IN THE SUPREME COURT OF THE STATE OF KANSAS
No. 128,275
THE COOPER-CLARK FOUNDATION, Individually and on Behalf of All Others Similarly Situated, Plaintiff,
v.
SCOUT ENERGY MANAGEMENT, LLC, et al., Defendants.
SYLLABUS BY THE COURT
1.
The Uniform Certification of Questions of Law Act, K.S.A. 60-3201 et seq., authorizes the Kansas Supreme Court to answer questions of Kansas law certified by a court of another jurisdiction when the answer may be determinative of a pending case in the certifying court and there appears to be no controlling Kansas precedent.
2.
A court interprets an oil-and-gas lease according to its plain language to determine the parties' allocation of costs affecting royalty obligations. If the lease expressly assigns the relevant costs, those terms control. If the lease is silent or ambiguous, the court may construe it by applying the marketable condition rule to fill the contractual gap and allocate costs based on the parties' presumed intent.
3.
A court must give effect to the express terms of an oil-and-gas lease when determining royalty obligations. Royalty clauses using terms such as "proceeds if sold at
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the well" or "market value at the well" if natural gas is sold off the leased premises must be interpreted according to their plain meaning and cannot be sidestepped to extend the marketable condition rule beyond what is necessary to fill contractual gaps.
4.
The marketable condition rule does not apply categorically. What it means to be marketable is a fact question tied to the specific oil-and-gas lease at issue. In other words, the analysis requires a case-by-case examination.
5.
Relevant considerations for deciding when natural gas is marketable include the lessee's duty to exercise reasonable diligence in finding a market for the gas with due regard for both the lessor and lessee's interests under similar circumstances; the location of the sale; the gas' condition when delivered to the purchaser; whether the purchaser accepted the gas in a good-faith transaction; and the terms of any purchase agreements that can help explain how the gas was marketed and priced. Additional factors include, if applicable, whether a market existed at the wellhead; whether any midstream services were necessary to sell the gas; whether the services made the gas marketable or merely transported or further enhanced already marketable gas; as well as any industry practices and market conditions relevant to determining marketability or value. These considerations are illustrative, not exhaustive.
On certification of a question of law from the United States District Court for the District of Kansas, KATHRYN H. VRATIL, certifying judge. Oral argument held May 12, 2025. Opinion filed September 11, 2026. The question certified is determined.
Rex A. Sharp, of Sharp Law, LLP, of Prairie Village, argued the cause, and Scott B. Goodger and Hammons P. Hepner, of the same firm, were with him on the briefs for plaintiff.
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Robert W. Coykendall, of Morris Laing Law Firm, of Wichita, argued the cause, and Jeffrey C.
King, pro hac vice, of K&L Gates LLP, of Fort Worth, Texas, and Christopher A. Brown, pro hac vice, of the same firm, of Dallas, Texas, were with him on the briefs for defendants.
Charles C. Steincamp and Diana E. Stanley, of Depew Gillen Rathburn & McInteer, L.C., Wichita, and Joseph A. Schremmer, of University of Oklahoma School of Law, of Norman, Oklahoma, were on the brief for amicus curiae Kansas Independent Oil and Gas Association.
Keith A. Brock, of Anderson & Byrd, LLP, of Ottawa, was on the brief for amicus curiae Eastern Kansas Oil & Gas Association.
David G. Seely and Ryan K. Meyer, of Fleeson, Gooing, Coulson & Kitch, L.L.C., of Wichita, were on the brief for amici curiae Eastern Kansas Royalty Owners Association and Southwest Kansas Royalty Owners Association.
The opinion of the court was delivered by
BILES, J.: In this certified question from the United States District Court for the District of Kansas, we are asked to clarify implied contractual duties allegedly owed under several thousand Kansas oil-and-gas leases. The litigation prompting the inquiry claims Scout Energy Management, LLC, and its associated defendants owe Cooper-Clark Foundation for underpaid royalties from natural gas production. The Uniform Certification of Questions of Law Act, K.S.A. 60-3201 et seq., allows us to answer questions of law from other courts when our response may be determinative in a pending case and there appears to be no controlling Kansas precedent.
In Kansas, when "oil or gas is discovered in paying quantities, the lessee has an implied obligation to produce and market production diligently" unless the express contractual terms in the applicable oil-and-gas lease provide otherwise. Robbins v. Chevron U.S.A., Inc., 246 Kan. 125, 131, 785 P.2d 1010 (1990); see also Gilmore v. Superior Oil Co., 192 Kan. 388, 392, 388 P.2d 602 (1964) ("Kansas has always
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recognized the duty of the lessee under an oil and gas lease not only to find if there is oil and gas but to use reasonable diligence in finding a market for the product, or run the risk of causing the lease to lapse."). But there is no implied duty on lessees to engage in an undertaking that is not profitable to them even though it might, or would, result in profit to lessors. Adolph v. Stearns, 235 Kan. 622, 626, 684 P.2d 372 (1984).
