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The Anderson Living Trust v. Energen Resources Corp.

United States Court of Appeals, Tenth Circuit

March 2, 2018


         Appeal from the United States District Court for the District of New Mexico (D.C. No. 1: 13-CV-00909-WJ-CG) (D. N.M.)

          Bradley D. Brickell, Brickell & Associates, P.C., Norman, Oklahoma (Margaret M. Branch and Cynthia L. Zedalis, Branch Law Firm, Albuquerque, New Mexico, Karen Aubrey, Law Office of Karen Aubrey, Santa Fe, New Mexico, and Brian K. Branch, Law Office of Brian K. Branch, Albuquerque, New Mexico, with him on the briefs), for Appellants.

          Christopher A. Chrisman, Holland & Hart LLP, Denver, Colorado (Bradford C. Berge, Holland & Hart LLP, Santa Fe, New Mexico, and Jessica M. Schmidt, Holland & Hart LLP, Denver, Colorado, with him on the brief), for Appellee.

          Before TYMKOVICH, Chief Judge, HARTZ, and O'BRIEN, Circuit Judges.


         Appellants, the Anderson Living Trust, the Pritchett Living Trust, the Neely-Robertson Revocable Family Trust, and the Tatum Living Trust (collectively the Trusts), and Appellee, Energen Resources Corporation, have petitioned for panel rehearing. Neither party has requested en banc review. Both parties have filed responses to the other's petition. The Trusts have filed a motion for leave to file a reply.

         The Trusts' petition for panel rehearing is GRANTED to the extent we have removed footnote 19 from the opinion filed on January 9, 2018, which was unopposed. Their petition is DENIED in all other respects. We have considered the Trusts' reply and GRANT their motion for leave to file it. The Clerk is directed to show it filed on the docket effective the date of this order.

         Energen's petition for panel rehearing is GRANTED to the extent we have clarified in the, that Energen does not market (sell) the gas it produces on the leased properties at the wellhead. The changes are reflected on pages 7 and 8 of the revised Opinion.

         The Clerk is directed to file the attached revised Opinion effective the date of this order.


         Fossil fuels are the decomposed remains of pre-historic flora (coal) and fauna (oil and gas). They have driven the world's economy (particularly that of the United States) for over a century. Discovering marketable deposits, extracting them from the ground, refining them, and delivering them to consumers in useful form is big business, on one hand fraught with risk and on the other richly rewarding. That being so, it has attracted the attention of governments as a lucrative source of tax revenue as well as royalties, bonuses, etc., derived from government-owned reserves and as a way of directing public policy. Since oil and gas are the most energy dense[1] and convenient of the fossil fuels, litigation and regulation abound with respect to them. But, in large measure mineral owners (private and public) and those involved with mineral producers have been free to contractually "strike their own deals." Myriad matters are involved; here we are principally concerned with construing the language of leases in accordance with prevailing law-both statutes and case law. Statutes, of course, properly direct policy. So do cases, more covertly, but no less dramatically.

         Oil and gas law is rife with duties owed by the lessee to the lessor. Some of those duties are expressed in an agreement (the lease). Others duties are imposed by the courts as implied covenants. See generally, 6 Peter Linzer, Corbin on Contracts § 26.1 (Joseph M. Perillo ed. 2010). This case involves the implied covenant to market gas. It benefits the lessor, in particular, by insuring that the lessee uses reasonable efforts to market potential production. That way the lessor can enjoy the benefits the lease provides. This case deals with that implied covenant, but more particularly with what has come to be known as the marketable condition rule. In its purest form, that advocated by appellants, it not only requires the lessor to market the gas, but to do so solely at its expense. Colorado has adopted a version of the marketable condition rule, which applies only when the lease does not provide otherwise. Years ago we predicted New Mexico would not adopt the marketable condition rule and so far neither the legislature nor the New Mexico Supreme Court has done so. Accordingly, our decision rests on the terms of the leases involved. We rely on the text of the leases and the meaning commonly ascribed to the language used (the essence of the common law, which reflects the practices of the community, rather than dictates practices to the community).

