Mineral owners in Texas have learned that their leases should provide for a “cost-free” royalty. By this, they generally understand that the lease should prohibit the lessee from deducting any costs from their royalty. Herein, then, are some ruminations about what lawyers and oil companies refer to as “post-production costs.”
The problem of post-production costs generally arises only in relation to gas production. The typical oil and gas lease provides that the royalty on gas shall be a specified fraction of “the market value at the well”, or of the “amount realized at the well,” or the “net proceeds at the mouth of the well.” The phrase “at the well,” as interpreted by Texas courts, has a highly specialized meaning. It means that the lessee, in calculating the royalty, can deduct any costs incurred to make the gas marketable and to get the gas to the point of sale. (I’ll bet most mineral owners don’t realize that when they sign a lease.) Such costs are referred to as “post-production costs” because they are incurred after the gas is produced but before it is sold, and they can be quite significant.
Suppose the following facts: ABC Oil Company drills the Jones #1 gas well on the Jones farm. ABC has a lease from Jones that provides for payment of a 1/4th royalty on the “amount realized at the mouth of the well.” The Jones #1 gas as it comes from the ground contains quantities of water, hydrogen sulfide and other impurities that have to be removed before the gas can be sold to a pipeline. Also, the gas itself is actually a mixture of several different hydrocarbon gases – methane, ethane, butane and propane. Although most natural gas is methane — the same gas you burn in your stove — some natural gas contains significant quantities of “heavier” gases such as ethane, butane and propane. If there are enough of those other gases, they must be separated from the methane before the methane can be sold to a pipeline, because the heavier gases tend to condense into a liquid in the pipeline and cause problems with the pipeline’s transmission system. The heavier gases can be sold as separate products. They generally have a higher value per unit volume than methane because they have a higher heating value. That is, they produce more heat per unit volume when they are burned as fuel.
So ABC Oil Company installs separators and treaters on the Jones lease to remove the water and hydrogen sulfide from the gas. The cost of such treatment is $.10 per mcf. ABC also contracts with XYZ Processing Company to “process” the gas to remove the heavier hydrocarbons. Its agreement with XYZ Processing Company provides that XYZ gets to keep 25% of the heavier gases as its fee for processing the gas from the Jones #1 well. ABC also enters into a contract with Big Inch Pipeline Company to transport the methane to Commercial Plastics Company for $.05 per mcf, and ABC enters into a contract to sell the gas to Commercial Plastics Company for $5.00 per mcf. Finally, ABC agrees to sell its 75% of the heavier gases to NGL Purchasing Company for $7.00 per mcf.
In its first month of production, the Jones #1 produces 100,000 mcf of gas. 1,000 mcf of that gas is used as fuel to run the treaters to remove the water and hydrogen sulfide. After the remaining gas is treated and processed, it becomes 90,000 mcf of methane and 9,000 mcf of heavier gases. ABC gets back the 90,000 mcf of methane, which it sells to Commercial Plastics for $450,000, and it gets back 75% of the 9,000 mcf of heavier gases, which it sells to NGL Purchasing Company for $47,250. ABC Oil Company thus receives $450,000 for the methane and $47,250 for the heavier gases, for a total of $497,250.
Here is how ABC would calculate its royalty payment to Jones:
|Gross Proceeds of Sale:
|Less Treating Cost:
|Less Transportation Cost:
In doing this calculation, ABC has reasoned that, to find the “net amount realized at the mouth of the well,” it should take the gross amount realized and deduct the post-production costs incurred. So the net amount realized is $482,250, and it pays Jones 25% of that amount. This amounts to $4.82/mcf on the original 100,000 mcf produced, and that is what is shown on Jones’ check detail: 100,000 mcf produced, at $4.82/mcf.
So what post-production costs were borne by the royalty owner? Certainly his 1/4th of the treating and transportation costs. But what about the gas burned in the treaters? Most leases provide that no royalty is owed on gas used as fuel on the lease. But this fuel is certainly a post-production cost. At $5.00/mcf, the fuel cost is $5,000. And what about the cost of processing the gas to separate out the heavier gases? ABC paid XYZ Processing Company 25% of the heavier gases as its processing fee. This is certainly a post-production cost as well – at $7/mcf, a cost of $15,750. So the total post-production costs charged to the royalty owner are in fact:
The royalty owner’s 1/4th of those costs is $8,938. That is more than 7% the royalty owner’s share of the gross value of the gas.
ABC Oil Company argues that it is fair for Jones to bear his share of these post-production costs because the treating, processing and transportation make the gas more valuable for both ABC and Jones. In fact, I have recently seen “cost-free” royalty provisions in leases offered by oil companies that provide something like the following:
Lessor’s royalty shall never bear any of the costs of treating, marketing, processing, gathering or transporting gas produced from the leased premises; provided, however, that Lessor’s royalty shall bear its share of such costs to the extent that such activities increase the value of the gas so produced.
Of course it is true that all of the post-production activities do increase the market value of the gas. Most of the activities are necessary to place the gas in a condition so that it is marketable at all. A provision like the one above is misleading, because under such a lease the lessee would always be able to deduct post-production costs.
One might reply to ABC Oil Company that it would be “fair,” using its argument, for Jones to bear his share of all operating costs for the well, since the cost of operating the well certainly serves to increase the value of the gas. In fact, under this reasoning, why shouldn’t Jones bear his share of the cost of drilling the well? Without those costs, there would certainly be no gas. But to ask Jones to bear such costs would defeat the very idea of a “royalty,” which is generally understood as a share of revenue free of the cost of producing that revenue.
I am trying to make two points by the above example: first, the issue of what post-production costs, if any, should be borne by the royalty owner is not a simple one and should be specifically addressed in any lease negotiation. Second, there is no “fair” way to allocate post-production costs between the lessee and the royalty owner. The allocation of such costs is purely a matter of the bargaining strength of each side in the negotiation of the lease.
More next week on post-production costs.