ROGERS v. WESTERMAN FARM CO. No. 99SC293.
29 P.3d 887 (2001)
James P. ROGERS; Estate of Charles R. Brophy; Desmond D. Brophy; Donald R. Brophy; Douglas K. Brophy; James P. Brophy III; Estate of James P. Brophy; Joseph Paul Brophy; Joseph Paul Brophy, Jr.; Martin D. Brophy; Thomas E. Brophy; Todd R. Brophy; Conrad Oil & Gas, Ltd.; Marguerite Conrad; Harris Lett; Otto E. Lueking, Jr.; and Kitzmiller Grazing Association, Inc., Petitioners/Cross-Respondents, v. WESTERMAN FARM COMPANY; Estate of H.G. Westerman; Carl A. Westerman; Loyle P. Miller; Joe Gray; JG-Kansas No. 2 Venture; Dr. Ralph M. Connell; Connell Family Living Trust; Thomas J. Jeffrey; Meredith Mallory, Jr.; the Travis Family Trust B; Rosewood Resources, Inc.; J-W Operating Company; American Exploration Company; American Production Partnership V Ltd.; FMP Operating Co., L.P.; Freeport McMoran Inc.; Mesa Operating L.P.; Mesa Petroleum Company; MTS Limited Partnership; Ninian Oil Company; Samedan Oil Corporation; and Tejay Operating Company, Respondents/Cross-Petitioners.
Supreme Court of Colorado, En Banc.
As Modified on Denial of Rehearing August 27, 2001.
Stead & Heath, P.C., Robin Stead, Donald F. Heath, Jr., Oklahoma City, OK, Dufford, Waldeck, Milburn & Krohn, LLP, William H.T. Frey, Flint B. Ogle, Grand Junction, CO, Attorneys for Amicus Curiae National Association of Royalty Owners, Inc.
Justice MARTINEZ delivered the opinion of the court.
I. FACTS AND PROCEDURE
This case involves a dispute arising from various oil and gas leases over royalty payments
In the course of the proceedings in this case, terminology specific to the oil and gas industry has been used, some of which requires explanation and, where used inconsistently, resolution as to its meaning. Accordingly, in the following sections outlining the facts and procedure, we have explained and resolved some differences in the use of terminology where appropriate in order to allow for a better understanding of the relevant facts and to properly analyze the issues raised in this case.
A. Condition of Gas
The parties appear to argue about the physical condition of the gas at the well. However, a stipulation contained in the jury instructions reveals that the parties actually agree on the physical condition of the gas, but disagree about the terminology used to describe the gas. Thus, we briefly review the parties' use of the differing terminology and explain how the stipulation indicates that the parties are actually in agreement about the physical condition of the gas.
According to the lessors, when the gas emerges from the well it is "raw gas," meaning to the lessors that it is not in a condition to meet the specifications of the interstate pipeline. The lessors further argue that the gas at the well is at a low pressure (from 15 to 250 pounds per square inch gauge (psig)), and is water-saturated, with 40 pounds of water per million cubic feet (mmcf). The lessors contend that in order for the gas to meet the interstate pipeline specifications, the gas must be "treated," specifically, compressed and dehydrated. To do so, the gas enters a gathering system, a set of low pressure pipes which gathers gas from various wells and moves it to the main line. The gathering system collects gas, which is then compressed from low pressure gas to high
Although the lessees agree that the gas must be gathered, compressed, and dehydrated before the gas can enter the interstate pipeline, they disagree with the description of the physical condition of the gas as it emerges from the well. The lessees argue that the natural gas at issue is almost pure methane and directly usable in its natural state at the well. Instead of being raw, as the lessors contend, the lessees argue that the gas is dry, that is, virtually free of liquid hydrocarbons, and sweet, that is, free of chemical impurities, such as hydrogen sulfide and other sulphur compounds, when it emerges from the well. Further, the lessees argue that the gas is directly usable at the well both commercially and domestically, and does not require any processing in order to be used. Finally, the lessees emphasize that the gas has been used in its natural state from the well for many years, both by local consumers and by the lessors in lieu of royalty payments.
According to a stipulation by the parties in Jury Instruction 4, the parties agree that the gas at issue is predominantly free of hydrogen sulfide
Dehydration involves the removal of water from fluid produced from wells. Oil and Gas Terms, supra, at 260. The parties agree that the gas in this case is dehydrated after compression to remove liquid prior to the gas entering the interstate pipeline. The parties also agree that the gas is usable by the lessors directly from the well, without requiring any liquid removing processes to be completed prior to the use of the gas. Thus, the parties, through their arguments, agree that the gas is dry when it emerges from the well, irrespective of their disagreement about the purpose of the dehydration process.
Finally, notwithstanding the parties' use of differing terminology to describe the physical condition of the gas, the parties agree that the gas must be gathered, compressed, and dehydrated in order to enter the interstate pipeline. Thus, the actual dispute raised in this case is whether the gas is marketable at the well prior to gathering, compressing, and dehydration, or marketable after these processes have been completed and the gas is ready to enter the interstate pipeline. Since we believe that the parties agree that the gas is both sweet and dry, we will analyze this case with the understanding that the gas here is sweet and dry as it emerges from the well.
