Commingled Oil and Gas – Why allocation matters

by King & Spalding
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Frequently oil and gas are transported through or stored in facilities where they are commingled with the oil or gas of third parties. If the transportation system or storage facility has been properly developed, it will include a detailed allocation procedure that enables the users of the facility (each, a "Shipper") to identify, at any time, how much of the commingled oil or gas belongs to each Shipper. But if the developers of the facility did not provide for the allocation of the oil or gas or if the allocation procedure is faulty, then what is the position at law? Who owns the oil or gas and in what proportions?

This paper: (1) examines how the English courts have resolved the issue of title in commingled goods under English law and specifically addresses such issues as they arise in the context of gas commingling and oil blending; and (2) looks at some of the commercial ramifications of allocation procedures.

Position under English Law

The cases in English law that address the issue of title in commingled goods have largely arisen in insolvency proceedings where a party has transferred goods to another (for sale or storage) and such party has stated that it retains title to the goods (for the storage cases) or retains title to the goods until some later event happens (in the sale cases). Dispute have then arisen and the courts have had to determine whether such party did in fact retain title to the goods. Importantly, these cases do include some provision whereby there is retention of title but they do not contain detailed provisions that determine how title in the mixed product is determined.

The cases tend to fall into two distinct groups:

(1) mixed storage, where two substantially similar goods are mixed together and the original separate components cannot be distinguished in the mix; and

(2) mixed incorporation or consumption, where two separate goods are brought together and form an entirely new product.

Often, when gas is commingled in transportation pipelines all the gas meets the same gas specification and it is the energy value of the gas that is critical rather than its composition. The Shippers are not interested in which molecules of gas they get re-delivered to them from the pipeline as long as they get back the same amount of energy that they delivered into the pipeline. In these circumstances, the commingling of gas tends to fall into the first group of cases – mixed storage.

However, the composition of different oils can vary substantially (e.g., density/API, sweet, sour, waxy, acidic, etc.) and when mixed together for storage or transportation, the blend of oils is, in effect, a new product. Importantly, these differences in composition have substantial impact on the value of a particular crude oil or oil product and Shippers are concerned to ensure that they keep "title" to the value that they are introducing into the relevant pipeline or storage system. For example, this concern applies to both mixing different crude oils when transported and stored in oil pipeline systems and to oil product storage terminals, where different petroleum products (e.g., different grades of gas oil) are deliberately blended in a tank to create a new product that meets a particular market specification. In these circumstances, the blended oil tends to fall into the second category of cases – mixed incorporation.

Nevertheless, there are some gas pipeline systems where the composition of the gas matters (e.g., the CATS pipeline in the North Sea, which provides gas transportation and processing services to approximately 20 Shippers). In CATS, the gas transported has significant quantities of the heavier (and more valuable) natural gas components (propane, butane and condensate) and these are separated from the gas before the gas is re-delivered to the Shippers. Consequently the amount of each of these components delivered into CATS by each Shipper needs to be determined as well as the amount of gas for each Shipper. This is, in effect, mixed incorporation.

But what is common to both oil and gas transportation and storage systems is that generally the agreement between the Shipper and the transportation or storage facility operator provides that the Shipper retains title to its oil or gas.

In general, the English courts have taken the view that:

(1) in situations of mixed storage, title does not pass and the original owners are entitled to their respective shares of the mixed pool. So for gas Shippers, the position is fairly clear and reflects what is desired by the Shippers, although given the contractual complexity of many gas transportation systems, an allocation agreement is still necessary to facilitate daily operations; and

(2) in comparison, where there has been mixed incorporation, which results in the "destruction" of the original product supplied as part of the manufacturing process, the original owner no longer retains title in the resulting product. This would obviously be a problem for oil Shippers, but importantly and in the context of oil blending, the English courts recognise that where blending is effected pursuant to a contract, the contracting parties can determine themselves how title on blending will transfer. So for oil blending, an allocation agreement that determines who holds title to which part of the blended oil is vital.

Mixed Storage

As with any contract case, the starting point is always the terms of the agreement between the parties. If it provides that title passes once the goods are put into mixed storage or incorporated into other goods, that is the end of the seller's right. However, if the relevant clause purports to retain title whilst the goods are stored by the buyer, the question will arise as to whether title has been retained successfully. Unless the contract provides otherwise, the simple act of mixing similar goods, or the fact that as a consequence of the way in which the buyer has stored the goods it becomes impossible for the seller to point to particular goods and identify them as the goods he supplied, does not cause title to pass.

