Abandoned cattle pens made from Amoco’s tubing string, Mallet Ranch Headquarters, north Terry County, Texas.
Olivia Holmes on Lazy S Ranch, Hockley County, Texas.
Spade Ranch, West Texas
1940s mural by Frank Mechau, Terry County, Texas.
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.”).
Conclusion.
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.]]>
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.
Conclusion
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.]]>
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.]]>
Holmes with his Lucchese on a "dead man" in the North Permian Basin
Net worth under GAAP.
Net worth under GAAP means a business’s total assets less total liabilities. This valuation measure works from GAAP’s “balance sheet” methodology for determining “equity.” GAAP uses the formula of “assets” less “liabilities” equal equity. In trial courts, parties may dispute the assets in this formula: one party, for instance, may claim that business’s partial, non-controlling ownership of other businesses should be excluded from assets, whereas another party may claim the opposite. Or, one party may claim that a civil money judgment subject to appeal is not a true liability and so should be excluded from liabilities, whereas the other party claims that such judgment is the most true and dangerous liability on the balance sheet.
Value “as a going concern.”
Going-concern valuations seek to value businesses or assets in light of their future earnings. These measures work from the assumption that the particular business or asset under consideration will not be liquidated or will not otherwise cease to exist, but rather will continue into the future and so will make future earnings.
Many such going-concern valuations exist, and many are potentially inaccurate because of complexity, manipulation, or speculation in the underlying methodology. Appellate courts tend to review going-concern valuations with special scrutiny. The most common and probably most accurate going-concern valuation is the discounted cash-slows measure. This measure, even when applied traditionally, is quite complex.
A valuation expert will project into the future (e.g., into the next 5-20 years) the likely cash flows, such as net profits, that a business or business asset may generate. Then, the expert will discount (lessen) the sum of those cash flows under a “time value of money” assumption – namely, the commonly accepted assumption that a dollar’s value today is worth more than the same dollar’s value 10 years from now – and even more than the same dollar’s value 20 years from now. To bring the future cash flows to “present value,” the expert will use a discount rate; frequently, this rate is the business’s “cost of capital” rate or the rate at which it must borrow money from its bank.
