Barry C. Bartel, April 11, 2014

1. Colorado Gas Royalty Lawat the Intersection of Implied Covenants and Class Treatment: A Look Back and a Look Forward Barry C. Bartel, April 11, 2014

2. Marketable Product Rule • Garman v. Conoco, Inc., 886 P.2d 652 (Colo. 1994) • Rogers v. Westerman Farm Co., 29 P.3d 887, 906 (Colo. 2001)

3. Once gas is deemed marketable based on a factual determination, the allocation of all costs can properly be determined. Absent express lease provisions addressing allocation of costs, the lessee's duty to market requires that the lessee bear the expenses incurred in obtaining a marketable product. Thus, the expense of getting the product to a marketable condition and location are borne by the lessee. Once a product is marketable, however, additional costs incurred to either improve the product, or transport the product, are to be shared proportionately by the lessor and lessee. All costs must be reasonable.Rogers v. Westerman Farm Co., 29 P.3d 887, 906 (Colo. 2001)

4. Once gas is deemed marketable based on a factual determination, the allocation of all costs can properly be determined. Absent express lease provisions addressing allocation of costs, the lessee's duty to market requires that the lessee bear the expenses incurred in obtaining a marketable product. Thus, the expense of getting the product to a marketable condition and location are borne by the lessee. Once a product is marketable, however, additional costs incurred to either improve the product, or transport the product, are to be shared proportionately by the lessor and lessee. All costs must be reasonable.Rogers v. Westerman Farm Co., 29 P.3d 887, 906 (Colo. 2001)

5. Colorado royalty law • Look back: implied covenants • Intersection with class action law • Five trends that result

7. A look back.

8. “Our nation’s deference to private ownership of minerals is inherited from England, where the common law applied the Latin maxim, cujus est solum, ejus est usque ad coelum et ad inferos: to whomsoever the soil belongs, he owns also to the sky and to the depths.” James C. Smith, Theories of Subsurface Ownership: An Overview, 14 E. MIN. L. FOUND. § 4.01 (1993).

9. “Our nation’s deference to private ownership of minerals is inherited from England, where the common law applied the Latin maxim, cujus est solum, ejus est usque ad coelum et ad inferos: to whomsoever the soil belongs, he owns also to the sky and to the depths.” James C. Smith, Theories of Subsurface Ownership: An Overview, 14 E. MIN. L. FOUND. § 4.01 (1993).

10. 1859: Venango County, Pennsylvania • “The Pennsylvania Start-up That Changed the World,” Daniel Yergin, The Pennsylvania Start-up That Changed the World, FORBES, Sept. 3, 2009.

11. Who gets what when natural gas is produced? • Written oil and gas lease • “[F]rom the very beginning of the industry the stormcenter of litigation in the jurisprudence has been the degree of diligence which an oil and gas lessee should exercise in the development of the lands covered by his lease.” James A. Veasey, The Law of Oil and Gas, 18 MICH. L. REV. 446, 454 (Apr. 1920)

12. MAURICE H. MERRILL, THE LAW RELATING TO IMPLIED COVENANTS IN OIL AND GAS LEASES 20 (1926), 23 (1940). • Four implied obligations • to begin drilling • to keep drilling • to operate diligently • to protect the resource.

13. Davis v. Cramer, 808 P.2d 358, 361 (Colo. 1991) “Most commentators divide the implied covenants into four categories: exploration, development, production (including marketing), and protection against drainage. Merrill, The Law Relating to Covenants Implied in Oil and Gas Leases, § 4 (2d ed. 1940); Kulp, Oil and Gas Rights, § 10.66 (1955); Sullivan, Handbook of Oil and Gas Law, §§ 87–93 (1955); see 5 Kuntz, supra, at § 55.1. Another commentator divides production into the duty to produce and to market. Brown, The Law of Oil and Gas Leases, § 16.02 (1958). Regardless, the necessity of the duty to market ‘is obvious in order that the lessor may receive the consideration for the lease, that is, the royalties which are to be paid.’ 2 Summers, supra, at § 400; see also Hemingway, Law of Oil and Gas, § 6.4 (1983).”