B. How the Gas Moves from the Wellhead to the Pipeline
There are numerous gas purchase contracts and gathering, dehydration, and compression contracts that were submitted as exhibits in this case. The gas purchase contracts
It appears that initially most of the contracts, which were executed in the 1970's between the lessees and the gas companies that bought the gas, provided for the gas to be sold at the wellhead, with the buyer of the gas undertaking the performance of the gathering, compression, and dehydration necessary for the gas to subsequently enter the pipeline. In general, the purchaser of this gas was also the company that transported the gas through the pipeline. In the late 1980's and early 1990's, a number of the contracts were amended to provide for sale of the gas away from the well, in addition to continued provisions for the sale of the gas at the well. In general, these amended contracts provided for an alternate point of sale, usually directly to an interconnection point of a gathering system and the buyer's pipeline. Under these amendments, the gas was sold to the buyer, with the point of delivery being a gathering system, instead of at the well. The amendments resulted in the buyer contracting with another company, usually Yuma Gathering System, who would perform gathering, compression, and dehydration of the gas, and transport the processed gas directly to the buyer at the interstate pipeline.
Finally, the record reflects other contracts which were entered into between the lessees and Yuma Gathering System, which provided for the sale of gas directly to Yuma Gathering System. Under these contracts, Yuma Gathering System would receive the gas directly from the lessees, process the gas, and subsequently sell the gas to a third party at the interstate pipeline.
C. Payment of Royalties
The royalties on the gas sold were computed in two ways based on where the gas was sold.
The lessors also argue that the sales made at the well were not arms-length transactions by the lessees, and that the purchasers of the gas, who subsequently sold the gas downstream at the interstate pipeline for a higher price, were closely linked with the lessees. Accordingly, the lessors contend that these transactions were improper and constituted a breach of the duty to market the gas. The lessees argue, however, that the royalties paid on the gas sold at the well were properly paid because the gas was marketable at the well, and the royalties were calculated using the gross proceeds received by the lessees for those sales.
For the gas sold away from the wells, the lessors were paid royalties based on the price of the gas sold minus deductions for the cost
Under the work-back method, "costs of transportation, processing and treatment are deducted from the ultimate proceeds of sale of the oil or gas and any extracted or processed products to ascertain wellhead value." Oil and Gas Terms, supra, at 1188. According to the lessees, the royalty calculations were made by deducting the "reasonable transportation related costs" from the price obtained for the gas at the interstate pipeline after it had been gathered, compressed, and dehydrated. The lessees contend that these expenses were properly deductible, since the gas was marketable at the well and these "transportation" expenses served only to increase the value of an already marketable product. Moreover, the lessees argue that since the royalties under the leases were to be paid based on the value "at the well," the work-back calculation was the appropriate method to determine the amount of the royalty payments under the leases.
D. Trial Court Proceedings
The lessors claim that the lessees engaged in improper practices by: (1) taking deductions from royalties for costs such as gathering, dehydration, and compression; and (2) selling the gas to an affiliate at less than arms length and/or selling the gas at an artificially low price.
After various pre-trial motions filed by the parties, this case went to trial and was heard by a jury. Prior to trial, the trial court made rulings on issues based on pre-trial motions which were relevant to the ultimate decision rendered by the jury. First, the trial court determined that the leases were silent regarding allocation of costs, and therefore, no testimony or evidence should be presented to the jury regarding the lease language.
The trial court's instruction to the jury
Both parties appealed. On appeal, the lessees argued that the trial court erred in not giving effect to the lease language because the "at the well" and "at the mouth of the well" lease language determined the point of valuation for royalty payments, and was therefore sufficient to determine the allocation of costs. The lessees further argued that the jury instruction regarding marketability was erroneous because it included a good faith assessment and resulted in an
E. Court of Appeals' Decision
On appeal, the court of appeals first determined that some meaning must be given to those provisions in the leases containing the "at the well" or "at the mouth of the well" language. Rogers v. Westerman Farm Co.,
The court of appeals next considered the trial court's gas marketability jury instruction. After discussing the conclusion that the sole issue to be decided in determining marketability is whether the product is sufficiently free from impurities that it will be taken by a purchaser, the court of appeals determined that the trial court erred in including a good faith assessment in the instruction. Id. The court of appeals reasoned that a lessee's good or bad faith is a separate issue from the determination of whether a product is marketable, because marketability turns solely on the condition of the product. Ultimately, however, the court of appeals concluded that although the trial court's jury instruction was erroneous, the fact that the gas was actually sold at the well showed that it was marketable there, and, as such, the instruction was not prejudicial to either party. Id. at 974. Furthermore, the court of appeals held that because the instruction required the jury to consider whether the lessees were acting in good faith, the jury's finding that royalty payments made for sales at the well was not improper, and, therefore, must have entailed a determination that the lessees acted in good faith with respect to those sales. Id.
Relying on a commentator's article, the court of appeals determined that the gas was in a marketable condition at the wellhead. Id. at 974-75. Accordingly, the court of appeals concluded that the trial court erred in submitting the issue of marketability for gas sold away from the well to the jury. In its analysis, the court of appeals concluded that the gas was marketable based on its condition, and that the costs deducted by the lessees were for transportation of the product. Therefore, the court of appeals held that, as a matter of law, the lessees properly deducted costs before making royalty payments for gas sold away from the well. Id. at 975. Accordingly, the court of appeals held that the judgment against the lessees for the deduction of costs must be reversed. Id.
