Watts v. Atlantic Richfield Co.

F I L E D
United States Court of Appeals
Tenth Circuit
PUBLISH
JUN 10 1997
UNITED STATES COURT OF APPEALS
PATRICK FISHER
Clerk
TENTH CIRCUIT

MOSE C. WATTS, individually; MOSE C. WATTS,
Co-Trustee of the Mose C. Watts Ranch Trust; RONALD
W. MCGEE, as Co-Trustee of the Mose C. Watts Ranch
Trust; EDITH B. WARTICK; JOHN ALLEN WARTICK;
RITA L. PARK; JUDITH ANN HOLLINGBACK;
THOMAS OWEN WARTICK; EDITH B. WARTICK,
Co-Trustee of the Edith B. Wartick Trust; JOHN ALLEN
WARTICK, Co-Trustee of the Edith B. Wartick Trust;
RITA L. PARK, Co-Trustee of the Edith B. Wartick Trust;
THE WARTICK FAMILY LIMITED PARTNERSHIP, an
Oklahoma Limited Partnership; RAAN LADAWN JONES,
also known as Ladawn Jones; WINFREY TURNER,
individually; BILLY JEAN TURNER; TRUMAN
MATHIEWS, individually; DEVOLA MATHIEWS,
individually; TRUMAN MATHIEWS, Trustee of the No. 96-7041
Truman Mathiews Trust and of the Devola Mathiews
Trust; DEVOLA MATHIEWS, Trustee of the Truman
Mathiews Trust and of the Devola Mathiews Trust; H. L.
DOLLINS, III; ANGELINA DOLLINS; NANCEY
DOLLINS SUDDUTH; VIOLET DOLLINS; GEORGE
MILTON DOLLINS; DAVID DOLLINS; JACK
DOLLINS; BEVERLY ANN DOLLINS; CREEDA JUNE
DOLLINS; ROCKY DEAN DOLLINS; KAREN DANON
CHANEY; ROBSON ROYALTY CO.; JERRY L.
DOLLINS; RUTH EVERY; RUTH EVERY, as Trustee of
the Allen Every Revocable Trust; RUTH EVERY, as
Trustee of the Ruth Every Revocable Trust; W. P.
LERBLANCE; EARL JEFFREY; JAMES DAVID
LUCAS, also known as David Lucas; BETTY LEFLORE;
HELEN CALDWELL; FRANCES RICHMOND; JAMES
F. ELLIOTT; LINDA L. ANGELI; DEBBIE HOLUBY;
BILLIE JEAN LEFLORE; NEIL WAYNE DOLLINS,
 Plaintiffs - Appellants,

v.

ATLANTIC RICHFIELD COMPANY; VASTAR
RESOURCES, INC.,

Defendants - Appellees.

APPEAL FROM THE UNITED STATES DISTRICT COURT
FOR THE EASTERN DISTRICT OF OKLAHOMA
(D. Ct. No. CV-95-339)

Terry Joe Barker, Pezold, Richey, Caruso & Barker, Tulsa, Oklahoma (Danny P.
Richey and Joseph C. Woltz, Pezold, Richey, Caruso & Barker, Tulsa, Oklahoma,
Douglas G. Dry, Wilburton, Oklahoma, and George Zellmer, Allford, Ashmore,
Ivester & Zellmer, McAlester, Oklahoma, with him on the briefs), appearing for
the Plaintiffs-Appellants.

Jay A. Brandt, Hutcheson & Grundy, Dallas, Texas (Cynthia L. Frankel and
Nishita S. Shah, Hutcheson & Grundy, Dallas, Texas, and Joe Stamper, Stamper
& Hadley, Antlers, Oklahoma, with him on the brief), appearing for the
Defendants-Appellees.

Before TACHA, McWILLIAMS, and BALDOCK, Circuit Judges.

TACHA, Circuit Judge.

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 Several lessors of oil and gas mineral interests (“Lessors”) brought this

diversity action against their lessee, Atlantic Richfield Company and Vastar

Resources, Inc. (collectively “ARCO”). Lessors allege that ARCO: (1) failed to

pay royalties on proceeds received from the settlement of certain disputes with its

gas purchaser, Arkla Energy Resources (“Arkla”), (2) failed to obtain the highest

price available for Lessors’ gas, and (3) failed to protect several of Lessors’ units

against drainage. The district court granted summary judgment to ARCO on all

three claims. We exercise jurisdiction pursuant to 28 U.S.C. § 1291. For the

reasons set forth below, we reverse and remand for further proceedings.

BACKGROUND

Lessors own oil and gas mineral interests located in the Wilburton Field in

Latimer County, Oklahoma. There are forty-one separate oil and gas leases

between Lessors and ARCO setting forth the respective obligations of the

parties. 1

1
The leases provide in pertinent part:

Leases #1-22
The lessee shall pay lessor, as royalty, one-eighth of the proceeds from the
sale of the gas, as such from wells where gas is only found. . .

