Oil and Gas Lawyer Blog

Twenty years ago I wrote an article, “Issues Concerning Royalty Valuations and Deductions,” published in the Petroleum Accounting and Financial Management Journal. One of those issues I discussed was the recurring problem of post-production cost deductions. In the article I contrasted the approaches to lease construction illustrated by two cases: Heritage Resources v. NationsBank, 939 S.W.2d 118 (Tex. 1996), and Rogers v. Westerman Farm Co., 29 P.3d 887 (Colo. 2001). A recent decision from the Colorado Supreme Court, Board of County Commissioners of Boulder County, Colorado v. Crestone Peak Resources Operating, LLC, 2023 WL 8010221 (Nov. 20, 2023), further illustrates the contrasting approaches taken by Texas and Colorado courts in construing oil and gas leases.

First, Heritage v. NationsBank and Rogers v. Westerman. Both decided whether post-production costs could be charged to the royalty owner in two oil and gas leases. The NationsBank lease provided that “there shall be no deductions from the value of the Lessor’s royalty by reason of any required processing, cost of dehydration, compression, transportation or other matter to market such gas.” But because the lease provided for gas royalties based on “market value at the well,” the Texas Supreme Court held that transportation costs were deductible from NationsBank’s royalty. The Westerman lease provided that the royalty would be “one-eighth of the gross proceeds received from the sale of such produced substances where same is sold at the mouth of the well, or … if not sold at the mouth of the well, … one-eighth of the market value thereof at the mouth of the well, but in no event more than one-eighth of the actual amount received by the lessee for the sale thereof.” The Colorado Supreme Court held that the lessee must bear all post-production costs necessary to get the gas into “marketable condition.”

The Heritage court hung its opinion on the term “at the mouth of the well.” Since royalty is to be based on the market value at the well, there can be no deductions from that value, so the no-deductions clause was “surplusage.” The Westerman court instead said the term “at the mouth of the well … says nothing about the parties’ intent with respect to allocation of costs,” and concluded that the lease is “silent with respect to allocation of costs.”

This case illustrates an increasing problem related to salt water disposal in the Permian Basin. Recent articles in Texas Monthly and other publications have documented leaks from old abandoned wells caused by injection of massive quantities of salt water into shallow formations.Iskandia Energy Operating, Inc. v. SWEPI LP, No. 08-22-00103-CV, El Paso Court of Appeals, October 31, 2023.

Iskandia acquired oil and gas leases covering some 5,000 acres in Loving County, along with more than 100 producing wells. Iskandia planned to re-stimulate the wells and increase production.  The wells produce from formations in the Delaware Mountain Group in the Delaware Basin lobe of the Permian Basin–the Cherry Canyon, Bell Canyon and Brushy Canyon formations. These formations are just above the Bone Springs and Wolfcamp formations, which are the principal formations being drilled by operators in the Delaware lobe. Iskandia’s wells produce oil and salt water; the salt water is re-injected into the producing formation. Iskandia produces and re-injects about 6,000 barrels per day on its leases, which maintains the formation pressure and facilitates continued oil production.

SWEPI owns and operates leases adjacent to the Iskandia leases and is drilling wells in the Bone Springs and Wolfcamp. These wells also produce large volumes of salt water, and SWEPI has drilled disposal wells on its leases that inject that water into the Delaware Mountain Group formations. Iskandia produced evidence that SWEPI is injecting more than 2 million barrels per month into the DMG, and has injected more than 75 million barrels in just three years.