14. Davis v. Cramer, 808 P.2d 358, 361 (Colo. 1991) “Most commentators divide the implied covenants into four categories: exploration, development, production (including marketing), and protection against drainage. Merrill, The Law Relating to Covenants Implied in Oil and Gas Leases, § 4 (2d ed. 1940); Kulp, Oil and Gas Rights, § 10.66 (1955); Sullivan, Handbook of Oil and Gas Law, §§ 87–93 (1955); see 5 Kuntz, supra, at § 55.1. Another commentator divides production into the duty to produce and to market. Brown, The Law of Oil and Gas Leases, § 16.02 (1958). Regardless, the necessity of the duty to market ‘is obvious in order that the lessor may receive the consideration for the lease, that is, the royalties which are to be paid.’ 2 Summers, supra, at § 400; see also Hemingway, Law of Oil and Gas, § 6.4 (1983).”

15. Analyzing implied covenants related to drilling the initial well, how many further wells are necessary, and what is necessary to protect against drainage, require fact-specific inquiries. • A breach of one of those obligations could lead to cancellation of the lease. See, e.g., Brewster v. Lanyon Zinc Co., 140 F. 801, 814 (8th Cir. 1905) (a leading case discussing cancellation for breach of implied covenants). • Production (including marketing)

16. Rogers v. Westerman Farm Co., 29 P.3d 887, 906 (Colo. 2001) “Once gas is deemed marketable based on a factual determination, the allocation of all costs can properly be determined. Absent express lease provisions addressing allocation of costs, the lessee's duty to market requires that the lessee bear the expenses incurred in obtaining a marketable product. Thus, the expense of getting the product to a marketable condition and location are borne by the lessee. Once a product is marketable, however, additional costs incurred to either improve the product, or transport the product, are to be shared proportionately by the lessor and lessee. All costs must be reasonable.”

17. Rogers v. Westerman Farm Co., 29 P.3d 887, 906 (Colo. 2001) “Once gas is deemed marketable based on a factual determination, the allocation of all costs can properly be determined. Absent express lease provisions addressing allocation of costs, the lessee's duty to market requires that the lessee bear the expenses incurred in obtaining a marketable product. Thus, the expense of getting the product to a marketable condition and location are borne by the lessee. Once a product is marketable, however, additional costs incurred to either improve the product, or transport the product, are to be shared proportionately by the lessor and lessee. All costs must be reasonable.”

18. Gas produced at the well (producer pays) • Things done to gas • gather • dehydrate • compress • treat • process • What value is royalty paid on? • Depending on where sold, what can be deducted? • Does the gas have to be in a certain condition?

19. Rogers v. Westerman Farm Co., 29 P.3d 887, 896-97 (Colo. 2001) “In order to resolve the dispute among the parties here, we must look to the actual language of the leases at issue and determine if they address the allocation of costs, and thus, the calculation of royalty payments. We first note that there are four variations of lease language at issue in this case. However, notwithstanding the distinct language of each of the four lease types, there is some language common to all four lease types. Specifically, all of the leases contemplate that the royalties are to be computed ‘at the well’ or ‘at the mouth of the well.’ We have not previously interpreted the type of lease language presented by the leases at issue in this case. Despite the differing language in each of the four types of leases, and despite the arguments raised that the ‘at the well’ and ‘at the mouth of the well’ language provides for the allocation of costs, we conclude that all of the leases are, in fact, silent with respect to the allocation of costs.”

20. Rogers v. Westerman Farm Co., 29 P.3d 887, 896-97 (Colo. 2001) “In order to resolve the dispute among the parties here, we must look to the actual language of the leases at issue and determine if they address the allocation of costs, and thus, the calculation of royalty payments. We first note that there are four variations of lease language at issue in this case. However, notwithstanding the distinct language of each of the four lease types, there is some language common to all four lease types. Specifically, all of the leases contemplate that the royalties are to be computed ‘at the well’ or ‘at the mouth of the well.’ We have not previously interpreted the type of lease language presented by the leases at issue in this case. Despite the differing language in each of the four types of leases, and despite the arguments raised that the ‘at the well’ and ‘at the mouth of the well’ language provides for the allocation of costs, we conclude that all of the leases are, in fact, silent with respect to the allocation of costs.”