Leases #23-24
The lessee shall pay to lessor for gas produced from any oil well and used
by the lessee . . . as royalty 1/8 of the market value of such gas at the mouth
of the well; if said gas is sold by the lessee, then as royalty 1/8 of the
proceeds of the sale thereof at the mouth of the well.

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I. T HE R OYALTY D ISPUTE AND S ETTLEMENT A GREEMENT

Lease #25, as contained in the record on appeal, is illegible.

Leases #26-30
And where gas only is found one-eighth of the value of all raw gas at the
mouth of the well, while said gas is being used or sold off the premises . . .

Leases #31-36
To pay lessor for gas of whatsoever nature or kind produced and sold or
used off the premises . . . one eighth (1/8) at the market price at the well for
the gas sold . . .

Lease #37
If gas, as above defined, produced from any well is sold by Lessee, then
Lessee shall pay Lessor one quarter (1/4) of the proceeds thereof at the well
received by the Lessee from the sale . . . All such payments shall be
received and accepted by Lessor as full compensation for all such gas.

Lease #38
The Lessee shall deliver to the credit of the Lessor as royalty . . . the equal
of 1/4 part of all oil produced and saved from the leased premises . . . or at
Lessee’s option, Lessee may from time to time purchase such royalty oil by
paying to the Lessor for such 1/4 royalty the market price at the well . . .

Lease #39
The lessee shall pay lessor, as royalty on gas . . . the market value at the
mouth of the well of one-eighth of the gas so sold or used, provided that on
gas sold at the wells the royalty shall be one-eighth of the amount realized
from such sale. . .

Leases #40-41
To pay lessor one-eighth (1/8) of the gross proceeds each year, payable
quarterly, for the gas from each well where gas only is found. . .

App’t. App. at 100-193.

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 Pursuant to a long-term gas purchase contract, ARCO has supplied Arkla, a

natural gas pipeline and gas purchaser, with natural gas produced from the

Wilburton Field at stipulated prices. In 1988, ARCO and Arkla became involved

in litigation over Arkla’s refusal to purchase gas from the Wilburton Field. Arkla

contended that it was not obligated to take gas from ARCO’s Wilburton wells

because the gas did not meet quality specifications and, therefore, ARCO had

improperly classified the wells as § 103 wells under the Natural Gas Policy Act

(“NGPA”). See 15 U.S.C. § 3313. Based on Arkla’s refusal to take gas and pay

the correct contract price, ARCO brought a claim for breach of contract against

Arkla. In its complaint, ARCO sought damages of $279 million, reflecting the

highest lawful price Arkla allegedly was obligated to pay for NGPA § 103 gas.

During settlement negotiations, ARCO and Arkla became involved in a

separate dispute involving Arkla’s gas purchases from a field located off the

shore of Louisiana in the Gulf of Mexico, known as the Mississippi Canyon. In

1987, the parties had attempted to resolve the dispute regarding the Mississippi

Canyon by entering into a Compromise and Settlement Agreement (“1987

Settlement Agreement”) under which Arkla made a recoupable $30 million

prepayment to ARCO for gas from the Mississippi Canyon. The parties, however,

continued to dispute their respective obligations under the 1987 Settlement

Agreement.

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 On February 8, 1989, ARCO and Arkla entered into a settlement agreement

(“1989 Settlement Agreement”) resolving both the Wilburton litigation and the

Mississippi Canyon dispute. ARCO agreed to sell gas from the Wilburton Field

to Arkla at an initial price of $2.20 per MMbtu to be adjusted later according to a

formula. In return, ARCO received: (1) sixty monthly recoupable prepayments of

$5 million ($300 million total) for gas from the Wilburton Field, (2) a new gas

gathering system in the Wilburton Field, (3) Arkla’s agreement to enter into a gas

transportation contract, at specified discount rates, for gas from the Wilburton

Field, (4) a $35 million recoupable prepayment for gas from the Mississippi

Canyon, and (5) a January 1, 1995 deadline for ARCO to refund any unrecouped

portion of the $300 million prepayment for the Wilburton Field, the $35 million

prepayment for the Mississippi Canyon, and the $30 million prepayment under the

1987 Settlement Agreement.

Since the 1989 Settlement Agreement, ARCO has paid Lessors royalties on

gas produced and sold from the Wilburton Field. ARCO, however, has not paid

royalties on any of the other settlement proceeds. Lessors brought this suit

against ARCO seeking damages for ARCO’s failure to pay royalties on the

settlement proceeds. Lessors sought royalties under six separate legal theories:

(1) breach of the contractual duty to pay royalties, (2) breach of the implied

covenant to market, (3) breach of fiduciary duty, (4) constructive fraud, (5)

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breach of the duty of good faith, and (6) civil conspiracy. Lessors also sought

damages against ARCO for failing to obtain the best price available for Lessors’

gas under the 1989 Settlement Agreement. The district court granted summary

judgment to ARCO on both of Lessors’ claims.

