Fawcett v. Oil Producers, Inc. of Kansas
352 P.3d 1032, 302 Kan. 350, 2015 Kan. LEXIS 376 (2015)
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Rule of Law:
When an oil and gas lease provides for royalties based on a share of proceeds from the sale of gas at the well, the operator's implied duty to market the minerals produced and to bear the expense of making the 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 at the wellhead; post-sale, post-production expenses necessary to transform raw natural gas into interstate pipeline quality are therefore shared costs, not solely the operator's responsibility.
Facts:
- L. Ruth Fawcett Trust and other mineral rights owners (Fawcett) held 25 oil and gas leases entered into between 1944 and 1991.
- Oil Producers, Inc. of Kansas (OPIK) was the lessee-operator of the wells under these leases.
- The leases generally required OPIK to pay Fawcett a fractional share of 'proceeds from the sale of gas as such at the mouth of the well where gas only is found' or 'if sold at the well'.
- OPIK sold raw natural gas at the wellhead to third-party purchasers (midstream gatherers and processors).
- Raw natural gas coming from the ground is not suitable for transportation in interstate pipelines and requires processing to meet quality specifications.
- The third-party purchasers took title to the gas at the wellhead, transported it to processing plants, processed it to separate natural gas and natural gas liquids, and then resold the processed products.
- The price OPIK received from these third-party purchasers for the raw gas was based on a formula starting with the purchasers' resale price or a published index price, from which certain deductions were made for costs like gathering, compression, dehydration, treatment, processing, and fuel charges incurred by the purchasers.
- Fawcett's royalty payments were calculated based on OPIK's proceeds after these deductions.
- OPIK did not charge royalty owners for any services it performed on the leased premises to meet contractual quality requirements at the wellhead for delivery to third-party purchasers.
Procedural Posture:
- L. Ruth Fawcett (plaintiff class) sued Oil Producers, Inc. of Kansas (OPIK) in Seward District Court (trial court) alleging underpayment of royalties.
- The district court granted Fawcett partial summary judgment, finding that OPIK owed a duty to make gas marketable free of cost and therefore could not deduct expenses such as gathering charges, compression charges, dehydration, treatment, processing, fuel charges, fuel lost or unaccounted for, and/or third-party expenses incurred to make the gas marketable.
- The district court also granted Fawcett summary judgment for royalty reductions attributable to conservation fees, based on the Kansas Supreme Court's decision in Hockett v. The Trees Oil Co. (2011).
- The district court found its partial summary judgment order involved a controlling question of law with substantial ground for difference of opinion and certified it for interlocutory appeal.
- OPIK filed a timely application for interlocutory review, which the Court of Appeals granted.
- The Court of Appeals (appellant OPIK, appellee Fawcett) affirmed the district court's order granting Fawcett partial summary judgment, holding that royalty must be paid on the pre-deduction contract prices (termed OPIK's 'gross proceeds') and that OPIK's obligation prohibited deductions from royalties except as expressly authorized in the lease.
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Issue:
Does an oil and gas lease operator's implied duty to make gas 'marketable' require the operator to bear all post-production, post-sale expenses necessary to transform raw natural gas sold at the wellhead into the quality required for interstate pipeline transmission before calculating royalties?
Opinions:
Majority - Biles, J.
No, an oil and gas lease operator's implied duty to make gas 'marketable' does not, as a matter of law, extend to post-sale expenses for transforming raw natural gas sold at the wellhead into interstate pipeline quality for royalty calculation purposes. The court noted that Kansas caselaw (e.g., Waechter v. Amoco Production Co.) establishes that 'proceeds if sold at the well' clauses are clear and unambiguous, entitling lessors to a proportionate share of the amount actually received by the lessee for gas sold at the wellhead in a good faith sale. The 'marketable condition rule,' a corollary of the implied duty to market, requires operators to prepare unmerchantable raw gas for market free of cost. This duty is satisfied when the operator delivers the gas to the purchaser in a condition acceptable to the purchaser in a good faith transaction at the point of sale. The court distinguished prior Kansas cases like Gilmore and Schupbach, where compression costs incurred on the leased premises to make gas acceptable for delivery to a purchaser were the operator's sole responsibility, from the Sternberger case, which allowed sharing of transportation costs when royalties were based on market value at the well. The court concluded that when gas is sold at the well, it has been marketed, and the operator cannot deduct pre-sale expenses required to make the gas acceptable to the third-party purchaser. However, post-sale, post-production expenses to further fractionate raw natural gas or transform it into interstate pipeline quality are different and are to be shared. The court explicitly declined to follow the Colorado Supreme Court's ruling in Rogers v. Westerman Farm Co., which had interpreted 'at the well' language differently and extended the 'marketable condition' duty to post-production processing for interstate pipeline quality, finding it at odds with Kansas caselaw giving effect to 'at the well' language. The court emphasized that royalty owners' interests are protected by the implied covenant of good faith and fair dealing and the implied duty to market, which requires operators to market gas on reasonable terms. Since Fawcett did not challenge OPIK's good faith or prudence in entering the purchase agreements, the court found the post-sale processing expenses deducted by third-party purchasers were appropriately shared.
Analysis:
This decision significantly clarifies the scope of the 'marketable condition rule' and the allocation of post-production costs for 'proceeds if sold at the well' oil and gas leases in Kansas. By drawing a clear line at the point of a good faith sale at the wellhead, the Kansas Supreme Court provides greater certainty for operators and royalty owners regarding financial responsibilities. This ruling distinguishes Kansas law from jurisdictions with broader interpretations of the marketable condition rule, reinforcing the importance of specific contractual 'at the well' language. It means that while operators bear the cost to make gas acceptable to a purchaser at the well, subsequent processing for higher quality (like interstate pipeline transmission) can result in shared costs, potentially impacting the net royalties received by lessors and influencing future lease negotiations and industry practices in the state.
