Watts v. Atlantic Richfield Co.

F I L E D
United States Court of Appeals
Tenth Circuit
PUBLISH
JUN 10 1997
UNITED STATES COURT OF APPEALS
PATRICK FISHER
Clerk
TENTH CIRCUIT
MOSE C. WATTS, individually; MOSE C. WATTS,
Co-Trustee of the Mose C. Watts Ranch Trust; RONALD
W. MCGEE, as Co-Trustee of the Mose C. Watts Ranch
Trust; EDITH B. WARTICK; JOHN ALLEN WARTICK;
RITA L. PARK; JUDITH ANN HOLLINGBACK;
THOMAS OWEN WARTICK; EDITH B. WARTICK,
Co-Trustee of the Edith B. Wartick Trust; JOHN ALLEN
WARTICK, Co-Trustee of the Edith B. Wartick Trust;
RITA L. PARK, Co-Trustee of the Edith B. Wartick Trust;
THE WARTICK FAMILY LIMITED PARTNERSHIP, an
Oklahoma Limited Partnership; RAAN LADAWN JONES,
also known as Ladawn Jones; WINFREY TURNER,
individually; BILLY JEAN TURNER; TRUMAN
MATHIEWS, individually; DEVOLA MATHIEWS,
individually; TRUMAN MATHIEWS, Trustee of the No. 96-7041
Truman Mathiews Trust and of the Devola Mathiews
Trust; DEVOLA MATHIEWS, Trustee of the Truman
Mathiews Trust and of the Devola Mathiews Trust; H. L.
DOLLINS, III; ANGELINA DOLLINS; NANCEY
DOLLINS SUDDUTH; VIOLET DOLLINS; GEORGE
MILTON DOLLINS; DAVID DOLLINS; JACK
DOLLINS; BEVERLY ANN DOLLINS; CREEDA JUNE
DOLLINS; ROCKY DEAN DOLLINS; KAREN DANON
CHANEY; ROBSON ROYALTY CO.; JERRY L.
DOLLINS; RUTH EVERY; RUTH EVERY, as Trustee of
the Allen Every Revocable Trust; RUTH EVERY, as
Trustee of the Ruth Every Revocable Trust; W. P.
LERBLANCE; EARL JEFFREY; JAMES DAVID
LUCAS, also known as David Lucas; BETTY LEFLORE;
HELEN CALDWELL; FRANCES RICHMOND; JAMES
F. ELLIOTT; LINDA L. ANGELI; DEBBIE HOLUBY;
BILLIE JEAN LEFLORE; NEIL WAYNE DOLLINS,
Plaintiffs - Appellants,
v.
ATLANTIC RICHFIELD COMPANY; VASTAR
RESOURCES, INC.,
Defendants - Appellees.
APPEAL FROM THE UNITED STATES DISTRICT COURT
FOR THE EASTERN DISTRICT OF OKLAHOMA
(D. Ct. No. CV-95-339)
Terry Joe Barker, Pezold, Richey, Caruso & Barker, Tulsa, Oklahoma (Danny P.
Richey and Joseph C. Woltz, Pezold, Richey, Caruso & Barker, Tulsa, Oklahoma,
Douglas G. Dry, Wilburton, Oklahoma, and George Zellmer, Allford, Ashmore,
Ivester & Zellmer, McAlester, Oklahoma, with him on the briefs), appearing for
the Plaintiffs-Appellants.
Jay A. Brandt, Hutcheson & Grundy, Dallas, Texas (Cynthia L. Frankel and
Nishita S. Shah, Hutcheson & Grundy, Dallas, Texas, and Joe Stamper, Stamper
& Hadley, Antlers, Oklahoma, with him on the brief), appearing for the
Defendants-Appellees.
Before TACHA, McWILLIAMS, and BALDOCK, Circuit Judges.
TACHA, Circuit Judge.
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Several lessors of oil and gas mineral interests (“Lessors”) brought this
diversity action against their lessee, Atlantic Richfield Company and Vastar
Resources, Inc. (collectively “ARCO”). Lessors allege that ARCO: (1) failed to
pay royalties on proceeds received from the settlement of certain disputes with its
gas purchaser, Arkla Energy Resources (“Arkla”), (2) failed to obtain the highest
price available for Lessors’ gas, and (3) failed to protect several of Lessors’ units
against drainage. The district court granted summary judgment to ARCO on all
three claims. We exercise jurisdiction pursuant to 28 U.S.C. § 1291. For the
reasons set forth below, we reverse and remand for further proceedings.
BACKGROUND
Lessors own oil and gas mineral interests located in the Wilburton Field in
Latimer County, Oklahoma. There are forty-one separate oil and gas leases
between Lessors and ARCO setting forth the respective obligations of the
parties. 1
1
The leases provide in pertinent part:
Leases #1-22
The lessee shall pay lessor, as royalty, one-eighth of the proceeds from the
sale of the gas, as such from wells where gas is only found. . .