1. T HE D RAINAGE I SSUE

In the mid-1980s, ARCO discovered the Arbuckle formation, a large source

of natural gas underlying other formations in the Wilburton Field. ARCO is the

operator of fourteen of sixteen wells producing gas from the Arbuckle formation

pursuant to private joint operating agreements with other working interest

owners. 2

On January 31, 1991, the Oklahoma Corporation Commission (“OCC”)

issued Field Rules, retroactive to May 1, 1990, recognizing the Arbuckle

Formation as a common source of supply, meaning that any one well could

ultimately drain all the gas in the formation. The Field Rules established certain

limits on the monthly production of each unit, called “allowables.” The OCC

determined that because seven of the Arbuckle wells were limited in their ability

2
Each well is composed of a separate 640-acre drilling and spacing unit. See
Okla. Stat., tit. 52, § 87.1 91993) (authorizing the Oklahoma Corporation Commission to
establish well spacing units to prevent waste and to protect the correlative rights of
interested parties in a common source of supply). Unless the OCC grants an exception,
only one well is permitted to be drilled in each drilling and spacing unit.

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to produce gas, the Field Rules were necessary to ensure that each well would

produce approximately its fair share of the gas.

The Field Rules contained several provisions concerning the treatment of a

well that is underproducing its allowable, known as an “underage.” The Field

Rules specified that underages accumulated by a well could be carried forward

and added onto that well’s monthly allowable, effectively increasing the limit on

future production. If a well’s underages exceeded a specified amount, however,

those underages would be canceled. The Field Rules contained an “Effective

Date” provision as follows:

These rules shall be effective May 1, 1990, and the Unit Operator of
each Unit shall have the period from the effective date of the rules to
December 31, 1991 to adjust any over and under production before it
is adjusted in accordance with [the cancellation provision].

App’t. App., Vol. I at 227 (emphasis added).

After the Field Rules were issued, three of ARCO’s wells (the Yourman

No. 2, the Costilow No. 3, and the Kilpatrick No. 2) began to accrue underages

each month and were approaching the point at which their underages would be

canceled pursuant to the Field Rules. In early 1991 ARCO performed “workover”

operations on the three underproducing wells to increase their deliverability. The

successful workovers resulted in increased production in all three wells and

permitted two of the wells to make up their underages and meet the allowables

established by the Field Rules.

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 Several of the Lessors owning interests in adjacent units contend that the

workovers caused the three wells to drain gas from their units, resulting in

decreased production relative to the “draining” wells. Before the district court,

Lessors sought damages against ARCO for uncompensated drainage, asserting a

number of theories including: (1) breach of the implied covenant to protect

against drainage, (2) tortious drainage, (3) breach of fiduciary duty, (4) breach of

good faith, (5) conversion, and (6) unjust enrichment. In addition, Lessors

contended that by selectively performing the workovers on units in which ARCO

has a greater working interest, ARCO acted tortiously, wantonly and maliciously,

subjecting ARCO to liability for punitive damages. The district court granted

summary judgment to ARCO on the basis that the Field Rules bar all of Lessors’

claims.

DISCUSSION

We review the grant of a motion for summary judgment de novo, applying

the same standard used by the district court pursuant to Fed. R. Civ. P. 56(c).

Harvey E. Yates Co. v. Powell, 98 F.3d 1222, 1229 (10th Cir. 1996) [hereinafter

Yates]. Summary judgment is appropriate “if the pleadings, depositions, answers

to interrogatories, and admissions on file, together with the affidavits, if any,

show that there is no genuine issue as to any material fact and that the moving

party is entitled to a judgment as a matter of law.” Fed. R. Civ. P. 56(c).

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Appellants, as the nonmoving party, must go beyond the pleadings and “must set

forth specific facts showing that there is a genuine issue for trial as to those

dispositive matters for which [they] carr[y] the burden of proof.” Applied

Genetics Int’l v. First Affiliated Sec., Inc., 912 F.2d 1238, 1241 (10th Cir. 1990).

“We view the evidence and draw any inferences therefrom in the light most

favorable to the party opposing summary judgment.” Coosewoon v. Meridian Oil

Co., 25 F.3d 920, 929 (10th Cir. 1994). “If there is no genuine issue of material

fact in dispute, we must determine whether the substantive law was correctly

applied by the district court.” Yates, 98 F.3d at 1229.