Both parties petitioned for a writ of certiorari to the court of appeals. The lessors raised three issues: (1) whether the court of appeals erred in reversing the jury's verdict that the gas sold away from the well was not marketable at the well; (2) whether the court of appeals erred in holding that costs incurred
Our analysis of this case begins with a discussion of the "at the well" and "at the mouth of the well" lease language in dispute here. We review the language of each of the four lease types and conclude that the "at the well" language is silent with respect to allocation of costs. We next review the "at the well" language to determine if, at a minimum, it addresses the allocation of transportation costs. We conclude that it does not. Instead, in order to determine allocation of costs where the lease language is silent, we must look to the implied covenant to market, and thus, whether the gas is marketable.
After determining that the lease language is silent, and thus, the implied covenant to market controls, we next discuss our previous holding in Garman v. Conoco,
Finally, we review the court of appeals' analysis of the jury instruction regarding marketability. We agree with the court of appeals that the trial court's instruction to the jury was erroneous. However, we disagree with the court of appeals that such error was not prejudicial, and instead conclude that the jury instruction resulted in substantial and prejudicial error, requiring reversal and a new trial. Finally, we disagree with the court of appeals' determination that the gas was marketable as a matter of law, and instead confirm our view that marketability is a question of fact.
A. Leases and the Allocation of Costs
This court granted certiorari on four issues raised by the parties below.
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"
The parties argue that the "at the well" lease language is determinative of the allocation of costs. Specifically, the lessees collectively argue that "at the well" or "at the mouth of the well" establishes a geographical point of valuation for determining royalty payments. As such, the lessees argue that costs incurred with respect to the processing of the gas after that point are to be shared by the lessors and lessees. The lessors, however, do not agree. For example, at least one of the lessors argues that our decision in Garman determined that "at the well" language is silent with respect to allocation of costs. We reject both parties' arguments.
Notwithstanding an initial misleading appearance that the lease language provides for allocation of costs, it is apparent that when scrutinized in depth, each lease clause provision inadequately addresses allocation of costs. For example, the Type I lease contains two separate clauses. The first clause provides for royalties based on the gross proceeds from the sale of gas at the wellhead. Assuming a commonly understood definition of "gross proceeds," this language seemingly suggests that costs would not be shared.
Similarly, the Type II lease provides that the royalties are to be calculated based on "the proceeds from the sale of gas . . . at the mouth of the well." Commentators have suggested that a proceeds clause must either specify the place where proceeds are to be calculated, or the expenses which can be deducted. 3 Howard R. Williams & Charles J. Meyers, Oil and Gas Law § 646.1, at 608.4-608.6 (2000)[hereinafter Williams & Meyers]. Assuming this position is adopted, this lease language indicates that the royalties are to be paid based on sales at the physical location of the well. However, this is not the only view. The Arkansas Supreme Court, for example, has held that "proceeds at the well" means gross proceeds where the lease does not refer to costs or use the term "net proceeds." Hanna Oil & Gas Co., v. Taylor,
Likewise, the Type III lease provides that the royalties are to be paid based on the "market price at the well for the gas sold." While the term "market price" suggests the actual price for which gas is purchased and sold, commentators and courts have also used the term interchangeably with "market value." Oil and Gas Terms, supra, at 605-606. For gas actually sold at the well, this language might suggest that the royalty payments should be equal to the actual price received when the gas is sold, without any deductions for costs. Assuming, under the language in this type of lease, that the gas is sold at the well, there may be no costs to be allocated because this language only contemplates a sale at the physical location of the wellhead. However, because the sale of gas anywhere other than at the wellhead is not even contemplated by this language, this provision is surely silent with respect to any gas sold away from the well.
Finally, the Type IV lease provides that royalties are to be calculated based on the "proceeds received for gas sold from each well . . . or the market value at the well of such gas used off the premises." The first portion of this language regarding proceeds is unclear as to whether it is intended to refer to proceeds from the sale at the location of the well, or proceeds from the sale at the place of sale, if other than at the physical location of the well. In a proceeds type lease, the instrument should specify either the place where royalties are to be calculated, or the expenses to which the lessor is subject. 3 Williams & Meyers, supra, § 646.1, at 608.4-628.6. Thus, differing interpretations of this language are possible because the intended meaning of this clause is unclear.
Furthermore, the reference to a calculation based on market value of gas used off the premises does not clearly establish whether such a calculation would apply to gas sold off the premises. The use of the word "or" in the lease implies that there is a distinction between the calculation for gas sold from the physical location of a well and gas used off the premises. Neither phrase, referring to proceeds for gas sold at the well, or market value at the well for gas used off the premises, indicates whether there was an intent to allocate costs between the parties, nor whether deductions would be made prior to calculating royalties. Thus, like the other three types of leases, the Type IV lease language is also silent as to cost allocation.