Leases #23-24
The lessee shall pay to lessor for gas produced from any oil well and used
by the lessee . . . as royalty 1/8 of the market value of such gas at the mouth
of the well; if said gas is sold by the lessee, then as royalty 1/8 of the
proceeds of the sale thereof at the mouth of the well.
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I. T HE R OYALTY D ISPUTE AND S ETTLEMENT A GREEMENT
Lease #25, as contained in the record on appeal, is illegible.
Leases #26-30
And where gas only is found one-eighth of the value of all raw gas at the
mouth of the well, while said gas is being used or sold off the premises . . .
Leases #31-36
To pay lessor for gas of whatsoever nature or kind produced and sold or
used off the premises . . . one eighth (1/8) at the market price at the well for
the gas sold . . .
Lease #37
If gas, as above defined, produced from any well is sold by Lessee, then
Lessee shall pay Lessor one quarter (1/4) of the proceeds thereof at the well
received by the Lessee from the sale . . . All such payments shall be
received and accepted by Lessor as full compensation for all such gas.
Lease #38
The Lessee shall deliver to the credit of the Lessor as royalty . . . the equal
of 1/4 part of all oil produced and saved from the leased premises . . . or at
Lessee’s option, Lessee may from time to time purchase such royalty oil by
paying to the Lessor for such 1/4 royalty the market price at the well . . .
Lease #39
The lessee shall pay lessor, as royalty on gas . . . the market value at the
mouth of the well of one-eighth of the gas so sold or used, provided that on
gas sold at the wells the royalty shall be one-eighth of the amount realized
from such sale. . .
Leases #40-41
To pay lessor one-eighth (1/8) of the gross proceeds each year, payable
quarterly, for the gas from each well where gas only is found. . .
App’t. App. at 100-193.
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Pursuant to a long-term gas purchase contract, ARCO has supplied Arkla, a
natural gas pipeline and gas purchaser, with natural gas produced from the
Wilburton Field at stipulated prices. In 1988, ARCO and Arkla became involved
in litigation over Arkla’s refusal to purchase gas from the Wilburton Field. Arkla
contended that it was not obligated to take gas from ARCO’s Wilburton wells
because the gas did not meet quality specifications and, therefore, ARCO had
improperly classified the wells as § 103 wells under the Natural Gas Policy Act
(“NGPA”). See 15 U.S.C. § 3313. Based on Arkla’s refusal to take gas and pay
the correct contract price, ARCO brought a claim for breach of contract against
Arkla. In its complaint, ARCO sought damages of $279 million, reflecting the
highest lawful price Arkla allegedly was obligated to pay for NGPA § 103 gas.
During settlement negotiations, ARCO and Arkla became involved in a
separate dispute involving Arkla’s gas purchases from a field located off the
shore of Louisiana in the Gulf of Mexico, known as the Mississippi Canyon. In
1987, the parties had attempted to resolve the dispute regarding the Mississippi
Canyon by entering into a Compromise and Settlement Agreement (“1987
Settlement Agreement”) under which Arkla made a recoupable $30 million
prepayment to ARCO for gas from the Mississippi Canyon. The parties, however,
continued to dispute their respective obligations under the 1987 Settlement
Agreement.
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On February 8, 1989, ARCO and Arkla entered into a settlement agreement
(“1989 Settlement Agreement”) resolving both the Wilburton litigation and the
Mississippi Canyon dispute. ARCO agreed to sell gas from the Wilburton Field
to Arkla at an initial price of $2.20 per MMbtu to be adjusted later according to a
formula. In return, ARCO received: (1) sixty monthly recoupable prepayments of
$5 million ($300 million total) for gas from the Wilburton Field, (2) a new gas
gathering system in the Wilburton Field, (3) Arkla’s agreement to enter into a gas
transportation contract, at specified discount rates, for gas from the Wilburton
Field, (4) a $35 million recoupable prepayment for gas from the Mississippi
Canyon, and (5) a January 1, 1995 deadline for ARCO to refund any unrecouped
portion of the $300 million prepayment for the Wilburton Field, the $35 million
prepayment for the Mississippi Canyon, and the $30 million prepayment under the
1987 Settlement Agreement.
Since the 1989 Settlement Agreement, ARCO has paid Lessors royalties on
gas produced and sold from the Wilburton Field. ARCO, however, has not paid
royalties on any of the other settlement proceeds. Lessors brought this suit
against ARCO seeking damages for ARCO’s failure to pay royalties on the
settlement proceeds. Lessors sought royalties under six separate legal theories:
(1) breach of the contractual duty to pay royalties, (2) breach of the implied
covenant to market, (3) breach of fiduciary duty, (4) constructive fraud, (5)
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breach of the duty of good faith, and (6) civil conspiracy. Lessors also sought
damages against ARCO for failing to obtain the best price available for Lessors’
gas under the 1989 Settlement Agreement. The district court granted summary
judgment to ARCO on both of Lessors’ claims.
