Mosburg Primer GBA8 4-20-99-2a

INTERNET OIL & GAS PRIMER™

GAS IMBALANCE AND GAS BALANCING AGREEMENTS

PART EIGHT: EQUITABLE BALANCING: "In-Kind" Balancing

Rights of an Underproduced Party to "Equitable" Balancing/Accounting or Damages. The right to produce disproportionately has usually been justified, where any "justification" is even set forth, by reliance upon the laws of cotenancy.¹ By similar reasoning, the courts have consistently held that this "sans contract" right to overproduce does not give a permanent windfall to the Overproduced Party: at some stage and by some means, the Overproduced Party must permit the Underproduced Party to attain a condition of "balance."²

One cause of confusion in analyzing the rights of the parties in a potential "imbalance" situation has been uncertainty concerning the basis on which their interests in gas is owned by the parties. Such a determination would involve both an analysis of the laws of cotenancy, and the degree to which such principles may have been modified either contractually (e.g., by entering into a joint operating agreement) or as a result of state statutes.

Under one theory, the ownership of the parties is "molecular" -- as each molecule of gas is produced, that molecule is owned in the same percentages in which the working interest is owned. Under this theory, there is a much greater exposure to breach-of-contract or even tort liability if a party produces disproportionately without contractual (e.g., gas balancing agreement) or "acquiescence" authorization. However, under a second theory, the ownership is not molecular but "reserve" ownership -- each party merely owns its percentage of the reserves produced from the well. Under this theory, there is less "breach of rights" exposure until a party becomes permanently overproduced.

The significance of the distinction between the molecular and reserve ownership theories has been summarized as follows by one commentator:

"If each co-owner owns an undivided interest in each molecule or cubic foot of gas produced from the unit well, then it could be argued that management or disposition of any of the gas requires the consent of all co-owners. On the other hand, if a co-owner of gas production has the right only to his pro rata share of production, then it could be argued that any co-owner may produce and dispose of his share of production in his sole discretion, provided sufficient gas remains in the reservoir for the remaining co-owners to obtain their pro rata share of production."³

Unfortunately, there has been little discussion by the courts as to the basis upon which gas discovered as a result of multi-party development pursuant to an operating agreement is actually owned by the parties.⁴

There are various methods by which some form of balance between the parties may be attained. To quote the Oklahoma Supreme Court:

"The law has been settled for some time that a producing cotenant must account to a non-producing cotenant for the market value of the production less any reasonable and necessary expenses of developing, extracting and marketing. Further, certain practices of the industry have been acknowledged by the courts to remedy situations like that apparently existent here where only certain working interest owners have sold production. These practices involve balancing in kind the production from the well by allowing cotenants . . . the opportunity to market gas from the well (i.e. taking a certain percentage of an overproduced party's gas until any imbalance in the cotenant's takes from the well are made up), by periodic cash balancing whereby underproduced cotenants receive cash from producing cotenants in proportion to their respective interests and cash balancing upon any particular gas reservoir's depletion."⁵ (Emphasis supplied.)

Thus, there are various ways in which an Underproduced Party could be brought into balance, even absent any express contractual or statutory remedies. These include:

(1) Equitable "Volumetric" (In-Kind) Balancing;⁶

(2) Monetary Relief, which could include:

(a) The right to an equitable Accounting;

(b) Damages for Breach of Contract;

Let's look at each of these separately.

There has been confusion in the past as to whether or not an Underproduced Party has any inherent "equitable" right to make up its underage through "volumetric balancing" -- through itself now taking in excess of its Operating Agreement percentage until it recovers its underages -- absent an enforceable contract which so provides. While the courts have recognized that volumetric ("in kind") make-up represents the preferred industry practice, and have voiced a court preference for such a remedy, certain decisions have still found reasons to deny such equitable volumetric balancing under the "particular" circumstances before them.⁸ As stated by one Court:

"The district court held balancing in kind is the preferred method for gas balancing in the industry. . . . The few cases to address this issue are in accord, as are the authors who have addressed the subject. * * * These authorities do not espouse requiring in kind balancing in every instance. Rather, they reflect prevailing sentiment to use in kind balancing unless the equities dictate otherwise."⁹

(One reason for the courts' hesitancy to use their discretionary equitable powers to order such balancing could be the issue of how much of the Overproduced Party's normal share of production should now be turned over to the Underproduced Party, and related issues such as the hostility toward "cyclical balancing," all to be discussed in later articles in this Primer.)

