“Fossil fuels are the decomposed remains of prehistoric flora (coal) and fauna (oil and gas). They have driven the world’s economy (particularly that of the United States) for over a century. Discovering marketable deposits, extracting them from the ground, refining them, and delivering them to consumers in useful form is big business, on one hand fraught with risk and on the other richly rewarding . . . Since oil and gas are the most energy dense and convenient of the fossil fuels, litigation and regulation abound with respect to them. “
– Circuit Judge Terrence L. O’Brien, writing for the Tenth Circuit in Anderson Living Tr. v. Energen Res. Corp., No. 16-2124, 2018 WL 328884 (10th Cir. Jan. 9, 2018).
Poetic introduction aside, this case delves into two important issues in royalty litigation. Attorneys and landmen in the San Juan Basin, Permian, etc. should take note. As should royalty practitioners elsewhere, because one of the issues (royalty implications of fuel gas) is regularly the subject of royalty audits and lawsuits.
Marketable Condition Rule
First, the case addresses whether and to what extent New Mexico adopts the so-called “marketable condition rule.” Jurisdictions that follow this rule interpret the implied covenant to market in oil and gas leases such that lessees generally bear more of the cost of post-production expenses in the calculation of royalty payments. The gist of the rule is that lessees must first make the hydrocarbons “marketable” at their own expense. After that, post-production expenses can be charged to royalty owners if they are cost-justified. If and when a product is “marketable” is usually the subject of controversy.
In this case, the plaintiffs (a group of New Mexico royalty trusts) sued Energen for breach of this implied covenant, relying on the marketable condition rule. They had leases specifying that royalty is paid based on the “market value at the well” or the “prevailing field market price.” The federal district court granted Energen’s motion to dismiss this claim prior to discovery for failure to state a claim. On appeal from this order, the Tenth Circuit recognized that New Mexico has not yet decided whether to follow the marketable condition rule, but recognized that the Tenth Circuit, predicting New Mexico law, had already decided that New Mexico would not adopt the rule. Notably, the Tenth Circuit declined to certify a question to the New Mexico Supreme Court on this issue.
Lessees (or their midstream providers) often use produced natural gas as fuel to power equipment needed to process the gas and/or move the gas through gathering systems and transmission lines. Here, the royalty trusts (including an additional one from Colorado) alleged that Energen must pay them royalty on the volumes of gas used as fuel. The Tenth Circuit largely rejected this claim, but it’s important that practitioners are aware of this decision, especially its reasoning:
- The “free use” clause in the New Mexico leases permitted the lessee to use gas in “furtherance of the lease operations.” This is a broad view of free use clauses in that is driven by purpose of the relevant activity, not location (on/off lease). Not so for the Colorado leases, because Colorado has not favorably cited a case adopting this broad view, like New Mexico has.
- When the royalty clause calls for payment on “marketed” volumes of gas, fuel gas is excluded from the calculation because it is never marketed (i.e. sold). By contrast, when the royalty clause calls for payment on “produced” volumes, royalty is owed on fuel gas, because fuel gas was “produced” even though it was later burned before being sold. This is intuitive based on the plain language, but this is one of the first published cases to directly address this distinction.
- In a twist, the Court then held that because some of the relevant royalty provisions call for valuation at the “prevailing field market price . . . at the time when produced,” the lessee “may deduct the value of the fuel gas consumed as a post-production cost (along with other post-production costs), but it must also pay royalty on the wellhead value of the fuel gas consumed.” This is confusing because, unless I’m mistaken, the result is that these will cancel out because the value of the gas when used is unlikely to differ much (if at all) from the value at the wellhead.