         The San Juan Basin, located in northwestern New Mexico and southern Colorado, is a rich source of oil and natural gas. Energen owns and operates oil and gas wells in the Basin.[2] Its wells are subject to leases and other agreements (many of which are quite old) requiring it to pay a monthly royalty or overriding royalty[3] on production to the Anderson Living Trust, the Pritchett Living Trust, the Neely-Robertson Revocable Family Trust (N-R Trust), and the Tatum Living Trust. The royalty interests of the Anderson, Pritchett, and N-R Trusts (collectively the New Mexico Trusts) derive from wells located in New Mexico, the Tatum Trust's royalty interest from wells located in Colorado.

         Believing Energen was systematically underpaying royalties, all of the Trusts filed a putative class action complaint against it.[4] The New Mexico Trusts claimed Energen was improperly deducting from their royalties their proportionate share of (1) the costs it incurs to place the gas produced from the wells in a marketable condition (post-production costs) and (2) a privilege tax the State of New Mexico imposes on natural gas processors (the natural gas processors tax). They also alleged Energen had not timely paid royalties or interest thereon, as required by the New Mexico Oil and Gas Proceeds Payments Act. Both the New Mexico Trusts and the Tatum Trust further claimed Energen was wrongfully failing to pay royalty on the gas it used as fuel.

         The district judge dismissed the New Mexico Trusts' marketable condition rule claim for failure to state a claim under Fed.R.Civ.P. 12(b)(6) and entered summary judgment in favor of Energen on the remaining claims. All of the Trusts appeal from those judgments.[5] Our review is de novo. Birch v. Polaris Indus., Inc., 812 F.3d 1238, 1251 (10th Cir. 2015) (grant of summary judgment is reviewed de novo); Thomas v. Kaven, 765 F.3d 1183, 1190 (10th Cir. 2014) (grant of motion to dismiss under Fed.R.Civ.P. 12(b)(6) is reviewed de novo).

         For the most part we agree with the district judge, particularly in the following respects:

         First, under New Mexico law, Energen had the duty to diligently market the gas for the benefit of the New Mexico Trusts but that duty did not prohibit it from deducting from their royalty payments their proportionate share of post-production costs-those costs necessary to make the gas marketable (i.e., the marketable condition rule does not apply in New Mexico).

         Second, nothing in the New Mexico Natural Gas Processors Tax Act or other New Mexico law prohibited Energen from deducting the Trusts' proportionate share of the tax from their royalties.

         Finally, the Anderson and Pritchett Trusts' lease allows Energen to use produced gas as fuel without paying royalty on it.

         In some respects, we part ways with him. They relate to: (1) the fuel gas claims made by the N-R Trust and Tatum Trust and (2) the New Mexico Trusts' claim under the New Mexico Oil and Gas Proceeds Payments Act. As to the former, the N-R Trust's overriding royalty agreement requires royalty to be paid on all gas produced, including that gas used as fuel. And the Tatum Trust's leases explicitly prohibit Energen from deducting post-production costs (Energen treats its use of the fuel gas as an in-kind post-production cost). Moreover, the "free use" clauses and royalty provisions in the Tatum Trust's leases limit the free use of gas to that occurring on the leased premises. Because use of the fuel gas occurs off the leased premises, Energen owes royalty on that gas. With regard to the latter, the judge was right in permitting Energen to hold funds owed to the N-R Trust in a suspense account until a title issue concerning a well was resolved in favor of that Trust. However, he did not address whether the N-R Trust was entitled to statutory interest on those funds. It was so entitled, yet the current record (at least as we read it) does not show interest to have been paid on the funds.

         We now explain. Because all claims do not apply to all appellants, we discuss the issues separately, providing a brief background of the facts relevant to each.[6]

         I. Marketable Condition Rule-New Mexico Trusts

         A. Background

         The gas produced from Energen's wells on the leased properties is not marketed (sold) at the wellhead. See 8 Howard R. Williams & Charles J. Meyers, Oil and Gas Law, at 830 (2011) (defining "[p]roduction of gas" as "[t]he act of bringing forth gas from the earth"). It is first gathered, compressed, dehydrated, and treated.[7] Energen contracts with third-party companies to perform these services. It then sells the processed gas at the tailgate of the third-party processing plants to various energy companies.

