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GAS IMBALANCE AND GAS BALANCING AGREEMENTS

Copyright  1999 by Lewis G. Mosburg, Jr. All Rights Reserved.

PART NINE: EQUITABLE BALANCING: CASH BALANCING

In our last article, we commenced a discussion of the concept of "equitable balancing."¹ Under this concept, there is to be no permanent "windfall" to an Overproduced Party: at some point in time, and by some means, the Underproduced Party must be made whole (or relatively whole).²

Our last article focused on one means of equitable balancing:  "in kind" or "volumetric" make-up. In this article, another means of balancing will be considered:  cash balancing.

A number of interesting issues arise in connection with cash balancing.  At what price will the Overproduced Party be required to account? Could there be interest, or even punitive damages?  When will the balancing take place?  Can a party be forced to give -- or receive -- a cash settlement prior to depletion of the reserves?

The answer to each of these questions will depend upon the legal theory upon which the balancing is based.³ And that legal theory will depend, at least in part, upon the manner in which the imbalance arose.

The theories upon which a cash recovery could be ordered include:

• The right to an Equitable Accounting, based either upon the law of co-tenancy or industry custom and practice;^3.5
• Damages for Breach of Contract; or
• Damages for the tort of Conversion.

If a Party is wrongfully denied the opportunity to take its share of production in kind when it is ready, willing and able to take that gas, the Overproduced Party – and, potentially, the Operator – would be liable for breach of contract and, depending upon the circumstances, possibly for tortious conversion of the gas.⁴ And in at least one case, Operator liability for tortious interference with contract was raised.⁵

Why the fuss over theories of liability, if the Overproduced Party will be required to account to the Underproduced Party in any event?  It comes down to the who and how much issues. If only an accounting is required, the Overproduced Party has not done anything "wrong."  Thus, it is unlikely that it will be required to account to the Underproduced Party at a price higher than the price it actually received for the overproduction.  (Indeed, the term "accounting" inherently calls for that accounting to be based upon what the accounting party received.) Likewise, only the party who actually received those funds should be called upon to account; thus, no liability for the Operator (unless it was the Overproduced Party) or any Production Purchaser.  On the other hand, if the Overproduced Party is guilty of a "wrong," such as breach of contract or conversion, the Overproduced Party very well may be required to account at a price higher than it received.⁶ And parties other than the Overproduced Party who participated in the "wrong" may be held liable as well.⁷

What constitutes conversion?  Legally, "conversion" constitutes the unlawful appropriation and use of another's property.  At one time it was argued that since each party to an AAPL Model Form Operating Agreement "owned" its Exhibit A interest in production,⁸ overproduction for whatever reason would automatically result in conversion of the Underproduced Party's gas. However, as we saw in Part 5 of this Internet Primer, it is now clear that the mere fact of overproduction does not, of itself, automatically constitute such a wrongful appropriation, despite the provisions of the operating agreement.⁹ However, if I purport to sell your gas for your account when my authority to make such a sale has been revoked, conversion would occur.¹⁰ Furthermore, if I sell more than my ownership share of gas when you have been wrongfully denied your opportunity to take your full share of production, conversion should also result.

If a party has been offered, but has declined (or been unable to accept) its full share of production, no "wrong" has been done by the Overproduced Party.  The Overproduced Party will still be required to account to the Underproduced Party,¹¹ but the "liability" will be less severe than if the taking had been wrongful. 

At what point in time may this cash balancing be demanded?¹² Under the law of co-tenancy, an Underproduced Party should be entitled to demand an accounting at any point in time; thus, several cases in Oklahoma have ordered periodic, followed by ongoing, gas balancing.¹³ However, several states have rejected this approach; and the latest Oklahoma pronouncement – the Heiman case,¹⁴ discussed below -- seems significantly to retreat from this position.