Rather, the duty to market "demands that [lessees] market the gas on reasonable terms as determined by what an experienced operator of ordinary prudence, having due regard for the interests of both the lessor and lessee, would do under the same or similar circumstances." Fawcett v. Oil Producers, Inc. of Kansas, 302 Kan. 350, 366, 352 P.3d 1032 (2015) (Fawcett I); Smith v. Amoco Production Co., 272 Kan. 58, 84-85, 31 P.3d 255 (2001) ("Whether Amoco has performed its duty under the implied covenant to market here is a question of fact."). An offshoot of the implied duty to market is the marketable condition rule, which can operate in this context as a tool of contract construction to resolve ambiguity in the lease and determine the scope of a lessee's obligations. This rule may impose on lessees the obligation to make gas marketable at the lessee's own expense. Fawcett I, 302 Kan. at 360-61.
Cooper-Clark argues its leases imply Scout has a duty to make its raw natural gas marketable, so Scout alone must pay for various midstream processing costs incurred before it sold the gas to third parties. According to Cooper-Clark, the point of intended sale is the sole determinant of when natural gas becomes marketable, regardless of the differing terms contained in the thousands of leases at issue. On the other hand, Scout asserts the gas was already marketable at the wellhead because it could have been sold there for irrigation or consumption at a nearby farmhouse. Scout contends the processing in dispute merely enhanced the gas' value by broadening the market of potential buyers, thereby benefiting both Scout and Cooper-Clark. Compare Gilmore, 192 Kan. 388, Syl. ¶ 3 (when applicable, the marketable condition rule requires a lessee to bear necessary costs to make gas marketable and it cannot recover those costs from royalty owners),
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with Sternberger v. Marathon Oil Co., 257 Kan. 315, Syl. ¶ 3, 894 P.2d 788 (1995) (under the marketable condition rule, once gas is marketable, lessees may charge royalty owners for reasonable costs to "transport or enhance" the production's value).
Given these competing positions, the federal court asks us what it means in Kansas for natural gas to be "marketable," so it can decide Cooper-Clark's royalty underpayment claims. The certified question states:
"[U]nder the Marketable Condition Rule, does a lessee's duty to make the gas marketable at its own expense end when the gas is in such a condition that it can be sold in some market to some potential purchaser or does a lessee's duty continue until the gas is in such a condition that it can be sold in the market in which the lessee intends to sell and actually does sell the gas?"
Few facts were provided with the certified question, but the federal court advised, "Certainly, the Kansas Supreme Court can order the parties to provide whatever record would assist its deliberations." We accepted that invitation and had the litigants submit documents from the federal court record they rely on to advance their respective positions. Cooper-Clark responded with seven: plaintiff's motion for class certification and brief in support; plaintiff's reply brief in support of motion for class certification; "Gas Processing Agreements," filed under seal; "Linn Energy Irrigation Gas Sales Agreement Cancellation"; one expert witness declaration; and two expert reports. Scout submitted 18 documents, including defendants' response brief on class certification, along with witness declarations, depositions, affidavits, and other reports.
We also permitted amici curiae briefs by the Kansas Independent Oil and Gas Association, the Eastern Kansas Oil & Gas Association, the Eastern Kansas Royalty Owners Association, and the Southwest Kansas Royalty Owners Association. Their input assisted in our analysis.
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Against this backdrop, we answer the certified question as follows:
The marketable condition rule does not apply in categorical terms as framed by the federal court's inquiry. When parties dispute the allocation of costs affecting royalty obligations, a court interprets an oil-and-gas lease, just like with any other written instrument, beginning with its plain language and giving effect to the lease's express terms.
But if the lease is silent or ambiguous on that allocation, the court may apply the marketable condition rule to fill contractual gaps. Invoking this rule requires a factspecific inquiry into when natural gas becomes marketable because that determination affects the allocation of costs associated with bringing the gas to the market. This must be decided on a case-by-case basis under the terms of each particular lease at issue. Fawcett v. Oil Producers, Inc. of Kansas, 315 Kan. 259, 266, 507 P.3d 1124 (2022) (Fawcett II) ("[W]hat it means to be marketable remains an open factual question—not, as the Class argued, a legal requirement that gas must be in interstate pipeline condition before it is marketable."). The potential or actual point of sale is just one factor in that assessment. Cf. Fawcett I, 302 Kan. at 352 (noting whether the lessee fulfilled its "implied duty by entering into these purchase agreements depends on the circumstances as to the terms and time of sale").
In the natural gas context, other relevant considerations include the lessee's duty to exercise reasonable diligence in finding a market for the gas with due regard for both the lessor's and lessee's interests under similar circumstances; the location of the sale; the gas' condition when delivered to the purchaser; whether the purchaser accepted the gas in a good-faith transaction; and the terms of any purchase agreements that can help explain how the gas was marketed and priced. Additional factors include, if applicable, whether a market existed at the wellhead; whether any midstream services were necessary to sell the gas; whether the services made the gas marketable or merely transported or further
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enhanced already marketable gas; as well as any industry practices and market conditions relevant to determining marketability or value. These considerations are illustrative, not exhaustive.
