Opinion ID: 2633380
Heading Depth: 2
Heading Rank: 3

Heading: Marketability and the Allocation of Costs

Text: 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, 808 P.2d 358, 361 (Colo.1991). The covenant requires that the lessee exercise reasonable diligence to market the products, defined as whatever, in the circumstances, would be reasonably expected of all operators of ordinary prudence, having regard to the interests of both lessor and lessee. Id. at 363. Among the facts and circumstances which are to be considered in the determination of the lessee's diligence in marketing are, the availability of marketing facilities, such as pipe lines and the efforts of the lessee in securing the extension of pipelines into the field; the pressure and quality of gas as affecting its marketability; the cost of pumping oil, the amount produced, and the prevailing market price therefor; and the time and manner of the performance of such acts as might result in marketing. 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. [17] The first-marketable product rule states that the point where a marketable product is first obtained is the logical point where the exploration and production segment of the oil and gas industry ends, is the point where the primary objective of the lease contract is achieved, and therefore is the logical point for the calculation of royalty. [18] Anderson, Part 2, supra, at 637. Thus, this rule provides that royalty calculations should be made at the point where a first-marketable product has been obtained. Id. at 639-40. Under this theory, the point at which gas first becomes a marketable product would be established on the basis of a known and real market. [19] Id. at 640-41. Production, and thus, the lessee's duty to produce a marketable product, would end when a first-marketable product has in fact been obtained. Id. at 642. Thus, depending on the factual scenario, production could end at the point of extraction, or elsewhere. Id. There is a distinction between acts which constitute production and acts which constitute processing and refining of gas extracted by production. 3 Kuntz, supra,  40.5 at 351. Unquestionably, under most leases, the lessee must bear all costs of production. There is, however, no reason to impose on the lessee the costs of refining or processing the product, unless an intention to do so is revealed by the lease. It is submitted that acts which constitute production have not ceased until a marketable product has been obtained. After a marketable product has been obtained, then further costs in improving or transporting such product should be shared by the lessor and lessee if royalty gas is delivered in kind, or such costs should be taken into account in determining market value if royalty is paid in money. Id. 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. [20] First, we must look to whether the gas is in a marketable condition, that is, in the physical condition where it is acceptable to be bought and sold in a commercial marketplace. Second, we must look to location, that is, the commercial marketplace, to determine whether the gas is commercially saleable in the oil and gas marketplace. 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. [21] Anderson, Part 2, supra, at 642; see also Garman, 886 P.2d at 661 n. 28 (a determination of whether lessee diligent in marketing efforts is question of fact). Sans factual inquiry, it is impossible to determine the very existence of a market. Mittelstaedt, 954 P.2d at 1214 (Opala, J., dissenting). Treating marketability as a question of law ignores market realities. Id. 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.