Natural Gas Royalties - Lessor Vs. Lessee And The Implied Covenant To Market

Originally published by the Texas Bar Journal, October 2000 Issue

Oil and gas leases are negotiated contracts.¹ The relationship between the parties is, consequently, purely contractual.² Under such an arrangement, the lessee/producer acquires a fee simple determinable in the minerals giving it the right to explore for, produce and sell any oil or gas it discovers.³ The lessor/mineral interest owner, on the other hand, retains a possibility of reverter and, upon production, the right to be paid a royalty.⁴ As to the royalty amount, the parties to the lease are free to decide and define the type, basis or standard for the royalties to be paid.⁵

The basis for paying royalties depends upon the language of the lease and can vary significantly depending upon the parties’ negotiations.⁶ One common type of royalty clause requires that royalties be based on the amount realized from the sale of the gas or the right to receive a percentage of the "proceeds" from the sale of the production. Another common clause keys royalties to the market value of the gas at the well.

Just as royalty clauses can be different, the marketing of gas is very diverse. Today, natural gas is sold at one of many possible locations and to many different types of buyers. Gas sales occur immediately at the wellhead, at local gas processing plants, at major pipelines in the near vicinity of the field, at major market hubs like the Houston Ship Channel or Waha, Texas, or at one of many municipal city "gates" throughout the United States.⁷ Unlike 15 to 20 years ago when gas purchasers were limited to pipeline companies, producers today sell gas directly to a number of different buyers. These buyers include, for example, entities such as municipal utility companies, industrial consumers, and gas marketing companies. As a result, there are markets for natural gas as close as the wellhead itself or thousands of miles away.⁸

In light of the manner in which the industry has evolved, a continuing question in Texas is what is the royalty owner to be paid under his lease? As a result, there has been a proliferation of disputes, either in the negotiating room or the courtroom, over the implied covenant to market. Royalty owners claim that, regardless of the language of the lease, a covenant is implied requiring the lessee to diligently market and obtain the best price reasonably available. Producers counter that the language of the lease controls, not an implied covenant. This article will discuss the basis for implied covenants, when a marketing covenant has been implied and its effect, if any, on the amount of royalties a producer is obligated to pay its lessors.

The concept of implied covenants has existed in Texas oil and gas law since at least 1928.⁹ Texas law recognizes three categories of covenants that, under the appropriate circumstances, can be implied into oil and gas leases. These implied covenants are (1) to reasonably develop the premises, (2) to protect the leasehold, and (3) to manage and administer the lease.¹⁰ Included within the covenant to manage and administer the lease is (if necessary) an implied obligation to reasonably market the oil and gas produced from the premises.¹¹

Though the ability to imply a covenant exists, they are not lightly implied since it is not a court’s province to make contracts for the parties.¹² A covenant is not implied into an oil and gas lease as a matter of law – it is implied, if at all, in fact based on the language, or lack thereof, contained in the lease.¹³ Importantly, the implication of a covenant is justified only on the grounds of necessity.¹⁴ The express terms of an oil and gas lease will not be altered by an implied covenant in order to achieve what a court believes is a more balanced or fairer contract.¹⁵ As stated by the Texas Supreme Court in HECI Exploration Co.:

In other words, a covenant will be implied only if it is necessary to fulfill the intent of the parties as disclosed by the contract as a whole.¹⁷ As further explained in HECI Exploration Co.:

Gulf Production Co. v. Kishi¹⁹ is a perfect example of a court’s analysis to determine whether a covenant should be implied into a lease. In Gulf Production Co., the lessor signed two leases containing provisions stipulating to the number of wells the lessee would bring in after the discovery well was completed.²⁰ After the lessee completed the number of wells expressly agreed upon in the leases, it discontinued development.²¹ The lessor filed suit claiming that, though the lessee had drilled the number of wells expressly agreed upon, through the exercise of reasonable diligence more wells should have been drilled.²² The lessor asserted a cause of action under the implied covenant to reasonably develop and sought damages in the amount of royalties he would have been paid if more wells had been drilled.²³ Essentially, the lessor claimed that an implied covenant altered or amended the express terms of the leases.²⁴

In determining whether to imply the covenant to reasonably develop in spite of the express agreement of the parties, the Gulf Production Co. court stated:

After reviewing the leases, the Court held that the parties had expressly agreed upon the number of wells to be drilled and, thus, had agreed upon the diligence to be exercised by the lessee for development.²⁶ Accordingly:

As a result, the lessor could not assert a cause of action for breach of an implied covenant.²⁸ Since the lessee had complied with the express terms of the leases, it had no additional drilling obligations.