Where there has been consensual mixing, the seller retains title as a tenant in common into the mixed pool. The shares in that mixed pool will be proportionate to the goods in the pool supplied by the sellers who have retained title and any such goods to which title has passed to the buyer. This is supported by the House of Lords in Mercer v. Craven Grain Storage Ltd [1994] CLC 328 (HL). Here, the sellers of wheat brought an action for damages against the purchaser for the failure to re-deliver the wheat in question. One of the defences was that title to the wheat was lost when it was intermixed with grain of the same grade supplied by other sellers. The wheat was indistinguishable amongst the resulting mass. Moreover, that mass was a fluctuating mass because from time to time, wheat was taken from the storage facility and other wheat was added to the mass to replenish what was held in storage. The defence that title had passed was held to be unarguable at first instance, in the Court of Appeal and in the House of Lords. Lord Templeman specifically said that "title to the wheat lawfully mixed could not be acquired by the [storage company] which by no stretch of the imagination had any right thereto. The title must have remained with the growers from time to time interested in the mix in proportion to their respective tonnages."

This decision is an example of a line of authorities that can be traced back through to the 16th century. In Buckley v. Gross (1863) 3B & S 556, tallow that belonged to various different owners was mixed up in a molten mass. Identifying which parts of the molten mass belonged to which owner was impossible. Blackburn J. held that the owners were tenants in common in equal proportions of the mass. It is important to note that he made clear that "at all events they do not lose their property in it". Similar conclusions were made in Spence v. Union Marine Insurance Co Ltd (1867-68) L.R. 3 C.P. 427 (CCP) and Sanderman & Sons v. Tyzak & Branfoot Steamship Co Ltd [1913] AC 680.

Based on the facts in Mercer, it is arguable that the mixing of wheat of the same grade in a fluctuating mass is analogous to the commingling and transportation of different gas streams that meet the same specification (equivalent to mixing wheat of the same grade) with varying offtake of gas from the pipeline (fluctuating mass of wheat). If that is the case, it is expected that title to gas of the same specification in a commingled stream would be treated in the same manner.

In essence, the cases on mixed incorporation (commingling) provide that:

3A + 2A = 5A

and the parties that each provided "A" have title to the "5A" product in the proportions in which they provided it (i.e., 3:2).

Mixed Incorporation or Consumption

In cases where goods are supplied under a retention of title clause but are then mixed with another product so that they become incorporated with, or consumed by the other product, the incorporated ingredients become a new product and it is impossible to retain title in the old goods through and into the new product. However, the key point, that is often missed, is that those cases in which it was held that title in the goods passed to the buyer were cases in which the nature of the goods supplied was altered in some way.

Examples of oft-cited cases supporting this proposition include Borden (UK) Ltd v Scottish Timber Products Ltd [1979] 3 All ER 961 (CA), Re Bond Worth Ltd [1980] Ch. 228 (Ch D) and Re Peachdart Ltd [1984] Ch. 131 (Ch D).

In Borden (UK) Ltd v Scottish Timber Products Ltd [1979] 3 All ER 961 (CA), the seller supplied resin which was used in the manufacture of chipboard. The seller claimed that its retention of title clause to the resin allowed it to trace the resin into the finished product and claim a share of the chipboard. However, the Court of Appeal rejected this claim on grounds that once the resin was used in the manufacturing process, it lost its identity and title passed. The chipboard was a wholly new product and no interest in the chipboard could be implied to the seller.

In Re Bond Worth Ltd [1980] Ch. 228 (Ch D), the buyers were manufacturers of carpets. They purchased fibre from the sellers on terms that included a clause that purported to retain "equitable and beneficial title" in the goods. Slade J. held that as a matter of construction, legal title to the fibre passed on delivery from which it follows that there was not an attempt to retain title as such but only an interest in the title to the yarn. The fibre was spun, dyed and woven into carpets. It was held that title in that fibre could not have been retained by the seller. It passed when the fibre was used in the manufacturing process and it became something wholly different, namely, a constituent part of the carpet.

