To an angry and unhappy investor, every deal that does not turn out as expected seems a private misfortune. For lawyers, the dispute that walks in to the door is analyzed, prepared, and tried on its individual merits. Yet large economic changes often explain why a category of disputes has arisen and help predict new rounds of litigation.

Unexplained price changes underlie some of the largest groups of oil and gas investor disputes in the last half century. In as volatile an industry as oil and gas, prices frequently disappoint expectations, high prices lead to sketchy deals, and waves of litigation recur as unpredictably, although foreseeably, as business cycles themselves.

Oil and natural gas prices have risen dramatically in the last few decades, far outpacing the rate of inflation. The real price of oil was $26.46 per barrel in 1986.[i] Recently, the price has been around $100. In 1976, the average wellhead price of natural gas was $1.81 per mcf in real terms. In 2008, the price was over 4 times as much, at $8.12. Today, the real price is under $3.

It is not surprising that rapid price changes produce litigation. Parties enter contracts with price expectations tied to recent experience. When large-scale economic changes disrupt expectations, parties often look to the legal system to preserve their interests. Regulation increases the likelihood of uneven changes and puts more pressure on contract linkages and expectations. Regulation, of course, is a frequent presence in energy markets.

This article describes price changes and consequent litigation affecting investors from some of the largest economic and regulatory changes in the domestic oil and gas industry over the last 50 years. The examples are drawn from the United States, but a similar link between changing prices, regulatory shifts, contract expectations, and frequency of disputes should exist in any country in which litigation is an accepted outlet for contract disputes.

Rising Oil And Gas Prices And Unhappy Investors

An early category of disputes spanned the oil and natural gas industries. In the 1970s, as oil prices spiraled out of control in the energy crisis and burgeoning unregulated intrastate gas prices brought pressure on regulated interstate prices, the scarcity of oil and gas and rising price for oil made investing in an oil or gas well seem like a good hedge against inflation and a good bet on the merits. Figure 1 shows inflation-adjusted crude oil and natural gas prices every five years from 1960 to 1980, and in the boom years 1981 and 1982.

Industry companies increased drilling. Many nontraditional players, corporate and individual, flooded the market. The influx of money expanded drilling into speculative and marginal projects. Operators took greater risks. Disappointed investors often sued. The alleged problems ranged from misrepresentations about past track records to distortions of success as ventures proceeded, and excessive deductions from investment joint accounts.

The legendary companies that ended up in litigation serve as a reminder that boom times can be productive of overselling, overinvestment, disappointed expectations, and litigation as well as increased drilling, discoveries, and supply: Longhorn Oil Co. of Oklahoma City, promoted by founder Carl Swan, whose failure helped bring down Penn Square Bank and Continental Illinois National Bank and Trust Company; Home-Stake Production Co. of Tulsa; the $1.5 billion invested through the various partnerships run by Prudential Insurance Co. and its “direct-investment” group; the Denver-based fund operated by John King; the even larger programs of Denver’s Petro-Lewis (which attracted 183,000 investors and $2.6 billion between 1970 and 1984); and the equity partnerships offered by Davis Oil Co.[ii]

In today’s new era of relatively high oil prices, the oil industry likely will attract a new wave of non-industry investors. Much of the new drilling will be performed by major oil companies and credible, well-established independents. But some companies will raise funds beyond their capacity to manage. At the end of the day, a resurgence in disputes over the terms of the deal can be expected.

Rapid increases in drilling can affect costs, too. And the economic pressure of high world demand has encouraged rapid drilling even before the environmental consequences have been fully studied, as with the case of shale drilling. Some of the companies rushing to drill will turn out not to have had the expertise or care to drill safely. Environmental issues that perhaps should have been studied over a longer period of time may show that spillage risks were higher than understood at the time of drilling. Investors need to consider carefully whether their investment structure might subject them to liability beyond their paid-in or committed amounts.

A rapid drop in price like that recently witnessed in natural gas also can yield disappointed expectations. That, in turn, will lead to disputes over the meaning of deals that have to be performed in an unexpectedly low price environment.