Most courts seem to recognize that, except under unusual circumstances, an Underproduced Party should be granted the right to equitable volumetric balancing based upon custom and practice in the industry.¹⁰ This same custom and practice could be looked to in determining the percentage of an Overproduced Party's gas to be delivered as Make-Up Gas and in determining how such Make-Up Gas should be allocated among multiple Underproduced Parties which now wished to engage in volumetric balancing.¹¹

Coming Next: "Cash Balancing"

¹See e.g., Teel v. Public Service Co. of Oklahoma, 767 P.2d 391 (Okla. 1985); Anderson v. Dyco Petroleum Corp., 782 P.2d 1367 (Okla. 1989). But see Doheny v. Wexpro, 974 F.2d 130 (10^th Cir. 1992), in which the Court held that a Wyoming Unit Agreement does not create a co-tenancy among the working interest owners.

²"There is no dispute that the parties to this unit operating agreement must balance production. The dispute is over how balancing will be accomplished." Doheny v. Wexpro, id., at 133.

³Gates, "Partition of Land and Mineral Rights," 43 La. L. Rev. 1119, 1140-1141 (1983).

⁴See, however, Amoco Production Co. v. Thompson, 516 So.2d 376, 387 (La. Ct. App. 1987), holding that production from a Louisiana compulsory unit is subject to molecular ownership.

Note that this case involved: (1) Louisiana's unusual code provisions; (2) production from a compulsory unit under Louisiana's conservation code; (3) a situation where there was no special "take in kind" contractual provisions such as those contained in the Model Form Operating Agreement.

⁵Anderson v. Dyco Petroleum Corp., op. cit. n. 1.

⁶At English common law, in-kind balancing was a form of relief available against a cotenant who had committed waste. Kuntz, "Gas Balancing Rights and Remedies in the Absence of a Balancing Agreement," 35 Rocky Mountain Min. L. Inst. 13-1, §13.03[1].

⁷As mentioned in an earlier article in this Primer, partition as a possible remedy is being ignored because of the waiver of the right to partition contained in the majority of Joint Operating Agreements.

⁸See Doheny v. Wexpro, op. cit. n. 1. See also the language of the Oklahoma Supreme Court in Anderson v. Dyco Petroleum Corp., op. cit. n. 1, and Heiman v. Atlantic Richfield Co., 891 P.2d 1252 (Okla. 1995).

In Beren v. Harper Oil Co., 546 P.2d 1356 (Okla.App. 1975), the Court of Appeals had originally opted for in-kind rather than cash balancing as the preferred solution. 46 Okla. B.A.J. 1523, 1525. However, as a result of a limited granting of certiorari by the Oklahoma Supreme Court, in-kind balancing was deleted as a remedy: see Hoefling, "Gas Balancing Problems in a Deregulated Market: Changes and Possible Solutions Under Oklahoma Law," 225 Tulsa L. J. 63 (1989), hereinafter referred to as "Hoefling", at 73-74.

One Louisiana Court of Appeals decision has indicated that taking and balancing in kind is legislatively mandated in that state as to production from compulsory units (and potentially even in the absence of unitization) unless it can be shown that such "partition in kind" would lead to waste or a violation of a co-owner's right to take its equitable share of production or its correlative rights. See Amoco Production Co. v. Thompson, op. cit. n. 34. See also POGO Producing Co. v. Shell Offshore, Inc., 898 F.2d 1064 (5th Cir. 1990).

⁹Doheny v. Wexpro, op. cit. n. 1, 133. Note, however, that the Doheny case rejected the Underproduced Parties' position that an operating agreement creates a co-tenancy among the parties. Id. at 134.

¹⁰Some Gas Balancing Agreements provide for in-kind balancing from other properties upon the depletion of the recoverable reserves from the well or other balancing "Unit" whose production was imbalanced. However, it would be contrary to the custom and practice in the industry for a court to order such "cross-lease balancing" on an equitable basis, absent an express contractual obligation on the part of the Overproduced Party to provide such cross-lease gas (or on the part of the Underproduced Party to accept it in lieu of a monetary settlement).

¹¹If today's Gas Balancing Agreements are considered to reflect industry custom and practice, 50% of the Overproduced Party's Ownership Percentage should be made available as Make-Up Gas during non-peak periods, and should be allocated among multiple Underproduced Parties desiring such gas in the ratio of such Underproduced Parties' Ownership Percentages. However, it would prove more difficult to establish any generally-accepted industry custom and practice as to the percentage of gas, if any, to be made available as Make-Up Gas during the peak "Winter Period." (These issues concerning "cyclical make-up" will be discussed in a later article in this Primer.)

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