         Energen pays the New Mexico Trusts, as royalty, a portion of the downstream sales price. However, it deducts from that price each Trust's proportionate share of the fees it pays to third-party companies to make the gas marketable (post-production costs).

         The New Mexico Trusts claim this deduction is improper because, in their words, New Mexico law imposes an implied duty on Energen to market the gas for the benefit of the royalty owners and that duty necessarily prohibits Energen from deducting post-production costs from their royalty payments (generally referred to as the marketable condition rule).[8]

         The New Mexico Trusts' leases set the basis for royalty payments as the "market value at the well" or the "prevailing field market price." (Appellants' App'x at 342 (N-R Trust), 338 (Anderson and Pritchett Trusts).) Determining those amounts, however, is not straightforward, because Energen does not sell the gas it produces on these leased properties "at the well." As we explained in Abraham v. BP America Production Co.:

In order to determine the market value of the unprocessed gas at the well, producers sell refined natural gas and NGLs [natural gas liquids] at the tailgate of the processing plant (i.e., after processing) to establish a base sales amount, and deduct from that amount costs for transportation, processing, etc. This is called a "netback" or "workback" method, and it is widely accepted as the best means for estimating the market value of gas at the well where no such market exists.

685 F.3d 1196, 1200 (10th Cir. 2012).

         Properly understood, the netback method is not a means of cost-shifting; it is a means of determining the net profit on the oil and gas by "netting" the gross profit. The post-production expenses are not subtracted from the sales amount because the royalty owners are responsible for post-production expenses; they are subtracted as an accounting mechanism to determine the market value at the wellhead. Stated differently, "value added" to the gas produced at the wellhead solely through the effort and expense of the lessee must be deducted from an established market price of the improved product in order to make an accurate estimate of the value of the gas at the wellhead. In simple terms, if [A] the market value at the wellhead [B] the value added in the production process (post-production costs)[9] = [C] the value of the processed natural gas (the sales price of the processed gas), then [C] - [B] = [A]. Subtracting [B] does not shift some of the costs of production to the lessors; it is an accounting adjustment designed to effectuate the intention of the parties as it is expressed in the parties' agreement-the lease. The Fifth Circuit explained this rationale years ago:

[I]n the analytical process of reconstructing a market value where none otherwise exists with sufficient definiteness, all increase in the ultimate sales value attributable to the expenses incurred in transporting and processing the commodity must be deducted. The royalty owner shares only in what is left over, whether stated in terms of cash or an end product. In this sense he bears his proportionate part[] of that cost, but not because the obligation (or expense) of production rests on him. Rather, it is because that is the way in which [one] arrives at the value of the gas at the moment it seeks to escape from the wellhead.

Freeland v. Sun Oil Co., 277 F.2d 154, 159 (5th Cir. 1960).

         To recap: It is incorrect to assert, as the Trusts do, that royalty owners are "bearing post-production costs." They are not.[10] With that matter now settled, we press on to the marketable condition rule.

         B. New Mexico Has Not Adopted the Marketable Condition Rule

         As we will explain, the New Mexico Supreme Court has decided oil and gas well operators have a duty to market the gas for the benefit of the royalty owners and that duty is one implied as a matter of law (irrespective of the parties' agreement). See Davis v. Devon Energy Corp., 218 P.3d 75, 86 (N.M. 2009). However, it has yet to decide whether that duty includes the marketable condition rule.[11] Normally, in such circumstances, we would attempt to predict what that Court would do. Coll v. First Am. Title Ins. Co., 642 F.3d 876, 886 (10th Cir. 2011). However, "when a panel of this Court has rendered a decision interpreting state law, that interpretation is binding on district courts in this circuit, and on subsequent panels of this Court, unless an intervening decision of the state's highest court has resolved the issue." Wankier v. Crown Equip. Corp., 353 F.3d 862, 866 (10th Cir. 2003) (emphasis added).

