French v. Oxy: Royalty Burdens - Production or Post-Production Expenses

                On June 27, 2014, the Supreme Court of Texas made an important decision that will effect future oil and gas royalty payments. The decision was based on a dispute between a royalty owner and working interest owner of two oil and gas leases in Kent County, Texas. The basis of the dispute was whether the royalty owners were required to share in the cost of removing CO2 from casinghead gas produced through a well.

              “French,” owned royalty interests under two oil and gas leases still being held by production since the late 1940’s by Occidental Permian Ltd. (“Oxy.”) The first lease granted French 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 second lease called 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.” The term “royalty” as used in oil and gas leases, is generally considered free of the expenses of production but subject to postproduction costs. In other words, a royalty interest owner will not have to pay for the cost of extracting oil from the land, but will have to pay for the cost of treating the oil to make it marketable. This separation of payment responsibilities was the central issue between French and Oxy.

             In 1954, the two leases were pooled together to form one unit in order to increase the recovery of oil. French and Oxy entered into a Unitization Agreement in which French consented to the injection of extraneous substances into the oil reservoir and gave Oxy discretion in determining “whether and how to conduct these operations.” This secondary recovery operation involved injecting water into the reservoir to increase and maintain pressure lost through primary production and to sweep oil toward producing wells. The operation was very successful. The wells produced a total of more than 270 million barrels of oil and billions of cubic feet of casinghead gas. By the late 1990s, water flooding had become less effective and oil production had declined from 30,000 barrels per day to about 1,500 barrels per day. This decline in production forced Oxy to search for other alternative methods of recovery.

             Oxy decided that injecting CO2 into the reservoir was the best viable option. CO2 injection is similar to water injection in that both methods are designed to increase pressure and push oil and gas towards the wells. However, CO2 flooding is much more expensive than water flooding.

            Separating oil from water is a relatively simple operation. The oil and water mixture is placed in a large storage tank and the oil floats to the top of the tank. French was never charged by Oxy for this operation. Oxy treated the separation of oil from water as a part of production.

            Separating casinghead gas from CO2 is much more complicated. The CO2 flooding method resulted in the extraction of gas that was 85% CO2. Therefore, Oxy was unable to perform the complicated separation process. Oxy contracted with Kinder Morgan to build a plant that could process CO2 concentrated gas. Kinder Morgan then contracted with Torch Energy Marketing to further process the gas.

             In response to the method of CO2/casinghead gas separation chosen by Oxy, French sued Oxy for underpaying royalties since the beginning of the CO2 flood. French contended that Oxy’s CO2 separation method was a part of production and was supposed to be paid only by Oxy. At the District Court level, the trial court agreed with French and awarded them $10,074,262.33 in underpaid royalties. The Court of Appeals reversed the District Court’s decision due to discrepancies in the calculation of damages. The Court of Appeals did not address the question of whether the cost of separating CO2 from casinghead gas was a production or post production expense. The Supreme Court of Texas did address this important issue.

             Upon review, the Supreme Court of Texas looked to the original leases between French and Oxy. The first lease provided for a royalty on casinghead gas based on its market value at the well. French argued that these royalties should be based only on the value of the non-CO2 gas, the “native” gas, at the well, which could be determined by deducting only the processing costs unrelated to the removal of CO2 from the value of the final products. The second lease provided for a royalty based on the sales proceeds of casinghead gas products net of the cost of manufacturing them. French argued that that cost does not include the expense of removing CO2 from the gas. French claimed that the removal of CO2 for reinjection was a part of production, the expense of which was to be born solely by Oxy. Oxy argued that for both leases, the cost of removing CO2 was a postproduction expense involved in extracting the NGLs (Natural Gas Liquids) that must be deducted from their market price in determining royalties.

            French argued further that the process of separating CO2 from casinghead gas and the process of separating water from oil were the same. Oxy had always treated oil and water separation as a part of production, charging no part of the expense to French. Therefore, according to French, gas processing should be treated the same way.

            The Supreme Court disagreed, determining that oil and water are immiscible, and separating them is a relatively simple process compared to separating CO2 from gas, which requires special technology. Furthermore, separating water from oil is essential to continued economic production. The result of water flooding, which is critical to recovering the oil from the ground, is that an enormous amount of water is produced with the oil, more than 23 barrels of water to one barrel of oil. Separating the water is not only for reinjection into the reservoir; it is necessary to make the oil marketable. Without water flooding and the subsequent separation of oil and water, oil production would not be viable. The CO2 flood is also critical to continued oil production and the result is that the casinghead gas is more than 85% CO2. But separating CO2 from casinghead gas is not necessary for the continued production of oil, which was the purpose of both the water flood and separation. Gas processing is certainly economically beneficial to French and Oxy, but gas processing is not essential to the operation of the field as the water and oil processing is.

          The Supreme Court of Texas further states that “Not only is it unnecessary for continued oil production to separate the CO2 from the casinghead gas, Oxy has no obligation to do so.” Under the Unitization Agreement, Oxy had the right to re-inject the entire production of casinghead gas back into the reservoir, and Oxy considered that option. If Oxy decided to do so, 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. Therefore, the Supreme Court of Texas decided that CO2 removal was in fact a postproduction expense and since French gave Oxy the right and discretion to decide whether or not re-inject or process the casinghead gas, they must share in the cost of CO2 removal.