North Dakota Supreme Court Decides for Royalty Owner on Post-Production Costs

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In a short opinion, the Supreme Court of North Dakota decided a case brought by Newfield Exploration against the North Dakota Board of University and School Lands to determine how royalties on gas should be calculated under the State’s leases to Newfield. The case illustrates how post-production costs can sometimes be hidden in “percentage-of-proceeds” or “POP” contracts for the sale of gas. Newfield Exploration Company v. State of North Dakota, No. 2019088, 2019 WL 3024639, decided 7/11/2019.
Newfield sold its gas to Oneok. The opinion describes this contract as follows:
Title to the gas passes to Oneok when it receives the gas from Newfield, but payment to Newfield is delayed until after Oneok processes the gas into a marketable form and sells the marketable gas. The price Oneok pays to Newfield for the gas is calculated based on 70-80% of the amount received by Oneok when Oneok sells the marketable gas. The 20-30% reduction of the price for which the marketable gas is sold accounts for Oneok’s cost to process the gas into a marketable form and profit.
The lease royalty clauses provided:
Lessee agrees to pay lessor the royalty on any gas, produced and marketed, based on gross production or the market value thereof, at the option of the lessor, such value to be based on gross proceeds of sale where such sale constitutes and arm’s length transaction.
All royalties on … gas … shall be payable on an amount equal to the full value of all consideration for such products in whatever form or forms, which directly or indirectly compensates, credits, or benefits lessee.
The Court held that royalties must be paid on 100% of the sales price of the gas, before reduction for Oneok’s cost to process the gas.
Newfield’s compensation if calculated based on the amount Oneok receives for the marketable gas. This amount, from which Newfield attempts to base the State’s royalties, is reduced to account for the expenses Oneok incurred to make the gas marketable. Newfield directly benefits, or at the very least indirectly benefits, from the expenses Oneok incurs to make the gas marketable. Subpart (f) of the lease unambiguously provides the State’s royalty must include the value of any consideration, in whatever from, that directly or indirectly compensates, credits, or benefits Newfield. Here, Newfield unquestionably benefits from Oneok’s expenditures to make the gas marketable. Calculation of the royalties paid to the State based on an amount that has been reduced to account for expenses incurred to make the gas marketable, even though the cost to make the gas marketable only indirectly benefits Newfield, is contrary to the leases.
The Newfield-Oneok contract is what is commonly called a percentage-of-proceeds or “POP” contract. Texas law requires payors to identify separately on check details any post-production costs charged to the royalty owner. But when gas is sold under POP contracts, payors typically do not show the post-production costs imbedded in the POP contracts, on the grounds that those costs were not incurred by the payor and the payor must only report the net price received by the payor for the gas.
The North Dakota Supreme Court relied on the lease language requiring payment of royalty on the “full value of all consideration”, including any consideration “which directly or indirectly compensates, credits, or benefits lessee.” It’s not clear whether the court would have reached the same conclusion had the lease only provided for royalties based on the “gross proceeds” received from the sale of the gas.
The closest analogy to Newfield’s case in Texas of which I’m aware is Yturria v. Kerr McGee Oil & Gas Onshore, LLC, 291 Fed.Appx 626, 2008 WL 4155830 (5th Cir. 2008). In that case, the 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.” Kerr McGee’s contract with the Enterprise gas plant provided for the plant to charge a “T&F Fee” for the costs of transportation and fractionation of the NGLs. 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.

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