Deduction of Post-Production Expenses PDF

Oliva Gibbs LLP | oglawyers.com Deduction of Post-Production Expenses November 8, 2022 Brad Gibbs, Partner [email protected] www.oglawyers.com ...

Oliva Gibbs LLP | oglawyers.com Deduction of Post-Production Expenses November 8, 2022 Brad Gibbs, Partner [email protected] www.oglawyers.com  Oliva Gibbs LLP | oglawyers.com 2 Overview I. Historical Background of Deduction of Post-Production Expenses II. The Heritage Resources Case and Clauses Prohibiting Deductions III. Recent Case Law Regarding the Deduction of Post-Production Expenses IV. First Marketable Product Approach  Oliva Gibbs LLP | oglawyers.com 3 Historical Background  Under an oil and gas lease, the physical location of the “property” is the wellhead on the leased property.  The wellhead is the location where the lessee reduced the oil or gas to its physical possession.  Thus, historically, the wellhead, being the physical location of the property rights, was the location for calculating the value or price of the production under the oil and gas lease (TIP: analysis always starts with the lease).  Oliva Gibbs LLP | oglawyers.com 4 The Oil and Gas Lease  The oil and gas lease will contain one (or more) royalty clauses in which the lessee agrees to pay the lessor a royalty. The clause will generally set forth: (i) the royalty amount; (ii) the valuation method; (iii) the valuation point.  Thus, royalty clauses may address: o Royalty based on “proceeds” o Royalty based on “amount realized or received” o Royalty based on “market value” o Value of gas sold “at the well” o Value of gas used “off the leased premises”  Oliva Gibbs LLP | oglawyers.com 5 How is the Royalty Calculated? (“Valuation Yardstick”) Market Value Net Proceeds In Kind  The lessee covenants to pay  The royalties to be paid by  The lessee covenants to deliver as royalties on gas, produced lessee on gas produced from to the credit of the lessor, in from said land and sold or said land and sold on or off the pipeline the equal part of used, the market value at the the premises, are 1/8th of the 1/8th of the oil produced and well of 1/8th of the gas so net proceeds at the well saved. sold or used. received from the sale thereof.  Taking physical possession  Not always available or easy  Implicates the “workback to calculate method,” which is a market value proxy  Oliva Gibbs LLP | oglawyers.com 6 Where is the Royalty Calculated? (“Valuation Point”)  Traditionally, many oil and gas leases required that the lessee calculate the market value or price of its production “at the well,” at the “mouth of the well,” or “at the wellhead.”  Other royalty clauses included broader terms, such as “in the field of production.”  Other clauses require the value to be calculated at a point downstream, such as at the “point of delivery” or “point of sale.”  Oliva Gibbs LLP | oglawyers.com 7 Implied Covenant to Market  The Implied Covenant to Market o Imposes upon the lessee the duty to market hydrocarbons produced from a well and to obtain the best price and terms possible for the sale of production. o Serves as the basis for the “first marketable product doctrine” (Oklahoma, Colorado, Kansas, West Virginia, BLM/ONRR). o Texas courts have concluded that the implied covenant to market does not permit courts to rewrite a lease agreement contrary to the parties’ intent, even if a contrary interpretation would produce a more equitable agreement.  Texas applies the “at the well” approach (Ohio, Pennsylvania, New Mexico, North Dakota).  Oliva Gibbs LLP | oglawyers.com 8 Deduction of Costs Post-Production costs include:  By definition, royalty is paid free of the costs of  Dehydration and separation exploration, drilling and production of oil and gas (the “production costs”).  Compression  Key Point: Post-production costs/activities add  Removal of substances to make the production marketable value to the production in its raw state at the location of the wellhead prior to a final sale.  Gathering costs  Marketing  Severance or production taxes  Oliva Gibbs LLP | oglawyers.com 9 General Rule for Deduction of Costs  Although not subject to the cost of production, royalty is usually subject to post- production costs including taxes, treatment costs to render it marketable, and transportation costs.  The general rule is that royalty clauses based on “proceeds” or “amount realized” or “market value” at the well permit deduction of post-production costs from gas sales before paying royalties.  