1. T HE D RAINAGE I SSUE
In the mid-1980s, ARCO discovered the Arbuckle formation, a large source
of natural gas underlying other formations in the Wilburton Field. ARCO is the
operator of fourteen of sixteen wells producing gas from the Arbuckle formation
pursuant to private joint operating agreements with other working interest
owners. 2
On January 31, 1991, the Oklahoma Corporation Commission (“OCC”)
issued Field Rules, retroactive to May 1, 1990, recognizing the Arbuckle
Formation as a common source of supply, meaning that any one well could
ultimately drain all the gas in the formation. The Field Rules established certain
limits on the monthly production of each unit, called “allowables.” The OCC
determined that because seven of the Arbuckle wells were limited in their ability
2
Each well is composed of a separate 640-acre drilling and spacing unit. See
Okla. Stat., tit. 52, § 87.1 91993) (authorizing the Oklahoma Corporation Commission to
establish well spacing units to prevent waste and to protect the correlative rights of
interested parties in a common source of supply). Unless the OCC grants an exception,
only one well is permitted to be drilled in each drilling and spacing unit.
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to produce gas, the Field Rules were necessary to ensure that each well would
produce approximately its fair share of the gas.
The Field Rules contained several provisions concerning the treatment of a
well that is underproducing its allowable, known as an “underage.” The Field
Rules specified that underages accumulated by a well could be carried forward
and added onto that well’s monthly allowable, effectively increasing the limit on
future production. If a well’s underages exceeded a specified amount, however,
those underages would be canceled. The Field Rules contained an “Effective
Date” provision as follows:
These rules shall be effective May 1, 1990, and the Unit Operator of
each Unit shall have the period from the effective date of the rules to
December 31, 1991 to adjust any over and under production before it
is adjusted in accordance with [the cancellation provision].
App’t. App., Vol. I at 227 (emphasis added).
After the Field Rules were issued, three of ARCO’s wells (the Yourman
No. 2, the Costilow No. 3, and the Kilpatrick No. 2) began to accrue underages
each month and were approaching the point at which their underages would be
canceled pursuant to the Field Rules. In early 1991 ARCO performed “workover”
operations on the three underproducing wells to increase their deliverability. The
successful workovers resulted in increased production in all three wells and
permitted two of the wells to make up their underages and meet the allowables
established by the Field Rules.
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Several of the Lessors owning interests in adjacent units contend that the
workovers caused the three wells to drain gas from their units, resulting in
decreased production relative to the “draining” wells. Before the district court,
Lessors sought damages against ARCO for uncompensated drainage, asserting a
number of theories including: (1) breach of the implied covenant to protect
against drainage, (2) tortious drainage, (3) breach of fiduciary duty, (4) breach of
good faith, (5) conversion, and (6) unjust enrichment. In addition, Lessors
contended that by selectively performing the workovers on units in which ARCO
has a greater working interest, ARCO acted tortiously, wantonly and maliciously,
subjecting ARCO to liability for punitive damages. The district court granted
summary judgment to ARCO on the basis that the Field Rules bar all of Lessors’
claims.
DISCUSSION
We review the grant of a motion for summary judgment de novo, applying
the same standard used by the district court pursuant to Fed. R. Civ. P. 56(c).
Harvey E. Yates Co. v. Powell, 98 F.3d 1222, 1229 (10th Cir. 1996) [hereinafter
Yates]. Summary judgment is appropriate “if the pleadings, depositions, answers
to interrogatories, and admissions on file, together with the affidavits, if any,
show that there is no genuine issue as to any material fact and that the moving
party is entitled to a judgment as a matter of law.” Fed. R. Civ. P. 56(c).
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Appellants, as the nonmoving party, must go beyond the pleadings and “must set
forth specific facts showing that there is a genuine issue for trial as to those
dispositive matters for which [they] carr[y] the burden of proof.” Applied
Genetics Int’l v. First Affiliated Sec., Inc., 912 F.2d 1238, 1241 (10th Cir. 1990).
“We view the evidence and draw any inferences therefrom in the light most
favorable to the party opposing summary judgment.” Coosewoon v. Meridian Oil
Co., 25 F.3d 920, 929 (10th Cir. 1994). “If there is no genuine issue of material
fact in dispute, we must determine whether the substantive law was correctly
applied by the district court.” Yates, 98 F.3d at 1229.
