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Kansas Limits Oil & Gas Producers’ Implied Duties under the Marketable Condition Rule

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By Nathan K. Davis, Esq.

On July 2, 2015, the Kansas Supreme Court issued a unanimous decision in Fawcett v. Oil Producers, Inc. of Kansas, No. 108,666, 2015 WL 4033549, deciding a hotly and long contested debate between royalty owners and natural gas producers concerning the proper way to calculate royalty payments under the Marketable Condition Rule. This decision not only will have a significant effect on how natural gas royalty payments are calculated in Kansas, but it also may influence the outcome of pending cases in other Marketable Condition Rule jurisdictions.

By way of background, the class of plaintiffs in Fawcett included lessors that were seeking damages for the underpayment of natural gas royalties. The defendant lessee/producer, Oil Producers, Inc. of Kansas (“OPIK”), sold the gas to third-party purchasers at the wellhead pursuant to arm’s-length contracts. Those third-party purchasers then transported the gas downstream and processed it before delivering the gas into an interstate pipeline system. The price the third-party purchasers paid OPIK was based on a formula that started with the price the third-parties received for the processed gas less certain costs. OPIK calculated plaintiffs’ royalty payments based upon 100% of the proceeds it received from those third parties, and OPIK did not deduct any of the costs that it incurred in order to deliver the gas to the third-party purchasers. In other words, OPIK paid its royalty owners on the same basis as it was paid under its wellhead sales contracts.

The royalty owners argued that their royalty payments should not be calculated based on the proceeds OPIK received from the third-party purchasers for the sale of the gas at the wellhead. Rather, plaintiffs claimed the Marketable Condition Rule required their royalty payments to be calculated based on the value (and condition) of the gas when it was subsequently delivered into the interstate transmission pipeline system, i.e., that OPIK should gross up the proceeds it received from the wellhead sales to account for the post-sale costs the third-party purchasers incurred to transform the wellhead gas into interstate pipeline quality gas, including costs for gathering, compression, dehydration, treatment, processing, and fuel charges.

The trial court entered summary judgment in favor of the royalty owners, and the court of appeals affirmed. In reversing the lower courts, the Kansas Supreme Court clarified the duties owed by lessees/producers under Kansas’s Marketable Condition Rule, thus ending years of debate between royalty owners and producers in Kansas class action lawsuits.

Kansas always has imposed an implied duty on oil and gas lessees to use reasonable prudence when marketing oil and gas. Like several other states, Kansas adopted an extension of this implied duty to market, which is also known as the Marketable Condition Rule. When this rule is applicable, the lessee has the implied duty to produce a marketable product, the cost of which the lessee alone bears. After the lessee obtains a marketable product, any additional costs incurred by the lessee to enhance the value of the product can be deducted from royalty payments. Prior to Fawcett, the Kansas Supreme Court had not decided what it means for natural gas to be “marketable,” thus creating uncertainty about how to calculate natural gas royalty payments.

The Fawcett plaintiffs’ underpayment theory was premised on the argument that natural gas sold at the wellhead is not “marketable” as a matter of law or fact and does not become marketable until it is processed and enters an interstate pipeline. Thus, the royalty owners argued that their royalty payments should not be burdened by any of the post-production costs OPIK incurred both to transform the gas into a product that met interstate pipeline quality requirements and to transport the gas to the interstate pipeline. The Kansas Supreme Court squarely rejected the royalty owners’ attempt to equate “marketable condition” with interstate pipeline quality. In doing so, the Court held the duty to make gas marketable is satisfied when the lessee-producer delivers gas to a purchaser in a condition acceptable to the purchaser in a good-faith transaction. Because there was no question OPIK had done just that by selling the gas to third-party purchasers at the wellhead, the Court concluded OPIK had satisfied its implied duties under the Marketable Condition Rule. As a result, the costs OPIK incurred under its sales contracts with those third-parties were properly shared with the royalty owners.

While the full impact of Fawcett is yet to be realized, it should be dispositive in several pending class action lawsuits in Kansas and may influence the outcome of pending lawsuits in other states where natural gas producers and royalty owners continue to debate what it means for natural gas to be “marketable.”