When is natural gas considered to be in “marketable condition” for royalty payment purposes?

The “Marketable Condition Rule” used in oil and gas royalty valuation has been adopted in a growing minority of states, including Oklahoma. It is often viewed as an extension of the lessee’s “implied covenant to market” and states that production is not complete until the lessee has not only captured the production at the wellhead, but also has placed it in marketable condition. Any costs incurred to make the production marketable are not deductible from royalty.

Oklahoma, for one, has failed to enunciate a standard for marketability however, which makes it especially difficult for royalty owners trying to determine whether their lessee has complied with the rule. It also makes for an especially time-consuming process when courts attempt to determine the marketability of natural gas in litigation brought pursuant to the rule. Lacking a standard definition; the courts must look at the specifics of each case to determine whether the gas in question was placed in “marketable condition” before being transported or sold. Additionally, determining marketability on a case-by-case basis virtually ensures that anyone engaged in litigation brought pursuant to the rule will face a very burdensome and expensive litigation process; the results of which will be of little help in any other case.

The marketable product states need to instead define marketability using physical standards similar to those required by major commercial gas purchasers, by major gas gathering systems, and/or on standards required by the U.S. Government on its land based leases. A tangible definition would enable the courts to more certainly address marketability issues, and would allow royalty owners to more easily determine whether their gas was in marketable condition before being sold or transported off the lease, especially in cases where no market exists at the well.

Currently, even sour gas (gas containing corrosive hydrogen sulfide) is “marketable” to a purchaser possessing sweetening facilities, though most industry participants would not consider sour gas to be marketable at all, except to such purchasers. A court in Oklahoma could, under the current rule, find such gas to be marketable if a purchaser possessing sweetening facilities were available at the well, and allow royalty to be paid on the value the lessee receives for it from such a purchaser, rather than on the price received by the purchaser upon resale of the sweetened gas. Though the lessee made no direct deductions from royalty for sweetening, the costs of removing the contaminant were nonetheless indirectly deducted by the purchaser. If there had been no purchaser possessing sweetening facilities willing to purchase the sour gas, and the lessee had instead decided to build its own sweetening facility, it is unlikely the lessee would have been able to deduct the lessor’s share of such a facility, because a court would likely find that the gas was not marketable in that form since no one was willing to buy it that way.

If there were in fact a more tangible definition of the marketable product rule, based more on the physical properties of natural gas rather than simply its ability to be sold, then there would be no reason for such an illogical scenario as the one above where deductions are allowed to be made (indirectly) by a purchaser with sweetening facilities, but are not allowed to be made (directly) by the lessee when no such purchaser is available. It would also make it easier for those royalty owners willing to do so, to determine marketability on their own. Royalty owners often have no idea what is done to their gas after it emerges from the well; nor do they know for certain which, if any, of those costs they are required to share. If they knew what physical state their gas had to be in before being marketable, and what condition it was in as it emerged from the well, then it would be easier to determine which costs of improving the gas they were required to share.

The rule in its current form may even cause some lessees to forego mutually beneficial marketing opportunities, and instead sell to a monopolistic wellhead purchaser; since a lessee cannot currently predict with certainty that the lessor would share in the costs of improving the gas or transporting it to a higher-priced market. If a fair, easily verifiable, and unmolestable definition of marketability were adopted, perhaps a more standardized lease form would be acceptable to royalty owners. This would mitigate many of the current accounting nightmares and expense faced by lessees in their attempts to accommodate various lease types, and would also simplify lease interpretation by the courts.

By Frederick M. Scott CMM, RPL

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