I. ARCO’ S D UTY TO P AY R OYALTIES
The district court granted summary judgment to ARCO on Lessors’ claim
for royalties because the leases did not provide for royalties to be paid on the
proceeds of settlements and because none of the proceeds constituted payment for
the production and sale of gas. The court reasoned that because the ARCO/Arkla
litigation involved disputes over gas quality and Arkla’s obligation to take gas
from ARCO’s wells, the settlement consideration did not constitute payment for
the production and sale of gas. Thus, the district court concluded that the
settlement consideration was not royalty bearing. In so holding, the court
analogized such settlement consideration to non-royalty bearing take-or-pay
payments.
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On appeal, Lessors contend that the district court erred in concluding that
the settlement proceeds were not royalty bearing. Lessors argue that Arkla would
not have made the settlement payments to ARCO if Arkla were not to receive
something in return. What Arkla received in return could only have been gas
production:
The only good or service sold by ARCO to Arkla under the 1989
Settlement Agreement is natural gas. The disputes between ARCO
and Arkla over “interpretation of purchase contract” and “collateral
issues” were disputes over the terms (i.e., price and quality) under
which this gas production was to be sold. There is nothing in the
record to show that ARCO provided anything to Arkla under the
1989 Settlement Agreement other than gas production. Because
whatever settlement consideration ARCO received was necessarily
for the production of gas, it was subject to royalties.
App’t. Reply Br. at 11-12.
a. Royalties Are Due Only on Actual Production
We begin our analysis by looking to the royalty clauses in the leases
between ARCO and Lessors. Although containing slightly varying language, all
of the leases require royalties to be paid only on the proceeds from the sale of gas
produced from the wells—that is, gas physically extracted from the earth and
sold. Under the plain terms of these so-called “production-type” leases, the lessee
is not obligated to pay a royalty on the value of gas in the abstract, but only on the
cash value of gas that is actually produced and sold from the leased property. See
Yates, 98 F.3d at 1230 (discussing “production-type” leases); see also Roye
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Realty & Dev., Inc. v. Watson, No. 76848, 1996 WL 515794, at *9 & n.8 (Okla.
Sept. 10, 1996) [hereinafter Roye Realty] (stating that royalties are payable under
production-type lease language only when gas is “produced and sold” and
distinguishing cases in which royalties are payable on the “amount realized” from
the sale of gas).
Because the leases expressly require royalties to be paid on gas actually
produced, we hold that the district court erred in concluding that royalties are not
payable here because the leases do not expressly require the payment of royalties
on settlement proceeds. If the settlement proceeds constitute payment for gas
actually produced and sold, it is immaterial that the leases do not explicitly
provide for the payment of royalties on settlement proceeds. Rather, for the
proceeds to be non-royalty bearing, the leases would have to expressly exclude
settlement proceeds. See Yates, 98 F.3d at 1231 (“[A]ny portion of a settlement
payment that is . . . for gas actually produced and taken by the settling purchaser
is subject to the lessor’s royalty interest.”). Thus, the mere failure to expressly
include settlement proceeds in the royalty provision of a lease, by itself, does not
preclude the payment of royalties on such proceeds.
Similarly, we hold that the district court erred in concluding that the
proceeds in this case should be treated like nonrecoupable take-or-pay
settlements. Under a take-or-pay clause, a purchaser must take a specified
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volume of gas or, failing that, must pay a sum representing the difference between
the specified minimum and the volume of gas actually taken—that is, a payment
in lieu of production. See Diamond Shamrock Exploration Corp. v. Hodel, 853
F.2d 1159, 1164 (5th Cir. 1988) [hereinafter Diamond Shamrock] (discussing
take-or-pay clauses). Thus, “proceeds received by the lessee in settlement of the
take-or-pay provision of a gas supply contract (for either accrued take-or-pay
deficiencies or to abrogate future take-or-pay obligations) are not royalty bearing
because they are payments for non-production.” Yates, 98 F.3d 1236; see also
Roye Realty, 1996 WL 515794 at *9; Diamond Shamrock, 853 F.2d at 1167-68.
The non-royalty bearing nature of take-or-pay proceeds does not mean that
all settlement proceeds are non-royalty bearing. The relevant question in both
cases (take-or-pay payments and settlement proceeds) is “whether or not the funds
making up the payment actually pay for any gas severed from the ground.”
Independent Petroleum Ass’n of Am. v. Babbitt, 92 F.3d 1248, 1260 (D.C. Cir.
1996). In short, the nature of the settlement proceeds determines whether they are
royalty bearing. The central question in this case, therefore, is whether the
settlement consideration paid to ARCO constitutes payment, at least in part, for
gas actually produced and sold or whether it constitutes payment for something
other than the production and sale of gas. To that question we now turn.
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b. Are the Settlement Proceeds Attributable to Actual Production?
