Tara Petroleum Corp. v. Hughey

• Decision Date: 09 June 1981
• Docket Number: No. 53585,53585
• Citation: 630 P.2d 1269,1981 OK 65
• Parties: TARA PETROLEUM CORPORATION, Jarrett Oil Company, Appellants, v. Chester HUGHEY, Individually and as Administrator of the Estate of William F. Hughey, Deceased, Coy Brown, W. E. Pugh, James D. Howard, Dick Steelman, and Wilcoy Petroleum Company, Appellees.
• Court: Oklahoma Supreme Court

Page 1269

630 P.2d 1269

1981 OK 65

TARA PETROLEUM CORPORATION, Jarrett Oil Company, Appellants, v. Chester HUGHEY, Individually and as Administrator of the Estate of William F. Hughey, Deceased, Coy Brown W. E. Pugh, James D. Howard, Dick Steelman, and Wilcoy Petroleum Company, Appellees.

No. 53585.

Supreme Court of Oklahoma.

June 9, 1981.

Rehearing Denied July 28, 1981.

Appeal from the District Court of Greer County; Charles M. Wilson, Trial Judge.

The assignee-producers under a 1973 oil and gas lease sold natural gas pursuant to a two-year gas purchase contract from 1976 to 1978. During that time the purchaser of the gas, a middleman with a contract to resell the gas at the ceiling price allowed by the Federal Power Commission, received substantially more for the gas than it paid the producers. The royalty owners' royalties were based on the lower price. They sued the original lessee, the first purchaser of the gas, and the producers for additional royalties. Judgment was taken against the original lessee and the first purchaser, who appeal.

REVERSED.

Sparks & Sparks, Tulsa, for appellants.

Yonne P. McDaniel, Mangum, for appellee, Chester Hughey, Individually and as Administrator of the Estate of William F. Hughey, Deceased.

John C. Buckingham, Oklahoma City, for appellees, Coy Brown, W. E. Pugh, James D. Howard, Dick Steelman, and Wilcoy Petroleum Company.

LAVENDER, Justice:

This appeal is from a judgment of the District Court of Greer County, Oklahoma, awarding $18,000 in additional royalties under an oil and gas lease to the plaintiff-lessor.

The property involved is described as lots 3 and 4 and the south half of the northwest quarter of section 5, township 5 north, range 23 west of the Indian Meridian, Greer County, Oklahoma. It contains some 161 acres.

In 1973 the four lessors, as the sole heirs of William F. Hughey, deceased, executed the lease to Tara Petroleum Corporation ("Tara"). Six months later Tara assigned the lease to an individual, Coy Brown, reserving an overriding royalty of 1/8 of the 7/8 working interest and reserving the right to purchase any gas produced at 31cents per mcf.

In 1974 Coy Brown drilled a well on the property, ¹ but it was not a producer. Then in February of 1976 he assigned the lease to Wilcoy Petroleum Company ("Wilcoy"), a corporation owned by him, his wife Wilma, his brother-in-law W. E. Pugh, and Pugh's wife Maudine. In addition to the one to Wilcoy, there also appears of record another assignment of the lease from Coy Brown, this one dated and filed May 19, 1976, in which Brown reserved an interest in the lease and assigned decimal interests to W. E. Pugh, Dick Steelman, and James D. Howard. ²

Wilcoy apparently with the financial help of Steelman and Howard drilled a producing gas well on the property in February 1976. In that same month Wilcoy, as seller, entered into a gas purchase contract with Jarrett Oil Company ("Jarrett") as the buyer. The contract was for two years and extended automatically from year to year thereafter. It could be terminated at the end of the two-year period or on any anniversary of that date upon ninety days notice by either party.

Production from the Hughey well began in March of 1976. Although the gas purchase contract called for the seller, Wilcoy, to pay "all royalties, overrides and production payments," the buyer, Jarrett, made the actual payments. At the end of the two-year period, Wilcoy terminated the contract.

It is the royalties for those two years March 1976 through February 1978 that concern us in this action. They were based on the contract price Jarrett paid Wilcoy for the gas: 32cents per mcf the first year, 33cents the second, adjusted for BTU content. During that time Jarrett sold the gas from the Hughey well, and other gas it purchased in the field, to El Paso Natural Gas Company. Jarrett's contract with El Paso Natural Gas provided for Jarrett to receive for its gas the ceiling price permitted by the Federal Power Commission. Nearly five months after Jarrett began purchasing gas from the Hughey well, the Federal Power Commission substantially raised the ceiling price. Thereafter Jarrett received much more from El Paso Natural Gas than the 32cents or 33cents it paid Wilcoy for the gas from the Hughey well. The price went as high as nearly $1.30 per mcf.

