Current Legal Standard in Oklahoma
By: Kevin Ferdowsian, JD
Abstract
As a general matter, the propriety of post-production deductions depends primarily on the lease terms burdening the mineral interest as it relates to the operator/lessee’s implied duty to market where the costs of obtaining a marketable product are borne solely by the lessee. The seminal case on post-production cases for royalty interests is Mittelstaedt vs. Sante Fe Minerals 139 F.3d 912 (1998). The Court in Mittelstaedt ruled that proportional deductions for post-production costs against revenue for royalty interest owners may occur when the working interest owner can prove that 1) the costs enhanced the value of an already marketable product, 2) that such costs are reasonable, and 3) the actual royalty revenues increased in proportion with the costs assessed against the non-working interest.
Oklahoma Law
In Oklahoma, Working Interest owners bear an implied duty to market hydrocarbons without cost to lessor/royalty interest owner. Simply stated, the Lessee(s)/Working Interest Owners have the obligation to obtain a marketable product at its sole cost prior to deducting any costs to Lessor. The dispute over who bears post-production costs often arises as to what constitutes the point of establishing a marketable product, i.e. was the hydrocarbon a marketable product prior to incurring post-production costs primarily including processing, transportation, treatment, dehydration and compression.
The Mittelstaedt case confirms that the lease language is a determinative factor in what operators/working interest owners can deduct against the royalty owner’s revenue. The standard “at the well” assumption with a work back method does not apply in Oklahoma when the lease is clear as to what costs can be deducted. If there is no market “at the well” and the Lessee has the duty to market (as in Oklahoma) then properly crafted restrictions on deductions should result in lessee bearing the costs of these post production costs. In Wood v. TXO (854 P.2d 880), the Court ruled that the producer has the duty to produce a marketable product without cost to the lessor. Much of the determination hinges on whether the producer has obtained a marketable product and lessee will argue that the gas at the well has “value” so that is the point at which it may deduct reasonable post production costs. However, royalty owners will argue that the gas is not marketable until it has been delivered to a main transmission line and that all costs associated with its delivery to the main transmission line should be borne by the producer under Oklahoma’s duty to market.
The statute of limitations for a written contract in Oklahoma is five (5) years from the date in which the injured party knew or ought to have known about the injury. Because revenue sheets provide a breakdown of post production costs, only those deductions which occur five years prior to filing of a claim may be sought for reclamation. However, the Oklahoma Production Revenue Standards Act enforces a six percent (6%) automatic interest penalty for any revenues not tendered to royalty owner, so a claim may reasonably ask the court for relief equal to the amount improperly deducted over the five year term prior to filing plus a 6% per annum interest payment.
Dehydration
From Mittelstaedt, “Generally, costs have been construed as either production costs which are never allocated, based upon the nature of the cost as it relates to the duties of the lessee created by the express language of the lease, the implied covenants, and custom and usage in the industry. We conclude that dehydration costs necessary to make a product marketable, or dehydration within the custom and usage of the lessee’s duty to create a marketable product, without provision for cost to lessors in the lease, are expenses not paid from the royalty interest. However, excess dehydration to an already marketable product is to be allocated proportionally to the royalty interest.” The proof of the point of excess dehydration, in this instance, is the lessee’s; therefore, without proof, it would appear that none of the dehydration costs, when the lease explicitly prohibits their deduction, should be deducible against the royalty interest owner’s revenue. In TXO Prod. Corp. v State ex rel Commissions of the Land Office 903 P.2d 259 (1994), the Court concluded that because the removal of moisture from the gas was necessary to sell the gas, and that it occurred prior to entry into the purchasers pipeline, that absent an explicit allowance for deduction, that the Lessee should bear the entire cost of dehydration, as it is essential to create a marketable product. The TXO Prod. Corp. case solidified Oklahoma’s first marketable product rule.