I. ARCO’ S D UTY TO P AY R OYALTIES

The district court granted summary judgment to ARCO on Lessors’ claim

for royalties because the leases did not provide for royalties to be paid on the

proceeds of settlements and because none of the proceeds constituted payment for

the production and sale of gas. The court reasoned that because the ARCO/Arkla

litigation involved disputes over gas quality and Arkla’s obligation to take gas

from ARCO’s wells, the settlement consideration did not constitute payment for

the production and sale of gas. Thus, the district court concluded that the

settlement consideration was not royalty bearing. In so holding, the court

analogized such settlement consideration to non-royalty bearing take-or-pay

payments.

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 On appeal, Lessors contend that the district court erred in concluding that

the settlement proceeds were not royalty bearing. Lessors argue that Arkla would

not have made the settlement payments to ARCO if Arkla were not to receive

something in return. What Arkla received in return could only have been gas

production:

The only good or service sold by ARCO to Arkla under the 1989
Settlement Agreement is natural gas. The disputes between ARCO
and Arkla over “interpretation of purchase contract” and “collateral
issues” were disputes over the terms (i.e., price and quality) under
which this gas production was to be sold. There is nothing in the
record to show that ARCO provided anything to Arkla under the
1989 Settlement Agreement other than gas production. Because
whatever settlement consideration ARCO received was necessarily
for the production of gas, it was subject to royalties.

App’t. Reply Br. at 11-12.

a. Royalties Are Due Only on Actual Production

We begin our analysis by looking to the royalty clauses in the leases

between ARCO and Lessors. Although containing slightly varying language, all

of the leases require royalties to be paid only on the proceeds from the sale of gas

produced from the wells—that is, gas physically extracted from the earth and

sold. Under the plain terms of these so-called “production-type” leases, the lessee

is not obligated to pay a royalty on the value of gas in the abstract, but only on the

cash value of gas that is actually produced and sold from the leased property. See

Yates, 98 F.3d at 1230 (discussing “production-type” leases); see also Roye

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Realty & Dev., Inc. v. Watson, No. 76848, 1996 WL 515794, at *9 & n.8 (Okla.

Sept. 10, 1996) [hereinafter Roye Realty] (stating that royalties are payable under

production-type lease language only when gas is “produced and sold” and

distinguishing cases in which royalties are payable on the “amount realized” from

the sale of gas).

Because the leases expressly require royalties to be paid on gas actually

produced, we hold that the district court erred in concluding that royalties are not

payable here because the leases do not expressly require the payment of royalties

on settlement proceeds. If the settlement proceeds constitute payment for gas

actually produced and sold, it is immaterial that the leases do not explicitly

provide for the payment of royalties on settlement proceeds. Rather, for the

proceeds to be non-royalty bearing, the leases would have to expressly exclude

settlement proceeds. See Yates, 98 F.3d at 1231 (“[A]ny portion of a settlement

payment that is . . . for gas actually produced and taken by the settling purchaser

is subject to the lessor’s royalty interest.”). Thus, the mere failure to expressly

include settlement proceeds in the royalty provision of a lease, by itself, does not

preclude the payment of royalties on such proceeds.

Similarly, we hold that the district court erred in concluding that the

proceeds in this case should be treated like nonrecoupable take-or-pay

settlements. Under a take-or-pay clause, a purchaser must take a specified

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volume of gas or, failing that, must pay a sum representing the difference between

the specified minimum and the volume of gas actually taken—that is, a payment

in lieu of production. See Diamond Shamrock Exploration Corp. v. Hodel, 853

F.2d 1159, 1164 (5th Cir. 1988) [hereinafter Diamond Shamrock] (discussing

take-or-pay clauses). Thus, “proceeds received by the lessee in settlement of the

take-or-pay provision of a gas supply contract (for either accrued take-or-pay

deficiencies or to abrogate future take-or-pay obligations) are not royalty bearing

because they are payments for non-production.” Yates, 98 F.3d 1236; see also

Roye Realty, 1996 WL 515794 at *9; Diamond Shamrock, 853 F.2d at 1167-68.

The non-royalty bearing nature of take-or-pay proceeds does not mean that

all settlement proceeds are non-royalty bearing. The relevant question in both

cases (take-or-pay payments and settlement proceeds) is “whether or not the funds

making up the payment actually pay for any gas severed from the ground.”

Independent Petroleum Ass’n of Am. v. Babbitt, 92 F.3d 1248, 1260 (D.C. Cir.

1996). In short, the nature of the settlement proceeds determines whether they are

royalty bearing. The central question in this case, therefore, is whether the

settlement consideration paid to ARCO constitutes payment, at least in part, for

gas actually produced and sold or whether it constitutes payment for something

other than the production and sale of gas. To that question we now turn.

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 b. Are the Settlement Proceeds Attributable to Actual Production?

