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 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.
In Texas, the general rule is that royalties are not subjected to the costs of production, but are usually subjected to post-production costs, including taxes, treatment costs to render the hydrocarbons marketable, and transportation costs. (This can be altered by the language of a specific lease). Ms. French and the other royalty owners alleged that Occidental Permian had underpaid their royalties. They claimed that their royalties should have been paid on all the gas that came out of the well, and not the gas remaining after the CO2 was removed (which was a much smaller quantity of gas). The trial court agreed with the Plaintiffs, and awarded Ms. French and the other royalty owners $10.5 million in compensation.
Eastland Court of Appleals
The Court of Appeals, in a decision written by Chief Justice Jim R. Wright, overturned the decision of the trial court and the $10.5 million judgment. The Court found that the trial court had improperly relied on expert testimony. The expert’s estimate of the market value of the gas at the well was questionable because it was not based on specific past sales of similar gas products that were infused with carbon dioxide. The carbon dioxide levels in the gas in question were far in excess of a level of CO2 as a normal impurity in the gas. The Court of Appeals stated: “Because we have held that it is necessary to render the stream marketable, we also hold that it is a cost of manufacturing that must be deducted in order to determine the net proceeds from the sale, and thus the royalty.”
The Texas Supreme Court
In the Supreme Court, the principal issues are: 1) whether the gas should be valued in its original state, before extraction from the well, or at the wellhead where it is commingled with carbon dioxide; 2) whether removing, compressing, and transporting carbon dioxide should be classified as a production operation; and 3) whether carbon dioxide removal off site for reuse is a production operation. Oral Argument occurred on February 5, 2014, but no opinion has been rendered. You can access the briefs of the parties here.
The decision of the Texas Supreme Court will have a substantial impact on Texas mineral owners who receive royalties from wells where CO2 is used to increase production.
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