The court must also consider all applicable lease terms, especially those in the royalty clauses. Fawcett I, 302 Kan. at 359. Express contract language regarding the basis for royalty payments such as "proceeds if sold at the well" or "market value at the well" if natural gas is sold off the leased premises must be given effect and cannot be sidestepped to overextend the marketable condition rule's role in filling gaps in a contract. When our caselaw has implied this duty, it consistently does so only after examining the governing lease's royalty provisions, particularly those describing how royalties are to be determined, as well as the surrounding circumstances. Our approach remains unchanged.
In reaching this conclusion, we reject Cooper-Clark's "intended market theory"
drawn from Cooper Clark Foundation v. Oxy USA Inc., 58 Kan. App. 2d 335, 347, 469 P.3d 1266 (2020) ("Oxy") ("[W]hen parties define a market for gas through their conduct, that gas is marketable when it is in a condition acceptable for that intended market."). As we explain, what Cooper-Clark touts as an objective standard for deciding marketability is premised on a faulty reading of Fawcett I, which did not treat the sale location alone as determinative. Fawcett I, 302 Kan. at 352. We similarly reject Scout's claim that its obligations under the leases are necessarily satisfied if some production could theoretically be sold at the wellhead. The task at hand is more complex, especially because a lessee must exercise reasonable diligence when marketing natural gas with "due regard for the interests of both the lessor and lessee." 302 Kan. at 366.
What follows is our explanation for this circumstance-dependent response.
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STANDARD OF REVIEW
By statute, a certified question presents only questions of law subject to unlimited review. Our review is confined to the questions identified in the certification order; any other questions of law or fact fall outside the jurisdictional reach allowed by K.S.A. 60- 3201. See Bruce v. Kelly, 316 Kan. 218, 223-24, 514 P.3d 1007 (2022).
FACTUAL AND PROCEDURAL BACKGROUND
K.S.A. 60‑3203 requires a certification order to "set forth the questions of law to be answered and a statement of all facts relevant to the questions certified and showing fully the nature of the controversy in which the questions arose." The certification order here provides this limited factual basis to frame the legal question presented:
"Plaintiff and putative class members—the lessors (nonworking interest owners)—own royalty interests in various natural gas leases in Kansas. Defendants—the lessees (working interest owners)—operate the wells on the various leases and pay the lessors royalties on gas from the wells. Plaintiff alleges that defendants have breached the gas leases because they deducted from royalty payments to plaintiff and putative class members certain processing costs necessary to make the gas 'marketable.' The implied covenant to market provides that absent an agreement to the contrary, defendants (as lessees and working interest owners) have the duty to produce a marketable product, and they alone bear the cost of doing so. . . .
"Plaintiff alleges that defendants improperly deducted processing costs from royalties on gas which they sold at the tailgate of the processing plant, i.e. in the interstate pipeline market. In seeking class certification, plaintiff argues that such gas is not marketable unless and until it is 'in a condition acceptable to the actual purchaser [the interstate pipeline market], not to any potential purchaser.' In making this argument, plaintiff invokes [Fawcett v. Oil Producers, Inc. of Kansas, 302 Kan. 350, 352 P.3d 1032
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(2015) (Fawcett I)], and Cooper Clark Found. v. Oxy USA Inc., 58 Kan. App. 2d 335, 469 P.3d 1266, rev. denied (2020). Plaintiff argues that defendants therefore bear all costs of processing to make their gas acceptable in the interstate pipeline market.
"Defendants respond that 'gas is and can be marketable at the well even when it is not sold there and even when the gas is enhanced by processing or otherwise prior to its sale.' Defendants base their argument on [Coulter v. Anadarko Petroleum Corp., 296 Kan. 336, 292 P.3d 289 (2013), Sternberger v. Marathon Oil Co., 257 Kan. 315, 894 P.2d 788 (1995)], and Matzen v. Hugoton Prod. Co., 182 Kan. 456, 321 P.2d 576 (1958). Defendants argue that for at least some of the wells, plaintiff and putative class members must bear a proportionate share of processing costs because the gas from those wells is in marketable condition before it reaches the interstate pipeline market, even if it is ultimately destined for that market."
The reader will note the federal court identifies plaintiffs as "lessors" who are "nonworking interest owners" holding the royalty interests in the natural gas leases in controversy. Similarly, it refers to defendants as "lessees" who are "working interest owners" operating the wells and paying the "lessors" royalties on the natural gas extracted from the wells. Like the federal court, we strive to avoid causing confusion when discussing cases that use "lessors" and "lessees." We recognize this terminology can seem interchangeable with other terminology, and our caselaw does not always spell out who each party is. Our Court of Appeals helpfully noted this in Oxy, 58 Kan. App. 2d at 338 ("[E]ach lease has a lessor, the landowner who grants rights to extract gas beneath the surface, and a lessee, the gas company that takes the gas to market it.").
