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Fawcett v. Oil Producers, Inc.

Supreme Court of Kansas

July 2, 2015

L. RUTH FAWCETT, Appellee,
v.
OIL PRODUCERS, INC. OF KANSAS, Appellant

Page 1033

Review of the judgment of the Court of Appeals in 49 Kan.App.2d 194, 306 P.3d 318 (2013) .

Appeal from Seward District Court; KIM R. SCHROEDER, judge.

SYLLABUS

BY THE COURT

The lessee-operator of the oil and gas leases at issue in this case has an implied duty to market the minerals produced. To satisfy this duty, the operator must market its production at reasonable terms within a reasonable time following production. It must also prepare the raw production, if unmerchantable in its natural form, free of cost to the royalty owners. The production is merchantable once the operator has put it into a condition acceptable to a purchaser in a good faith transaction. Royalty owners in this case were not entitled to judgment as a matter of law on their theory that post-production, post-sale expenses necessary to transform raw natural gas into the quality required for interstate pipeline transmission were attributable solely to the operator as part of the operator's responsibility to make the gas marketable.

Robert W. Coykendall, of Morris, Laing, Evans, Brock & Kennedy, Chtd., of Wichita, argued the cause, and Will B. Wohlford and Julia Gilmore Gaughan of the same firm, of Topeka, were with him on the briefs for appellant.

Rex A. Sharp, of Gunderson Sharp LLP., of Prairie Village, argued the cause, and Barbara C. Frankland and David E. Sharp, of the same firm, of Houston, Texas, were with him on the briefs for appellee.

David W. Nickel, of DePew Gillen Rathbun & McInteer, LC, of Wichita, was on the brief for amicus curiae Kansas Independent Oil and Gas Association.

David E. Pierce, of Topeka, was on the brief for amicus curiae Eastern Kansas Oil & Gas Association.

Curtis M. Irby, of Glaves, Irby and Rhoads, of Wichita, was on the brief for amicus curiae DCP Midstream, LP.

OPINION

Page 1034

BILES, J.:

This is a class action for underpayment of royalties claimed under 25 oil and gas leases entered into between 1944 and 1991. The controversy arises because the lessee-operator sells its raw natural gas at the wellhead to third parties, who in turn process the gas before it enters the interstate pipeline system. The price the operator is paid--and upon which royalties have been calculated--is based on a formula that starts with the price those third parties receive for the processed gas (or a published index price) then deducts certain costs incurred or adjustments made. The class argues those subtracted costs and adjustments are the operator's sole responsibility because the gas is not in a marketable condition when it leaves the wellhead, so the royalties the class receives are less than they should be. It is represented to us that most natural gas produced in Kansas is sold under formula-based purchase agreements similar to those in this case.

The issue has been stated in various ways, but in its simplest form the court must decide whether the operator may take into account the deductions and adjustments identified in the third-party purchase agreements when calculating royalties. The district court granted summary judgment to the class for an as-yet undetermined amount of unpaid royalties. The Court of Appeals affirmed. Fawcett v. Oil Producers, Inc. of Kansas, 49 Kan.App.2d 194');">49 Kan.App.2d 194, 195, 306 P.3d 318 (2013). We reverse on the issue subject to our review and remand for further proceedings.

The operator sold the gas at the well to various purchasers. Fawcett, 49 Kan.App.2d at 199 (" [T]he geography of the sale of gas was at the well and the geography for the computation of the royalty was also at the well." ). Under Kansas law, the leases imposed on the operator an implied duty to market the minerals produced. See Robbins v. Chevron U.S.A., Inc., 246 Kan. 125, 131, 785 P.2d 1010 (1990) (implied duty to market); Gilmore v. Superior Oil Co., 192 Kan. 388, 392, 388 P.2d 602 (1964); see also Smith v. Amoco Production Co., 272 Kan. 58, 81, 31 P.3d 255 (2001). To satisfy this duty, the operator had to market its production at reasonable terms within a reasonable time following production. See Smith, 272 Kan. at 81.

