The benefit to a mineral owner in exercising an oil, gas, and mineral lease (“OGL”) is the right to receive a royalty. A royalty is a percentage of the value of the minerals produced, which is affected by both the quantity of minerals produced and the price at which those minerals are sold. So, how does the lessee ensure that the lessor obtains a fair market price?
To protect leasing mineral owners from receiving royalty payments based on below-market sales, particularly when the production company sells to an affiliated company, courts have routinely held that an OGL contains the implied duty – meaning it exists despite not being expressly contained within the OGL – to diligently market the minerals produced. A production company’s failure to use good faith and diligence in the marketing of minerals produced can subject the production company to liability for the lower sales and, therefore, royalties.
The most common exception to this general rule of liability is when no market exists for the minerals produced. This can mean that there is either no use for or buyers for the minerals produced, or more often than it is not economically feasible to market the minerals because the costs of preparation and transportation exceed the revenues generated by the sale. For example, many oil and gas wells in South Texas burn (or “flare off”) all of the natural gas that is produced along with the more valuable crude oil. This is not because the natural gas is undesirable or unusable, but rather because the current low market price of natural gas does not pay the producer enough to cover the high expenses involved in treating and transporting natural gas to the nearest terminal or pipeline system. Because the cost to deliver the natural gas exceeds the market sales price of that gas, the producer is not held to the duty to market that commodity when doing so would result in a loss to the producer and no royalty payment to the mineral owner. Consequently, the natural gas is flared off at the well.
Remedies are available to leasing mineral owners when the producer fails to prudently market minerals, either by flaring when they could have been sold or by selling at below-market rates (generally to a company that is affiliated with the producer, which then resells the minerals at full market price). These remedies are measured in several ways, including lease cancellation and the payment of monetary damages if they can be calculated. The payment of money damages is the more commonly-applied remedy. This is because duties arising under an implied covenant are not conditions precedent under contract law and, therefore, lease cancellation resulting in a forfeiture of the producer’s real property interest is not generally an appropriate remedy for a breach of those duties.
Written By:
Edward Allred
Watts Guerra LLP
4 Dominion Drive, Bldg 3, Suite 100
San Antonio, Texas 78527
Office (210) 447-0500
Mobile (210) 685-1845
eallred@guerrallp.com
© Watts Guerra LLP 2015