Royalty, by definition, is a share of the “production” as it exists when it reached the mouth of the well. The lessee is solely responsible for bearing all costs necessary to achieve “production.”  Remember: downstream transporting and processing adds value that the royalty owner is not entitled to unless contracted for.  Oliva Gibbs LLP | oglawyers.com 10 Market Value at the Well Comparable Sales Method Workback or Netback Method  Lessee determined the market value of its  Lessee determined the market value of its production at the wellhead by averaging the production at the wellhead by taking the prices that the lessee and other producers sales price that it received for its production are receiving at the same time and in the at a downstream point of sale, then same field, for oil or gas of comparable subtracting the reasonable post-production quality, quantity and availability. costs that the lessee incurred after extracting the production.  Oliva Gibbs LLP | oglawyers.com 11 Net Proceeds or Amount Realized  Lessee calculates the royalty payments on the basis of the actual price of its production, measured at the wellhead.  If the lessee sold its production to a third-party purchaser at the wellhead, then the lessee had to pay lessors their proportional royalty share of the actual price that the lessee received for its production.  If the lessee sold its production at a point downstream of the wellhead, then lessee calculated the royalties owed under a workback method.  Oliva Gibbs LLP | oglawyers.com 12 “At the Well” Approach – Heritage Resources, Judice and Clauses Prohibiting Deductions (TX, OH, ND, PA, NM)  Oliva Gibbs LLP | oglawyers.com 13 Heritage Resources, Inc. v. NationsBank, Co., 939 S.W.2d 118 (Tex. 1996)  Facts: Heritage sold gas off the leased premises and deducted the cost of post- production transportation from the wellhead to the point of sale.  Royalty Clause (e.g.): 1/4 of the “market value at the well” for all gas produced from the leased premises; provided, however, that there shall be no deductions... by reason of any required processing, cost of dehydration, compression, transportation, or other matter to market such gas.  Issue: Since NationsBank offered no evidence of comparable sales, were post- productions costs using the “net-back” method proper?  Oliva Gibbs LLP | oglawyers.com 14 Heritage Resources, Inc. v. NationsBank, Co. (Cont.)  Holding: When royalty is based on “market value at the well” it bears its proportionate share of PPCs. The subsequent language prohibiting deduction of post-production costs is “surplusage” and cannot be enforced (the specific language of the lease will always control).  Concurring Opinion (Justice Owen): Parties could have said that the royalty owners would receive their royalty based on the market value of the point of delivery or sale. They also could have said that the lessee would pay all post- production costs in addition to the payment of market value at the well (an “Add-Back” or “Proceeds Plus” provision).  Oliva Gibbs LLP | oglawyers.com 15 Judice v. Mewbourne Oil Co., 939 S.W.2d 133 (Tex. 1996)  Facts: Mewbourne sold gas off the leased premises and deducted the cost of post- production compression to move the gas from the wellhead to the point of sale pursuant to two leases and three division orders.  Royalty Clauses (e.g.): Based on market value at the well (similar to Heritage)  Holding: This phrase means value at the well, net of any value added by compressing the gas after it leaves the wellhead (decided same day as Heritage)  Note: Two division orders stated that the “settlement for gas sold shall be based on the gross proceeds realized at the well.” Court notes that these phrases are contradictory. Another division order referenced net proceeds which permits the deduction of PPCs  Oliva Gibbs LLP | oglawyers.com 16 Anti-Heritage Clauses  Following the Heritage and Judice decisions, many lessors sought to avoid the application of Heritage and the deduction of post-production costs and included “Anti-Heritage Clauses”.  The inclusion of Anti-Heritage Clauses and the industry practice of deducting transportation and other post-production costs has led to a wave of royalty litigation.  Including an Anti-Heritage Clause generally does not free you from PPC’s, because Heritage only stands for the idea that you have to read the specific language of the lease. Hyder, 483 S.W.3d 870 (Tex. 2016)  Oliva Gibbs LLP | oglawyers.com 17 Expanding Heritage Resources – The Chesapeake Cases (2014)  Oliva Gibbs LLP | oglawyers.com 18 Warren v. Chesapeake Exploration, L.L.C., 759 F.3d 413 (5th Cir. 2014)  Facts: CHK was selling gas at the well to an affiliate and paying royalty based on the “full amount it realized at the well.” PPC’s were being netted back to the well from a downstream point of sale.  