Operators May Deduct Costs Associated with Recovery Operations from Royalties

The Texas Supreme Court in French v. Occidental Permian Ltd., No. 12-1002, 2014 Tex. LEXIS 533 (Tex. June 27, 2014) addressed the issue of deductions for costs associated with recovery operations from royalties and whether certain expenses are considered production costs or postproduction costs.  The Plaintiffs (collectively “French”) owned the royalty interests under the Fuller Lease and the Codgell Lease,[1] and the Defendant, Occidental Permian Ltd. (“Oxy”) owned the working interest.  Id. at *2-4.  “[U]nder both leases, the casinghead gas royalty is net of postproduction expenses but not production expenses.  Postproduction, as the word itself implies, ordinarily means after production in time, but in this case, the royalty owners contend that the production process does not end at the wellhead.”  Id. at *8.

Shortly, after primary production began, the Leases were pooled in 1954 to form the Cogdell Canyon Reef Unit, which unitization agreement provided that “the royalty owners consented to the injection of extraneous substances into the oil reservoir and gave the working interest complete discretion in determining whether and how to conduct operations.”  Id. at 9.  Thus, Oxy had the discretion to reinject casinghead gas as part of the operations.  The unitization agreement provided that the parties agreed that no royalty would be paid on such reinjected casinghead gas.  Id. at *11.

In 2001, Oxy began a CO2 flood in the unit, which was very successful and without the CO2 flood oil production would have no longer been economically viable and “more than half the oil in the reservoir would have been lost forever.”  Id. at *14.  “The processing was undisputedly a postproduction expense shared by the royalty owners and the working interest.  French received royalties based on the value of the NGLs and residual gas net of the processing costs.”   Id., at *16.  However, an ordinary gasoline plant was unable to process gas that was 85% CO2, thus, Oxy contracted with Kinder Morgan to construct a plant to process the gas and Kinder Morgan received a monthly fee and 30% of the total NGLs in kind.  Id., at *16-17.  Accordingly, Oxy paid “French a royalty on 70% of the NGLs, but not on the 30% given to Kinder Morgan as in-kind compensation, or on any of the residual gas also given as in-kind compensation.  Oxy [considered] the monetary fee paid to Kinder Morgan a production expense and [did] not any part of it to French.”  Id., at *17.

French brought suit and alleged that Oxy underpaid royalties on casinghead gas and asserted that the processing the casinghead gas is a part of production that must be borne by Oxy.  Id., at *18.  French claimed a royalty “based on the value of the native casinghead gas stream that was being processed at the Fuller Plant before the CO2 flood.  Oxy [countered] that removal of the CO2 is necessary to make the casinghead gas marketable and is therefore a postproduction expense that must be shared by the royalty owners.”  Id., at *19.

French argued that the process of separating CO2 injected into the field from the casinghead gas should be treated the same as the process of separating water into the field from oil, which Oxy has treated as a part of production and did not charge expenses for separating the injected water from oil.  The Texas Supreme Court rejected French’s argument and explained that separating oil and water is a relatively simple process, but separating CO2 from gas requires special technology.  Id., at *25.  The Court explained that “[n]ot only is it unnecessary for continued oil production to separate the CO2 from the casinghead gas, Oxy has no obligation to do so.  The Unitization Agreement gives it the right to reinject the entire production of casinghead gas into the field, and in developing the CO2 flood, Oxy  considered that option.  Had it pursued that course, French would not be entitled to any royalty on the casinghead gas.  Instead, Oxy decided to process the gas to obtain a more concentrated stream of CO2 for reinjection and to extract the NGLs to be marketed.  Even so, it actually reinjects more than 10% of the gas produced directly back into the field.”  Id. at *26.

Thus, the Texas Supreme Court concluded that under the terms of the unitization agreement, French gave Oxy the authority to decide whether to reinject the casinghead gas and French benefitted from such reinjenction as the wells remained economically viable long after production would have otherwise ceased.  Therefore, French must share in the cost of the CO2 removal.  The French decision demonstrates that the public policy favors enhanced recovery operations.

After French, it is imperative for an operator to examine carefully the language of leases and any unitization agreements prior to making a determination whether to deduct certain expenses from royalties.  Absent a careful review of the language, an operator may be liable for underpaid royalties if the recovery expenses should not have been deducted.

[1] “The Fuller Lease calls for a royalty ‘on gas, including casinghead gas or other gaseous substance produced from said land and sold or used off the premises or in the manufacture of gasoline or other product therefrom’ equal to ‘the market value at the well of one-eighth (1/8th) of the gas so sold or used.’  The Cogdell Lease calls for a royalty of ‘1/4 of the net proceeds from the sale’ of gasoline or other products manufactured and sold’ from casinghead gas ‘after deducting [the] cost of manufacturing the same.’”  French, 2014 Tex. LEXIS 533, at *3-4.