In Re Peachdart Ltd [1984] Ch. 131 (Ch D), the seller supplied leather to a company that manufactured handbags. The contract purported to retain title until payment was made for all the leather supplied. It also provided that if the leather was incorporated into other goods, then property in the whole of those other goods "shall be and remain with the seller" until payment in full for all leather supplied. Vinelott J. held that property passed to the buyer when the leather was incorporated into the handbag-making process. He also held that the rights given to the seller over the handbags was a charge because it gave the seller rights over property of the buyer.

It is easy to assume that these cases show that if there has been any mixing so that the seller cannot point to a particular item and say that the item in question was the item he supplied, then his retention of title claim fails. However, what these cases demonstrate is that title is lost when something happens to the goods to cause title to pass to the buyer. What causes title to pass is the incorporation or consumption of those goods as part of a manufacturing process.

Oil Blending

A case that encapsulates the distinction between: (1) mixed storage; and (2) mixed incorporation or consumption, is Glencore International AG v. Metro Trading International Inc (No 2) [2001] 1 All ER (Comm) 103 (QBD (Comm)).

In this case, the buyer was in the business of buying, blending and selling fuel oil. The buyer bought fuel and other oil products from various sources, blended it, stored it and then sold it. The buyer was in receivership. The seller had delivered oil products to the buyer, which had been mixed with other oil and subsequently formed part of consignments of oil sold to third parties. The seller claimed that the proceeds of sale were its property.

Moore-Bick J. held that the commingling of the oil in storage with similar oil belonging to another claimant, or the buyer itself, would not cause property to pass to the buyer (absent a clause in the contract to that effect) and that the contributors to the bulk would become co-owners of the bulk in proportion to the quantities of oil which they had contributed to it. Moore-Bick J. also held that where the oil had been blended with other products resulting in the "destruction" of the original product supplied, this would normally justify the inference that title was intended to be passed from the seller to the buyer when the blending took place.

As part of the judgment, the court stated: "The essential distinction between blending and commingling is that where blending has taken place the resultant product is different in nature from both its original constituents. This creates certain conceptual difficulties in the case of unauthorised blending to which I shall return, but should not ordinarily create difficulties where the blending is carried out pursuant to a contract. In such a case the general rule is that the parties are free to decide for themselves at what stage, if any, in the process property in the original goods shall pass to the blender and on what terms. This includes the right to decide who is to own the resultant blend." Therefore, the court recognised that parties can determine themselves how title can transfer on blending.

Accordingly, where there had been a commingling of oil in storage with oil belonging to other persons, title had not passed, unless the parties had agreed otherwise and the seller was entitled to a share of the proceeds from the sale of commingled oil. In contrast, where the oil has been blended with other products belonging to other persons, in the absence of agreement to the contrary, property in the oil would have passed to the buyer on delivery. However, the parties to the contract are, in principle, free to decide for themselves when property in the constituents is to pass and who is to acquire title to the resultant blend.

Applying Glencore to oil pipelines, it seems apparent that if two oils are mixed that have some fundamentally different properties (and arguably value is a different property), then this is not commingling but blending. The equation of 3A + 2A = 5A does not apply as the "As" are not the same. In effect, you have:

A + B = C

and the inference is that title was intended to be passed when the blending took place, and in the absence of any agreement to the contrary, title to product C belonged to the buyer.

Therefore, an allocation agreement that determines when title in the various constituents is to pass, and who holds title to which part of the blended oil, is vital to protect the interests of the Shippers and any other parties involved.

Conclusion

English law distinguishes between situations of mixed storage, which is the mixing of goods which are substantially the same (commingling), where title does not pass and the original owners are entitled to their respective shares of the mixed pool, and scenarios where there had been mixed incorporation (blending) resulting in the "destruction" of the original product such that the original owner no longer retains title in the resulting product.

Evidently, oil and gas Shippers will be concerned if they risk losing title to their product if it is blended together with another product of different quality. To mitigate such risk, it is imperative that an allocation agreement is entered into setting out when title in the constituents is to pass (if at all) and who holds title to the resultant blended product.

Merrick White
Singapore
+65 6303 6031

mjwhite@kslaw.com
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Sylvia Meilisa Taslim
Singapore
+65 6303 6037

staslim@kslaw.com
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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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