing”: “[I]n order to determine a wellhead price at which [lessee] sells gas to [its affiliate], defendants essentially admit they continue to deduct post-production expenses. To determine the wellhead price, the defendants use a ‘work-back method’ which ‘involves subtracting postproduction costs that enhance the value of the gas from the interstate connection price.’ . . . The defendants cannot avoid [the marketable product rule] by simply reorganizing their businesses and making intra-company wellhead sales.”).
The marketable product rule achieves more protection for royalty owners, better shielding them from post-production deductions, than the Texas approach. The rule depends less on subjective concepts like “reasonableness,” “diligence,” and “best price” under the circumstances. Those subjective concepts underpin Texas’s “duty to market,” making it particularly susceptible to litigation vicissitudes. The rule, on the other hand, employs the more-objective concepts of the marketability of an oil and gas product, and the market-nature of a sales location. As long as courts recognize that the marketable product rule demands royalty calculations on those prices resulting from sales of commercially usable products at active, populated markets, then the rule will continue to shield royalties from deductions.