Given the limited factual background supplied with the certified question, the parties offered more factual and procedural material to assist our understanding. We summarize that information but caution these are not factual findings. Cf. Hodes & Nauser, MDs, P.A. v. Schmidt, 309 Kan. 610, 617, 440 P.3d 461 (2019).
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In September 2022, Cooper-Clark filed a federal complaint claiming Scout Energy Management, LLC, Scout Energy Group III, LP, Scout Energy Partners III-A, LP, Scout Energy Partners III-B, LP, Scout Energy Group V, LP, Scout Energy Partners V-A, LP, and Scout Energy Partners Co-Invest V-A, LP, underpaid royalties on natural gas produced from Kansas wells by deducting the cost of services Cooper-Clark alleges were needed to make the gas a marketable product. Scout Energy Group, Scout Energy Partners, and Scout Energy Partners Co-Invest own the working interests, while Scout Energy Management operates them. Scout Energy Group contracts with SEG Plantco V, LLC to process the gas at the Jayhawk Gas Plant in Ulysses, Kansas.
Scout countered that it properly deducts expenses associated only with processing the gas and does not pass along other costs it incurs. Scout contends the gas at issue is already marketable at the wellhead, so its midstream services merely enhance the gas' value by broadening the market for sale, benefiting both Scout and Cooper-Clark.
To press ahead with its claim, Cooper-Clark wants to certify a class of similarly situated royalty owners under Federal Rule of Civil Procedure 23(b)(3). It defines this class as:
"All persons who are royalty owners: (a) in Kansas wells where Scout Energy Management, LLC was the operator and Scout Energy Group V, LP, Scout Energy Partners V-A, LP, or Scout Energy Partners Co-Invest V-A, LP was a working interest owner; and (b) who were paid royalties for gas or its constituents produced from said wells dedicated under the Gas Processing Agreements, dated October 31, 2019, by and between SEG V Plantco, LLC and Scout Energy Group V, LP, from December 1, 2019, to the date Class Notice is given.
"Excluded from the Class are: (1) Defendants, their affiliates, and employees, officers, and directors; (2) agencies, departments, or instrumentalities of the United States of America or the State of Kansas; (3) any Indian tribe as defined at 30 U.S.C. § 1702(4) or Indian allottee as defined at 30 U.S.C. § 1702(2); (4) [a]ny NYSE or NASDAQ listed
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company (and its subsidiaries) engaged in oil and gas exploration, gathering, processing, or marketing; and (5) royalty owners whose leases expressly authorize the deduction of the costs to gather, compress, dehydrate, treat, or process the gas or otherwise make the gas or its constituents marketable products." (Emphases added.)
Cooper-Clark, which owns royalty interests in 16 gas-producing wells operated by Scout Energy Management, asserts commonality with 6,279 other class leases. It identifies 56 distinct gas royalty clauses among them. For example, the royalty clause in Key Identifier No. 1, which appears in 2,115 leases, provides: "The lessee shall monthly pay lessor as royalty on gas marketed from each well where gas only is found, [1] X/X of the proceeds if sold at the well, or [2] if marketed by lessee off the leased premises, then X[/]X of its market value at the well . . . ." (Emphases added.) Key Identifier Nos. 8 (78 leases) and 9 (74 leases) appear similar but are substantively different. No. 8 states: "To pay the lessor the equal X/X of the net proceeds, payable quarterly each year for the gas from any such well where gas only is found . . . ." (Emphasis added.) No. 9 provides: "To pay lessor X/X of the gross proceeds each year, payable quarterly, for the gas from each well where gas only is found . . . ." (Emphasis added.)
Many of the putative class leases appear amenable to analysis as explained below, but others cannot be understood on their face without additional context, which we do not attempt here. For instance, Key Identifier No. 56 reflects a more atypical formulation: "Type '1' royalty clause is stricken," and the lease notes "royalty for gas is 'an amount as shown by separate stipulation entered by lessors and lessees.'" But Cooper-Clark indicates "no stipulation appears in file."
In the federal litigation, Cooper-Clark nonetheless treats these differing royalty provisions as sufficiently equivalent to support class commonality on the grounds that none contain any language regarding deductions. It contends the gas must meet interstate purchaser specifications and that any processing at the Jayhawk Gas Plant necessary to
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achieve marketability in the actual sales market is not deductible from royalties. It maintains express lease language referencing the basing of royalty payments "at the well" or "market value at the well" does not negate Scout's implied duty to market because the class gas was not sold at the well. It rejects Scout's assertion that there was a market at the wellhead as too incidental to establish a meaningful defense.