Falling Gas Prices And Take-Or-Pay Cases

Natural gas price decreases in the mid-1980s brought about a wave of litigation. The price spikes that occurred in the late 1970s and early 1980s had led to increased natural-gas drilling, boosted supply, and relieved pressure on prices. Meanwhile, industrial and individual consumers tried to shift to cheaper fuels. In 1984, inflation-adjusted wellhead gas prices averaged $4.93 per mcf. But by 1987, market prices had fallen 42 percent to around $2.85, where they remained for the next four years.[iii]

During this period, natural gas generally was sold to interstate pipeline companies under “take-or-pay” contracts. Facing high, rising gas prices, pipelines previously had bought all the gas they could under long-term contracts to protect their long-term supply. The contracts generally committed buyers to take or pay for a high percentage of a property’s production capacity at an escalating, regulated “maximum lawful price.” This promise required buyers to pay for gas even when they did not want to take it.

This practice was thrown into disarray in the early 1980s as supply came back into better balance with demand and Congress began to deregulate natural gas prices. Prices for unregulated gas not subject to existing contracts began to fall, with average nominal market prices hitting $1.34 per mcf in July 1991. Short term, “spot market” prices (a relatively new term and market at that time) fell even more dramatically, with sales occurring at prices around $1.

Pipelines found themselves stuck with long-term contracts obligating them to pay for large volumes of expensive gas.

As prices fell, a number of buyers became unwilling to continue purchasing gas under high-priced, long-term take-or-pay contracts. Naturally, this hurt investors in equity investments structured under a joint operating agreement as well as those in partnerships and funds, if their projects drilled into gas fields. Producers sought to protect their interests under such agreements by suing.

To pipelines’ chagrin, and producers’ delight, courts generally enforced the take-or-pay buyers’ promises to pay prepayments. As Dallas federal trial judge Jerry Buchmeyer explained,

"The purpose of the 'take or pay' clause is to apportion the risks of natural gas production and sales between buyer and seller. . . . The buyer bears the risk of market demand. The take-or-pay clause ensures that if the demand for gas goes down, seller will still receive the price for the Contract Quantity delivered each year."[iv]

Many of these cases settled, often for substantial amounts. From the rare cases that went to trial came two of the largest jury verdicts in the United States.[v] Buyers ended up paying sizable damages, in some cases hundreds of millions of dollars.

When a producer recovered, by judgment or settlement, it should have passed on the benefit to its investors. The lack of litigation over sharing at the investment level suggests that many producers may have shared these revenues in relatively transparent “JOA” equity investments. Investors in large partnerships or funds, in contrast, are less likely to see the components of revenues credited to their interests and more likely to have missed refusals to pass back take-or-pay payments.

The Development Of Market Centers And The Oil Posted Price Cases

Regulation can be conducive to litigation because administrative decisions tend to come in discrete, lumpy stages. This lumpiness increases the risk of shocks to settled expectations and shocks make litigation more likely.

One major wave of regulatory cases emerged when oil price deregulation largely coincided with the development of efficient market-center pricing on the oil side of the industry. This wave of litigation, which had arrived by the mid-1990s, concerned posted prices. Posted prices are prices set and posted by the oil company.

Oil prices historically were not regulated. The Nixon Administration embarked on a short-lived experiment in regulation during the high priced 1970s; but Ronald Reagan lifted controls as his first official act in 1980.

Over the next few years, oil became widely traded. The trading supported development of the NYMEX futures market, which began in 1983. Trading locations developed at the major geographic hubs, with publicly reported oil prices. These hubs are shown in Figure 4:

Major oil companies kept using the “posted” prices for their internal pricing and as default prices when they exchanged oil with each other.

With market trading centers, buyers and sellers began to determine oil prices through frequent arm’s length transactions outside of the posted-price framework. In the mid and late 1980s, market prices at trading centers rose above the average oil company’s posted price, even after adjusting for the cost of transportation and other services needed to move oil from the well to the market center. At times the difference could be a dollar or more a barrel. Yet producers not infrequently paid their equity partners, as well as royalty owners and even state severance taxes, using posted prices. The amount by which some of the largest oil companies’ posted prices fell below market center prices over the period 1987-1998 can be seen in Figure 5 by the amount by which each companies’ line falls below the $0.00 line at the top:

This price divergence became widely known in the industry. ARCO shifted to market center prices and began using a netback approach (deducting costs from the point of sale back to a given lease). But other companies did not. The posted price issue came to widespread public attention when the States of Texas, Colorado, and New Mexico investigated their oil royalty receipts and found that they were receiving less than the market price payment for their oil. The Texas General Land Office filed a posted price case in 1994. Many other cases quickly followed.