Based on the authority discussed above, inserting implied covenants in oil and gas leases can be summed up very easily. If the parties have a written express agreement concerning an obligation of a lessee that sets forth an objective standard for compliance, no implied covenant will increase or alter the express agreement. On the other hand, if the parties have not agreed upon an express term that adequately sets forth or describes an objective standard for compliance, a court will imply a covenant to the extent necessary to fulfill the intentions of the parties, as those intentions have been set forth in the lease agreement. As the San Antonio Court of Appeals simplistically stated:

The implied covenant to market requires the lessee to "market the production with due diligence and obtain the best price reasonably possible."³⁰ The lessee’s conduct is measured by what a reasonably prudent operator would do under the same or similar circumstances.³¹ The question that has log-jammed lessor/lessee disputes is when should the covenant be implied? In today’s gas market the answer to the question can, potentially, mean millions of dollars.

Many argue that the question has already been answered by the Texas Supreme Court in Cabot Corp. v. Brown³² and that, regardless of the language in the lease, the lessee must comply with the implied covenant to market. As discussed supra, this position is probably incorrect. As of this date, there are no published opinions that directly judicially resolve the issue concerning leases that require that gas royalties be paid based on the "market value at the well." At least two unpublished opinions, however, squarely discuss the implied covenant’s affect on a market value royalty clause and have ruled that the implied covenant does not alter a market value lease.³³ Even without the reliance on unpublished opinions, which is prohibited,³⁴ a review of the published implied covenant law discussed infra, provides the necessary guidance for determining the answer.

When the royalty clause directly ties the lessor’s compensation to the performance of the lessee in selling the gas, the covenant to market is, and should be, implied.³⁵ Typical language used in such a clause is the "net proceeds of the sale" or the "amount realized from the sale." Such an implication is logical because the interests of the lessee and lessor are directly aligned. The parties agreed that the lessee would pay the royalty based solely on the price it received. In determining the intent of the parties, as a Court is required to do when construing a lease,³⁶ it is sensible that the lessee should pay royalties based on the highest price reasonably possible since that is the same amount it should be seeking for itself. Under such a clause, the producer agreed that the royalty owner could rely upon it to market the gas and obtain the best price it could and that the royalty owner would share in the result of the price achieved. Since it is implicit in such a clause that the failure of the producer to obtain the best price reasonably obtainable is a breach of the lease, there is no need for the parties to have expressed it.³⁷ Accordingly, in reviewing a royalty clause if the amount of the royalty depends upon the price at which the product is marketed, there is an implied covenant to market.³⁸

The same cannot be said for terms that are not tied to the sales performance of the lessee but that expressly set a basis or standard for the lessee’s compliance with its royalty obligations. A "market value at the well" clause is such a term. A classic market value royalty clause states:

The Texas Supreme Court has opined on the meaning of "market value at the well" on at least four occasions.⁴⁰ The phrase "market value at the well" has a "commonly accepted meaning in the oil and gas industry."⁴¹ Market value at the well means market price in the field as determined through objective data like comparable sales of like production.⁴² A comparable sale is one that is comparable in time, quality, quantity, and availability.⁴³

This phrase is clear and unambiguous and expressly states an objective standard for acceptable performance. As the courts have continuously held, market value and amount realized are not the same.⁴⁴ They are not the same because under one clause whether there has been compliance is subjective (what a reasonably prudent operator would do), and under the other clause evidence of compliance is objective (what has gas actually been sold for in the field).

It follows that the contract for the sale of production by the lessee has no bearing on the obligation to pay royalties in a market value lease.⁴⁵ When Exxon argued that the sales contract did bear on the royalty obligation in a market value lease, the Texas Supreme Court responded:

In fact, under a typical market value lease, production does not have to be sold in order for the lessor to be entitled to a royalty. For example, if after production a lessee utilizes the gas as fuel for field compressors or to power a processing plant, the lessee must still pay a royalty based on the market value of the gas at the well on the date of production.⁴⁷