Scout responds by arguing marketability turns on whether the gas is capable of being marketed, not whether it has been marketed, and that gas may be marketable even in the absence of an actual market. Gas from some of the wells at issue, Scout continues, was or could be sold at or near the well for residential, irrigation, or field use, showing a functioning wellhead market. More importantly, Scout claims express lease language should govern and that most leases require royalties to be calculated "at the well," even if marketed off the leased premises, thereby permitting midstream cost deductions from proceeds before computing royalties. It also contends variations in lease terms and the varying extent to which the gas required processing introduces individualized issues that defeat commonality and preclude class-wide resolution. Lastly, it argues Cooper-Clark's "intended market theory" would disrupt settled Kansas oil-and-gas law and improperly prioritize implied duties over express agreements.
Given these contrasting views, the federal court concluded no existing Kansas precedent directly resolved the issue. It noted Fawcett I's statement that "[w]hat it means to be 'marketable' remains an open question," as reason for pause. 302 Kan. at 363. And it hesitated to rely on Oxy to support Cooper-Clark's "intended market theory" because the panel's decision was not controlling, had not been cited as authority by any other court, and our court had characterized the panel's analysis as "novel." Fawcett II, 315 Kan. at 282-83.
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DISCUSSION
In Kansas, parties to an oil-and-gas lease set the terms of their agreement, and those express provisions govern. See Coulter v. Anadarko Petroleum Corp., 296 Kan. 336, Syl. ¶ 10, 292 P.3d 289 (2013). This principle has long been in our law and remains unchanged today. See, e.g., Monfort v. Lanyon Zinc Co., 67 Kan. 310, 72 P. 784 (1903) (holding lease did not imply an obligation to drill a well within five years and lessee complied with its express terms by making the required annual payments); Fawcett I, 302 Kan. at 365 (interpreting lease by giving effect to the parties' chosen terms). Drawing on examples from our caselaw, we show how the specific lease language and circumstances surrounding a lease control when and how a contractual gap is filled by implying the duty to market or the marketable condition rule.
In 1910, the court in Howerton v. Kansas Nat. Gas Co., 81 Kan. 553, 106 P. 47 (1910), first recognized a contract's express provisions implied a lessee had a duty to produce and market. There, the landowners (lessors) executed a lease granting the lessee the exclusive right to explore for and produce oil and gas on their land for a 10-year period. Over the next four years, the lessee did not develop the property or market any gas beyond drilling just one well. They sued to cancel the lease, arguing the lessee had failed to fulfill the lease's purpose. The lessee responded that cancellation was unwarranted because it had not breached the lease's express provisions.
The Howerton court acknowledged the lessee had met the express terms when it drilled a well within the first year, as the lease required, but then held the lessee was also bound by a covenant implied by the contract's language. To reach that conclusion, it applied established principles of contract interpretation to discern the parties' intent by construing the lease as a whole. The court focused on two provisions: one granting the lessee "'the exclusive right . . . to enter upon, operate for and procure oil and gas'" from
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the premises and the other requiring "[a]ll wells were to be located so as to interfere as little as possible with the cultivation of the premises." (Emphases added.) 81 Kan. at 555- 58. And from this, it observed:
"It is clear that the ordinary mind would infer from this, not only that one well should be drilled within the limited time, but that the gas therefrom, if found in paying quantities, should be produced and marketed for the mutual benefit of the parties, and that if gas was found in paying quantities in the first well, other wells would be drilled and operated in the reasonable development of the property for the purposes indicated in the lease. It is unreasonable to suppose that it was understood that the completion of one well without operation or production, except to furnish gas for the plaintiff's home, was all that the [lessee] was bound to do for more than four years, in which time it might be fairly presumed many wells would be drilled in nearby territory and gas marketed therefrom, as in fact, actually occurred. If, however, the terms of the writing require such an interpretation, it must be so made, for the contract must govern, however disappointing to the expectation of parties." (Emphasis added.) 81 Kan. at 558.
The Howerton court concluded that the lease language expressly obligated drilling at the same time it implied duties to reasonably develop and produce gas found in paying quantities, including marketing the gas to effectuate the lease's purpose. 81 Kan. at 558. The court ordered the lease's cancellation. 81 Kan. at 565.
A few years later, the court decided Ely v. Wichita Nat. Gas Co., 99 Kan. 236, 161 P. 649 (1916), which Cooper-Clark argues supports its intended market theory derived from Oxy. Specifically, Cooper-Clark relies on the Ely court's statement: "'Where it is provided that the [gas] sold shall be "merchantable," the [gas] must be of a quality such as is generally sold in the market and suitable for the purpose for which [the gas is] intended . . . .'" 99 Kan. at 247. But Cooper-Clark's reliance on Ely is misplaced because it was not about a lessee's implied duty to market arising from an oil-and-gas lease like
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the ones between Cooper-Clark and Scout. Cooper-Clark cherry-picks Ely's language to suit its position without considering whether it even applies. Let's consider the dispute in Ely to explain.