In determining whether the settlement proceeds constitute payment for gas

actually produced and sold, we begin with our recent decision in Harvey E. Yates

Co. v. Powell, 98 F.3d 1222. In Yates, we addressed whether proceeds from the

settlement of take-or-pay and pricing disputes were subject to the lessee’s duty to

pay royalties. The parties in Yates, as in this case, operated under a standard

production-type lease where the duty to pay royalties was contingent upon the

actual production and sale of gas. Id. at 1230. After deregulation of natural gas

pricing, the gas purchasers in Yates reduced their gas “takes” and unilaterally

lowered to market level the purchase price of gas actually taken, prompting a

lawsuit by the gas producer. Id. at 1227. The parties subsequently entered into a

settlement agreement in which the producer agreed to accept a nonrecoupable

“buy-down” payment in exchange for certain price and take reductions in the gas

supply contract. Id. The producer paid royalties on the proceeds from gas sold at

the lower market price but failed to pay royalties on the nonrecoupable buy-down

payment. Id. at 1227-28.

In Yates, we developed three “guiding principles” in deciding whether

royalties are payable on settlement proceeds:

First, royalty payments are not due under a “production”-type lease
unless and until gas is physically extracted from the leased premises.
Second, nonrecoupable proceeds received by a lessee in settlement of
the take-or-pay provision of a gas supply contract are specifically for

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 non-production and thus are not royalty bearing. Third, any portion
of a settlement payment that is a buy-down of the contract price for
gas that is actually produced and taken by the settling purchaser is
subject to the lessor’s royalty interest at the time of such production,
but only in an amount reflecting a fair apportionment of the price
adjustment payment over the purchases affected by such price
adjustment.

Id. at 1231. In effect, we concluded that when a lessee accepts a settlement

payment in exchange for a reduced future price term, the lessors are entitled to a

royalty payment on two components, each of which constitutes consideration for

actual production: “(1) the proceeds obtained by the lessee from the sale of gas at

the bought-down price; and (2) a commensurate portion of the settlement

proceeds that is attributable to price reductions applicable to future production

under the renegotiated gas sales agreement as production occurs.” Id. at 1236.

In this case, the parties apparently do not dispute that ARCO has already

paid royalties on the sixty monthly prepayments of $5 million (or $300 million) as

gas was taken by Arkla during the five-year period from February 1, 1989 through

January 31, 1994. This amount represents the first component addressed in Yates,

the proceeds from the sale of gas at the bought-down price. Because royalties

have already been paid on this amount, the sole controversy is whether ARCO

must pay royalties on any of the other items of settlement consideration. Under

Yates, if Arkla gave any of the other items of consideration in exchange for

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ARCO’s settling past price deficiencies or agreeing to future sales at a lower

price, Lessors are entitled to a royalty on the value of those items.

On appeal, Lessors contend that Yates, handed down after the district

court’s decision in this case, is dispositive and requires reversal of the grant of

summary judgment in favor of ARCO. In particular, Lessors assert that the record

contains evidence that a portion of the settlement proceeds constitutes

consideration for a reduction in the price ARCO was willing to accept for gas

under the terms of its contract with Arkla. According to Lessors, prior to the

1989 Settlement Agreement, Arkla was obligated to purchase gas at the NGPA

§ 103 price, which ranged between $3.40 and $4.60 per MMBtu. Lessors point to

the complaint ARCO filed in its lawsuit against Arkla, in which ARCO alleged

damages of $279 million based on its claim that the parties’ contract required

Arkla to pay a price in excess of the $2.20 per MMBtu for which ARCO

ultimately settled. Lessors also point to Section 4.1 of the 1989 Settlement

Agreement, which explicitly refers to the new price as a “price reduction.”

Lessors contend that under Yates, royalties are payable on any portion of

settlement proceeds that constitutes consideration for a reduction in the price a

purchaser is obligated to pay for gas production.

ARCO contends that Yates is not controlling in this case because there is

no evidence that the 1989 Settlement Agreement resulted in a “buy down” of the

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actual price Arkla paid for gas. At argument, counsel for ARCO insisted that

Arkla has never paid the higher NGPA § 103 price and, in fact, paid a pre-

settlement price below the $2.20 price which ARCO ultimately accepted. ARCO

thus contends that the Settlement Agreement actually resulted in a price increase

for Lessors’ gas. As counsel for ARCO confirmed at argument, however, the

record before us does not show what price Arkla actually paid for gas prior to the

1989 Settlement Agreement. Even if ARCO were correct that an actual price

increase removes this case from the ambit of Yates, providing an alternate basis

for affirmance, such facts are not in the record, and thus, summary judgment in

favor of ARCO on this basis is premature.