Our view that the leases are silent with respect to the allocation of costs is further solidified by the notion in contract law that language should be construed as a whole, and specific phrases or terms should not be interpreted in isolation. Simon v. Shelter Gen. Ins. Co.,
Although courts and commentators have disagreed over whether "at the well" language addresses allocation of costs,
Although Anderson does not necessarily agree with the view that "at the well" language is silent with respect to allocation of costs, he does suggest that this language is sufficiently unclear that it may or may not accomplish the lessees' objectives, to share proportionately in costs, when read together with the royalty clause as a whole. See Anderson, Part 2, supra, at 635. Moreover, Anderson has suggested that lessees, in order to avoid alerting lessors of their motives, have intentionally used "at the well" language to avoid directly stating their objectives in sharing costs. See id. In a similar view, the Kansas Supreme Court, in Gilmore v. Superior Oil Co., implicitly suggested that a lease containing "at the well" language was ambiguous, and as such, should be construed in favor of the lessor and against the lessee.
In a subsequent case, the Kansas Supreme Court adopted the position that "at the well" lease language may be silent as to post-production cost deductions. Specifically, in Sternberger v. Marathon Oil Co., the Kansas Supreme Court found that a lease directing royalty payments of "one-eighth (1/8) of the market price at the well for gas sold or used" was silent with respect to deductions.
The court of appeals' interpretation does not acknowledge that the "at the well" and "at the mouth of the well" language has greater implications than the limited significance of a mere determination of a location for royalty valuation purposes. Thus, attempting to give such limited significance to "at the well" language requires assumptions to be made about the nature of the costs involved.
Gas marketability must be addressed first, together with the function of the actual costs incurred. It must be determined whether those actual costs stem from the transportation of a marketable product, or whether they were costs incurred to make the product marketable. Therefore, we decline to adopt the view that "at the well" or "at the mouth of the well" language determines the allocation of transportation costs, but is silent with respect to all other costs. This view is both internally inconsistent and inconsistent with our view that the implied covenant to market controls the allocation of costs under circumstances where lease language fails to address cost allocation.
Moreover, by holding that "at the well" allocates transportation costs, the court of appeals does not acknowledge that the general rule regarding transportation costs assumes that gas is marketable as it emerges from the wellhead. Instead, the court of appeals essentially adopts the rule that, as a matter of law, transportation costs are deductible.
The general rule that transportation costs are allocated between the two parties after the gas is marketable is really part of a much broader rule. That broader rule holds that costs incurred after a marketable product has been obtained, that either enhance the value of the product or cause the product to be transported to another location, are shared by the lessee and the lessor. 3 Eugene Kuntz, A Treatise on the Law of Oil and Gas, § 40.5, at 351 (1989 & 2001 Supp.)[hereinafter Kuntz]. Accordingly, the analysis of whether transportation costs are deductible begs the question of when the gas is marketable.
If gas is marketable at the physical location of the well, then transportation costs may be shared between the lessee and the lessor. However, if gas is not marketable at the physical location of the well, either because it is not in a marketable condition, or because it is not acceptable for a commercial market, then the lessee has not met its burden of making the gas marketable. Thus, transportation costs may not be deducted from royalty payments. Adopting the view that the "at the well" language determines which costs are deductible from royalty payments fails to acknowledge that deductibility of costs is determined by whether gas is marketable, not by the physical location of the gas or the condition of the
Other jurisdictions have given differing views of the meaning of "at the well" language, and have found that instead of being silent, that language is sufficient to allocate costs. Specifically, in Piney Woods Country Life School v. Shell Oil Co., the Fifth Circuit concluded that "at the well" describes both location (place of sale) and quality of gas for the purpose of determining royalty calculations.
Similarly, the Michigan Court of Appeals concluded that "at the well" language "refers to proceeds minus refining and transportation costs, as opposed to proceeds at the point of sale, where refining and transportation costs are not deducted." Schroeder v. Terra Energy, Ltd.,
Likewise, Texas law supports the view that "at the well" establishes the point of valuation at the physical location at the mouth of the well. Martin v. Glass,
We disagree, however, with these jurisdictions because they fail to recognize that the implied covenant to market controls the lessee's duty to make the gas marketable. Instead, these jurisdictions have adopted the rule that the lessee's duty has ended once gas is severed from the wellhead, and thus, any costs incurred subsequent to that physical removal are to be shared by the parties. In Colorado, we decline to follow the rule that gas is "produced" once physically severed, and thus, decline to adopt the reasoning regarding the deductibility of costs adopted by these jurisdictions. See Garman, 886 P.2d at 657-61. However, notwithstanding the fact that we may be in the minority of states adopting this approach, we believe that it is the more sound analysis, and that it is consistent with our jurisprudence.
Finally, in interpreting leases like those in this case, we are mindful of the generally accepted rule that oil and gas leases are strictly construed against the lessee in favor of the lessor. Wilson v. Wakefield, 146 Kan. 693, 72 P.2d 978, 980 (1937); Ladd v. Upham, 58 S.W.2d 1037, 1039 (Tex.Civ.App. 1933); Davis v. Cramer,
Accordingly, based on our interpretation of the "at the well" and "at the mouth of the well" language common to the four lease types at issue, we conclude that the leases in this case are silent with respect to allocation of costs. We disagree with those jurisdictions that conclude that "at the well" is sufficient to allocate costs. Moreover, we disagree with the conclusion that "at the well" language addresses transportation costs, while not addressing other costs incurred in processing the gas. Instead, we conclude that because the leases are silent, we must look to the implied covenant to market, and our previous decision in Garman v. Conoco, to determine the proper allocation of costs.
