Last November, the Texas General Land Office lost its appeal in Commissioner v. SandRidge Energy, Inc., in the El Paso Court of Appeals. For the first time, a court has ruled that a lessee can deduct post-production costs under the Texas General Land Office’s Relinquishment Act lease form, citing Heritage Resources v. NationsBank, 939 S.W.2d 118 (Tex. 1996).
The case actually involves several oil and gas leases owned by SandRidge in Pecos County, some covering lands owned by private parties, some covering Relinquishment Act lands. (The State owns the minerals under Relinquishment Act land; the surface owner is agent for the state in granting oil and gas leases, for which the surface owner receives ½ of bonuses and royalties. The lease must be approved by the GLO and be on the approved GLO lease form.) The most interesting part of the case is the court’s interpretation of the GLO’s Relinquishment Act lease form. There are somewhere between 6.4 million and 7.4 million acres of Relinquishment Act lands in Texas, principally in West Texas, in and around the Permian Basin.
SandRidge’s wells on the leases in dispute produce mostly carbon dioxide, mixed with some natural gas. Originally, SandRidge paid the GLO royalties on its sales of natural gas and carbon dioxide. More recently, SandRidge made an agreement with Oxy USA; SandRidge built a plant, the Century Plant, to extract the CO2 from SandRidge’s gas. Oxy owns and operates the plant and gets the CO2 extracted; SandRidge gets the natural gas. Oxy doesn’t charge SandRidge for separating the gas from the CO2. Oxy uses the CO2 in secondary recovery projects. The plant reportedly cost a billion dollars.
When the Century Plant was up and running, SandRidge stopped paying royalties on CO2 under its Relinquishment Act leases. The State sued, and the parties filed motions for partial summary judgment. The trial court ruled in favor of SandRidge.
The GLO relied on the following provisions of the Relinquishment Act leases:
4(B). NON PROCESSED GAS. Royalty on any gas (including flared gas), which is defined as all hydrocarbons and gaseous substances not defined as oil in subparagraph (A) above, produced from any well on said land (except as provided herein with respect to gas processed in a plant for the extraction of gasoline, liquid hydrocarbons or other products) shall be 25% part of the gross production or the market value thereof, at the option of the owner of the soil or the Commissioner of the General Land Office, such value to be based on the highest market price paid or offered for gas of comparable quality in the general area where produced and when run, or the gross price paid or offered to the producer, whichever is the greater ….
7. NO DEDUCTIONS. Lessee agrees that all royalties accruing under this lease (including those paid in kind) shall be without deduction for the cost of producing, gathering, storing, separating, treating, dehydrating, compressing, processing, transporting, and otherwise making the oil, gas and other products hereunder ready for sale or use. Lessee agrees to compute and pay royalties on the gross value received, including any reimbursements for severance taxes and production related costs.
The State argued that SandRidge was paying for the cost of treating the natural gas by giving the CO2 to Oxy, and that this cost is not deductible under the Relinquishment Act lease form. SandRidge argued that the cost of treating the gas is deductible, based on Heritage v. NationsBank. In Heritage, the Texas Supreme Court held that, where a lease provides for royalties based on “market value at the well,” a lessee may deduct post-production costs even if the lease prohibits such deductions. According to the Court, “from SandRidge’s perspective, Heritage stands for the principle that a market value at the well clause trumps any other provision that conflicts with it.” SandRidge argued that the paragraph 4(B) of the Relinquishment Act lease is in effect a market-value-at-the-well royalty provision. The El Paso Court of Appeals agreed. It said that the clause provides for royalties based on the wellhead measurement of gas volume. “The royalty is therefore owed on the substance so measured: raw gas, including all of its components. ‘When there is a wellhead measurement, payment is due for gas in its natural state, not on the liquid hydrocarbons which are later extracted.’ ConocoPhillips Co. v. Incline Energy, Inc., 198 S.W.3d 377, 381 (Tex.App.–Eastland 2006, pet denied)(citing Carter v. Exxon Corp., 842 S.W.2d 393 (Tex.App.–Eastland 1992, writ denied)).”
To my knowledge, this is the first appellate decision applying the Heritage rationale to a royalty clause that does not contain “market-value-at-the-well” language.
The GLO intends to appeal to the Texas Supreme Court. The Supreme Court has already agreed to hear Chesapeake’s appeal in the Hyder case, which also implicates Heritage.