Since market value sets an express, determinable, verifiable, ⁴⁸ objective standard as to what royalties are due and payable, it follows that when the parties to a lease select a market value clause, they have expressly agreed that the diligence, or lack thereof, of the lessee in selling the production, is irrelevant and not subject to scrutiny. The partners have also agreed that they have not aligned or tied their interests together in relation to the sale of production. If the producer makes a marketing decision that results in selling the production for less than market value, the royalty owner is not burdened by the bad result.⁴⁹ The opposite should also be true. If the producer sells the production for more than market value, the royalty owner should not share in the surplus price.⁵⁰ Requiring the parties to accept less or pay more than market value would change the contract and render the express clause meaningless – a result the Supreme Court has prohibited.⁵¹ This conclusion is shared by many oil and gas commentators.⁵²

As stated supra, many argue that Cabot Corp. v. Brown⁵³ holds that the implied covenant applies to a market value lease. Cabot, however, does not conclude, nor stand for the proposition, that an implied covenant creates a duty requiring a "market value at the well" lessee to pay gas royalties based on anything other than the market price at the wellhead.

Martha Brown (the plaintiff/lessor) sued because Cabot (the defendant/lessee) had used technicalities relating to a division order and interstate versus intrastate sales to pay a royalty based on 38 or 80 cents per mcf. At the same time, Cabot was effectively selling the gas for $1.35 per mcf.⁵⁴ In reversing a verdict for Ms. Brown, the Court never reached the question of whether Cabot had breached any implied covenants. Rather, the holding in Cabot was that when a lessor signs a division order specifically setting forth the basis for payment, the order will control.⁵⁵ Despite this limited and clearly stated ruling, the Cabot opinion included dictum indicating that:

This statement, which lies at the heart of royalty owners’ arguments should not have precedential value, and has not served as the basis for any subsequent ruling from the Texas Supreme Court. Indeed, the only Texas Supreme Court opinion addressing the issue at all is the concurrence of Justice Owen, joined by Justice Hecht, in Heritage Resources, Inc. v. NationsBank,⁵⁷ wherein Justice Owen opined that the implied duty to market does not override the express market value clause.⁵⁸

Moreover, a detailed review of Cabot shows that when considered in the context of the facts in Cabot, the seemingly controversial statement is quite limited. Under the division order in Cabot, the lessee paid royalties on the gas produced from the subject leases based on prices established in the interstate gas market and as regulated by the Federal Power Commission ("FPC"). After exchanging the gas with a pipeline company, the lessee sold it in the significantly higher intrastate market.⁵⁹ As a result, the lessee was receiving a higher price for the production than it was paying to the royalty owners, and because the lessee could have petitioned to abandon FPC jurisdiction, it controlled the market into which the gas was sold. As a result, the lessee controlled which market value at the well – interstate vs. intrastate - would be used for royalty purposes. Due to deregulation, this was a factual scenario that is very unlikely to reoccur.

Thus the lessors in Cabot did not seek to recover more than the market value of the gas, nor did they seek to recover the actual proceeds of the sale.⁶⁰ They sought only to have their royalties based upon the relevant intrastate market value of the gas, an option arguably within the control and discretion of Cabot. To the extent the Texas Supreme Court addressed a lessee’s obligations outside of the division orders (which were the basis for the actual holding), it noted that market value royalties should be based on the relevant market, and it reiterated that "proceeds" clauses and "market value at the well" clauses are different and carry different obligations.⁶¹

Though much mud has been thrown into the water in order to cloud the view of the courts concerning the implied marketing covenant, a simple rule of thumb should resolve any royalty issue. That rule is if the royalty relies upon the performance results of the producer, there will be a covenant implied. If the royalty does not rely upon the performance results of the producer and expressly states the standard for royalty payment, the court should not imply a covenant.

The ever changing gas industry continuously causes conflict between lessors and lessees. The cry of one side or the other is about what is "fair." The lessees made that cry in Exxon Corp. v. Middleton⁶² and the lessors make the cry today because of the producer’s access to higher priced downstream gas markets. What the parties to a lease need to understand is that "fairness" has nothing to do with the agreement of the parties. An unwritten covenant can not, and should not be, be implied into a contract in order to make the agreement fairer.⁶³ The moral of the story concerning royalty rights in an oil and gas lease is to pay closer attention to drafting and to set forth the intentions of the parties in such a way as to resolve any doubt.

1 See Heritage Resources, Inc. v. NationsBank, 939 S.W.2d 118, 121 (Tex. 1996)(contractual construction rules used to interpret oil and gas lease); Hitzelberger v. Samedan Oil Corp., 948 S.W.2d 497, 503 (Tex. App. – Waco 1997, writ denied)("oil and gas lease is a contract and must be interpreted as a contract").

