XAE CORP. v. SMR Property Management Co.
1998 OK 51, 69 O.B.A.J. 2137, 968 P.2d 1201 (1998)
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Rule of Law:
The implied covenant to market, which typically obligates an oil and gas lessee to bear post-production costs to make gas marketable, does not extend to an overriding royalty interest owner when the interest is granted by a separate conveyance as an in-kind interest deliverable at the wellhead, unless an express obligation to market is undertaken in the instrument creating the overriding royalty interest.
Facts:
- In 1967, J.C. Barnes Oil Company (predecessor to SMR) executed a conveyance granting an overriding royalty interest to Clayton E. Lee and R.L. Beasley, whose successors are the plaintiffs.
- The conveyance provided an "undivided ⅛ of ⅞ of all gas, gas condensate or other gaseous hydrocarbons… to be delivered to the Assignees herein, free and clear of all costs and expenses whatsoever, save and except gross production taxes or other governmental taxes properly chargeable thereto."
- The parties agreed that this clause created an "in-kind" overriding royalty interest, meaning it was a fraction of the gas produced, not a fraction of the gas sold.
- The assignment did not contain any express provision that placed a duty on the lessee or operator to market the gas product.
- The plaintiffs did not take their share of gas in-kind, but instead authorized SMR Property Management Company to market their share.
- SMR deducted charges for gathering, delivering, and treating the gas (specifically, removing large quantities of hydrogen sulfide and carbon monoxide in an amine treatment facility) from the amounts paid to the plaintiffs for their overriding royalty interests.
- The gas was sold at the outlet from the amine treatment facility, which was located "on or near" the subject leases.
Procedural Posture:
- Plaintiffs, successors to an overriding royalty interest, sued SMR Energy, Inc. (SMR) to recover deductions made for gathering, delivery, and treatment charges from their overriding royalty payments.
- Plaintiffs moved for summary judgment in the trial court, arguing they were entitled to their interest free of such costs because the production process includes making the gas marketable, and the gas was not marketable in its natural state.
- SMR also moved for summary judgment, contending that the plaintiffs' in-kind royalty meant delivery at the wellhead, making plaintiffs responsible for subsequent expenses, and that implied covenants of the oil and gas lease do not apply to overriding royalty owners.
- The trial judge determined as a matter of law that the gas was not in marketable form at the wellhead, that SMR had a duty to make the gas marketable, and granted summary judgment for the overriding royalty interest owners (plaintiffs).
- The Court of Civil Appeals affirmed the trial court's judgment.
- Defendants/appellants SMR sought certiorari from the Oklahoma Supreme Court to review the question of whether the implied covenant to market extends to an overriding royalty interest owner.
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Issue:
Does the implied covenant to market, usually applicable to an oil and gas lessee's duties to a lessor, extend to an overriding royalty interest owner, requiring the operator to bear the costs of gathering, processing, and compressing gas to make it marketable, when the interest is an in-kind interest deliverable at the wellhead and the creating instrument contains no express marketing obligation?
Opinions:
Majority - Hargrave, Justice
No, the implied covenant to market does not extend to an overriding royalty interest owner in this case because the instrument creating the interest did not undertake such an obligation, and the interest itself was an in-kind interest deliverable at the wellhead. The Court held that implied covenants in an oil and gas lease ordinarily cannot be enforced by an overriding royalty interest owner. Citing `Kile v. Amerada Petroleum Corp.`, the Court reiterated that unless expressly assumed, such covenants do not extend to lease assignments reserving an overriding royalty interest, as the relationship is typically one of grantor and grantee, not lessor and lessee. The Court explicitly disagreed with `Garman v. Conoco, Inc.` from Colorado, which had applied the implied covenant to market to overriding royalty owners, stating that Oklahoma's approach to implied covenants differs. The `Garman` rationale, applied to a lessor's royalty in `Mittelstaedt v. Santa Fe Minerals, Inc.`, was deemed inapplicable to overriding royalty interests. The Court emphasized that an overriding royalty interest is carved out of the working interest and is not a property interest of greater dignity than the lease itself. Furthermore, because the interest in this case was an "in-kind" interest, `Application of Martin` dictates that delivery is at the wellhead. The decision of the overriding royalty owners not to take the gas in kind does not impose different duties on the lessee. Therefore, any costs incurred after delivery at the wellhead, such as gathering, processing, and compressing, were properly deductible before the royalty was paid, as the duty to deliver gas in marketable form arises from the lessee’s implied duty under the oil and gas lease to market the product, a duty that does not automatically extend to an overriding royalty interest owner unless explicitly created by the assignment.
Concurring-in-part-and-dissenting-in-part - Summers, Vice Chief Justice
Justice Summers concurred with much of the majority's opinion but dissented from its method of determining when an implied covenant is present and its reliance on `Kile v. Amerada Petroleum Corp.` The Justice argued that while implied covenants arising from an oil and gas lease generally do not extend to overriding royalty interests, the issue here was whether implied covenants arise from the assignment of the override itself. He contended that contract jurisprudence, including implied-in-fact and implied-in-law covenants, should apply to instruments creating royalty interests. Justice Summers criticized `Kile's` rationale for denying an implied covenant solely due to the absence of an express covenant, calling it "untenable" because implied covenants exist in the absence of express ones. He pointed to `Rees v. Briscoe`, which recognized implied covenants in overriding royalty interests by examining the purpose of the transaction and the reasonable expectations and intent of the parties, especially when the override was the sole consideration. Therefore, he argued that the Court should examine the intent of the parties and the nature of the agreement. Since the summary judgment record lacked undisputed material facts on the parties' intent or custom and usage, Justice Summers concluded that summary judgment for either party was inappropriate and the case should be remanded to the District Court for trial.
Analysis:
This case significantly clarifies the scope of the implied covenant to market in Oklahoma, drawing a critical distinction between a lessor's royalty interest and an overriding royalty interest. By explicitly rejecting the application of the `Garman v. Conoco` rationale to overriding royalties, the Oklahoma Supreme Court reinforces its jurisprudential leanings, which limit the expansion of implied covenants beyond their traditional lessor-lessee context. This decision underscores the paramount importance of precise contractual drafting in assignments creating overriding royalty interests, particularly regarding the allocation of post-production costs. Future cases involving overriding royalty interests in Oklahoma will heavily rely on the express terms of their creating instruments, rather than relying on implied duties from the underlying lease, especially for in-kind interests.