Not all states have adopted the law of co-tenancy rule that permits a co-tenant to develop over the objection of his co-owner,¹⁵ nor will all states say that this rule should be extended to cover unilateral marketing.  Other courts have held that no co-tenancy is created by entering into a unit operating agreement,¹⁶   or have relied upon industry custom and usage as a basis for limiting an Underproduced Party to in-kind balancing, absent unusual circumstances.¹⁷

Rejection of the "law of co-tenancy" approach does not mean that cash balancing is no longer available to an Underproduced Party. However, the basis for the cash balancing now becomes industry custom and usage.¹⁸ And under this approach, absent overriding equities, the Underproduced Party will be required to rely upon in-kind balancing as a remedy until depletion of the reserves:  only at such depletion will cash balancing be ordered. As stated by the Court in Doheny v. Wexpro:¹⁹

 "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. . . . Historically, equities requiring cash balancing have included well depletion . . . ."  (Emphasis supplied)

Where a party is unable to secure a market, courts may lean toward a finding of an "inequity" that dictates cash balancing prior to depletion, particularly if the Overproduced Party is quite large, and the Underproduced Party quite small.²⁰   On the other hand, the mere fact that the Overproduced Party can negotiate a better price should not be an "inequity" which would permit the Underproduced Party to in effect "piggyback" on the Overproduced Party's contract through periodic cash balancing.²¹

As mentioned, what appeared to be relatively clear law in Oklahoma was quietly overthrown by the Oklahoma Supreme Court's decision in Heiman v. Atlantic Richfield Co.²² In Heiman, the Court brought Oklahoma in line with what now appears to be a unanimous viewpoint: in-kind balancing will be the exclusive means of balancing until depletion of the reserves, unless equities exist which call for an earlier cash balancing.²³

 While a general rule concerning cash balancing now appears to have emerged, the details of that rule are not clear. Many issues that would be addressed in a Gas Balancing Agreement have not as yet been addressed by the Courts, including:

• Does the "depletion" which generally must occur before an obligation arises to cash balance mean depletion of the well, depletion of the producing horizon, or depletion of the entire Contract Area?  (Industry custom and usage would favor balancing as each producing horizon in a well depleted where onshore wells were involved.)
• Is the "unit" for balancing to be the volume of the overproduction, or the heating value of the gas taken? (Industry custom and usage would favor volumetric balancing onshore and heating value balancing offshore.)
• At what price must the Overproduced Party account to the Underproduced Party?

The "price" issue raises its own nightmares. While it now appears fairly settled that the Overproduced Party normally will account only at the price that it received,²⁴ issues can still arise. For instance:

• What if a sale is made to an affiliate?²⁵ What if the gas is used (e.g., processed for the manufacture of fertilizer) rather than sold?  In either of these situations, the Courts are apt to utilize a "fair market value" approach, which raises the additional issue: what is "fair market value," particularly for these purposes?
• The Underproduced Party may have taken some "Makeup Gas."  If so, against what overproduction will this be applied?  Since gas will have been sold by the Overproduced Party at differing prices over the period of overproduction, this decision can make a huge difference in determining the amount of the settlement owed the Underproduced Party; and there is no clear industry custom and usage.²⁶
• Gas may have been processed after it production; the value of the resulting liquids often exceeds – and significantly exceeds – the value of the "wet" gas at the wellhead and/or the price paid for the residue gas at the tailgate of the plant. When this occurs, does the "price received" by the Overproduced Party include only the price received at the wellhead, or even at the plant tailgate, or are the proceeds of the liquids also to be included?²⁷

None of these questions have as yet been addressed by the Courts in connection with equitable balancing. However, as will be discussed in later articles in this Internet Primer, all of these issues will be covered in a well-drafted Gas Balancing Agreement.)

Coming Next: "Special Duties of the Operator"

¹Equitable balancing is so named because it arises from a court's inherent power to "do equity" among the parties. This is to be contrasted with the "contractual balancing" which results under a Gas Balancing Agreement.

