Texas Oil and Gas Attorney Blog

A decision from the United States Tax Court in December 2013 has interesting implications for Texas oil and gas leases and Texas mineral owners. In Dudek v. Commissioner, the Tax Court examined the characterization of lease bonus and whether bonus is eligible for depletion allowance.

The Dudek decision dealt with three main issues: 1) whether the bonus payment received by the taxpayer pursuant to an oil and gas lease is taxable as ordinary income or as a capital gain; 2) whether the taxpayer is entitled to a depletion deduction; and 3) whether the taxpayer is liable for an accuracy-related penalty under section 6662(a) for a substantial understatement of income tax.

Michael Dudek, the taxpayer and the petitioner in this case, is a certified public accountant and an attorney licensed to practice law in Pennsylvania. In 1996 and 1998, Dudek and his wife, Brenda, bought a total of 353 acres of land. The Dudeks leased the oil and gas rights to EOG Resources Inc., receiving a 16% royalty and a bonus of over $883,000. As many of you know, bonus is consideration for the primary term of the lease and is not contingent on any extraction or production of oil or gas. The Dudeks reported the lease bonus as a long term capital gain on their income tax return.

The Texas Supreme Court will hear a new case involving royalties on natural gas. Those involved with oil and gas law in Texas will be paying attention, as the case will probably be important. The case is is Occidental Permian Ltd. v. Marcia Fuller French et al, and it is one of the first cases to deal with allocation of the cost of removing carbon dioxide from produced gas following tertiary recovery of that gas with CO2. The appeal was heard by the Eastland Court of Appeals of Texas in October 2012.

The Facts

The Plaintiffs in the trial court, Ms. French and others, were the lessors on two different oil and gas leases in Scurry County and Kent County, Texas. Occidental Permian began injecting wells on these leases with carbon dioxide (CO2) in 2001 in order to boost oil production. As a result, the well produced natural gas that was about 85% CO2. Occidental had the gas treated off site to remove the carbon dioxide and sold the resulting gas. The extracted CO2 was sent back to the well to be reinjected. Occidental paid royalties on the gas after it was treated, and also deducted the treatment costs from the Plaintiffs’ royalties.

A case is winding its way through the courts could be especially important in light of the large number of new oil and gas pipelines being constructed in Texas today. The case was heard by theTexas Court of Appeals in Tyler last year and is currently being heard by the Texas Supreme Court.

The case, Enbridge Pipelines (East Texas) LP v. Gilbert Wheeler, Inc., concerns landowners seeking property damages for the pipeline company’s violation of a pipeline right of way easement agreement. There are two main issues. The first issue is whether the cost to restore the property is the proper measure of damages for the breach of contract alleged by the landowners. The second issue is whether the Court of Appeals erred by holding that the landowners waived their claims by failing to submit a jury question on the nature of the property injury.

Factual Background

The Texas Court of Appeals in Beaumont, Texas recently decided a very interesting the case that has huge implications for Texas land and mineral owners: Environmental Processing Systems LC v. FPL Farming Ltd. The Texas Supreme Court recently heard oral argument on this case.

The Facts

As many Texas mineral owners are aware, salt water is often produced by an oil well in conjunction with the oil. Generally, this salt water is required by law to be collected and taken to saltwater injection wells that are licensed by the Texas Railroad Commission. The salt water is then injected back into the subsurface, where it came from. But one cannot always control where the saltwater goes after it is injected.

The Houston Court of Appeals in Texas recently addressed the issue of surface owners rights in the case of Key Operating & Equipment Inc. v. Will and Loree Hegar. The case involves the use of the surface of the Plaintiffs’ land by an oil and gas operator. In Texas, the owner of the minerals generally has an implied easement for reasonable use of the surface in order to explore, develop and extract the minerals. In this case, the mineral owner wanted to make continued use of a road on the Plaintiffs’ surface estate to access minerals on other tracts, after that surface estate had been severed from its minerals, and after the minerals under the Plaintiffs” tract and the minerals under the other tracts had been pooled.

The Defendant, Key Operating and Equipment owned mineral rights and operated wells on two tracts of land (the Richardson and Rosenbaum-Curbo tracts) in Washington County, Texas since the late 1980’s. The mineral leases allowed for pooling, and in 2002, Key pooled mineral interests in the two tracts, and used the road across the Curbo tract to access their two producing wells on the Richardson tract. At the time of the suit, there was no longer a producing well on the Curbo tract. In 2002, the Hegars bought the surface of the Curbo tract and a 1/4 interest in the minerals. They knew about the lease and the road–which they used themselves to get to their house. They objected, however, when Key drilled a new well on the Richardson tract and used the road more frequently. Mr. Hegar stated, “We’re trying to raise a family and we can’t do it with a highway going through our property.” So in 2007, they sued Key for trespass and asked for a permanent injunction to prohibit Key from using the road. The Hegars claimed that no oil is actually being produced from the Curbo tract and Key only pooled the interests in order to continue to use the access road. Key claimed that the Curbo oil is migrating towards the Richardson tract, and that is why they pooled the two tracts.

The trial court agreed with the Hegars and permanently enjoined Key from using the road “for any purpose relating to the extraction, development, production, storage, transportation, or treatment of minerals produced from an adjoining” tract.

Faced with a rising tide of sweeping municipal legislation banning hydrocarbon extraction, mineral owners and oil and gas operators are taking the fight to court. The Independent Petroleum Association of New Mexico, along with an individual landowner and two limited liability corporations, are suing Mora County, New Mexico, alleging that the ordinance passed by the county violates the Plaintiff’s constitutional rights and exceeds the authority of the county council.

The Mora County ordinance, the first of its kind in the United States, is described by the county as a measure to protect the local water sources and the communities that rely on them. However, the ordinance specifically targets oil and natural gas extraction. The suit alleges that the real purpose of the ordinance, rather than protection of natural water sources, is to prevent lawful development of oil and natural gas resources within Mora County. The ordinance prohibits the extraction of water for use in the extraction of subsurface oil or gas, and also prohibits importing water into the county for that purpose. The ordinance further provides that no permits, licenses, privileges or charter issued by any state or federal agencies that violate the ordinance will be valid. The ordinance passed by Mora County is a variation on an ordinance developed by Pennsylvania attorney Thomas Linzey and adoption of similar ordinances is being considered by dozens of communities across the country.

The Independent Petroleum Association argues that the ordinance violates the substantive due process rights of the organization’s members and exceeds the authority of the county council. They further argue that the ordinance violates fundamental property rights, and that the ordinance does not meet the strict scrutiny standard because the ban is not narrowly tailored to serve a compelling governmental interest. In particular, they note that even though the stated purpose of the ban is to protect the water supply, the ban applies only to hydrocarbon extraction while ignoring the agricultural industry, a source of significant water pollution.