Whether the operator fulfilled this implied duty by entering into these purchase agreements depends on the circumstances as to the terms and time of sale, which are not in dispute in this case. Instead, the class invokes the " marketable condition rule," which is a corollary of the duty to market. Broadly speaking, the rule requires operators

Page 1035

to make gas marketable at their own expense. See Sternberger v. Marathon Oil Co., 257 Kan. 315, 330, 894 P.2d 788 (1995) (" The lessee has the duty to produce a marketable product, and the lessee alone bears the expense in making the product marketable." ).

The class contends raw natural gas coming from the well is not marketable until it enters an interstate pipeline, so its royalties cannot be reduced by the deductions in these purchase agreements relating to transforming the gas into a condition suitable for that transmission system. We disagree. We hold these leases do not impose on the operator as a matter of law the responsibility to perform the post-production, post-sale gathering, compressing, dehydrating, treating, or processing that may be necessary to convert the gas sold at the wellhead into gas capable of transmission into interstate pipelines.

The class was not entitled to summary judgment, except as to conservation fees, which the operator concedes were wrongly deducted prior to the royalty calculation based on our recent decision in Hockett v. The Trees Oil Co., 292 Kan. 213, 251 P.3d 65 (2011) (conservation fee is expense attributable solely to well operator). That issue was resolved by the district court and is not in controversy on appeal.

Factual and Procedural Background

Production of natural gas is a complicated process. Title to the gas can change hands numerous times as it travels from the ground to an eventual end user. In this case, the chain starts with the plaintiff class, which consists of mineral rights owners, who lease their rights in exchange for a royalty interest in the oil and gas produced. The L. Ruth Fawcett Trust represents the class based on its royalty interests located in Seward County. We refer to the plaintiff class as " Fawcett." Oil Producers, Inc. of Kansas (OPIK) is the lease operator, which means it owns the wells from which the oil and gas are produced. See Williams & Meyers, Manual of Oil and Gas Terms, pp. 709, 815 (15th ed. 2012) (defining operator and producer).

Natural gas coming from the ground in its raw condition is not suitable for transportation in interstate pipelines. For our purposes, it is sufficient to note that natural gas must meet certain quality specifications before it can enter an interstate gas pipeline and it must be processed to achieve those specifications. Some of this may occur at the wellhead, such as when an operator performs separating or dehydrating, as needed. But most processing required to transform raw natural gas into pipeline-quality gas occurs away from the wellhead, such as at processing plants, where other valuable components of the raw gas can be isolated and sold separately. See www.naturalgas.org for a summary of the industry process; see also Wallace B. Roderick Revocable Living Trust v. XTO Energy, Inc., 281 F.R.D. 477, 479-80 (D. Kan. 2012), vacated by 725 F.3d 1213 (10th Cir. 2013).

OPIK does not charge royalty owners for any services it performs on the leased premises. But OPIK does not own gathering or processing facilities. Instead, it sells the gas at the wellhead to midstream gatherers and processers (the third-party purchasers), who prepare the raw natural gas for eventual delivery into the interstate pipeline system. Those third-party purchasers take title to the gas at the wellhead; transport it to processing plants; process it, separating the natural gas and the natural gas liquids contained in the raw gas; and eventually sell the natural gas and natural gas liquids to someone else. The price OPIK gets for the raw gas is dependent in the first instance on what the third-party purchasers are paid for the processed gas or a contractually set index price.

The operator and amici argue these gas sales contracts are structured to allow OPIK and its royalty owners to jointly share in higher " downstream" market values as the gas gets closer to the consumer--after the specified expense deductions to account for services provided by the third-party purchasers to process the gas and transport it from the wellhead to the downstream resale location. But from Fawcett's perspective, its royalty payments are being reduced for expenses Fawcett claims are OPIK's sole ...


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