Seth Ely agreed to supply natural gas to Wichita Natural Gas Company, which operated a pipeline system distributing gas to cities and factories. The contract with Ely required the gas company to purchase at least 5 million cubic feet of "merchantable" gas daily from Ely. But when Ely delivered his gas, containing only 500-550 British thermal units per cubic foot, Wichita Natural Gas refused it as not merchantable because its other suppliers delivered gas with around 1,000 BTUs. The court held Ely's gas was not "merchantable" within the meaning of the contract. It interpreted "merchantable" as requiring conformity to "ordinary and reasonable [market] standards"—specifically, that the gas had to be of "average grade or value of similar [gas] sold in the same market." 99 Kan. at 246-47. And it explained Ely did not meet that standard because the low BTU content rendered the gas unfit. 99 Kan. at 247.
Importantly, Ely interpreted the downstream purchase agreement's express use of "merchantable gas" to determine whether the product supplied met the commercial standards required by that agreement in the relevant market setting. 99 Kan. at 239. In contrast, the federal case here asks whether the upstream leases between Cooper-Clark and Scout imply any duties on Scout under Kansas law. They are not the same thing. Our caselaw describing the duty to market and its corollary marketable condition rule plainly shows the difference in circumstances. Relying on Ely's discussion of merchantability, divorced from its contractual and factual context, disrespects key legal and practical distinctions governing different oil-and-gas agreements.
For its part, Scout relies on Sternberger v. Marathon Oil Co., 257 Kan. 315, 894 P.2d 788 (1995), in which the court held gas may be marketable at the wellhead even if no actual sale occurs there. But this holding also must be understood in its specific
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contractual and factual context. The Sternberger court relied on Scott v. Steinberger, 113 Kan. 67, 213 P. 646 (1923), Voshell v. Indian Territory Illuminating Oil Co., 137 Kan. 160, 19 P.2d 456 (1933), and Molter v. Lewis, 156 Kan. 544, 134 P.2d 404 (1943), which we discuss in chronological order before returning to Sternberger.
In Scott, the issue was whether the value of the lease's reference to "all gas produced and marketed" should be calculated for royalty purposes at the well or at the downstream point of sale after the lessee incurred substantial transportation and infrastructure costs. 113 Kan. at 67. The Scott lease provided:
"'[Lessee] shall deliver to the credit of [lessor] free of cost in the pipe lines to which [lessee] may connect [lessor's] wells one-eighth of all oil produced and saved on said premises, and shall pay the market price for same in cash if [lessor] shall so desire, and shall pay to [lessor] one-eighth of all gas produced and marketed.'" (Emphases added.) 113 Kan. at 67.
The court observed the lease was "somewhat ambiguous" as to where the price should be fixed, so it considered the context in which the contract had been executed, including the fact no pipelines existed nearby at the time the lease was signed. 113 Kan. at 68. From this, the court inferred the parties had contemplated a pipeline would need to be built to transport the gas downstream. It also considered that the lease set the royalty payments at the same percentage for any gas "produced and marketed" through pipelines. 113 Kan. at 68-69 ("The place of measurement and for fixing the lessor's share was at the connection with the pipe line."). The court concluded the parties intended for the royalty payment to be based on the value at the wellhead rather than the higher downstream sale price. 113 Kan. at 70.
In remanding the dispute to the district court for recalculation of royalties based on connection into the pipeline, the Scott court explained: "If there was a market price at the
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point of delivery that would control, but if there was no market price there, then the lessor would be entitled to the reasonable value thereof, to be ascertained upon competent evidence." (Emphasis added.) 113 Kan. at 69.
In Voshell, after the local market, where the oil had previously been sold, ceased to exist, the lessee transported the oil from McPherson to an El Dorado refinery and deducted the associated transportation costs from the market price in El Dorado. The royalty owner asserted those deductions resulted in an underpayment of royalties. In the lease, the lessee agreed "[t]o deliver to the credit of lessor, free of cost, in the pipe line to which he may connect his wells, the equal one-eighth part of all oil produced and saved from the leased premises." Voshell, 137 Kan. at 161. This "free of cost" provision led the lessor to believe the lessee must pay the full market price without any deductions.
The Voshell court, citing Scott as "analogous," rejected that interpretation.137 Kan. at 162-63. It held that once the lessee was forced to transport the oil to a more distant market, the royalty owner was entitled only to his proportional share of the selling price less transportation charges and not the "posted price" in the production area where a market no longer existed. 137 Kan. 160, Syl. The Voshell court explained:
"From this and much similar evidence the trial court correctly concluded that there was no market in the Voshell field for the oil in which these litigants were interested, and therefore the value of plaintiff's royalty oil at the time and place it was turned into the pipe line was not shown, and in consequence plaintiff failed to show any damage in excess of the amount tendered him, the selling price at El Dorado less the cost of transportation." 137 Kan. at 165.