The companies often defended the difference between their posted prices and the prices they received at market centers by claiming that the gap between their posted price and their higher downstream sales prices reflected value added by their effort and skill. Many pointed out that their marketing affiliate “paid” its producing affiliate at the posted price, as though internal accounting proves true value. Royalty and working interest owners claimed that the companies were refusing to share the true market price.

The private cases were consolidated in federal court in Corpus Christi, Texas. The major defending oil companies settled for approximately $230 million.

Interestingly, though, the equity investors, the cash investors, did much worse than royalty owners. Working interest owners received only 3 to 13 percent of their claimed damages, while “Direct” royalty owners (those with a lease directly with the lessee producer) averaged 53 cents on the dollar. One reason for this difference may be that royalty owners generally benefit from an implied duty to market, which requires the lessee to use its best efforts to get the best price reasonably possible. Yet many standard joint operating agreements can be read to require the operator to act as a fiduciary in marketing production for the investment’s joint account, so it is surprising that working interest owners fared so poorly.

The federal government, a royalty owner, pursued its claims in a qui tam lawsuit. The total federal settlement was for nearly $440 million, as shown in Figure 6:

To date, total disclosed payments to private working and royalty interest owners, to state lessors including very large settlements with the State of Alaska, and to the federal government total over $2.2 billion (in 2011 dollars).[vi] As with take-or-pay settlements, so the settlements in the posted-price cases should have been passed back to the equity investors as well as the operating company for their proportionate interests, and to royalty owners for theirs.

Market Centers And Natural Gas Litigation

A similar problem of underpayment emerged in natural gas. As the natural gas industry was deregulated in stages beginning in the mid 1980s, companies often used netback methods to calculated implied values at the wellhead for royalty purposes. If the lease allows deductions, the producer may subtract the cost of moving gas and related services conducted between the well and the available market. If it does not, or in “marketable condition” states where many deductions are not permitted, then the market value of the gas, without deductions, should be used. So far the bulk of litigation over this practice has concerned royalty owners, not working interest owners.

Whistleblowers brought natural gas qui tam lawsuits under the False Claims Act claiming that major gas producers systematically underpaid the federal government using affiliate prices, improper deductions, and improper reporting. A qui tam lawsuit has resulted in total settlements of nearly $300 million through 2011.[vii]

Actions alleging underpayments of gas royalties have resulted in recoveries to date of at least $1.9 billion (in 2011 dollars).[viii] To the extent that natural-gas prices used to pay investors were improperly low, equity, partnership, and fund investors should have been made whole.

Shale And Natural Gas Pricing: The New Frontier?

The recent changes in the world’s energy picture from the realization that natural gas embedded in shale, shale oil, and certain tight oil can be produced economically will almost certainly open a new frontier for disputes.[ix] The early period of shale development occurred when prices in the United States were in the $6 to $8 per mcf range. Since then gas prices have declined dramatically. With inflation-adjusted gas prices dropping to under $3, some companies have begun shutting in marginal wells.

The rapid change in the context of shale investments can be seen by comparing natural gas prices in Figure 9 for the 2006-2007 time period, when gas shale drilling was ramping up, with the much lower prices thereafter.

Low natural gas prices will continue if this unexpected boost in supply remains unbalanced by compensating increases in demand. Massive investment in liquid natural-gas facilities, on the other hand, would increase demand for exports, substitution of cleaner natural gas for coal and even oil could boost domestic demand, and either effect could bring boom times back to the natural gas market. History suggests that investors who put their money into shale producers (from investors who bought shares of publicly traded E&P companies to parties who invested on a JOA or partnership equity basis) will be looking closely at their investment decision whenever experience does not match expectations.

Economic Changes And Litigation

These examples illustrate that significant price changes often have generated widespread litigation affecting investors. Structural changes, like the shift of oil and natural gas marketing away from the lease, also create a strong incentive for further attempted redefinitions of contract rights. So do regulatory changes.

As with the inevitability of death and taxes, so it is certain that changing oil and natural gas prices and structures will lead to new clusters of litigation. Shale litigation already has become a boom field for lawyers.

