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 energy 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 energy 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 energy 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 (see “Deductions from Freehold Royalties”).
An energy 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 energy 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 energy 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 (see “Split Title Problem”).
Virtually every aspect of the complex oil and gas business has the potential to create conflicts between an energy company-lessee's other business interests and that company's duties and obligation to its lessors under lease agreements. Governments and large corporate owners of mineral rights such as Encana Corporation or ExxonMobil Canada are fully capable of drafting leases which adequately protect their interests as lessors, monitoring the activities of their energy company-lessees, and enforcing the terms of their lease agreements. Individual 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 energy 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 energy 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, the late John B. Ballem, Q.C. 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."
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“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
A fiduciary relationship imposes duties of loyalty to its freehold owner-lessor upon an energy company-lessee. The judicial remedy for a breach of fiduciary duty is generally much more severe than the remedy for a mere contractual breach.
The late Mr. Ballem was correct to the extent that, almost half a century 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 the legislation”.
When Mr. Ballem’s comments were made, the object of the Alberta Oil and Gas Conservation Act (the “Act”) was, in part, “to afford to each owner the opportunity of obtaining his just and equitable share of the production of any pool” 2. In 1969, the Act was amended and the reference to “just and equitable” was dropped from this section 3. In recent years, the role of the Alberta Energy Resources CoAlberta Energy Regulator (formerly known as the “Energy Resources Conservation Board”)nservation Board or AER (formerly known as the “ERCB”) in protecting equity appears to have been compromised by the demands of the energy industry to realize economic efficiencies in the face of a mature Western Canadian Sedimentary Basin, rising exploration and development costs and low natural gas prices (see “The Role of Regulatory Authorities”).
1. Scope of the Fiduciary Relationship, Ballem J.B., 1964, 3 Alta. L.R. 349
2. Oil and Gas Conservation Act, S.A. 1957, c.63, s. 4(d)
3. Oil and Gas Conservation Act, S.A. 1969, c. 83, Part 1 4(d)