2See Amoco Production Co. v. Alexander, 622 S.W.2d 563, 571 (Tex. 1981)(breach of implied covenant is a breach of contract, not a tort permitting exemplary damages); Hurd Enterprises Ltd. v. Bruni, 828 S.W.2d 101, 109-10 (Tex. App.-San Antonio 1992, writ denied)(no duty of good faith and fair dealing); Atlantic Richfield Co. v. Long Trusts, 860 S.W.2d 439-44 (Tex. App.-Texarkana 1993, writ denied)(no fiduciary or agency relationship, merely a contractual obligation to pay a royalty).

3Jupiter Oil Co. v. Snow, 819 S.W.2d 466, 468 (Tex. 1991); Hurd Enterprises, Ltd., 828 S.W.2d at 109-110.

4 Jupiter Oil Co. 819 S.W.2d at 469 (mineral interest owner retains reverter interest); Hurd Enterprises, Ltd.., 828 S.W.2d at 109-110(lessor acquires title to gas in place subject only to the contract obligation to pay royalties).

5 Hurd Enterprises, Ltd.., 828 S.W.2d at 110.

6 For example, during a class certification hearing held in November of 1999, an expert witness testified that one major gas producer had at least 151 different and unique royalty clauses in its various leases each of which considered different factors for the payment of royalties to various lessors. Neinast, et al. v. Union Pacific Resources Company, et.al., Cause No. 32040 (pending 21^st Judicial District Court of Washington County, Texas).

7 The location of the actual sale depends upon a number of factors that a producer must take into consideration. Some of the more important factors are the quality of the gas, the availability of pipeline capacity, the ability to move the gas to market centers or to city gates, as well as economic factors such as supply and demand and weather conditions.

8 The change in the market structure is primarily due to the deregulation of the natural gas industry as a result the Natural Gas Policy Act of 1978. 15 U.S.C. § § 3301 et seq. This topic could be, and has been, the subject of many articles relating to FERC order 636.

9See Freeport Sulphur Co. v. American Sulphur Royalty Co. 117 Tex. 439, 6 S.W.2d 1039 (1928).

10 Amoco Production Co, 622 S.W.2d at 567.

11Amoco Production Co. v. First Baptist Church of Pyote, 579 S.W.2d 280, 284-87 (Tex. Civ. App.—El Paso 1979, writ ref’d n.r.e). See also Hutchings v. Chevron U.S.A., Inc., 802 S.W.2d 752, 760 (Tex. App.—El Paso 1993, writ denied).

12 HECI Exploration Co. v. Neel, 982 S.W.2d 881, 888 (Tex. 1998) (citing Gulf Prod. Co. v. Kishi, 129 Tex. 487, 103 S.W.2d 965, 968 [Tex. Comm. App. 1937, opinion adopted]).

13 Danciger Oil & Refining Co. v. Powell, 137 Tex. 484, 154 S.W.2d 632, 635 (1941).

14 HECI Exploration Co., 982 S.W.2d at 889; Danciger Oil & Refining Co., 154 S.W.2d at 635; W.T. Waggoner Estate v. Sigler Oil Co., 118 Tex. 509, 19 S.W.2d 27, 31 (1929).

15Id.

16 HECI Exploration Co., 982 S.W.2d at 888 (quoting Danciger Oil & Refining Co., 154 S.W.2d at 635).

17Danciger Oil & Refining Co., 154 S.W.2d at 635.

18 Id. at 889 (emphasis added).

19129 Tex. 487, 103 S.W.2d 965 (Tex. Comm. App. 1937, opinion adopted).

20 Id. at 966-967.

21 Id. at 968.

22 Id.

23Id.

24 Nine years prior to the opinion in Gulf Production Co., an implied covenant to reasonably develop was recognized in W.T. Waggoner Estate v. Sigler Oil Co., 118 Tex. 509, 19 S.W.2d 27 (1929) wherein it was held that when a lease failed to define the lessee’s development duties, the court would imply a covenant to develop the lease with reasonable diligence. Id. at 29.

25 103 S.W.2d at 969.

26 Id.

27 Id.

28 Id. at 971.

29 Magnolia Petroleum Co. v. Page, 141 S.W.2d 691, 693 (Tex. Civ. App. – San Antonio 1940, writ ref’d) (emphasis added).

30 Cabot Corp. v. Brown, 754 S.W.2d 104, 106 (Tex. 1987).

31 Id.

32 The royalty clause at issue in Cabot Corp. was a "market value at the well" provision. Id.

33 Yzaguirre v. KCS Resources, Inc., No. 05-97-02020-CV (Tex. App.-Dallas 2000); De los Santos v. Coastal Oil & Gas Corporation, No. 05-97-00029-CV (Tex. App.-Dallas 1999, pet. denied).

