It is time to start chipping away at the giant iceberg of issues surrounding post-production deducts and the litigation that follows. This will be one of the multiple posts that address the lessor/lessee relationship, the implied duty of the lessee to market the lessor’s share of production, and the responsibilities of each party to pay for their shares of post-production expenses. As you are well aware, I am merely a lease-schlepping landman and my opinion should not replace the counsel of a well-schooled (and likely well-paid) oil and gas attorney.
The most important issue that complicates this discussion is that Oklahoma law does not define marketability and in what state produced gas is marketable. Unless the oil and gas lease addresses the lessee’s duty to market or negates the implied duty to market, Oklahoma oil and gas lessees are subject to an implied covenant to market produced hydrocarbons. In Mittelstaedt v. Sante Fe Minerals, Inc., the Oklahoma Supreme Court stated that the lessee has a duty to provide a marketable product available to market at the wellhead or leased premises. But, they did not go so far as to define marketability.
The next question is then, under what circumstances can a lessor be charged costs against their royalties if the production is sold off-lease? The Court writes:
“We conclude that the lessor must bear a proportionate share of such costs (transportation, compression, dehydration, blending) if the lessee can show
(1) that the costs enhanced the value of an already marketable product
(2) that such costs are reasonable, and
(3) the actual royalty revenues increased in proportion with the costs assessed against the non-working interest.”
Recently, an Oklahoma court took one step towards defining marketability in its decision in Pummill v. Hancock Exploration, LLC when it wrote that:
“…gas does not become marketable until it is capable of being sold in the commercial interstate market.”
This would imply that if costs were incurred to gather, compress, dehydrate, and process the gas in order for it to be in a condition to be sold in the commercial interstate market, that none of those charges could be proportionally borne by the lessor unless the oil and gas lease stated that the lessor would be responsible for its share of costs. However, any costs incurred after the gas is marketable could be charged to the lessor if they complied with the Mittelstaedt decision and were not expressly forbidden in the oil and gas lease.
As you can see, once an ambiguously worded royalty clause and an attorney drafted post-production clause are thrown into the mix, the outcomes can become exponentially more complex.
Some important questions regarding deductions include:
- Does the oil and gas lease royalty clause expressly allow or prohibit the deduction of costs?
- Is there a provision in the exhibit that conflicts with the royalty clause in the lease?
- Does the implied covenant to market apply?
- At what point did the gas become marketable?
- If costs were incurred after the gas became marketable, do they comply with the conditions of the Mittelstaedt decision?
- Is an affiliate of the operator marketing the gas or is it an arm’s length transaction?
- Where is the gas actually being sold and who is buying the gas?
I am working on a flow chart / process to assist lessees and Oklahoma lessors in determining appropriate deduction actions. If this would be of interest to you / your company or if you would like a consultation regarding a royalty issue, please contact your correspondent or OklahomaMinerals.com. Thanks for reading.