         The district judge decided the issue was put to rest in Elliott Indus. Ltd. P'ship v. BP Am. Prod. Co., 407 F.3d 1091 (10th Cir. 2005). Energen argues we are obligated to honor Elliott's holding. We agree.

         C. Elliott Decides the Issue

         In Elliott, the royalty agreement required the well operators to pay Elliott Industries a royalty on the "'market value of the gas at the well.'" 407 F.3d at 1100. To establish that value, the operators deducted their post-production costs from the downstream sales price, including 39% of the natural gas liquids, which the operators retained as an in-kind fee for their processing services (i.e., the netback or workback method, see supra at 8-10). Id. Elliott objected to the 39% in-kind deduction, arguing, among other things, it was not a legitimate post-production cost and its deduction results in an underpayment of royalty. Id. at 1100, 1107. It claimed the operators had an implied duty to market the gas, which also prohibited them from deducting post-production costs from the royalty payment. Id. at 1113. We concluded the operators had complied with the implied duty to market under New Mexico law-they were actively producing gas, processing it, and selling the refined natural gas and natural gas liquids. Id. (citing Darr v. Eldridge, 346 P.2d 1041, 1044 (N.M. 1959) (the implied duty to market requires oil and gas well operators/lessees "to make diligent efforts to market the production in order that the lessor may realize on his royalty interest.") (quotation marks omitted)).

         Elliott (like the New Mexico Trusts here) claimed the implied duty to market included the marketable condition rule, which prohibited the operators from deducting the costs necessary to make the product marketable, including the cost of removing the natural gas liquids from the gas, in calculating the value of the gas at the wellhead under the netback method. Id. at 1113-14. Not so, we said: "This conception of the implied duty to market finds no support within New Mexico case law." Id. at 1114 (emphasis added).

         Although the New Mexico Trusts acknowledge Elliott, they provide a host of technical reasons why we should ignore it. Energen, of course, presents contrary arguments. That particular debate may seem arcane and the arguments tedious, but the discussion is necessary. So, as some residents of the Tenth Circuit might say: Saddle up!

         D. Dicta

         The New Mexico Trusts tell us Elliott's discussion of the marketable condition rule is dicta. According to them, the panel had already decided the implied duty to market claim failed because Elliott had dismissed its claim for breach of the royalty agreement. They are incorrect, both factually and legally.

         Elliott did not dismiss its breach of contract claim; it never brought one. 407 F.3d at 1107 ("Elliott . . . has never asserted an unequivocal and straight-forward contract claim alleging a breach of [the operators'] express obligations to pay royalties. In fact, Elliott steadfastly disclaims any cause of action for breach of an express contract."). Our discussion of the marketable condition rule was not dicta.

         In lieu of raising a breach of contract claim, Elliott relied on the implied duty to market, claiming that duty should govern because the contract did not specifically address the 39% in-kind processing fee. Id. at 1111. According to Elliott, that duty prohibited the operators from deducting from the royalty payment the cost of removing the natural gas liquids from the gas. Id. at 1107-08, 1113. We rejected that argument on two grounds.

         First, Elliott could not show that an implied duty to market existed in that case because other than asserting that the royalty agreement did not address the 39% processing charge, it did not otherwise rely on the agreement. Id. at 1113. Without the agreement, we could not determine "whether any implied duty to market was intended by the parties or would contradict the express provisions of that agreement . . . . This court cannot speculate as to what [the agreement] contain[s] or how to construe the scope of any implied covenant to market that may exist." Id. (citing Cont'l Potash, Inc. v. Freeport-McMoran, Inc., 858 P.2d 66, 80 (N.M. 1993)).

         Second, even ignoring Elliott's "strategic choice" not to rely on the express terms of the royalty agreement, the implied duty to market claim "still fail[ed]." Id. Elliott tried to use the implied duty to supplement the express provisions of the agreement, including the "at the well" language. Id. Doing so was improper, we said, because "under New Mexico law, covenants are not implied for subjects that are treated in express provisions." Id. (citing Cont'l Potash, Inc., 858 P.2d at 80). Moreover, the operators were actively marketing the gas and New Mexico law did not support the applicability of the marketable condition rule. Id. at 1113-14.