In Molter, the court considered whether the lease permitted the lessee to share trucking costs with the royalty owner. 156 Kan. at 545. The lease stated: "'[The] lessee covenants and agrees . . . [t]o deliver to the credit of lessor, free of cost, in the pipe line to which he may connect his wells, the equal one-eighth part of all oil produced and saved
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from the leased premises.'" 156 Kan. at 544. With no pipeline serving the leasehold, the lessee trucked the production, including the royalty owner's one-eighth share, to distant connections to obtain a market. The Molter court held the lease's language required the lessee to make a reasonable effort to connect a pipeline at no cost to the royalty owner, but if, despite that effort, the lessee still needed to truck the oil to market "to prudently operate the lease," the resulting transportation costs could proportionally reduce the royalty. 156 Kan. 544, Syl.
Together, Scott, Voshell, and Molter consistently establish that in Kansas, when leases are silent or ambiguous on valuation or delivery, surrounding circumstances determine whether royalty valuation is anchored at the wellhead or derived from downstream sales and whether transportation costs may be deducted. If the lessee must transport production to a distant market because no local market exists, the royalty owner must bear a proportionate share of the reasonable transportation costs. In such cases, the royalty may be calculated based on the net proceeds—e.g., sale price less transportation costs.
With that context, we return to Sternberger. There, the royalty owners challenged whether the leases permitted the lessee to deduct expenses after the lessee laid its own gas gathering pipeline system. As the court observed, there was no market for the gas, and without the pipeline system, "the wells would have remained nonproductive and the gas would not have been sold." 257 Kan. at 318. The lease obligated the lessee to pay royalties at one-eighth "of the market price at the well for gas sold or used." 257 Kan. at 321. This provision, in the lessors' view, meant the lessee could not deduct its pipeline construction costs incurred to get the gas to the purchaser. The Sternberger court disagreed. It held the lessee could deduct the challenged expenses as a post-production transportation cost from the gross sale proceeds because the undisputed facts showed there was no market at the wellhead as identified in the lease. 257 Kan. at 342.
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The Sternberger court explained the lease "clearly" tied royalty payments to "market price at the well" and, relying on Scott, Voshell, and Molter, held that when royalties are based on market value or delivery "at the well," and no local market existed, the royalty owners must proportionally bear any reasonable transportation costs. 257 Kan. at 331. Finally, the court observed that the absence of a purchaser at the wellhead, standing alone, did not render the gas unmarketable because there was no other evidence the gas needed further processing before it could be sold. 257 Kan. at 331 ("[T]here is no evidence in this case that the gas produced by [lessee] was not marketable at the mouth of the well other than the lack of a purchaser at that location.").
Scout also cites Coulter v. Anadarko Petroleum Corp., 296 Kan. 336, 292 P.3d 289 (2013), to contend gas can be marketable at the well even without an actual sale there. But Coulter adds little beyond reiterating Sternberger's holding. Its summary of Sternberger, however, clearly and succinctly captures the governing point of law:
"We believe that the law according to Sternberger can be summarized as follows.
The lessee (oil and gas company) must bear the entire expense of producing the gas at the wellhead pursuant to the terms of the oil and gas lease. Additionally, the lessee must also bear the entire cost of putting the gas in condition to be sold pursuant to the court-made 'marketable condition rule.' But once the gas is in marketable condition, regardless of whether a market actually exists at that point, the lessor (royalty owner) can be charged with his/her/its proportionate share (e.g., 1/8) of the cost to transport the gas to a market and a proportionate share of the cost to enhance the value of the gas stream, e.g., the processing costs to extract a saleable component such as helium.
....
"If the gas is deemed to be in marketable condition at the well site, Sternberger says that the lessee can charge the royalty owners for both transportation and valueenhancement costs pursuant to the royalty provision of the oil and gas lease . . . ." 296 Kan. at 362-64.
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More recently, the Fawcett I court fleshed out the implied duty to market and marketable condition rule in a class action in which the royalty owners claimed underpayment. In that case, the lessee sold raw natural gas at the wellhead to third-party purchasers, with the sales price determined by a formula beginning with what the third- party purchasers received for processed gas downstream (or a published index price) less certain midstream processing expenses. The class contended the formula improperly passed along the post-production costs necessary to render the gas marketable downstream.
The Fawcett I court disagreed. It framed the issue as whether the gas was marketable under lease terms specifying royalty calculations based on delivery at the well. The lease language in controversy had two general formats for calculating royalties. One referred to "proceeds from the sale of gas as such at the mouth of the well," while the other referenced "the proceeds if sold at the well." 302 Kan. at 354. The leases at issue did not define what the term "'proceeds'" meant and were silent as to deductions. 302 Kan. at 354.
The Fawcett I court determined that, under the leases, the formula-based royalty calculation used for the good-faith sales to third-party purchasers at the well did not improperly deduct costs associated with midstream services. See 302 Kan. at 352 ("[T]hese leases do not impose on the operator as a matter of law the responsibility to perform the post-production, post-sale gathering, compressing, dehydrating, treating, or processing that may be necessary to convert the gas sold at the wellhead into gas capable of transmission into interstate pipelines."). The court reviewed the caselaw, including Sternberger, before it concluded: "[W]hen a lease provides for royalties based on a share of proceeds from the sale of gas at the well, and the gas is sold at the well, the operator's
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duty to bear the expense of making the gas marketable does not, as a matter of law, extend beyond that geographical point to post-sale expenses." (Emphases added.) 302 Kan. at 365.