Royalty Clause: 22.5% of the “amount realized computed at the mouth of the well.” Addendum stated that “notwithstanding anything to the contrary, all royalty shall be free of all costs and expenses related to the exploration, production and marketing of all oil and gas production, including compression, dehydration, treatment and transportation.  Holding: “Amount realized” is the how, but “at the well” is the where (two-part analysis). PPCs are deductible.  Oliva Gibbs LLP | oglawyers.com 19 Warren v. Chesapeake Exploration, L.L.C. (Cont.)  Quote: “It has become too easy for courts to avoid considering explicitly negotiated lease language and simply stamp it as ‘See Heritage, Return to Sender,’ without opening the envelope.”  Per the Court: o If the lease had just said 22.5% of the amount realized – no deduction of PPCs o The parties could have deleted the phrase “computed at the mouth of the well.” o They could have said that lessor was entitled to 22.5% of the “actual proceeds of the sale, regardless of the location of the sale.” o Perhaps they could have said that sale to “affiliate” is not a “point of sale” for calculating PPCs...  Oliva Gibbs LLP | oglawyers.com 20 Potts v. Chesapeake Exploration, L.L.C., 759 F.3d 413 (5th Cir. 2014)  Facts: Chesapeake Operating, Inc. (“COI”) was selling gas to affiliate Chesapeake Energy Marketing, Inc. (“CEMI”) at the wellhead. CEMI was then treating and selling downstream to unaffiliated purchasers for a higher price. PPCs were being netted back and Lessor’s were being paid 1/4th of the price received from CEMI.  Royalty Clause: Royalties shall be based on the “market value at the point of sale” and all royalty “shall be free of all costs and expenses related to marketing.” Also stated that payments shall be based on sales to “unrelated third parties... through arms-length negotiations.” If sold to an affiliate, royalties shall be paid based on “prevailing values at the time in the area” (note this part does not specify a valuation point).  Oliva Gibbs LLP | oglawyers.com 21 Potts v. Chesapeake Exploration, L.L.C. (Cont.)  Holding I: The value of the Lessor’s royalty is a percentage of market value at the point of sale, which in this case is at the well. A “net-back” method of calculation does not “burden” or reduce the value of the royalty.  Holding II: Since the gas was being sold to an affiliate, royalties are to be paid on “prevailing values at the time in the area,” which does not require the point of sale to be the point at which the gas was sold to a non-affiliate entity (i.e. “at the well calculation is permissible”).  Note: Too operator friendly? Frustrating the parties’ intent?  Oliva Gibbs LLP | oglawyers.com 22 “See Heritage, Return to Sender?” (Recent Texas Cases)  Oliva Gibbs LLP | oglawyers.com 23 Chesapeake Exploration, L.L.C. v. Hyder, 483 S.W.3d 870 (Tex. 2015)  Royalty Clause I: 25% of the price actually received received by Lessee... free and clear of all production and post-production costs and expenses. o Holding I: This is a “proceeds lease” provision that does not bear post-production costs. The “price received” basis for payment excuses PPCs.  Royalty Clause II: A perpetual cost-free (except only its portion of production taxes) overriding royalty of 5.0% of gross production obtained...” Also included an Anti-Heritage Clause. o Holding II: “Cost-free” in this context includes PPCs. This is because production taxes are generally considered to be a PPC, so including it separately would otherwise make no sense (no dogs, except for cats). Anti-Heritage Clause is meaningless surplusage. (Remember: Heritage only stands for a four-corners reading of the lease)  Oliva Gibbs LLP | oglawyers.com 24 Burlington Res. Oil & Gas Co., LP v. Tex. Crude Energy, LLC, 573 S.W.3d 198 (Tex. 2018)  Royalty Clause: The ORRI shall be delivered to the Assignee into the pipeline... and the value paid to Lessor. “Value” shall refer to (i) in the event of an arm’s length sale on the leases, the amount realized from such sale of such production... (ii) in the event of an arm’s length sale off the leases, the amount realized for the sale of such production.  Issue: Whether Texas Crude holds royalties on products at the well or on treated and transported products at the downstream point of sale.  Holding: The valuation method (yardstick) is “amount realized” (no PPCs), but the valuation point (where) is “into the pipeline” (synonymous with “at the well” = bears PPCs).  