In determining whether the settlement proceeds constitute payment for gas
actually produced and sold, we begin with our recent decision in Harvey E. Yates
Co. v. Powell, 98 F.3d 1222. In Yates, we addressed whether proceeds from the
settlement of take-or-pay and pricing disputes were subject to the lessee’s duty to
pay royalties. The parties in Yates, as in this case, operated under a standard
production-type lease where the duty to pay royalties was contingent upon the
actual production and sale of gas. Id. at 1230. After deregulation of natural gas
pricing, the gas purchasers in Yates reduced their gas “takes” and unilaterally
lowered to market level the purchase price of gas actually taken, prompting a
lawsuit by the gas producer. Id. at 1227. The parties subsequently entered into a
settlement agreement in which the producer agreed to accept a nonrecoupable
“buy-down” payment in exchange for certain price and take reductions in the gas
supply contract. Id. The producer paid royalties on the proceeds from gas sold at
the lower market price but failed to pay royalties on the nonrecoupable buy-down
payment. Id. at 1227-28.
In Yates, we developed three “guiding principles” in deciding whether
royalties are payable on settlement proceeds:
First, royalty payments are not due under a “production”-type lease
unless and until gas is physically extracted from the leased premises.
Second, nonrecoupable proceeds received by a lessee in settlement of
the take-or-pay provision of a gas supply contract are specifically for
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non-production and thus are not royalty bearing. Third, any portion
of a settlement payment that is a buy-down of the contract price for
gas that is actually produced and taken by the settling purchaser is
subject to the lessor’s royalty interest at the time of such production,
but only in an amount reflecting a fair apportionment of the price
adjustment payment over the purchases affected by such price
adjustment.
Id. at 1231. In effect, we concluded that when a lessee accepts a settlement
payment in exchange for a reduced future price term, the lessors are entitled to a
royalty payment on two components, each of which constitutes consideration for
actual production: “(1) the proceeds obtained by the lessee from the sale of gas at
the bought-down price; and (2) a commensurate portion of the settlement
proceeds that is attributable to price reductions applicable to future production
under the renegotiated gas sales agreement as production occurs.” Id. at 1236.
In this case, the parties apparently do not dispute that ARCO has already
paid royalties on the sixty monthly prepayments of $5 million (or $300 million) as
gas was taken by Arkla during the five-year period from February 1, 1989 through
January 31, 1994. This amount represents the first component addressed in Yates,
the proceeds from the sale of gas at the bought-down price. Because royalties
have already been paid on this amount, the sole controversy is whether ARCO
must pay royalties on any of the other items of settlement consideration. Under
Yates, if Arkla gave any of the other items of consideration in exchange for
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ARCO’s settling past price deficiencies or agreeing to future sales at a lower
price, Lessors are entitled to a royalty on the value of those items.
On appeal, Lessors contend that Yates, handed down after the district
court’s decision in this case, is dispositive and requires reversal of the grant of
summary judgment in favor of ARCO. In particular, Lessors assert that the record
contains evidence that a portion of the settlement proceeds constitutes
consideration for a reduction in the price ARCO was willing to accept for gas
under the terms of its contract with Arkla. According to Lessors, prior to the
1989 Settlement Agreement, Arkla was obligated to purchase gas at the NGPA
§ 103 price, which ranged between $3.40 and $4.60 per MMBtu. Lessors point to
the complaint ARCO filed in its lawsuit against Arkla, in which ARCO alleged
damages of $279 million based on its claim that the parties’ contract required
Arkla to pay a price in excess of the $2.20 per MMBtu for which ARCO
ultimately settled. Lessors also point to Section 4.1 of the 1989 Settlement
Agreement, which explicitly refers to the new price as a “price reduction.”
Lessors contend that under Yates, royalties are payable on any portion of
settlement proceeds that constitutes consideration for a reduction in the price a
purchaser is obligated to pay for gas production.
ARCO contends that Yates is not controlling in this case because there is
no evidence that the 1989 Settlement Agreement resulted in a “buy down” of the
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actual price Arkla paid for gas. At argument, counsel for ARCO insisted that
Arkla has never paid the higher NGPA § 103 price and, in fact, paid a pre-
settlement price below the $2.20 price which ARCO ultimately accepted. ARCO
thus contends that the Settlement Agreement actually resulted in a price increase
for Lessors’ gas. As counsel for ARCO confirmed at argument, however, the
record before us does not show what price Arkla actually paid for gas prior to the
1989 Settlement Agreement. Even if ARCO were correct that an actual price
increase removes this case from the ambit of Yates, providing an alternate basis
for affirmance, such facts are not in the record, and thus, summary judgment in
favor of ARCO on this basis is premature.