²Of course, the Underproduced Party could bring disaster upon itself: see Chevron U.S.A., Inc. v. Belco Petroleum Corp., 755 F.2d 127 (5th Cir. 1985), discussed in a later article in this Internet Primer.  Likewise, the Underproduced Party usually is made only relatively whole: as discussed below, in the event of a cash accounting, the Overproduced Party normally will be required to account to the Underproduced Party only at the Overproduced Party's own price (even if it is lower than that which the Underproduced Party would have received if it had taken its full share of the gas "in kind").  Likewise, the Underproduced Party normally misses out on a "time value of money" basis, since any cash accounting by the Overproduced Party normally will not include any recovery of interest.

³The legal theory will also affect to whom the Underproduced Party may look for its settlement.

^3.5"The law has been settled for some time that a producing cotenant must account to a non-producing cotenant . . . . 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." Anderson v. Dyco Petroleum Corp., 782 P.2d 1367 (Okla. 1989) (emphasis supplied), hereinafter referred to as "Dyco."

⁴See Teel v. Public Service Co. of Oklahoma, 767 P.2d 391 (Okla. 1985), hereinafter referred to as "Teel," for an instance of conversion.  For a case involving breach of contract, see Pelto Oil Co. v. CSX Oil & Gas Corp., 804 S.W.2d 583 (Tex.Civ.App. 1991).

⁵See Transcontinental Gas P.L. v. American National Pet. Co., 1991 Tex. App. Lexis 230 (Opinion – January 29^th), 1991 Tex. App. Lexis 595 (Motion to Withdraw – March 21^st).

⁶In Teel, op. cit. n. 4, which involved conversion, liability was imposed at the highest fair market value existing at any time between the conversion of the gas and the verdict, plus interest.

⁷In Teel, op. cit. n. 4, which involved conversion, the Production Purchaser was held liable.  (The Underproduced Party had already settled with the Overproduced Party.)  Cf. Dyco, op. cit. n. 3.5, where a Production Purchaser was held to owe no liability to an Underproduced Party absent conversion.

⁷See Part 5 of this Internet Primer in the Newsletter "Archives."

⁸See Article III.B of the 1989, 1982 and 1977 versions of the AAPL Model Form and ¶4 of the 1956 version.

⁹Dyco, op. cit. n. 3.5.

¹⁰Teel, op. cit. n. 4.

¹¹See Part 5 of this Internet Primer.

¹²Statutes in a particular state may give a different answer to this question, as will be discussed in a later article in this Internet Primer series.

¹³Teel, op. cit. n. 3; Beren v. Harper Oil Co., 546 P.2d 1356 (Okla.App. 1975); United Petroleum Exploration, Inc. v. Premier Resources, Ltd., 511 F.Supp. 127 (W.D. Okla. 1980).

¹⁴Heiman v. Atlantic Richfield Co., 891 P.2d 1252 (Okla. 1995), hereinafter referred to as "Heiman."

¹⁵Kuntz, "Gas Balancing Rights and Remedies in the Absence of a Balancing Agreement," 35 Rocky Mountain Min. L. Inst. 13-1 (1990), §13.04.  States that have rejected the majority view include Illinois, Louisiana, Michigan and West Virginia.

¹⁶Doheny v. Wexpro Co., 974 F.2d 130 (10^th Cir. 1992).

¹⁷See, e.g., Doheny v. Wexpro, id., and Amoco Production Co. v. Thompson, 516 So.2d 376 (La.Ct.App. 1987), hereinafter referred to as "Amoco v. Thompson." Cf. Heiman, op. cit. n. 14, and POGO Producing Co. v. Shell Offshore, Inc., 898 F.2d 1064 (5^th Cir. 1990).  Note also that the bankruptcy of the Overproduced Party could affect the right of the Underproduced Party to take gas in kind: thus, in In re Partners Oil Co., 216 B.R. 399 (S.D. Tex. 1998), the Overproduced Party was permitted to sell gas free and clear of the Underproduced Party's "lien" on the gas, with the Underproduced Party's lien being transferred to the proceeds of the sale.  The court rejected the argument that the Underproduced Party had a property interest in the excess gas.