Court – ”Amount realized” is not a trump card (but “at the well” may be?!)...  Oliva Gibbs LLP | oglawyers.com 25 Devon Energy Prod. Co., L.P. v. Sheppard, 2020 Tex. App. LEXIS 8378 (Corpus Christi)  Royalty Clause: On gas, 1/5th of the greater of (1) the market value at the wellhead, or (2) the gross proceeds realized from the sale of such gas, free of all costs and expenses, to the first non-affiliated third-party purchaser under a bona fide arms length sale or contract. o The parties (and court) agree that this provision creates a proceeds lease and requires the royalty to be paid without deducting PPCs from the sale downstream to third-party purchasers.  However, unique “Proceeds Plus” Clause: If any sale of gas shall include any reduction or charge for the treatment, transportation, processing or marketing the gas, then such deduction shall be added to the market value or gross proceeds...  Holding: Depending on the particular sales contract, any PPC reduction (even after point of sale) may have to be added to the sales price. On appeal to the TSC...  Oliva Gibbs LLP | oglawyers.com 26 Fun Quotes from Burlington/Sheppard  We can only speculate as to how many  “If you can’t understand what your dollars and hours would have been contract means without asking the saved had the parties drafted the lawyer who wrote it, you should not be leases, in Justice Blacklock’s words, “to surprised later if judges – who can’t just say exactly what they intended, without take your lawyers word for it – also resort to industry jargon, outdated have trouble understanding what it legalese, or tenuous assumptions about means.” – Justice Blacklock how judges will interpret industry jargon or outdated legalese.” – Sheppard Court quoting Justice Blacklock  Oliva Gibbs LLP | oglawyers.com 27 Bluestone Nat. Res. II, LLC v. Randle, 620 S.W.3d 380 (Tex. 2020)  Royalty Clause: Lease provided for “market value at the well.” However, an ADDENDUM that “supersedes any provisions to the contrary” stated that gas royalties should be based on the gross value received, along with typical ”no deductions” language specifying that royalties shall be paid without deduction for PPCs.  Issue: Whether royalties under the lease accrue under the gross value received, or the value received net of postproduction costs.  Bluestone’s Argument: The addendum provides a yardstick (gross value received), but no valuation point (so it has to be “at the well”)  Holding: When proceeds are valued in “gross,” the valuation point is necessarily the point of sale because that is where the gross is realized or received. Remember back in Judice the court said that “gross” and “at the well” are contradictory. Addendum controls and Randle wins.  Oliva Gibbs LLP | oglawyers.com 28 Fun Quotes From Bluestone II v. Randle  When proceeds are valued in "gross”... the valuation point is necessarily the point of sale because that is where the gross is realized or received.  If our jurisprudence is less than precise in articulating some of these concepts, it is nonetheless clear that royalties computed on gross amounts received means royalties are paid based on point-of-sale proceeds without deduction of postproduction costs.  [However], even with a proceeds clause, parties can agree to allocate postproduction costs in any way they desire, including moving the point of valuation in a way that reflects a net-proceeds computation.  Oliva Gibbs LLP | oglawyers.com 29 So, it’s settled right?  The magic words for the valuation yardstick are “gross” vs. “net”  The magic words for the valuation point are “at the well” or “point of sale”, etc.  Use of the word “gross” implies a valuation point at the point of sale and “net” implies at the well  At the well” and “into the pipeline” are analogous per Burlington and Bluestone o That would be too easy... o Food for thought, where exactly is the “point of sale” or “point of delivery”? Is it where title transfers? Does the sale have to be to a non-affiliate? Arms-length negotiation? Off the lease? At the tailgate of the processing plant? Best practice is to define the point of sale or delivery…  Oliva Gibbs LLP | oglawyers.com 30 Nettye Engler Energy, LP v. BlueStone Natural Res. II, LLC, 639 S.W.3d 682 (Tex. 2022) – “Into the Pipeline” Revisited  Royalty Clause: A deed provided that the royalty owner’s share be delivered “free of cost in the pipeline, if any, otherwise free of cost at the mouth of the well or mine.”  