         Our rejection of the marketable condition rule constituted an alternative rationale for rejecting Elliott's implied duty to market claim. "Alternative rationales, . . . providing as they do further grounds for the Court's disposition, ordinarily cannot be written off as dicta." See Surefoot LC v. Sure Foot Corp., 531 F.3d 1236, 1243 (10th Cir. 2008); see also United States v. Rohde, 159 F.3d 1298, 1302 (10th Cir. 1998) (alternative holdings are not dicta).

         Admittedly, we could have resolved Elliott's implied duty to market claim without reaching the applicability of the marketable condition rule. However, we could have also decided the claim solely by rejecting the marketable condition rule. The New Mexico Trusts have not explained why we ought label the latter dicta, but not the former. See Rohde, 159 F.3d at 1302 n.5 (10th Cir. 1998) ("Were this panel inclined to engage in the business of labeling as dicta one of the two alternative grounds . . ., it would then confront defendant's failure to demonstrate why that label ought not adhere to the alternative which is innocuous to her theory, rather than to the alternative which undermines it.").

         E. Reliance on Continental Potash

         The New Mexico Trusts also attack Elliott for relying on Continental Potash, Inc. v. Freeport-McMoran, Inc., 858 P.2d 66 (N.M. 1993), which they say was subsequently limited by Davis, 218 P.3d 75. For what it's worth, we agree with their reading of Davis; but it doesn't help them.

         In Continental Potash, the New Mexico Supreme Court said covenants will not be implied on contracting parties when the issue is expressly covered in the parties' agreement. 858 P.2d at 80 ("The general rule is that an implied covenant cannot co-exist with express covenants that specifically cover the same subject matter"; "when the contract between the parties speaks to the obligation sought to be implied, courts will not write that implied obligation into the contract."). However, in Davis, the Court clarified that Continental Potash was speaking only to those covenants "implied in fact, " i.e., those implied based on the language of the parties' agreements. 218 P.3d at 85. Not surprisingly, covenants implied in fact require analyzing the parties' intentions as expressed in their agreement. Id. But, as Davis makes clear, there are also covenants implied as a matter of law. Id. Duties implied by law apply to the parties irrespective of the language of their agreement. Id. Davis said the implied duty to market falls in the latter category. Id. at 86. It thus undermines Elliott, but only in part.

         The Elliott panel relied on Continental Potash as one basis for rejecting Elliott's implied duty to market claim-it could not determine whether an implied duty to market existed without knowing from the royalty agreement whether such duty was intended, nor could Elliott use the duty to supplement the royalty agreement's terms because covenants are not implied for subjects expressly treated in an agreement. Elliott, 407 F.3d at 1113. Davis, however, said the implied duty to market is one implied by law, which does not require analysis of the parties' agreement and applies notwithstanding that agreement.[12]

         But Davis does not undermine Elliott's decision that the marketable condition rule finds no support in New Mexico law because, semantics aside, the Davis Court explicitly declined to decide that issue, finding it not ripe for review. Id. at 80-81 ("[W]e do not address the existence of the marketable condition rule in New Mexico . . . . [N]othing in this opinion should be construed as either the recognition or disapproval of the marketable condition rule, its scope, or its applicability."). It assumed the marketable condition rule applied in New Mexico only because the trial judge concluded it did. Id. at 80. Even more to the point, the New Mexico Supreme Court subsequently clarified: "[I]n Davis we declined to address whether the marketable condition rule is inherent in the implied covenant to market, and whether, if recognized in New Mexico, the marketable condition rule would be implied in fact or at law." ConocoPhillips Co. v. Lyons (Lyons), 299 P.3d 844, 860 (N.M. 2012) (citation omitted).

         Notwithstanding that fairly clear statement, the New Mexico Trusts nevertheless tell us the Davis Court implicitly imposed the marketable condition rule on New Mexico. According to the Trusts, the Davis Court surely would have recognized the extreme waste of judicial resources that would occur for it to grant class certification in that appeal based on the trial judge's adoption of the marketable condition rule only to later say in a second appeal that the marketable condition rule does not exist in New ...

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