Marketable Product: What Did Kuntz Say? What Did Merrill Say?

Abstract

I have written extensively about the marketable-product approach to royalty valuation, first articulated by the late Professor Maurice Merrill in his volume dealing with implied covenants and subsequently by the late Professor Eugene Kuntz in his seminal legal treatise on oil and gas law. Two companion articles contained a thorough - some might say exhausting - discussion of royalty valuation commentary and case law, including a discussion of the views of Kuntz and Merrill. My limited purpose today is to focus on the views of Kuntz and Merrill without discussing the full myriad of case law on this divisive topic.In my opinion, the Kuntz marketable-product approach represents the appropriate default rule for royalty valuation. Unfortunately, Kuntz’s logical and sensible view has been rejected by lawyers for royalty owners and lawyers for lessees because neither group is happy with what would be the resulting outcome. Lawyers for lessees believe that Kuntz’s and Merrill’s views go too far in protecting the interests of royalty owners. Lawyers for royalty owners believe that Kuntz’s and Merrill’s views do not go far enough in protecting the interests of royalty owners. Thus, when making royalty valuation arguments, both groups of lawyers take an “all or nothing” approach. As a result, and even more unfortunately, some courts have adopted this “all or nothing” approach to royalty valuation - some ruling in favor of royalty owners and some ruling in favor of lessees. At one extreme are the Alberta courts, where royalty valuation occurs at the mouth of the well. When calculating royalty in Alberta, lessees are allowed to deduct the costs of separating the oil and gas stream from associated saltwater as well as the costs associated with saltwater disposal. Even Texas has not gone this far - at least not yet, holding, under a common bifurcated royalty clause providing from proceeds of sale at the well or market value at the well for sales off the premises, that royalty must be valued on the leased premises, not strictly at the mouth of the well. The Texas court is so attached to its view that it even held that language expressly disallowing post-lease deductions was “surplusage” where the basic royalty clause called for royalty valuation “at the well.”The fact that some courts, including Texas, have rejected the Kuntz and Merrill approaches outright is puzzling since none of Kuntz’s contemporary scholars, including A. W. Walker, Jr., Howard Williams, or Charles Meyers, ever expressly disagreed with them about royalty-valuation. Kuntz’s immediate successor at the University of Oklahoma, Richard Hemingway, supported the marketable-product approach as the better one.At the other extreme is West Virginia, where the court essentially held that royalty is payable at the ultimate point of an actual arm’s-length sale, no matter how far downstream of the well that such a sale might occur - apparently even if the actual sale occurs at a location beyond an established market that is closer to the well. Not even Colorado has gone this far, but Colorado does require the lessee to pay royalty on gas that is in both a first marketable condition and at a first-market location. Clearly, the courts of Colorado and West Virginia have gone well beyond both Kuntz and Merrill. Indeed, in the leading West Virginia case, the court cited neither Kuntz nor Merrill.Oklahoma and Kansas are somewhere between the Texas and West Virginia extremes, so far closer to the Merrill and Kuntz approach. Because Professors Kuntz and Merrill are revered in Oklahoma and because existing royalty-valuation case law in both Kansas and Oklahoma are similar, one or both courts may end up where Kuntz or Merrill have argued. Kansas case law and perhaps Oklahoma case law are closest to the Kuntz and Merrill views. Neither the Kansas nor Oklahoma Supreme Court has expressly rejected what either Kuntz or Merrill have said about royalty valuation. Neither court has intentionally adopted either a rule of law or a rule of construction radically different from what Kuntz and Merrill have said in their respective treatises about royalty valuation.A careful reading of Kuntz and Merrill illustrates that neither scholar was out to make a radical change in royalty-valuation as practiced in the industry at the time of their writings - Merrill in the 1930s and Kuntz in the 1950s. Cases cited favorably by both scholars supported their measured approaches as explained in their respective treatises. Nevertheless, Professor Kuntz did take a somewhat different approach to royalty valuation than Merrill - a difference that is apparent when one compares what Kuntz said and where he said it in his treatise on oil and gas law with what Merrill says in his treatise on implied covenants. Notwithstanding the fact that Professors Kuntz and Merrill agree on the destination - that the marketable-product approach is the appropriate default rule - they reach their destination by different paths. Kuntz’s path follows the tracks of typical royalty clauses found in oil and gas leases. Merrill’s path does not track royalty clauses. Merrill chooses his own path - mapped out by his view of the implied covenant to market. Some courts have failed to recognize these different paths. For example, although the Colorado Supreme Court has cited Kuntz, the court’s own analysis is much closer to Merrill’s view.