B. Garman v. Conoco, Its Limitations, and the Implied Covenant to Market
Having concluded that the leases at issue in this case are silent with respect to the allocation of costs, we look to the implied covenant to market found in every oil and gas lease. Thus, our analysis is guided by our prior decision in Garman v. Conoco, where we addressed the application of the implied covenant to market to determine how to properly allocate costs.
In Garman, we answered a certified question from the U.S. District Court that asked, "Under Colorado law, is the owner of an overriding royalty interest in gas production required to bear a proportionate share of post-production costs, such as processing, transportation, and compression, when the assignment creating the overriding royalty interest is silent as to how post-production costs are to be borne?" Id. at 653. In our analysis, we made the assumption that the assignment creating the overriding royalty interest at issue was silent as to the allocation of post-production costs.
Our decision in Garman was limited in two ways. First, our ruling in that case only applied to leases that were silent with respect to the allocation of production costs. We determined that because the leases were silent on that issue, the implied covenant to market requires that the lessee produce gas and incur those expenses necessary to place gas in a condition acceptable for market. Second, we set forth criteria to assess whether the deduction of production costs from the royalty payments was appropriate, but only with respect to those production costs incurred after the gas was already marketable. Nowhere in Garman did we actually define marketable condition. The case before us, however, presents us with an opportunity to define marketability.
Our decision in Garman provides a framework for analysis of the issues presented in this case. However, further development regarding the concept of marketability is necessary in order to understand how costs are to be allocated in accordance with the implied covenant to market. Moreover, marketability must be defined in order to resolve this case and provide guidance to lower courts confronted with litigation addressing these issues. Accordingly, we next discuss how marketability is defined, and thus, how costs are to be allocated under the implied covenant to market.
C. Marketability and the Allocation of Costs
In order to resolve the dispute between the parties in this case, we must define marketability under Colorado law, and specifically under the implied duty to market found in every oil and gas lease. The court of appeals determined that marketability referred solely to the condition of the gas. Although the court of appeals was not without support in reaching this conclusion, we disagree with this analysis. Instead, we believe that the more accurate definition of marketability includes both a reference to the physical condition of the gas, as well as the ability for the gas to be sold in a commercial marketplace.
In Colorado, "we have recognized four implied covenants in oil and gas leases: to drill; to develop after discovery of oil and gas in paying quantities; to operate diligently and prudently; and to protect leased premises against drainage." Garman, 886 P.2d at 659. "Embodied in the covenant to operate diligently and prudently is the implied covenant to market." Davis v. Cramer,
2 Summers, supra, § 415 at 634.
In determining whether a lessee has met the obligations imposed by the implied duty to market, we look to the nature of the lessee's duty to market, and, implicitly, how a determination of marketability is made. In a footnote in Garman, we referred to two definitions of marketable condition. We said that "marketable means `fit to be offered for sale in a market; being such as may be justly and lawfully bought or sold . . . wanted by purchasers.'" Garman, 886 P.2d at 660 n. 26 (quoting Webster's 3rd New International Dictionary 1383 (1986)). We next stated that "Williams and Meyers define marketable condition as gas `sufficiently free from impurities that it will be taken by a purchaser.'" Garman, 886 P.2d at 660 n. 26 (quoting 8 Williams & Meyers at 692). Although seemingly helpful, those definitions were not incorporated into our discussion in Garman in defining the lessee's duty under the implied covenant to market, nor did we explain the meaning of those broad definitions. Certainly, these definitions could be interpreted as supporting our view here that in order to be marketable, gas must be in a certain physical condition, as well as being fit for sale in a commercial market. Accordingly, we consider these definitions consistent with our holding in this case. However, in order to fully understand the concept of marketability, we must go beyond those definitions.
We believe that the theory of the first-marketable product is helpful in guiding our definition of marketability, and what is meant by gas being in a marketable condition. Thus, in defining marketability, we look to the first-marketable product rule for guidance, but do not adopt it in its entirety.
There is a distinction between acts which constitute production and acts which constitute processing and refining of gas extracted
In looking to the first-marketable product rule for guidance in defining marketability, we must look to the practical implications of such a rule. In defining whether gas is marketable, there are two factors to consider, condition and location.
A market is a "[p]lace of commercial activity in which goods, commodities, securities, services, etc., are bought and sold." Black's Law Dictionary 970 (6th ed.1990). It is also defined as "[t]he region in which any commodity or product can be sold; the geographical or economic extent of commercial demand." Id. Thus, the determination of when gas is first-marketable is driven in part by the commercial realities of the marketplace. See Anderson, Part 2, supra, at 637 n. 112 (recognizing that a lease is a commercial transaction between lessee, as merchant, and lessor, as nonmerchant, and should be viewed based on commercial realities in the marketplace).
It may be, for all intents and purposes, that gas has reached the first-marketable product status when it is in the physical condition and location to enter the pipeline. See TXO Prod. Corp., 903 P.2d at 262-63 (implying that the standard for determining when gas is marketable is when it is fit to enter the pipeline, because costs of dehydration and gathering, which are required in order for the gas to enter the pipeline, are expenses borne by the lessee as part of the duty to market gas, and are not deductible expenses from royalty payments); R.E. Yarbrough & Co., 122 IBLA 217, 223 (1992)(gas not in marketable condition until prepared for delivery into pipeline); Wyo. Stat. § 30-5-304 (2000)(lessee pays all non-deductible costs of production including costs of gathering, compressing, dehydrating, and transporting the gas into the market pipeline); Jay G. Martin, Summary of Significant Gas Market and Transportation Changes Affecting Producers in the 1990's, 37 Rocky Mtn. Min. L. Inst. § 16.01 (1991)(production function of gas industry includes producer being responsible for "putting the gas into a marketable state by removing its impurities and gathering the gas from the various points of production (wellhead), and delivering it via gathering lines to a common point for delivery into the large diameter transmission lines").