Issue: Whether (i) a gas gathering system is a “pipeline” under the royalty provision and (ii) the valuation point should be the gas gathering system or the downstream transportation pipeline. In other words, whether (i) “delivery” occurred in the gathering pipeline or the transportation pipeline and (ii) whether gathering, compression, and processing costs prior to delivery to the transportation pipeline could be deducted.  Holding: A “gas gathering pipeline is a ‘pipeline’ in common, industry, and regulatory parlance, and the deed does not limit the delivery location to any specific pipeline nor prohibit delivery to a pipeline at or near the well, if any.” PPCs can be netted back to delivery into the gathering system.  Oliva Gibbs LLP | oglawyers.com 31 Nettye Engler Energy, LP v. BlueStone Natural Res. II, LLC (Cont.)  Takeaway: Per the TSC, “Burlington does not establish a rule that delivery ”into the pipeline,” or similar phrasing is always equivalent to an “at the well” delivery or valuation point. Rather Burlington merely emphasizes that all contracts, including mineral conveyances, are construed as a whole to ascertain the parties’ intent from the language they used to express their agreement.”  Burlington – “‘Into the pipelines’ in the context of these agreements, fixes the royalty’s valuation point at the physical spot where the interest must be delivered – at the wellhead or nearby.”  Bluestone II v. Randle – “Into the pipelines” is an “at the well” analog.  Oliva Gibbs LLP | oglawyers.com 32 Shirlaine West Props. Ltd. v. Jamestown Res., L.L.C., 2021 Tex. App. LEXIS 9379 (Ft. Worth) – Point of Sale Revisited  Royalty Clause: “Pay Lessor for gas including casinghead gas and other gaseous substances produced from said land and sold or used on or off the premises twenty-five percent (25%) of the market value at the point of sale, use or other disposition of all such gas.” Also had a ton of verbiage attempting to free the royalty from PPCs.  Holding: At the end of the day valuation point was the wellhead, which is where the point of sale occurred (title transferred), thereby making deduction of post-production expenses permissible.  Quote: This case is yet another episode in the endless struggle between lessors and lessees in the allocation of post-production costs.  Takeaway: It seems that valuation point is becoming the most litigated area because parties can often disagree as to what the point of “sale” or “delivery” is.  Oliva Gibbs LLP | oglawyers.com 33 “First Marketable Product” Approach (OK, CO, KS, WV, BLM)  Oliva Gibbs LLP | oglawyers.com 34 First Marketable Product Approach  Oklahoma does not follow the Texas approach, but instead has adopted the first marketable product approach.  The first marketable product approach is based on the implied covenant to market in oil and gas leases.  Under this approach, the phrase “at the well” may not actually mean at the well, but potentially a point much farther downstream when the gas is “marketable” and sold to a third party. o The point where a marketable product is first obtained is the logical point where the exploration and production segment of the oil and gas industry ends, is the point where the primary objective of the lease contract is achieved, and therefore is the logical point for calculation of royalty. Clough v. Williams Prod. RMT o However, post-production costs may be deducted if they enhanced the value of an already marketable product. Mittelstaedt v. Santa Fe Minerals, Inc.  Oliva Gibbs LLP | oglawyers.com 35 Federal (BLM/ONRR) - Limited Deductions (30 CFR 1206.140, et seq.)  General Rule – Royalty is due on production that is in “marketable condition” (sufficiently free of impurities and in a condition that is accepted by a purchaser under a sales contract typical of the area). o The Lessee is responsible for placing the lease production in marketable condition at no cost to the lessor o Four components to marketable condition: (i) compression; (ii) gathering; (iii) dehydration; and (iv) sweetening or treatment. Gas is generally not considered to be in marketable condition at the wellhead (even if it can be sold untreated) o Certain costs of “transportation” and “processing” are generally deductible. However, transportation does not start until after the central accumulation point (CAP) and gathering costs are thus not deductible.  Oliva Gibbs LLP | oglawyers.com Scan the QR code to register for upcoming sessions of our OG Energy Education Series. Continuing land and legal education at your fingertips. www.oglawyers.com/events https://oglawyers.com @OlivaGibbsLLP Oliva Gibbs LLP Oliva Gibbs LLP