Even if an oil company
leasing a particular tract of land had no other oil and gas
or other business interests, the relationship established between
the company and the owner-lessor under terms of an oil or gas
lease agreement would be inherently adversarial.
Both parties to the
lease agreement make a contribution to the arrangement for the
purpose of making a profit, but their contributions are made
at different times and in different ways. The owner-lessor’s
contribution is the entire interest in any leased substances
which may be found to exist beneath the lands, and is typically
made in exchange for an initial cash payment (the bonus consideration)
and a share in any production (the royalty). Once the lease
agreement is executed, the owner-lessor makes no further contribution
to the arrangement. The oil company-lessee's contribution is
in the form of technical expertise and capital and is mostly
made after the lease agreement has been executed. Although both
parties’ principal source of profit is production, the owner-lessor’s
profit from production is through royalties which are free and
clear of exploration and development costs, whereas the oil
company-lessee can only profit from production after it pays
the lease bonus consideration, all costs of exploration and
development, and the owner’s royalty share of production. As
a result, the interests of the owner-lessor
in maximizing production irrespective of cost are in continuous
conflict with the interests of the oil company-lessee in minimizing
all costs, including royalties.
The fundamental adversarial
nature of an oil or gas lease agreement is heightened by the
fact that most oil companies hold widespread oil and gas lease
interests and have other business interests. In many circumstances,
these other lease or business interests come into conflict with
the company’s duties and obligations to owner-lessors under particular lease agreements.
One of the other business
interests of many oil companies is building and operating gas
gathering and processing facilities. In the early years of western
Canadian oil and gas exploration, most of the natural gas which
was found in the search for oil was shut in due to a lack of
gas gathering and processing facilities and an absence of established
markets. To encourage the building of gas facilities and the
development of markets for the Crown’s natural gas, the
Alberta government implemented what has come
to be known as the gas cost allowance (“GCA”) system. Under
GCA, companies producing gas from Crown lands are allowed generous
deductions for their costs in making the gas ‘market ready’.
Deductible costs include all costs to operate gas gathering
and processing facilities (including a 10% overhead allowance),
annual facility depreciation on a straight-line, 20-year basis,
and a 15% rate of return on average invested capital. Although
in most early forms of freehold lease agreement, the freehold
owner reserved a “gross royalty on all leased substances produced
and marketed”, for various reasons royalties on gas produced
from freehold lands have also been subjected to deductions for
the costs of making the gas ‘market-ready’. The Alberta Government
has at all times prescribed regulations governing GCA and maintains
a team of auditors to enforce these regulations - there are
no regulations with respect to what items a lessee of freehold
lands includes in gas facility capital and operating costs or
what rate of return it may charge on its invested capital (“Deductions from Freehold Royalties”).
An oil company-lessee
that owns the facilities used to gather and process a freehold
owner-lessor's gas has a clear conflict
of interest in determining the costs to make the gas market-ready.
An unscrupulous oil company-lessee may effectively move its
profit source from the well head to the gas facility by paying
itself excessive gas gathering and processing fees. In some
instances, the fees charged by oil companies to make natural
gas market-ready have actually exceeded the market value of
the gas, and freehold owners have received invoices rather than
royalty checks.
A much more insidious
conflict arises in respect of royalty payments on split title
lands (“The Split Title Problem”).
Virtually every aspect of the complex oil and gas
business has the potential to create conflicts between an oil
company-lessee's other business interests and that company's
duties and obligation to its lessors
under lease agreements. To what extent, if any, should a lessee
be allowed to take into account its other business interests
in making decisions which impact specific lessors? Governments and large corporations such as Encana Corporation are fully capable of drafting leases
which adequately protect their interests as lessors,
monitoring the activities of their oil company-lessees, and
enforcing the terms of their lease agreements. Freeholders typically
are not.
In the United States, an entire body of oil and gas law known
as the Law of Implied Covenants has been developed by the courts
in an attempt to address the imbalance between oil companies
and freehold owners in drafting, monitoring and enforcing freehold
lease agreements. The Law of Implied Covenants effectively imposes
certain minimum standards of conduct on oil company-lessees.
No comparable body of law exists in Canada. In fact, the vast majority of existing
Canadian freehold lease agreements contain
an ‘entire agreement clause’. Under this clause, the freehold
owner specifically acknowledges that the lease contract contains
no implied covenants.
In 1964, Mr.
John B. Ballem asserted that:
"...the importance of protection of the mineral owner's
rights and property is manifested by an express declaration
that one of the objects of conservation legislation is to promote
equitable sharing among owners of the resource."
The legislatures do not
refer to fiduciary relationships but the undoubted effect of the
legislation is to require the mineral lessee to conduct himself
for the purposes of the lease as though he were a fiduciary in
the strictest sense. Because of the protection afforded to the
lessor by the legislation, and also
because of the express terms of the well-standardized mineral
lease, it is submitted that it is unlikely that the courts will
be required to devote much attention to the fiduciary relationship
between the lessee and the lessor.1
Mr. Ballem, who has
recently been acknowledged as the unofficial dean of Calgary’s
energy bar2, was correct to the extent that, more
than 35 years after his comments, Canadian courts have not been
called upon to address the issue of whether a fiduciary relationship
exists between an oil company-lessee and a freehold owner-lessor
under a freehold lease agreement. However, in the opinion of
the Freehold Owners Association, this has very little to do
with the “protection afforded to the lessor
by legislation”, as the legislation provides no such protection
(“The Role of Regulatory Authorities”).
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End Notes:
- Scope of the Fiduciary Relationship, Ballem
J.B., 1964, 3 Alta. L.R. 349
- Mr. N. Schultz, Vice President and General
Counsel for the Canadian Association of Petroleum Producers,
as quoted in the Calgary Herald Business Section, Oct. 28,
1999