We are not convinced, however, that an actual price increase would relieve
ARCO of its duty to pay royalties on proceeds received from the settlement of its
pricing claim. ARCO is correct that Yates involved a “buy-down,” or a reduction
in the actual price paid for gas. In Yates, the settling purchaser explicitly sought
and received a price reduction in exchange for a lump sum payment. See Yates,
98 F.3d at 1227. A “buy down,” however, is not the shibboleth that ARCO claims
it to be. Even absent a “buy down” (i.e., an actual price reduction), a lessee’s
refusal to pay royalties on the proceeds received from the settlement of a pricing
dispute would result in a windfall for the lessee. More importantly, such a refusal
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would constitute a breach of the lessee’s duty to pay royalties on proceeds from
the production and sale of gas. A brief example illustrates this point.
Suppose that a purchaser is obligated to take 1,000,000 units of gas at
$4.00 per unit payable in two equal installments of $2 million. Upon receiving
the first 500,000 units, the purchaser unilaterally reduces the price to $3.00 per
unit (claiming that the gas is of substandard quality) and remits payment of only
$1.5 million. In response, the producer files a lawsuit for $1 million, the amount
due on the past price deficiency and the anticipated future shortfall. Instead of
litigating the gas quality issue, the parties agree to settle their dispute. In
exchange for a one-time lump sum payment of $500,000, the producer agrees to
forgive the past price deficiency and to accept the lower price of only $3.00 per
unit for future production. In this situation, there has been no “buy down” (i.e.,
actual price reduction). The pre-settlement price and the post-settlement price are
both $3.00 per unit. Despite the absence of a price reduction, however, the lump
sum payment still constitutes proceeds from the sale of gas because it represents a
component of the true price paid for both past and future production under the
supply contract. No one would dispute, therefore, that the royalty owners are
entitled to their royalty share of the lump sum payment. The important factor
triggering the duty to pay royalties is not an actual price reduction, as ARCO
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contends, but rather an agreement by the producer to compromise its right to
pursue a higher price in exchange for a lump sum payment.
Although Yates involved an actual price reduction, the general rule
announced in Yates also applies in situations where the settlement of a pricing
dispute results in a post-settlement price that remains the same, as in the example
above, or where the price actually increases, as appears to be the case here. In
either situation, the lessee has agreed to compromise its pricing claim in exchange
for valuable consideration. From the point of view of the royalty owner, the
lessee has decreased the price at which it is willing to sell gas and thus has
unilaterally decreased the amount subject to the lessor’s royalty interest.
Therefore, whatever settlement consideration the lessee receives is a component
of the true price paid for the gas and is subject to the lessors’ royalty interest. In
sum, a lessor’s royalty interest is not limited to settlements involving an actual
“buy-down,” as in Yates, but extends to any settlement in which a producer
receives consideration for compromising its pricing claim, assuming of course
that the pricing claim relates to either past or future production actually taken by
the settling purchaser.
In this case, the 1989 Settlement Agreement included several items of non-
cash consideration in addition to Arkla’s agreement to make monthly prepayments
of $5 million for five years. ARCO does not dispute that royalties have not been
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paid on the value of these non-cash items. Thus, if such items constitute
consideration for the settlement of ARCO’s pricing claim, Lessors are entitled to
a royalty on their fair market value. Producers such as ARCO cannot escape the
duty to pay royalties merely by disguising the form of consideration received in
the settlement of pricing disputes. This is true irrespective of the collateral
benefits the items have conferred upon Lessors.
In Yates, we concluded that “there exists a genuine issue of material fact
whether the . . . settlement proceeds are attributable solely to take-or-pay
deficiencies (i.e., non-production), or whether they are attributable, at least in
part, to a price adjustment for the actual production of gas.” 98 F.3d at 1235.
Similarly, in this case, we conclude that there is a genuine issue of material fact
whether the settlement proceeds received by ARCO are attributable solely to the
resolution of collateral disputes (i.e., the Mississippi Canyon) or whether they
constitute payment, at least in part, for ARCO’s agreement to compromise its
pricing claim for gas actually produced and sold from the Wilburton Field.
Although the district court concluded that none of the settlement proceeds were
related to the production and sale of gas, the record does not allow us to rule out
such a finding. We therefore reverse the grant of summary judgment in favor of
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ARCO on the royalty issue and remand to the district court for further
proceedings on this question. 3
II. ARCO’ S D UTY TO O BTAIN THE H IGHEST P RICE A VAILABLE
Lessors argue that ARCO breached the implied covenant to market by
failing to obtain the highest price available for Lessors’ gas. The district court
granted summary judgment to ARCO on this claim because the court found that
Lessors could not show that the settlement price of $2.20 per MMbtu was not the
highest market price available to ARCO at the time of the 1989 Settlement
Agreement. The district court held that because ARCO obtained the best price
available, ARCO acted prudently and with due diligence in marketing the gas.