34 Tex. R. App. P. 47.

35 Davis v. CIG Exploration, Inc., 789 F.2d 328, 329 (5^th Cir. 1986); Hutchings v. Chevron U.S.A., Inc., 862 S.W.2d 752, 756 (Tex. App.-El Paso 1993, writ denied); Amoco Production Co. v. First Baptist Church of Pyote, 579 S.W.2d 280 (Tex. Civ. App.-El Paso 1979), writ ref’d n.r.e. per curiam, 611 S.W.2d 610 (Tex. 1980.

36 Heritage Resources, Inc., 939 S.W.2d at 121.

37 See Danciger Oil & Refining Co., 154 S.W.2d at 635.

38 El Paso Natural Gas Co. v. American Petrofina Co., 733 S.W.2d 541, 550 (Tex. App.-Houston [1^st Dist.] 1986, writ ref’d n.r.e), cert. dism’d, 485 U.S. 930 (1988).

39 See Middleton, 613 S.W.2d at 241.

40 Heritage Resources, Inc. v. NationsBank, 939 S.W.2d 118 (Tex. 1996); Judice v. Mewbourne Oil Co., 939 S.W.2d 133 (Tex. 1996); Exxon Corp. v. Middleton, 613 S.W.2d 240 (Tex. 1981); Texas Oil & Gas Corp. v. Vela, 429 S.W.2d 866 (Tex. 1968).

41 Heritage Resources, Inc., 939 S.W.2d at 122.

42 Heritage Resources, Inc., 939 S.W.2d at 122; Middleton, 613 S.W.2d at 246; Vela, 429 S.W.2d at 872.

43 Id.

44 Middleton, 613 S.W.2d at 245; Vela, 429 S.W.2d at 871.

45 Middleton, 613 S.W.2d at 245.

46 Id.

47 While this true, many leases exclude fuel from the royalty obligation.

48 Comparable sales are reported in a number of readily available publications such as Natural Gas Week, Natural Gas Intelligence and Inside-Ferc. These periodicals are newsletters and they independently survey buyers and sellers of natural gas at various major sales points and on major pipelines in Texas and in the United States. Each publishes a monthly average price at which natural gas was sold in arm’s-length transactions at each location. Additionally, most lessors receive royalty payments from more than one lessee. Each royalty check contains a stub that, pursuant to Tex. Nat. Res. Code § 91.502, must state the price per mcf at which the gas was sold. A simple comparison of check stubs provides a basic comparable sales analysis.

49 Vela, 429 S.W.2d at 870.

50 See De los Santos v. Coastal Oil & Gas Corporation, No. 05-97-00029-CV (Tex. App.-Dallas 1999, writ denied).

51 Heritage Resources, Inc., 939 S.W.2d at 121.

52 See generally, Scott Lansdown, The Implied Marketing Covenant in Oil and Gas Leases: The Producer’s Perspective, 31 St. Mary’s L.J. No. 2 297 (1999); Jacqueline Lang Weaver, When Express Clauses Bar Implied Covenants, Especially in Natural Gas Marketing Scenarios, 37 Natural Resources Journal 491, 530 (1998); Michael P. Irvin, The Implied Covenant to Market in the Deregulated Natural Gas Industry, Rocky Mountain Mineral Law Foundation 18-1, 18-21 (1996); Bruce M. Kramer and Chris Pearson, The Implied Marketing Covenant in Oil and Gas Leases: Some Needed Changes for the Eighties, 46 LA. L. Rev. 787, 815 n. 166 (1986).

53 Cabot Corp. v. Brown, 754 S.W.2d 104 (Tex. 1987).

54 Id. at 106.

55 Id. at 107.

56 Id. at 106.

57 Heritage Resources, Inc. v. NationsBank, 939 S.W.2d 118 (Tex. 1996).

58 Id. at 129.

59 Cabot, 754 S.W.2d at 105-106.

60 Id. at 106 ("Brown alleged . . . that Cabot had paid royalties based on a price less than market value").

61 Id. at 107.

62 611 S.W.2d at 245.

63 HECI Exploration Co., 982 S.W.2d at 889; Danciger Oil & Refining Co., 154 S.W.2d at 635; W.T. Waggoner Estate v. Sigler Oil Co., 118 Tex. 509, 19 S.W.2d 27, 31 (1929).