¹⁸"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." Doheny v. Wexpro, op. cit. n. 16, 133 (emphasis supplied).  See also Heiman, op. cit. n. 14.

¹⁹Op. cit., n. 16, at 133

²⁰See, e.g., Amoco v. Thompson, op. cit. n. 17.

²¹"The issue here is not whether plaintiffs are able to sell their gas, but rather whether they can do so at a price they deem appropriate.  An inability to market gas at a price that the underproduced party deems satisfactory is not an equity that dictates cash balancing." Doheny v. Wexpro, op. cit. n. 16, at 133.

²²Op. cit. n. 14.

²³"This summarizes the general rule that pre-depletion cash-balancing was not required for every well prior to the Sweetheart Act. . . . . Beren is an exception to the pre-Act general rule, and explains that a court may order predepletion cash-balancing, and that such an order is one in equity based upon the circumstances of the particular case before the court. . . .  We thus reject ARCO's argument that prior to the Sweetheart Act the sole remedy for the underproduced interest owners was a proceeding for an accounting upon well depletion."  Id., 1257-58.

Of course, it is in its views as to what does or does not constitute an "inequity" that each state may still distinguish itself. Thus, Oklahoma still appears more likely to find "equities" requiring pre-depletion cash balancing, an attitude in keeping with the legislative policy reflected in the Sweetheart Gas Act that will be discussed in a later article.

²⁴See Beren v. Harper Oil Co., op. cit., n. 13; United Petroleum Exploration, Inc. v. Premier Resources, Ltd., op. cit. , n. 13. See also Kaiser-Francis Oil Co. v. Producers Gas Co., 870 F.2d 563, 569 (10^th Cir. 1989), where the Tenth Circuit stated that "Cash balancing . . . is done at the price the overproduced party received for the gas."  (Emphasis supplied) Note that, under industry custom and practice, that accounting should be done without interest.

Some commentators have suggested that a different measure be used, at least under certain circumstances; suggested bases have included fair market value and the contract price of the Underproduced Party. See, e.g., 5 Kuntz, A Treatise on the Law of Oil and Gas §77.3; Smith, "Gas Marketing by Co-Owners:  Disproportionate Sales, Gas Imbalances and Lessors' Claims to Royalty," 39 Baylor L. Rev. 365, 387-389 (1987). And see the following dicta in Dyco, op. cit. n. 3.5: "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 . . . ."  (Emphasis supplied)

²⁵Since much of the domestic sales of natural gas involves sales by Majors to their marketing affiliates, the 1992 AAPL Model Form Gas Balancing Agreement uses the test of "Arms Length Agreement," rather than treating all sales to affiliates as "suspect."  See AAPL Model Form Gas Balancing Agreement – 1992 (Form 610-E), ¶¶1.01, 7.6. (More in a later article in this Internet Primer, when we undertake our discussion of Gas Balancing Agreements.)

²⁶Thus, the AAPL Model Form Gas Balancing Agreement suggests various alternatives.  See id.,  ¶7.4, Alternates 1 and 2.  (Another alternate would be a "weighted average" approach.)

²⁷Again, there is no clear industry custom and practice; and the AAPL Model Form provides alternatives. See id., ¶7.5.1 (Optional) and ¶7.5.2, Option 1 and Option 2.  As a matter of fact, until the attention of the industry was directed toward this issue as a result of the issuance of the AAPL Model Form, virtually no Gas Balancing Agreements covered this critical issue.

If the "proceeds" are calculated based upon a wellhead price for "wet" gas, an MMBTU calculation of the price or a BTU adjustment may serve as a partial compensation to the Underproduced Party for the value of the liquids.  However, the compensation is partial only and would be inapplicable if only the proceeds paid for dry residue gas were used to calculate the settlement amount.

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Copyright © 1997, 1998, 1999, and 2000 by Lewis G. Mosburg, Jr. and Ogden, the Invisible English Sheep Dog

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