Finally, the determination of marketability is a question of fact.
We recognize that pursuant to the first-marketable product rule, as explained by Anderson, transportation costs to a distant market are to be shared proportionately between the lessors and lessees. This allocation of transportation costs is consistent with the view the "at the well" language must be given some meaning. However, we have concluded that the "at the well" lease language in this case is silent as to allocation of all costs, including transportation costs. Under these circumstances, the logic of the first-marketable product rule requires that the allocation of all costs be determined based on when the gas is marketable. Thus, we decline to single out transportation costs and treat them differently than other costs.
In sum, in defining marketability under the implied covenant to market, we look to the first-marketable product rule for guidance. Gas is marketable when it is in the physical condition such that it is acceptable to be bought and sold in a commercial marketplace, and in the location of a commercial marketplace, such that it is commercially saleable in the oil and gas marketplace. The determination of whether gas is marketable is a question of fact, to be resolved by a fact finder.
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.
The following section addresses the jury instructions given in this case in light of our definition of marketability. In looking to our definition of marketability, the issue is raised by the trial court's instruction to the jury as to whether the determination of marketability also includes a consideration of the lessees' conduct. Thus, we also address this issue in our analysis of the jury instructions given in this case.
D. Jury Instruction Regarding Marketability
We have defined marketability as requiring that the gas be in a physical condition acceptable to be exchanged in a commercial market, and also in a location, the commercial marketplace, where the gas is commercially saleable. Here, we consider the jury instructions given by the trial court, and the court of appeals' analysis of those instructions, including the portion of the instruction related to the lessors' claims of bad faith by the lessees. We review the instructions to determine whether the trial court adequately instructed the jury on the issue of marketability. We conclude that it did not. We commence our discussion of the jury instructions with the court of appeals' conclusions.
The court of appeals analyzed the issue of marketability based on the jury instruction given by the trial court.
Notwithstanding its finding of error, however, the court of appeals considered the effect of this error on the lessors' claims. The court of appeals concluded that, with respect to sales at the wellhead, the erroneous instruction did not prejudice either party for two reasons. Id. at 974. First, the court of appeals reasoned that the lessors had not raised a valid claim that the gas was not marketable at the well because some of the gas was actually sold at the well. Thus, the court of appeals concluded that because the gas was sold, it must be marketable. Id.
Second, the court of appeals concluded that the only valid claim that the lessors could assert with respect to sales at the well was that the lessees acted unreasonably or in bad faith in selling the gas at the well. Thus, the court of appeals suggested that the jury, by determining that the gas was marketable at the well based on the instruction given, implicitly found that the lessees had acted reasonably and in good faith. Thus, the court of appeals concluded that the instruction was not prejudicial to either party. Id.
With respect to sales away from the well, however, the court of appeals determined that there was a more fundamental defect than the jury instruction itself. The court of appeals held that the trial court erred in submitting the issue of whether the gas was in a marketable condition to the jury with respect to sales away from the well, because the court of appeals concluded that the gas was marketable at the well as a matter of law. Id. Therefore, the court of appeals concluded that, because the gas was marketable at the well, all costs incurred subsequently were transportation costs, and thus, were deductible as a matter of law. Accordingly, the court of appeals held that because there was no issue of fact to be resolved, this question should not have been submitted to the jury. Id. at 974-75.
We first address the court of appeals' conclusion that the gas was marketable at the well as a matter of law, and thus, its determination that the marketability issue should not have been submitted to the jury with respect to gas sold away from the well. We disagree with the court of appeals, and conclude that the court of appeals erred in several aspects of this holding. First, we disagree with the court of appeals' conclusion that the gas was marketable as a matter of law. As we have previously stated, the question of marketability is one of fact, not law. Garman, 886 P.2d at 661 n. 28; Anderson, Part 2, supra, at 642. Thus, we disagree with the court of appeals' further conclusion that the costs at issue were properly deducted from the royalty calculations as a matter of law. Moreover, we hold that because the issue of whether gas is marketable is a factual inquiry, it was properly submitted to the jury.
Second, we disagree with the court of appeals' application of the first-marketable product theory. While it is true that Anderson suggests that the costs of compression should not always be borne by the lessee, and that transportation costs to a distant market should be shared by the lessor and the lessee, we have concluded, and Anderson agrees, that whether costs are deductible is based on whether a first-marketable product has been obtained, not on the label associated with any particular cost. See Anderson, Part 2, supra, at 640, 668-69, 682. Moreover, Anderson indicates that the determination of when gas is first-marketable is a question of fact, not a question of law, as suggested by the court of appeals. Id. at 642. Likewise, The dissent in Mittelstaedt advocates that Oklahoma should adopt the first-marketable
Finally, the court of appeals concluded that the gas was marketable at the physical location of the well, and as such, all costs incurred subsequently should be shared by the lessee and lessor. Such a conclusion was essentially an adoption of the reasoning followed in other states which contend that the point of marketability is at the physical location of the well. See generally Martin v. Glass,
Having confirmed that the issue of whether gas is marketable is a question of fact, and as such, was properly submitted to the jury with respect to all of the gas at issue in this case, we now analyze the actual instructions given to the jury regarding marketability. We first discuss the issue of whether the trial court's instruction to the jury was erroneous. The court of appeals suggested that the instruction was erroneous because it combined the issue of whether the gas was marketable with the issue of whether the lessees acted in good faith. We agree that this combination rendered the instruction erroneous.