The lessors felt that they were owed additional royalties for this two-year period. Their lease has a more or less standard "market price" royalty clause for gas. It reads:

In consideration of the premises the said lessee covenants and agrees:

2nd. To pay lessor for gas of whatsoever nature and kind produced and sold or used off the premises, or used in the manufacture of any products therefrom, one-eighth (1/8) at the market price at the well for the gas sold, used off the premises, or in the manufacture of products therefrom, said payments to be made monthly.... (Emphasis added.)

Under this clause the lessors asserted that they were entitled to have their royalties measured by the price El Paso Natural Gas paid Jarrett, rather than the contract price Jarrett paid Wilcoy.

The lessors sued the original lessee (Tara), the first purchaser of the gas (Jarrett), and Wilcoy, Brown, Pugh, Steelman, and Howard (collectively referred to as the "producers"). Another defendant, Falcon Oil and Gas Company, was let out of the suit, and all but one of the original plaintiff-lessors dismissed their actions. The trial court held for the remaining plaintiff against Tara and Jarrett, awarding a joint and several judgment for $18,000 for additional royalties. The court held for the producers on the plaintiff's actions against them. Tara and Jarrett appeal.

I.

Disputes between lessors and lessees over the amount of royalty to be paid on gas production have become relatively common. The kind of dispute we have before us today arises because lessees, in order to market the gas, must ordinarily enter into long-term gas purchase contracts. As the current price of gas increases, lessors with more recent leases, more recent wells, and more recent gas purchase contracts receive royalty on higher prices than their counterparts with older production. Understandably, this seems unfair to the lessors.

Here the plaintiff did not ask for additional royalties based on a price that other lessors received for their gas, he asked for additional royalties based on what was actually paid for his gas. A middleman Jarrett Oil Company is present here. Nevertheless, the question is the same: Is a lessor with a "market price" gas royalty clause ³ entitled to have his royalty calculated on the highest current price in the field? Put another way, is the "contract price" the price the producer gets according to the gas purchase contract the "market price" under the lease?

We hold that it is. In doing so, we recognize at the outset that some other jurisdictions have held otherwise. They are the Fifth Circuit, ⁴ Texas, ⁵ Kansas, ⁶ and Montana. ⁷ The cases from these jurisdictions have generated a fair amount of comment, ⁸ including comment by Oklahoma authors. ⁹ By and large, the results in those cases have been criticized. ¹⁰

Once a producing well is drilled, a producer has a duty to market the gas. ¹¹ In order to market gas it is usually necessary to enter into a gas purchase contract frequently a long-term one, much longer than the term of the contract involved in this case. We have recognized this necessity of the market, ¹² and we believe that lessors and lessees know and consider it when they negotiate oil and gas leases. Lessors and lessees also know that during the term of a gas purchase contract gas prices may increase, perhaps substantially. During the term a producer's revenues, fluctuations in production aside, will not increase. Yet if royalty must be paid on the basis of a "current," steadily-increasing "prevailing" price, then the lessor's share will take an ever larger and larger proportion of the producer's revenues. Consider for example the situation in this case: Under their contract the producers received 32cents per mcf the first year. The royalty share of that amount, one eighth, is 4cents. Yet by the end of the first year the first purchaser, Jarrett, was receiving nearly $1.28 for the gas. One eighth of $1.28 is 16cents. So if royalty were measured by the price El Paso Natural Gas paid Jarrett, the lessors' royalty would have quadrupled in one year to one half of the producers' revenues. And all the while, of course, the producers' revenue per mcf remained constant.

This would not be fair to the producers. We do not believe that the lessors in this case, the original lessee, or the assignee-producers ever contemplated that the lessors' royalty could be half of what the producers received for the gas. The better rule and the one we adopt is that when a producer's lease calls for royalty on gas based on the market price at the well and the producer enters into an arm's-length, good faith gas purchase contract with the best price and term available to the producer at the time, that price is the "market price" and will discharge the producer's gas royalty obligation. ¹³ As one respected author has said:

Conceding that competent parties should be held to their agreements even though improvident, the typical clause, as a minimum, seems to be freighted with inherent ambiguity when it is remembered that gas must be sold by long term contracts in which buyers have been able to obtain schedules of prices almost certain to get out of line with contemporary contracts being negotiated. It was this consideration which caused gas sellers, where they were able, to insist on the "most favored nations" clauses now outlawed by the Federal Power Commission in current contracting of jurisdictional sales by the device of refusing filing to such contracts. (In Vela, a life of the lease sales contract at 2.3cents per MCF, conceded to be reasonable in the circumstances of 1935 when...