21. Rogers v. Westerman Farm Co., 29 P.3d 887, 898 (Colo. 2001) Lease language with respect to deductions: • Type I: two separate clauses: • royalties based on the gross proceeds from the sale of gas at the wellhead. • for sales not occurring at the well, the royalties are to be paid based on the market value at the well, but in no event shall those royalties total more than 1/8th of the amount actually received for the sale. • Type II: the proceeds from the sale of gas ... at the mouth of the well • Type III: market price at the well for the gas sold • Type IV: proceeds received for gas sold from each well ... or the market value at the well of such gas used off the premises

22. Rogers v. Westerman Farm Co., 29 P.3d 887, 898 (Colo. 2001) Lease language with respect to deductions: • Type I: two separate clauses: • royalties based on the gross proceeds from the sale of gas at the wellhead. • for sales not occurring at the well, the royalties are to be paid based on the market value at the well, but in no event shall those royalties total more than 1/8th of the amount actually received for the sale. • Type II: the proceeds from the sale of gas ... at the mouth of the well • Type III: market price at the well for the gas sold • Type IV: proceeds received for gas sold from each well ... or the market value at the well of such gas used off the premises

23. Rogers v. Westerman Farm Co., 29 P.3d 887, 897 (Colo. 2001) “Despite the differing language in each of the four types of leases, and despite the arguments raised that the ‘at the well’ and ‘at the mouth of the well’ language provides for the allocation of costs, we conclude that all of the leases are, in fact, silent with respect to the allocation of costs.”

24. Piney Woods Country Life Sch. v. Shell Oil Co., 726 F.2d 225, 231 (5th Cir. 1984) “‘At the well’ therefore describes not only location but quality as well. Market value at the well means market value before processing and transportation, and gas is sold at the well if the price paid is consideration for the gas as produced but not for processing and transportation.”

25. Rogers v. Westerman Farm Co., 29 P.3d 887, 906 (Colo. 2001) “Once gas is deemed marketable based on a factual determination, the allocation of all costs can properly be determined. Absent express lease provisions addressing allocation of costs, the lessee's duty to market requires that the lessee bear the expenses incurred in obtaining a marketable product. Thus, the expense of getting the product to a marketable condition and location are borne by the lessee. Once a product is marketable, however, additional costs incurred to either improve the product, or transport the product, are to be shared proportionately by the lessor and lessee. All costs must be reasonable.”

26. Oklahoma Oklahoma: certified question: • In light of the facts as detailed below, is an oil and gas lessee who is obligated to pay “3/16 of the gross proceeds received for the gas sold” entitled to deduct a proportional share of transportation, compression, dehydration, and blending costs from the royalty interest paid to the lessor? Mittelstaedt v. Santa Fe Minerals, Inc., 1998 OK 7, 954 P.2d 1203, 1204-05

27. Oklahoma Mittelstaedt v. Santa Fe Minerals, Inc., 1998 OK 7, 954 P.2d 1203, 1210 “In sum, a royalty interest may bear post-production costs of transporting, blending, compression, and dehydration, when the costs are reasonable, when actual royalty revenues increase in proportion to the costs assessed against the royalty interest, when the costs are associated with transforming an already marketable product into an enhanced product, and when the lessee meets its burden of showing these facts.”

28. Naylor Farms, Inc. v. Anadarko OGC Co., CIV-08-668-R, 2011 WL 7053789 (W.D. Okla. July 14, 2011) on reconsideration in part, CIV-08-668-R, 2011 WL 7053794 (W.D. Okla. Oct. 14, 2011) (clarifying that court did not intend to imply that extraction of NGLs is necessary to put gas in marketable form) “The Court concludes that the Oklahoma Supreme Court in the cases cited above deems ‘marketable’ to be distinguishable from saleable. It would be hard to imagine any gas not being saleable at least for some price the moment it comes out of the ground. Yet the Supreme Court says the operator must make the gas marketable which by inference means of interstate or intrastate pipeline quality.”