The gradual worldwide increase in royalty and concession shares driven by national oil companies is another source of risk to investors. The risk can be seen in the cluster of national-oil-company disputes playing out in the bilateral investment-treaty disputes arbitrated through the World Bank’s International Center for Settlement of Investment Disputes. Royalty rates in private U.S. leases have gradually risen from the old one-eighth to one-sixth and even, in some areas, one-quarter. The greater the share paid to the landowner, the less available for the investors. The risk that investments will become even more burdened by the mineral owners’ share is one of the risks that investors in new programs need to consider.

The adoption of global warming controls, which may well include a price for carbon emissions, could lead to a separate round of energy litigation over who ultimately has to bear those new costs.

All of these factors form part of the investor’s long-term horizon. All need to be included in investment analysis.

About The Authors

JOHN BURRITT McARTHUR, a lawyer, has been trying complex commercial cases, including oil and gas cases, for 29 years. He has represented plaintiffs and defendants, producers and royalty owners, in oil and gas cases, and has authored dozens of article on oil and gas issues. In addition to his J.D, McArthur has master’s degrees in economics and in public administration and a Ph.D from the Goldman School of Public Policy at the University of California (Berkeley). McArthur has served as an arbitrator since 1995 and is a member of the commercial and energy panels of the AAA and CPR, the public arbitrator panel of FINRA, the panels of the international arbitration centers in Hong Kong, Kuala Lumpur, and Dubai, an associate member of the Chartered Institute of Arbitrators, and a member of the LCIA. His office is in Berkeley, Calif.

BARRY PULLIAM is managing director and head of the energy practice of the EconOne consulting firm in Los Angeles, Calif. He has testified as an expert in dozens of energy cases, including for producers, refineries, pipelines, gas processors, and chemical manufacturers. Pulliam, who holds a B.A. and M.A. in economics, has consulted with a number of state governments and the U.S. Department of Justice, the Federal Trade Commission, and the Department of the Interior on energy-related issues. Pulliam has worked extensively on such economic issues in energy cases as market definition, liability issues, value determinations, pricing and damages.

ROGER RIDLEHOOVER is an economist with Economic Science Associates in Los Angeles. Trained in economics at Texas A&M and UCLA, he has studied the oil and gas industries for many years on behalf of government agencies, royalty owners, producers, pipeline companies and other entities in energy-related industries.


[i] All prices referenced in this paragraph were obtained from the Energy Information Administration website (www.eia.doe.gov) and adjusted to 2010 dollars.

[ii] These programs are discussed in detail in John Burritt McArthur, Coming of Age: Initiating the Oilfield into Performance Disclosure, 55 S.M.U. Law Review 663 (1997).

[iii] Energy Information Administration, U.S. Natural Gas Wellhead Price.

[iv] Universal Resources Corp. v. Panhandle E. Pipe Line Co., 813 F.2d 77, 80 (5th Cir. 1987).

[v] The very large take-or-pay judgments included one of at least $600 million in Kimball v. Tenneco, Inc., No. 27,880-S (Tex. Dist. Ct. Dec. 1, 1988); over $600 million, remitted to roughly $480 million in El Paso Natural Gas Co. v. TransAmerican Natural Gas Corp., No. 85-09329 (Tex. Dist. Ct. May 24, 1988); and in addition, $412 million in Colorado Interstate Gas v. Natural Gas Pipeline Co., 661 F. Supp. 1448 (D. Wyo. 1987), aff'd in part and rev'd in part, 885 F.2d 683 (10th Cir. 1989)(reduced to $16 million); $108 million in Texas Crude Inc. v. Delhi Gas Pipeline Corp., No. 85-7-450 (Tex. Dist. Ct. Aug. 14, 1986); $65 million in Challenger Minerals v. Sonat, No. 84-C-3537-E (N.D. Okla. Sept. 9, 1986), and $50 million in Forest Oil Corp. v. Oneok, Inc., No. C-84-197 (Tex. Dist. Ct. May 30, 1984).

[vi]Oil & Gas Royalty and Tax Settlements Database, Jane Kidd of Econ One Research, Inc.

[vii] Id.

[viii] Id..

[ix] See generally Daniel Yergin, THE QUEST: ENERGY, SECURITY, AND THE REMAKING OF THE MODERN WORLD 262-63, 326-32 (2011).