Transportation
In Johnson v. Jernigan, 475 P.2d 396 (Okla. 1970), the Court ruled that on-lease sales should not incur any deductions against the royalty owner’s revenue, but that lessor may be required to pay its proportionate share of transportation costs when the sale occurs off the leased premises. However, a properly-crafted lease provision prohibiting the deduction of transportation costs as well as defining the point of marketability (at a point of sale) may challenge this ability of a lessee to deduct transportation costs. As Mittelstaedt suggests, an analysis of the lease terms in the context of the point of marketability and the Mittelstaedt inquiry (where lessee has the rebuttable burden to prove each point) is in order, and proving that the gas was enhanced by merely transporting it may be a difficult argument to defend. The Johnson Court decided as well that the burden was on the Lessee to take reasonable steps to maximize the value of the gas but that if it lay pipeline to transport the gas, then it could deduct the cost of laying the pipeline. Often, the deduction is taken into perpetuity, beyond the price of the pipeline construction costs, which appears to be at odds with the allowance in Johnson.
Compression
The destructibility of compression costs is complex. First, the prevailing market price is on a per mcf basis, but compressing dry gas decreases the cubic feet of gas being sold. The fractional compression is a strong factor in determining the volume of gas being sold. As such, the difficulty arises when computing volumes before and after compression, and these attendant calculations are not made available to royalty owners. Further, without evidence of an attempt to sell gas from the wellhead at its uncompressed state, it is difficult to argue or oppose a claim that it is marketable at the wellhead. In Wood v. TXO, 854 P.2d 880 (1992), the Oklahoma Supreme Court decided that when the gas at the wellhead is not capable of being sold, and needs further compression to market, that the Lessor should not bear the costs of compression therein. “If a lessee wants royalty owners to share in compression costs, that can be spelled out in the oil and gas lease.” Further, “We interpret the lessee’s duty to market to include the cost of preparing the gas for market.” In a net-proceeds lease, or when a lease is properly tailored to disallow the deductions for compressing gas, the lessee appears to have the duty to pay costs associated with compression. Again, under Mittelstaedt, the Lessee/Working Interest owner has the affirmative burden to show that the gas was marketable at the wellhead in order to deduct costs after that point. As the TXO Court indicates, that includes the compression of gas to prepare for sale.
Overriding Royalty Interests
Overriding royalty interests are described as a cost-free royalty. Many granting instruments describe the non-deductibility of costs associated with production of hydrocarbons. However, as the Court in XAE Corp. v. SMR Property Management Co. 968 P.2d 1201 holds, the overriding royalty interest is an in-kind interest. As such, it does not the hold the same standing as a royalty interest, and the duty of lessee to obtain a marketable product does not extend to the overriding royalty interest owner. However, an action may commence against the operator/lessee and discovery may be used to determine whether 1) the costs are accurate and not fraudulent and 2) the costs incurred by the operator have been recouped through the deductions. In either case, the override may have a claim for injury where the deductions were greater than a reasonable amount to recoup initial costs (such as in a gathering system), or where the deductions have been fraudulently obtained. Where there is evidence of fraud, the claim may be able to recover treble (or triple) damages.
Conclusion
The deductibility of post production costs in Oklahoma is a complex and unsettled issue. At first glance, Mittelstaedt appears to clarify and set bright line rules for determining if and when post production costs are deductible against a royalty owner. However, operators/lessees take advantage of the ambiguity in what constitutes an enhancement in the value of the hydrocarbons sold. Clearly, there are many instances where operators deduct without evaluating the lease terms and whether the lease allows for a given deduction under Oklahoma law. The deduction language in the lease must be parsed to determine whether a given deduction is allowable and compared to the revenue sheet(s) to determine whether the deduction comports to the lease provisions. When a market is not available at the wellhead or where an operator did not explicitly seek a market, it is reasonable to expect the burden of proving the deduction enhanced the value of the hydrocarbons, resulting in a higher price for the lessor, has not been met.