We are not convinced, however, that an actual price increase would relieve

ARCO of its duty to pay royalties on proceeds received from the settlement of its

pricing claim. ARCO is correct that Yates involved a “buy-down,” or a reduction

in the actual price paid for gas. In Yates, the settling purchaser explicitly sought

and received a price reduction in exchange for a lump sum payment. See Yates,

98 F.3d at 1227. A “buy down,” however, is not the shibboleth that ARCO claims

it to be. Even absent a “buy down” (i.e., an actual price reduction), a lessee’s

refusal to pay royalties on the proceeds received from the settlement of a pricing

dispute would result in a windfall for the lessee. More importantly, such a refusal

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would constitute a breach of the lessee’s duty to pay royalties on proceeds from

the production and sale of gas. A brief example illustrates this point.

Suppose that a purchaser is obligated to take 1,000,000 units of gas at

$4.00 per unit payable in two equal installments of $2 million. Upon receiving

the first 500,000 units, the purchaser unilaterally reduces the price to $3.00 per

unit (claiming that the gas is of substandard quality) and remits payment of only

$1.5 million. In response, the producer files a lawsuit for $1 million, the amount

due on the past price deficiency and the anticipated future shortfall. Instead of

litigating the gas quality issue, the parties agree to settle their dispute. In

exchange for a one-time lump sum payment of $500,000, the producer agrees to

forgive the past price deficiency and to accept the lower price of only $3.00 per

unit for future production. In this situation, there has been no “buy down” (i.e.,

actual price reduction). The pre-settlement price and the post-settlement price are

both $3.00 per unit. Despite the absence of a price reduction, however, the lump

sum payment still constitutes proceeds from the sale of gas because it represents a

component of the true price paid for both past and future production under the

supply contract. No one would dispute, therefore, that the royalty owners are

entitled to their royalty share of the lump sum payment. The important factor

triggering the duty to pay royalties is not an actual price reduction, as ARCO

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contends, but rather an agreement by the producer to compromise its right to

pursue a higher price in exchange for a lump sum payment.

Although Yates involved an actual price reduction, the general rule

announced in Yates also applies in situations where the settlement of a pricing

dispute results in a post-settlement price that remains the same, as in the example

above, or where the price actually increases, as appears to be the case here. In

either situation, the lessee has agreed to compromise its pricing claim in exchange

for valuable consideration. From the point of view of the royalty owner, the

lessee has decreased the price at which it is willing to sell gas and thus has

unilaterally decreased the amount subject to the lessor’s royalty interest.

Therefore, whatever settlement consideration the lessee receives is a component

of the true price paid for the gas and is subject to the lessors’ royalty interest. In

sum, a lessor’s royalty interest is not limited to settlements involving an actual

“buy-down,” as in Yates, but extends to any settlement in which a producer

receives consideration for compromising its pricing claim, assuming of course

that the pricing claim relates to either past or future production actually taken by

the settling purchaser.

In this case, the 1989 Settlement Agreement included several items of non-

cash consideration in addition to Arkla’s agreement to make monthly prepayments

of $5 million for five years. ARCO does not dispute that royalties have not been

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paid on the value of these non-cash items. Thus, if such items constitute

consideration for the settlement of ARCO’s pricing claim, Lessors are entitled to

a royalty on their fair market value. Producers such as ARCO cannot escape the

duty to pay royalties merely by disguising the form of consideration received in

the settlement of pricing disputes. This is true irrespective of the collateral

benefits the items have conferred upon Lessors.

In Yates, we concluded that “there exists a genuine issue of material fact

whether the . . . settlement proceeds are attributable solely to take-or-pay

deficiencies (i.e., non-production), or whether they are attributable, at least in

part, to a price adjustment for the actual production of gas.” 98 F.3d at 1235.

Similarly, in this case, we conclude that there is a genuine issue of material fact

whether the settlement proceeds received by ARCO are attributable solely to the

resolution of collateral disputes (i.e., the Mississippi Canyon) or whether they

constitute payment, at least in part, for ARCO’s agreement to compromise its

pricing claim for gas actually produced and sold from the Wilburton Field.

Although the district court concluded that none of the settlement proceeds were

related to the production and sale of gas, the record does not allow us to rule out

such a finding. We therefore reverse the grant of summary judgment in favor of

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ARCO on the royalty issue and remand to the district court for further

proceedings on this question. 3

II. ARCO’ S D UTY TO O BTAIN THE H IGHEST P RICE A VAILABLE

Lessors argue that ARCO breached the implied covenant to market by

failing to obtain the highest price available for Lessors’ gas. The district court

granted summary judgment to ARCO on this claim because the court found that

Lessors could not show that the settlement price of $2.20 per MMbtu was not the

highest market price available to ARCO at the time of the 1989 Settlement

Agreement. The district court held that because ARCO obtained the best price

available, ARCO acted prudently and with due diligence in marketing the gas.

