Defining the Royalty Obligation

John S. Lowe, Southern Methodist University, Dedman School of Law

Abstract

The restructuring of the natural gas markets in the 1980s and 1990s has fundamentally changed the way the natural gas industry conducts business. This structural change, in turn, has reignited old disputes between lessors and lessees over which revenues that lessees receive are subject to the royalty obligation.

The thesis of this article is that the current controversy over whether royalty is due on take-or-pay benefits is closely related to litigation of a generation ago about the meaning of "market value." The principles developed in the market value litigation are likely to be applied to resolve current royalty disputes, such as the issue of royalty on take-or-pay benefits.

The article first examines the background of the royalty on take-or-pay disputes, including the interpretative principles applied by the courts in market value royalty cases. The article traces the controversy over royalty on take-or-pay benefits, analyzing the cases and their theories in an attempt to rationalize the developing lines of precedent. After determining that the lines of cases are irreconcilable, it predicts the likely direction of future case law and suggests limits to the logic of the case law.

The article concludes by considering the implications of the royalty on take-or-pay benefits cases for other disputes about the extent of the royalty obligation. This article examines only whether the royalty clause of the typical oil and gas lease includes take-or-pay benefits and some other benefits provided by the deregulated gas markets. This analysis does not examine the related, but conceptually distinct, issues of what deductions may be made in calculating royalty and the scope of the implied covenants to market or to operate diligently and properly.