As part of its analysis, the Fawcett I court interpreted "proceeds" as the actual sale money received by the lessee from its third-party purchasers. 302 Kan. at 365. This meaning aligns with how Waechter v. Amoco Prod. Co., 217 Kan. 489, 537 P.2d 228 (1975), and Lightcap v. Mobil Oil Corp., 221 Kan. 448, 562 P.2d 1 (1977), defined the term. In Waechter, the court stated:
"Nor can we say the parties used the term 'proceeds' and 'market value' as equivalents in the royalty clauses. They were not used interchangeably. The term 'proceeds' was used only in context with the phrase 'if sold at the well', while the term 'market value' was used in the alternative phrase 'or, if marketed by lessee off the leased premises'. Proceeds ordinarily refer to the money obtained by an actual sale. This connotation is not without significance in the gas business. Where the sale is at the wellhead the lessor does not consent to the uncertainties of what the market or fair value or price of the gas may be-he is willing to take what the lessee sells it for, relying on the lessee's self-interest in obtaining the best price possible. Under the usual lease for every dollar the lessor receives the lessee receives seven. Where sale is off the leased premises market value at the well comes into play in determining royalty but other factors also may play a part in determining the parties' intention, such as items of expense away from the wellhead, other sales and the like, in determining just what that market value is. In such situation there is no real sale at the wellhead from which proceeds are derived. Contrariwise, where gas is sold at the wellhead there are 'proceeds' of that sale—the amount received by the seller from the purchaser." (Emphases added.) 217 Kan. at 512.
Lightcap followed Waechter and held:
"Where a lease calls for royalties based on the 'market value' of the gas sold, in the absence of proof of a contrary intent that value is the price which would be paid by a willing buyer to a willing seller in a free market.
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"Where a lease calls for royalties based on the 'proceeds' from the sale of gas, the term 'proceeds' means the money obtained from an actual sale and lawfully retained by the seller." 221 Kan. 448, Syl. ¶¶ 4-5.
Together, Waechter and Lightcap establish the term "proceeds" refers to actual sales revenue received by the lessee, while "market value" refers to the hypothetical price a willing buyer would pay in a free market. These terms are not interchangeable and must be interpreted according to their context in a specific lease. This seems especially relevant in Cooper-Clark's case because many of the royalty clauses refer either to "X/X of the proceeds if sold at the well" or "if marketed by lessee off the leased premises, then X[/]X of its market value at the well" when describing the basis for the royalty calculation.
After Fawcett I, a Court of Appeals panel considered an interlocutory appeal from a district court's grant of class certification in Cooper Clark Found. v. Oxy USA Inc., 58 Kan. App. 2d 335. In the federal litigation here, Cooper-Clark touts the Oxy panel's attempt to apply Fawcett I, but that attempt overextends Fawcett I's holding. See 58 Kan. App. 2d at 347 ("Fawcett [I] establishes a simple principle: when parties define a market for gas through their conduct, that gas is marketable when it is in a condition acceptable for that intended market."). Oxy's notion that "parties define a market for gas through their conduct" is accurate only in the limited context presented in Fawcett I when the leases expressly provided the lessee would pay one-eighth of the proceeds if gas was sold at the well, and the lessee, in fact, arranged a purchase price for a sale at the well. But the panel's statement cannot be generalized to other situations, such as those presented to the federal court by Cooper-Clark through its "intended market theory."
In other words, the Fawcett I court was fully aware of the case's factual reality. It did not treat the wellhead delivery location or downstream market location alone as
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determinative of marketability. Instead, it considered the whole context by thoroughly examining the lease agreements, the third-party gas purchase contracts, and the actual sale location to decide whether the challenged costs were the lessee's sole responsibility. The court indicated marketability must be determined on a case-by-case basis when it stated, "What it means to be 'marketable' remains an open question." Fawcett I, 302 Kan. at 363. And the Fawcett II court clarified this when it stated in reference to Fawcett I, "We therefore held that what it means to be marketable remains an open factual question—not, as the Class argued, a legal requirement that gas must be in interstate pipeline condition before it is marketable." (Emphasis added.) Fawcett II, 315 Kan. at 266.
Accordingly, when royalty underpayment is the issue, courts must first examine a lease's express terms, with particular attention to the royalty clauses, and then consider all relevant surrounding circumstances. The marketable condition rule applies only if the lease is silent or ambiguous as to valuation or allowable deductions. It cannot operate to override the express terms in a lease that peg royalty calculations on the "proceeds if sold at the well" or "market value at the well" when sold off the leased premises.
We hold that under the marketable condition rule the point at which gas becomes marketable requires a case-by-case analysis. The parties' cited caselaw does not support a categorical rule.
The question certified is determined.
LUCKERT and WALSH, JJ., not participating.