Lessors argue on appeal that the district court erred in granting summary

judgment to ARCO because the court reached its conclusion by resolving a

genuine dispute of material fact. Lessors contend that a genuine factual dispute

exists regarding whether ARCO’s decision to settle its pricing claim satisfies the

3
In addition to their claim for breach of the contractual duty to pay royalties,
Lessors contend that ARCO’s failure to pay royalties on the settlement proceeds
constitutes a breach of the implied covenant to market gas, breach of the duty of good
faith, breach of fiduciary duty, and unjust enrichment. In view of our holding that
Lessors may (depending on the facts) have a contractual right to royalties on at least some
portion of the settlement proceeds, we need not address Lessors’ alternative claims. We
see nothing in these claims that would “enlarge upon [Lessors’] contractual royalty
rights.” Yates, 98 F.3d at 1237 n.12; see also Cannon v. Cassidy, 542 P.2d 514, 516
(Okla. 1975) (failure to pay royalties does not constitute a separate breach of the implied
covenant to market).

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implied covenant to market. In particular, Lessors contend that a reasonable jury

could find that ARCO breached the implied covenant to market by entering into

the settlement agreement and accepting a price for gas lower than the price ARCO

should have received under its gas supply contract with Arkla.

Under Oklahoma law, a producer such as ARCO has the “duty to market the

gas produced from a well and to obtain the best price and terms available.” Barby

v. Cabot Corp., 550 F. Supp. 188, 190 (W.D. Okla. 1981) (citing Tara Petroleum

Corp. v. Hughey, 630 P.2d 1269, 1273 (Okla. 1981)). In marketing the gas and

obtaining the best price available, ARCO must exercise “that degree of diligence

exercised by a prudent operator having regard for the interests of both the lessor

and lessee.” Fisher v. Grace Petroleum Corp., 830 P.2d 1380, 1391 (Okla. Ct.

App. 1991). Lessors bear the burden of proving that ARCO violated this duty.

Barby, 550 F. Supp. at 190; Tara Petroleum Corp., 630 P.2d at 1274.

To prevail on their claim at trial, Lessors initially must show that a higher

price was available at the time of the settlement agreement. To survive a motion

for summary judgment, therefore, Lessors must “set forth specific facts showing

that there is a genuine issue for trial” regarding whether the $2.20 price was the

best available price for their gas. Applied Genetics Int’l v. First Affiliated Sec.,

Inc.,, 912 F.2d 1238, 1241 (10th Cir. 1990). Although not entirely clear from the

record, it appears that Arkla may have been obligated to pay the NGPA § 103

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price for Lessors’ gas. Indeed, this is what ARCO alleged in its lawsuit against

Arkla in Oklahoma state court. Under the 1989 Settlement Agreement, however,

ARCO agreed to a price below the § 103 price.

ARCO asserts that given the actual quality of the gas sold, ARCO could not

have charged the § 103 price under the contract. Thus, ARCO maintains that its

decision to settle with Arkla for the $2.20 price satisfied its duty to market the

gas in a prudent manner.

While ARCO’s ultimate decision to settle may have been a prudent business

decision, we cannot say as a matter of law that ARCO has satisfied the implied

covenant to market. Viewing the evidence and drawing all inferences in favor of

Lessors as the nonmoving party, we conclude that Lessors have shown facts

which support their contention that ARCO was entitled to receive the higher

NGPA § 103 price. In particular, Lessors have shown that ARCO’s existing

contract required Arkla to purchase gas from the Wilburton Field at the § 103

price. ARCO admits that whether Arkla was obligated to pay the higher § 103

price under the purchase contract was a “hotly contested” issue during the 1989

settlement negotiations. If ARCO was entitled to receive the higher NGPA § 103

price from Arkla (which appears to depend on the quality of the gas), then

ARCO’s decision to settle for the $2.20 price may have breached its duty to

market the gas and obtain the best price available. We therefore reverse the grant

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of summary judgment to ARCO on this claim and remand to the district court for

further proceedings.

III. T HE D RAINAGE C LAIM

Finally, Lessors argue that ARCO failed to protect their units against

drainage. The district court granted summary judgment to ARCO on this issue

because it found that a prior decision of the Oklahoma Corporation Commission

bars Lessors’ claim.

A. Implied Covenant to Protect Against Drainage

Under Oklahoma law, all oil and gas leases contain the implied covenant to

develop a lease as a prudent operator, which includes “a duty to protect against

drainage by the lessee’s other operations.” Leck v. Continental Oil Co., 800 P.2d

224, 228 (Okla. 1989) (quoting Samson Resources Co. v. Corporation Comm’n,

702 P.2d 19, 23 (Okla. 1985)). Normally, the duty to protect against drainage

requires the lessee to drill an offset well on the lessor’s land or pay damages to

the lessor to compensate for gas being drained by adjacent wells. See Leck, 800

P.2d at 227. Thus, an action for drainage is proper where a lessee operates wells

on the adjacent tracts in such manner as to “get a larger share” of the minerals

beneath the leased premises or “to favor one lessor at the expense of another.”