Lessors argue on appeal that the district court erred in granting summary
judgment to ARCO because the court reached its conclusion by resolving a
genuine dispute of material fact. Lessors contend that a genuine factual dispute
exists regarding whether ARCO’s decision to settle its pricing claim satisfies the
3
In addition to their claim for breach of the contractual duty to pay royalties,
Lessors contend that ARCO’s failure to pay royalties on the settlement proceeds
constitutes a breach of the implied covenant to market gas, breach of the duty of good
faith, breach of fiduciary duty, and unjust enrichment. In view of our holding that
Lessors may (depending on the facts) have a contractual right to royalties on at least some
portion of the settlement proceeds, we need not address Lessors’ alternative claims. We
see nothing in these claims that would “enlarge upon [Lessors’] contractual royalty
rights.” Yates, 98 F.3d at 1237 n.12; see also Cannon v. Cassidy, 542 P.2d 514, 516
(Okla. 1975) (failure to pay royalties does not constitute a separate breach of the implied
covenant to market).
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implied covenant to market. In particular, Lessors contend that a reasonable jury
could find that ARCO breached the implied covenant to market by entering into
the settlement agreement and accepting a price for gas lower than the price ARCO
should have received under its gas supply contract with Arkla.
Under Oklahoma law, a producer such as ARCO has the “duty to market the
gas produced from a well and to obtain the best price and terms available.” Barby
v. Cabot Corp., 550 F. Supp. 188, 190 (W.D. Okla. 1981) (citing Tara Petroleum
Corp. v. Hughey, 630 P.2d 1269, 1273 (Okla. 1981)). In marketing the gas and
obtaining the best price available, ARCO must exercise “that degree of diligence
exercised by a prudent operator having regard for the interests of both the lessor
and lessee.” Fisher v. Grace Petroleum Corp., 830 P.2d 1380, 1391 (Okla. Ct.
App. 1991). Lessors bear the burden of proving that ARCO violated this duty.
Barby, 550 F. Supp. at 190; Tara Petroleum Corp., 630 P.2d at 1274.
To prevail on their claim at trial, Lessors initially must show that a higher
price was available at the time of the settlement agreement. To survive a motion
for summary judgment, therefore, Lessors must “set forth specific facts showing
that there is a genuine issue for trial” regarding whether the $2.20 price was the
best available price for their gas. Applied Genetics Int’l v. First Affiliated Sec.,
Inc.,, 912 F.2d 1238, 1241 (10th Cir. 1990). Although not entirely clear from the
record, it appears that Arkla may have been obligated to pay the NGPA § 103
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price for Lessors’ gas. Indeed, this is what ARCO alleged in its lawsuit against
Arkla in Oklahoma state court. Under the 1989 Settlement Agreement, however,
ARCO agreed to a price below the § 103 price.
ARCO asserts that given the actual quality of the gas sold, ARCO could not
have charged the § 103 price under the contract. Thus, ARCO maintains that its
decision to settle with Arkla for the $2.20 price satisfied its duty to market the
gas in a prudent manner.
While ARCO’s ultimate decision to settle may have been a prudent business
decision, we cannot say as a matter of law that ARCO has satisfied the implied
covenant to market. Viewing the evidence and drawing all inferences in favor of
Lessors as the nonmoving party, we conclude that Lessors have shown facts
which support their contention that ARCO was entitled to receive the higher
NGPA § 103 price. In particular, Lessors have shown that ARCO’s existing
contract required Arkla to purchase gas from the Wilburton Field at the § 103
price. ARCO admits that whether Arkla was obligated to pay the higher § 103
price under the purchase contract was a “hotly contested” issue during the 1989
settlement negotiations. If ARCO was entitled to receive the higher NGPA § 103
price from Arkla (which appears to depend on the quality of the gas), then
ARCO’s decision to settle for the $2.20 price may have breached its duty to
market the gas and obtain the best price available. We therefore reverse the grant
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of summary judgment to ARCO on this claim and remand to the district court for
further proceedings.
III. T HE D RAINAGE C LAIM
Finally, Lessors argue that ARCO failed to protect their units against
drainage. The district court granted summary judgment to ARCO on this issue
because it found that a prior decision of the Oklahoma Corporation Commission
bars Lessors’ claim.
A. Implied Covenant to Protect Against Drainage
Under Oklahoma law, all oil and gas leases contain the implied covenant to
develop a lease as a prudent operator, which includes “a duty to protect against
drainage by the lessee’s other operations.” Leck v. Continental Oil Co., 800 P.2d
224, 228 (Okla. 1989) (quoting Samson Resources Co. v. Corporation Comm’n,
702 P.2d 19, 23 (Okla. 1985)). Normally, the duty to protect against drainage
requires the lessee to drill an offset well on the lessor’s land or pay damages to
the lessor to compensate for gas being drained by adjacent wells. See Leck, 800
P.2d at 227. Thus, an action for drainage is proper where a lessee operates wells
on the adjacent tracts in such manner as to “get a larger share” of the minerals
beneath the leased premises or “to favor one lessor at the expense of another.”
