Texas Supreme Court Clarifies Royalty Calculations For Enhanced Oil Recovery

In French v. Occidental Permian, Ltd., the Texas Supreme Court clarified royalty calculations for enhanced oil recovery.  The Court:

1. Rejected a royalty owners’ claim that royalties on casinghead gas should be determined as if the injected carbon dioxide (CO₂) was not present
2. Held that, under the applicable leases and Unitization Agreement, the costs of removing CO₂ from the gas were post-production expenses that royalty owners must share with the working interest owner

In the opinion, the Court emphasized the importance of efficient production of oil and gas and the prevention of waste.

Background

The Plaintiffs-Appellants, Marcia Fuller French and others (“French”), were lessors on two different oil and gas leases.  Both lease royalty provisions provided that the casinghead gas royalty was net of post-production expenses, but not production expenses.  The Defendant-Appellee, Occidental Permian Ltd. (“Oxy”) owned a working interest.  The parties had entered into a Unitization Agreement to allow secondary recovery operations.

Oxy began injecting wells on these leases with CO₂ in 2001 in order boost oil production when waterflooding became less effective.  As a result, the wells produced natural gas that was about 85% CO₂.  Although Oxy could reinject the entire casinghead gas stream, Oxy had the gas treated off site to remove the CO₂.   It sold the resulting gas and had the extracted CO₂ sent back to the well to be reinjected.  Oxy paid royalties on the gas after it was treated and deducted the treatment costs from French’s royalties.

French sued arguing that, except for the removal of contaminants and the extraction of NGL, the costs of processing the casinghead gas (including transportation costs) were production costs that should be borne solely by Oxy.  Conversely, Oxy argued the CO₂ removal was necessary to render the gas stream marketable.  At trial, the Court agreed with French and awarded her $10,074,262.33 in underpaid royalties and entered a declaratory judgment defining Oxy’s ongoing royalty obligations.  The court of appeals reversed with a focus on the damages calculations, but did not reach a decision on whether the cost of separating the CO₂ from the casinghead gas was a production expense.

Supreme Court’s Decision

The Court examined the parties’ agreements noting that French consented to the injection of extraneous substances into the oil reservoir and gave Oxy the right and discretion to decide whether to reinject or process the casinghead gas.  The Court further pointed out the Agreement provided that the royalty owners agreed to forego royalties on any unitized substances used in the recovery process.  The Court found that French benefited from that decision and therefore must share in the cost of the CO₂ removal.  The question then became whether the CO₂ processing was a production or post-production cost.

French argued that the CO₂ separation was akin to the removal of water from oil, which Oxy treated as a production cost.  The Court, however, found that oil and water are “immiscible” and separation of the two is a relatively simple process, unlike CO₂ and gas separation, which requires special technology.  Water separation is necessary for reinjection into the reservoir and to make the oil marketable.  Conversely, CO₂ separation is not necessary for continued production of oil.  The Court then noted that Oxy was not required to reinject the casinghead gas.  Therefore, based on the parties’ agreements, “French, having given Oxy the right and discretion to decide whether to reinject or process the casinghead gas, and having benefited from that decision, must share in the cost of the CO₂removal.”  Id. at 7.

Conclusion

The Court indirectly emphasized efficient production of oil and gas and prevention of waste.  The gas processing was economically beneficial to both French and Oxy.  The CO₂ separation increased the value of the stream to both Oxy and French by allowing sale of the extracted NGLs and allowing reinjection of more than 10% of the gas produced directly back into the field.  Because French received the benefit of Oxy’s decision, it had to share in the cost.

This opinion is an important reminder to carefully negotiate and agree to terms in all agreements.  It is a further reminder to proceed in an efficient and economic manner.