29. Naylor Farms, Inc. v. Anadarko OGC Co., CIV-08-668-R, 2011 WL 7053789 (W.D. Okla. July 14, 2011) on reconsideration in part, CIV-08-668-R, 2011 WL 7053794 (W.D. Okla. Oct. 14, 2011) (clarifying that court did not intend to imply that extraction of NGLs is necessary to put gas in marketable form) “The Court concludes that the Oklahoma Supreme Court in the cases cited above deems ‘marketable’ to be distinguishable from saleable. It would be hard to imagine any gas not being saleable at least for some price the moment it comes out of the ground. Yet the Supreme Court says the operator must make the gas marketable which by inference means of interstate or intrastate pipeline quality.”

30. Kansas Sternberger v. Marathon Oil Co., 257 Kan. 315, 331, 894 P.2d 788, 800 (1995) “Once a marketable product is obtained, reasonable costs incurred to transport or enhance the value of the marketable gas may be charged against nonworking interest owners. The lessee has the burden of proving the reasonableness of the costs. Absent a contract providing to the contrary, a nonworking interest owner is not obligated to bear any share of production expense, such as compressing, transporting, and processing, undertaken to transform gas into a marketable product. In the case before us, the gas is marketable at the well. The problem is there is no market at the well, and in that instance we hold the lessor must bear a proportionate share of the reasonable cost of transporting the marketable gas to its point of sale.”

31. “Marketable Product Rule” • Colorado (with location element) • Oklahoma • Kansas • Litigating in New Mexico • Not universal

32. North Dakota “[¶ 21] We conclude the term market value at the well is not ambiguous. We join the majority of states adopting the “at the well” rule and rejecting the first marketable product doctrine. Thus, we conclude the district court properly determined Petro–Hunt can deduct post-production costs from the plant tailgate proceeds prior to calculating royalty. We affirm the district court's order granting Petro–Hunt summary judgment regarding the use of the work-back method to calculate royalties.”Bice v. Petro-Hunt, L.L.C., 2009 ND 124, 768 N.W.2d 496, 502

33. Texas “Although it is not subject to the costs of production, royalty is usually subject to post-production costs, including taxes, treatment costs to render it marketable, and transportation costs. Martin v. Glass, 571 F.Supp. 1406, 1410 (N.D.Tex.1983), aff'd, 736 F.2d 1524 (5th Cir.1984); Williams & Meyers, supra, p. 857. However, the parties may modify this general rule by agreement. Martin, 571 F.Supp. at 1410.”Heritage Res., Inc. v. NationsBank, 939 S.W.2d 118, 122 (Tex. 1996)

34. Marketable product rule: • Conditions for royalty law • to intersect with • Class treatment

35. (a) Prerequisites. One or more members of a class may sue or be sued as representative parties on behalf of all members only if: (1) the class is so numerous that joinder of all members is impracticable; (2) there are questions of law or fact common to the class; (3) the claims or defenses of the representative parties are typical of the claims or defenses of the class; and (4) the representative parties will fairly and adequately protect the interests of the class. (b) Types of Class Actions. A class action may be maintained if Rule 23(a) is satisfied and if: * * * * * (3) the court finds that the questions of law or fact common to class members predominate over any questions affecting only individual members, and that a class action is superior to other available methods for fairly and efficiently adjudicating the controversy. Fed. R. Civ. P. 23

36. Class Certification (a) Prerequisites. One or more members of a class may sue or be sued as representative parties on behalf of all members only if: (1) the class is so numerous that joinder of all members is impracticable; (2) there are questions of law or fact common to the class; (3) the claims or defenses of the representative parties are typical of the claims or defenses of the class; and (4) the representative parties will fairly and adequately protect the interests of the class. (b) Types of Class Actions. A class action may be maintained if Rule 23(a) is satisfied and if: * * * * * (3) the court finds that the questions of law or fact common to class members predominate over any questions affecting only individual members, and that a class action is superior to other available methods for fairly and efficiently adjudicating the controversy. Fed. R. Civ. P. 23

37. Marketable Product Rule • common questions predominate if: • lease language does not override the implied covenant • the implied covenant is defined in a way that applies broadly • “Marketable Product” • Cases articulating the rule: • Rogers (Colorado) not a class action • Mittelstaedt (Oklahoma) not a class action • Sternberger (Kansas) was a class action • Supreme Courts have not addressed the marketable product rule in class context