Whether the lessees acted in bad faith is a separate issue from the determination of marketability for the purposes of determining allocation of costs and calculating royalty payments. An analysis of marketability allows for a determination of the proper allocation of costs, and thus, defines the calculation of royalty payments. In contrast, the bad faith of a lessee implicates the sale price of certain gas, either for less than it was worth, or to a related party for an artificially low price. Thus, in determining whether a lessee acted in bad faith, the focus is on the sale price of the gas, and what a fair sale price would have been had the lessee acted in good faith. A bad faith claim raises the issue of improper receipt and distribution of royalty payments, not calculation of the allocation of costs. Thus, a bad faith claim does not implicate allocation of costs in the first instance. Instead, a bad faith claim raises the issue of determining what a fair price would have been had the gas been sold in good faith.
A lessee's duty of good faith and fair dealing in performance of an oil and gas lease has developed through the law of implied covenants arising from contract law in general. See 5 Williams & Meyers, supra, § 802.1, at 8-14. In Colorado, every contract contains an implied duty of good faith and fair dealing. Amoco Oil Co. v. Ervin,
Regardless of the characterization of the lessee's duty as one requiring good faith and fair dealing, or acting as a prudent operator, analysis of the lessee's duty in either context relates to whether the lessee has breached that duty. See Davis v. Cramer,
As we have discussed, the determination of whether gas is marketable is a question of fact, and must be determined based on a condition and location in a commercial market. The commercial market and the condition of the gas dictates the marketability of the gas, not the independent actions of a particular lessee.
Thus, under the circumstances where bad faith of a lessee is at issue, it should be addressed and instructed separately from the issue of whether the gas is marketable.
We conclude that the instructions were erroneous for other reasons as well. Under Colorado law, all of the trial court's instructions are to be considered as a whole when determining whether the necessary law has been properly stated to the jury. Montgomery Ward & Co. v. Kerns, 172 Colo. 59, 63,
The language of the jury instruction at issue required the jury to evaluate marketability based on the condition of the gas.
When read carefully, it becomes clear that the instruction requests the jury to consider whether the gas is marketable based on the condition that it be taken by a purchaser. This language suggests that a single purchaser may be sufficient to establish that the gas is marketable. This suggestion is further solidified by the inclusion of the good faith requirement in the instruction. The good faith requirement suggests that as long as the lessees find a purchaser, and act in good faith and fair dealing in selling the gas to such a purchaser, that the gas is marketable. Under this instruction, it appears
Moreover, as we have discussed, the instruction erroneously requires the jury to consider whether the lessees acted in good faith in selecting a purchaser. This instruction is too narrowly tailored, and is limited to the actions of the lessees. It fails to address the broader concept of marketability. In other words, the instruction should have required the jury to analyze whether the gas was marketable by looking at more than just the sale of the gas by the lessees in this case. Whether the gas is marketable or not is a much broader question of fact, to be resolved based on whether there is a commercially viable market for the gas.
While we agree that a single purchaser, in a good faith purchase of gas, is evidence that there is a market for the gas, we do not agree that such a purchase conclusively establishes a market. The determination of whether a market exists is an issue of fact to be decided by a jury, based on the facts and circumstances, which may include factors other than a single purchase of gas. The jury instruction here erroneously implies that one sale to a purchaser in good faith establishes marketability. Instead, under our definition of marketability, the gas must be in such a physical condition and location that it is available for commercial exchange, in a viable market, i.e., a commercial marketplace. Moreover, if the instruction sufficiently advised the jury that in order to be marketable the gas must be available for sale in a commercial market, there would be no need for the good faith requirement. This is because the good faith notion is inherent in a commercial market. Thus, if the instruction were intended to define marketability in the context of a commercial market, the good faith requirement would be unnecessary.
The interpretation that the instruction at issue failed to adequately define marketability is further supported by looking at the other instructions given to the jury related to marketability. See Montgomery Ward & Co., 172 Colo. at 63, 470 P.2d at 36-37. Specifically, Instruction 15 stated that "gas can be marketable at more than one point in the field and in the production and distribution process." In general, we agree that this is an accurate statement. However, this instruction, in combination with the marketability instruction providing that gas is marketable when it is in a condition that it will be taken by a purchaser, suggests to the jury that the gas is marketable anywhere and anytime it is sold to a purchaser at any point in the field or process.