Id. (quotation omitted). Under Oklahoma law, the failure to protect against

drainage, under appropriate facts, “may be more than just a breach of the contract

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(lease), but could amount to a tortious act.” Id. (citing Morriss v. Barton, 190

P.2d 451, 457 (Okla. 1947)).

B. Effect of the OCC Field Rules

In this case, the district court did not separately address the merits of

Lessors’ various theories of liability in support of their drainage claim. Instead,

the district court held that Lessors’ drainage claim was barred by the

“governmental regulations” clause in their leases with ARCO. This clause states:

This lease shall not be terminated, in whole or in part, nor shall
lessee be held liable in damages, for failure to comply with the
express or implied covenants hereof, if compliance therewith is
prevented by, or if such failure is the result of any Federal or State
laws, executive orders, rules or regulations.

App’t. App. at 99. The district court concluded that any failure by ARCO to

protect Lessors from drainage was caused by ARCO’s compliance with the OCC

Field Rules. The court noted that under the Field Rules, ARCO had until the end

of 1991 “to adjust any over and under production.” Because ARCO performed

the workovers “in conformity with” the Field Rules, the court held that the

governmental regulations clause excused ARCO from any potential liability for

failure to comply with the covenant to protect against drainage. In so holding, the

court relied on Fransen v. Conoco, Inc., 64 F.3d 1481 (10th Cir. 1995).

We disagree that the governmental regulations clause bars Lessors’ claim

against ARCO for breach of the implied covenant to protect against drainage.

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While we recognize that “the express provisions of an oil or gas lease may negate

or modify the lessee’s implied covenants,” Fransen, 64 F.3d at 1488, we conclude

that the provisions of the Field Rules did not prevent or render impossible

ARCO’s compliance with its duty to protect against drainage. Although the Field

Rules may have allowed ARCO to perform the workovers, nothing in the Field

Rules excused ARCO from liability for drainage caused by the workovers. Put

differently, the Field Rules neither commanded ARCO’s selective performance of

workovers nor precluded ARCO from taking action with respect to Lessors’ wells

to prevent the alleged drainage from occurring. As such, the Field Rules did not

prevent ARCO’s compliance with its implied duty to protect Lessors’ units

against drainage.

We do not read Fransen as broadly as the district court. In Fransen, several

lessors alleged that their lessee breached the covenant to protect against drainage

by failing to drill an offset well on their property. Fransen, 64 F.3d at 1484-85.

The lessee defended on the basis that the OCC had specifically denied permission

to drill a second well on the lessors’ land, excusing the lessee from any liability

resulting from its failure to drill an additional well. Id. at 1488. We held that the

lessors’ drainage claim was barred because the OCC decision “prevented

compliance with any duty the defendants might otherwise have had to drill an

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offset well” and because “a prudent operator would not drill a well that was

prohibited by law.” Id.

ARCO contends that Fransen bars Lessors’ drainage claim in this case

because ARCO’s workover operations, as the district court put it, “equate[d] with

compliance with . . . the Field Rules.” Watts v. Atlantic Richfield Co., No. 95-

339-S, slip op. at 13 (E.D. Okla. Jan. 11, 1996). Mere compliance with a

governmental regulation, however, is insufficient to satisfy the standard contained

in a governmental regulations clause. Fransen makes clear that to satisfy this

standard, the governmental regulation at issue must preclude a lessee from

performing the sought-after relief. In Fransen, an OCC decision specifically

prevented the drilling of an offset well. Unlike the situation in Fransen, nothing

in the Field Rules prevented ARCO from taking steps to protect Lessors’ units

from drainage. More importantly, nothing in the Field Rules sanctioned the

selective performance of workovers on some wells thereby causing drainage from

other wells operated by the same lessee. Because Fransen is not so broad as to

bar Lessors’ claim for drainage, we reverse the grant of summary judgment in

favor of ARCO and remand for further proceedings.

CONCLUSION

Having reviewed the record and found that a genuine issue of material fact

exists regarding Lessors’ claim for royalties, we REVERSE the grant of summary

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judgment to ARCO and REMAND this claim to the district court to determine

which portions of the settlement, if any, are attributable to the resolution of

collateral disputes (and thus are not royalty bearing), and which portions are

attributable to ARCO’s settlement of past and future pricing deficiencies (and

thus are royalty bearing to the extent that the payment is linked to actual

production). We also REVERSE the grant of summary judgment to ARCO on

Lessors’ claims for failure to obtain the highest available price and REMAND for

further proceedings to determine whether ARCO violated the implied covenant to

market. Finally, we REVERSE the grant of summary judgment to ARCO on

Lessors’ claim for failure to protect against drainage and REMAND this claim for

further proceedings consistent with this opinion.

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