38. Wal-Mart Stores, Inc. v. Dukes, 131 S. Ct. 2541, 2550, 180 L. Ed. 2d 374 (2011) • Comcast Corp. v. Behrend, 133 S. Ct. 1426, 1432, 185 L. Ed. 2d 515 (2013)

39. Wallace B. Roderick Revocable Living Trust v. XTO Energy, Inc., 725 F.3d 1213 (10th Cir. Kan. 2013) • Chieftain Royalty Co. v. XTO Energy, Inc., 528 F. App'x 938 (10th Cir. Okla. 2013) (not selected for publication)

40. Wallace B. Roderick Revocable Living Trust v. XTO Energy, Inc., 725 F.3d 1213 (10th Cir. Kan. 2013) “Holdings: The Court of Appeals, Paul J. Kelly, Jr., Circuit Judge, held that: “1 district court abused discretion in relaxing and shifting burden of proof as to whether royalty owners of natural gas wells satisfied commonality requirement; “2 predominance of common issues was not established simply by virtue of lessee's uniform methodology of payments to royalty owners; and “3 lessee's previous settlement of natural gas royalty litigation did not collaterally or judicially estop lessee from litigating class certification issues. “Vacated and remanded.”

41. Wallace B. Roderick Revocable Living Trust v. XTO Energy, Inc., 725 F.3d 1213 (10th Cir. Kan. 2013) “1 district court abused discretion in relaxing and shifting burden of proof as to whether royalty owners of natural gas wells satisfied commonality requirement;” • lease language • marketable product • vacated certification

42. With the intersection of implied covenants and class treatment • A Look Forward: • Litigation over the meaning of lease language • Litigation over the existence and scope of the implied covenant (where is gas a marketable product) • New leases taking into account rulings • Litigation over class certification standards • Settlement

43. With the intersection of implied covenants and class treatment • A Look Forward: • Litigation over the meaning of lease language • Litigation over the existence and scope of the implied covenant (where is gas a marketable product) • New leases taking into account rulings • Litigation over class certification standards • Settlement

44. Lindauer v. Williams Prod. RMT Co., No. 10CA0798 (Colo. App. Apr. 21, 2011) (unpublished) • Class action • Settlement: all but two issues • gross proceeds leases • enhanced value of gas

45. Lindauer v. Williams Prod. RMT Co., No. 10CA0798 (Colo. App. Apr. 21, 2011) (unpublished) • “A provision in natural gas leases states that the lessee will pay the lessors a percentage of the ‘gross proceeds’ from gas ‘used off the premises.’” • Plaintiff: gross proceeds where sold • Defendant: silent under Rogers

46. Lindauer v. Williams Prod. RMT Co., No. 10CA0798 (Colo. App. Apr. 21, 2011) (unpublished) “In sum, we conclude that the term ‘gross proceeds’ as used in the leases here does not preclude Williams from deducting reasonable costs to transport gas on mainline transmission pipelines.”

47. With the intersection of implied covenants and class treatment • A Look Forward: • Litigation over the meaning of lease language • Litigation over the existence and scope of the implied covenant (where is gas a marketable product) • New leases taking into account rulings • Litigation over class certification standards • Settlement

48. In Mleynek et al. v. K.P. Kaufman Co., Inc., Case No. 07-CV-3268 (D. Ct. Denver County, Colo. 2009), the jury returned a verdict for defendant where the class claimed that defendant breached the leases by paying royalties on gas before it was in marketable condition.

49. Lindauer v. Williams Prod. RMT Co., No. 06CV317, Order Regarding Enhancement (D. Ct. Garfield County, Colo., Jan. 21, 2014) “The Court previously held that Williams could deduct from the royalty payments the transportation expenses it incurred to move gas downstream if doing so enhanced the value of the gas.”

50. Lindauer v. Williams Prod. RMT Co., No. 06CV317, Order Regarding Enhancement (D. Ct. Garfield County, Colo., Jan. 21, 2014) • Parties stipulated: • Time period involved • Average index price • Gross price that Williams received • Net price after deducting transportation • Starting point for evaluating whether value enhanced • The only issue remaining for the Court to determine is what price should be used to make the comparison.