Id. (quotation omitted). Under Oklahoma law, the failure to protect against
drainage, under appropriate facts, “may be more than just a breach of the contract
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(lease), but could amount to a tortious act.” Id. (citing Morriss v. Barton, 190
P.2d 451, 457 (Okla. 1947)).
B. Effect of the OCC Field Rules
In this case, the district court did not separately address the merits of
Lessors’ various theories of liability in support of their drainage claim. Instead,
the district court held that Lessors’ drainage claim was barred by the
“governmental regulations” clause in their leases with ARCO. This clause states:
This lease shall not be terminated, in whole or in part, nor shall
lessee be held liable in damages, for failure to comply with the
express or implied covenants hereof, if compliance therewith is
prevented by, or if such failure is the result of any Federal or State
laws, executive orders, rules or regulations.
App’t. App. at 99. The district court concluded that any failure by ARCO to
protect Lessors from drainage was caused by ARCO’s compliance with the OCC
Field Rules. The court noted that under the Field Rules, ARCO had until the end
of 1991 “to adjust any over and under production.” Because ARCO performed
the workovers “in conformity with” the Field Rules, the court held that the
governmental regulations clause excused ARCO from any potential liability for
failure to comply with the covenant to protect against drainage. In so holding, the
court relied on Fransen v. Conoco, Inc., 64 F.3d 1481 (10th Cir. 1995).
We disagree that the governmental regulations clause bars Lessors’ claim
against ARCO for breach of the implied covenant to protect against drainage.
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While we recognize that “the express provisions of an oil or gas lease may negate
or modify the lessee’s implied covenants,” Fransen, 64 F.3d at 1488, we conclude
that the provisions of the Field Rules did not prevent or render impossible
ARCO’s compliance with its duty to protect against drainage. Although the Field
Rules may have allowed ARCO to perform the workovers, nothing in the Field
Rules excused ARCO from liability for drainage caused by the workovers. Put
differently, the Field Rules neither commanded ARCO’s selective performance of
workovers nor precluded ARCO from taking action with respect to Lessors’ wells
to prevent the alleged drainage from occurring. As such, the Field Rules did not
prevent ARCO’s compliance with its implied duty to protect Lessors’ units
against drainage.
We do not read Fransen as broadly as the district court. In Fransen, several
lessors alleged that their lessee breached the covenant to protect against drainage
by failing to drill an offset well on their property. Fransen, 64 F.3d at 1484-85.
The lessee defended on the basis that the OCC had specifically denied permission
to drill a second well on the lessors’ land, excusing the lessee from any liability
resulting from its failure to drill an additional well. Id. at 1488. We held that the
lessors’ drainage claim was barred because the OCC decision “prevented
compliance with any duty the defendants might otherwise have had to drill an
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offset well” and because “a prudent operator would not drill a well that was
prohibited by law.” Id.ARCO contends that Fransen bars Lessors’ drainage claim in this case
because ARCO’s workover operations, as the district court put it, “equate[d] with
compliance with . . . the Field Rules.” Watts v. Atlantic Richfield Co., No. 95-
339-S, slip op. at 13 (E.D. Okla. Jan. 11, 1996). Mere compliance with a
governmental regulation, however, is insufficient to satisfy the standard contained
in a governmental regulations clause. Fransen makes clear that to satisfy this
standard, the governmental regulation at issue must preclude a lessee from
performing the sought-after relief. In Fransen, an OCC decision specifically
prevented the drilling of an offset well. Unlike the situation in Fransen, nothing
in the Field Rules prevented ARCO from taking steps to protect Lessors’ units
from drainage. More importantly, nothing in the Field Rules sanctioned the
selective performance of workovers on some wells thereby causing drainage from
other wells operated by the same lessee. Because Fransen is not so broad as to
bar Lessors’ claim for drainage, we reverse the grant of summary judgment in
favor of ARCO and remand for further proceedings.
CONCLUSION
Having reviewed the record and found that a genuine issue of material fact
exists regarding Lessors’ claim for royalties, we REVERSE the grant of summary
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judgment to ARCO and REMAND this claim to the district court to determine
which portions of the settlement, if any, are attributable to the resolution of
collateral disputes (and thus are not royalty bearing), and which portions are
attributable to ARCO’s settlement of past and future pricing deficiencies (and
thus are royalty bearing to the extent that the payment is linked to actual
production). We also REVERSE the grant of summary judgment to ARCO on
Lessors’ claims for failure to obtain the highest available price and REMAND for
further proceedings to determine whether ARCO violated the implied covenant to
market. Finally, we REVERSE the grant of summary judgment to ARCO on
Lessors’ claim for failure to protect against drainage and REMAND this claim for
further proceedings consistent with this opinion.
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