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Post-Production Costs in Texas-Part III: Yturria v. Kerr-McGee

Last week, in Post-Production Costs in Texas-Part II, I discussed the Texas Supreme Court’s decision in Heritage Resources v. NationsBank regarding the deductibility of post-production costs from lessor’s royalties under an oil and gas lease. Justice Priscilla Owen (now a judge on the U.S. Court of Appeals for the Fifth Circuit) filed a concurring opinion in Heritage in which she said that “it is important to note that we are construing specific language in specific oil and gas leases. Parties to a lease may allocate costs, including post-production or marketing costs, as they choose.” Justice Owen’s conclusion was put to the test in Yturria v. Kerr-McGee Oil & Gas Onshore, LLC, decided by the U.S. 5th Circuit Court of Appeals on September 8, 2008.

My firm represented the royalty owners in Yturria v. Kerr McGee, and I was the author of two of the oil and gas leases construed in that case. As the court points out, these were not “standard” oil and gas leases. They contained detailed provisions as to how royalties were to be calculated and paid. The language was crafted as part of the settlement of earlier litigation with Kerr McGee over royalty payments, and at the time the language was agreed to there were existing wells on the leases that produced substantial quantities of gas. The Kerr-McGee gas was processed before sale under a processing agreement between Kerr-McGee and the processor, Enterprise.; The processing agreement required that Enterprise pay Kerr McGee for 80% of the natural gas liquids extracted from the gas, based on posted prices, less a “T & F Fee” for the costs of transportation and fractionation of the liquids. The issue in the case was whether the royalty owners should bear their royalty share of the T & F Fees charged by Enterprise. The trial court and the court of appeals both ruled in favor of the royalty owners, holding that, under the particular language of the leases, the T & Fees could not be deducted from the lessors’ royalty.

┬áThe leases provided that Kerr-McGee would pay a royalty on natural gas liquids (called “plant products” in the leases) equal to “1/4th of 75% of all plant products, or revenue derived therefrom, attributable to gas produced by Lessee from the leased premises (whether or not Lessee’s processing agreement entitles it to a greater or lesser percentage).” The leases also provided that “Lessor’s royalty shall never bear, either directly or indirectly, any part of the costs or expenses of production, gathering, dehydration, compression, transportation (except transportation by truck), manufacture, processing, treatment or marketing of the oil or gas from the leased premises.” The court of appeals agreed with the royalty owners that the “revenue derived” from plant products was the gross revenue based on the price set forth in the Enterprise-Kerr-McGee processing agreement, before deduction of the T & F Fees.

This case illustrates that accounting for gas royalties can be a complex matter. The royalty owners discovered the T & F Fee deduction only after an audit of Kerr-McGee’s records and had to engage in four years of litigation to enforce the provisions in their leases.

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