Similarly, Instruction 17 provides that the jury, having heard evidence relating to both gas which was sold at the wells, and gas which was sold away from the wells, must apply the instructions to gas which has been sold in each place. By referring to gas being sold, this instruction, in combination with the others, suggests that gas may be marketable assuming it is sold to a purchaser in good faith. Gas is not marketable merely because it is sold. Moreover, this instruction further emphasizes that the single sale of gas at a particular location determines marketability. Thus, it adds to the notion that the jury was instructed that marketability can be established by a single sale to a purchaser in good faith. As we have discussed above, such a definition of marketability is erroneous. Accordingly, we conclude that the instruction was erroneous with respect to marketability and allocation of costs, and thus, the jury was not adequately instructed on the appropriate law.
Having found the instruction was erroneous, we next discuss whether such error was substantial and prejudicial. We disagree with the court of appeals that the error was not prejudicial. Instead, we conclude that the error was both substantial and prejudicial, and thus requires reversal.
We first address the court of appeals conclusion that the erroneous instruction was not prejudicial with respect to gas sold at the well because of the fact that the gas was sold meant that it was marketable. We disagree with this analysis. There is a difference
3 Kuntz, supra, § 40.5 at 351. Moreover, as we have previously determined, marketability is a question of fact, not law. Thus, we disagree with the court of appeals' conclusion that the gas was marketable based solely on the fact that it was sold, and as such, disagree with the court of appeals' conclusion that the instruction was not prejudicial on this basis.
The court of appeals also concluded that the instruction was not prejudicial with respect to the sale of the gas at the well because under the good faith requirement of the instruction, the jury must have found that the lessees acted both reasonably and in good faith regarding those sales. Accordingly, the court of appeals concluded that there was no prejudice to either party resulting from the instruction. Rogers, 986 P.2d at 974. We agree with the court of appeals that the trial court erred in including the lessors' bad faith claim in the instruction regarding marketability. However, we disagree with the court of appeals that there was no prejudice to either party with respect to the bad faith claim regarding this instruction.
Although the instruction required the jury to consider the lessees' behavior in selling the gas, and make an assessment as to whether the lessees acted in good faith, it did not require the jury to consider the lessees' conduct apart from the issue of whether the gas was marketable. Instead, the marketability instruction combined the two claims, and thus, did not allow for either claim to be independently resolved by the jury. The jury was only allowed to consider the potential bad faith of the lessees in the context of whether the gas was marketable. As we have previously discussed, any claims of bad faith regarding the lessees' conduct are separate and distinct from the issue of whether the gas was marketable.
It is possible, as the court of appeals suggested, that by finding that the gas was marketable both at the well and away from the well, the jury may have found that the lessees had not acted in bad faith. However, because the instructions did not address the claims raised by the lessors separately, it may also be possible that the jury did not fully consider the lessees' conduct.
The language in the instruction did not refer to the claim that the gas was sold at an artificially low price, nor did it refer to the claim that the gas was sold to an affiliated purchaser. As such, it is unlikely that the jury considered whether the lessees acted in bad faith based on the actual allegations raised by the lessors in this litigation. Thus, the instruction was prejudicial and substantial with respect to the bad faith claim. Accordingly, we disagree with the court of appeals and conclude that the bad faith claim was not effectively resolved by the jury, since there was no separate instruction given to the jury addressing bad faith. Therefore, because the error in the jury instruction was both substantial and prejudicial with respect to the bad faith claim, the trial court judgment must be reversed.
In addition, as we previously explained, the instructions as a whole focused the analysis of marketability on whether a single purchaser bought the gas in a good faith transaction,
Moreover, the instructions, when reviewed as a whole, may explain why the jury found that the same gas was both marketable at the well, and not marketable at the well. It appears that the jury reached its verdict by determining that the gas was in the condition that it could be taken by a purchaser both at the well and away from the well, and that the lessees sold the gas in good faith at both of those points. Thus, under these instructions, it is understandable why the jury reached two apparently inconsistent results. Moreover, the instructions collectively indicate, and the inconsistent jury verdicts suggest, that the trial court essentially instructed the jury that a good faith purchaser was all that was needed to establish marketability as a matter of law. Because the error in the jury instructions was both substantial and prejudicial, the trial court judgment must be reversed, and this case remanded for a new trial on both the issue of allocation of costs and the issue of the alleged bad faith of the lessees.
After assessing the "at the well" and "at the mouth of the well" language in this case, we conclude that the leases at issue here are silent with respect to the allocation of costs. Moreover, we decline to adopt the rule that the "at the well" language in the leases allocates transportation costs, while being silent as to other costs. Because we have determined that the leases are silent with respect to allocation of costs, we look to the implied covenant to market to determine the proper allocation of costs.
Under the implied covenant to market, the lessees have a duty to make the gas marketable. In analyzing that duty, we look to the first-marketable product rule as guidance and adopt a definition of marketability to include both a physical condition such that the gas would be acceptable for sale in a commercial market, and a location-based assessment, such that it would be saleable in a commercial marketplace. The determination as to when gas is marketable is a question of fact. Once a determination is made that gas is marketable, costs can be allocated accordingly.
Ultimately, we conclude that because the trial court's instructions to the jury did not accurately and properly instruct the jury on the appropriate law to apply in determining marketability, the instructions were erroneous. Moreover, the error was both substantial and prejudicial. Therefore, we reverse the court of appeals' decision, and remand this case to the court of appeals for further proceedings consistent with this opinion. Specifically, upon retrial, the jury instructions on marketability should reflect the concept of marketability that we have outlined here. Further, the bad faith claim should be addressed and instructed separately from the gas marketability issue.
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