In New Mexico, a challenge to a lower court’s decision has caused the state’s Supreme Court to take a longer look at what it means to pay a lessor an established portion of the “net proceeds” from the sale of gas.
More than a few months ago I wrote about the Commissioner of Public Lands of New Mexico auditing royalties paid under State oil and gas leases, and subsequently assessing ConocoPhillips Company and Burlington Resources Oil & Gas Company for underpayment of those royalties. The Commissioner claimed $24.5 million was owed because of alleged improper post-production deductions. Obviously, a lawsuit was filed. The District Court sided with ConocoPhillips and Burlington in a pretrial Motion, and dismissed the claims of the Commissioner. An appeal to the New Mexico Supreme Court was filed.
The specific language at issue in the 1931 and the 1947 statutory lease forms was as follows:
The lessee agrees to pay the lessor the one-eighth of the net proceeds derived from the sale of gas from each well. If casing-head gas produced from said land is sold by the lessee, the lessee shall pay the lessor as royalty one-eighth of the net proceeds of said sale; if casing-head gas produced from said lands is utilized by the lessee otherwise than for carrying on the lessee’s operations for producing oil or gas from said lands, then the lessee shall pay the lessor the market value in the field of the equal one-eighth part of the casing-head gas so utilized at the time of such utilization.
[…]
Subject to free use without royalty, as hereinbefore provided, the lessee shall pay the lessor as royalty one-eighth of the cash value of the gas, including casinghead gas, produced and saved from the leased premises and marketed or utilized, such value to be equal to the greater of the following amounts:
(a) the net proceeds derived from the sale of such gas in the field, or
(b) five cents ($.05) per thousand cubic feet (m.c.f.) . . . ;
Provided, however, the cash value for the royalty purposes of carbon dioxide gas and of hydrocarbon gas delivered to a gasoline plant for extraction of liquid hydrocarbons shall be equal to the net proceeds derived from the sale of such gas including any liquid hydrocarbons recovered therefrom.
The parties did not dispute that “net proceeds” meant “the sum remaining from gross proceeds of sale minus payment of expenses.” However, the Commissioner argued that the valuation point, pursuant to the lease language, was “in the field.” This, the Commissioner proffered, did not allow Lessees to deduct any “post-production expenses incurred between the wellhead and the field, i.e., plant tailgate, when calculating royalty payments.” Meanwhile, ConocoPhillips and Burlington argued that “the net proceeds language indicate[d] that the Legislature intended the valuation point to be at the wellhead.” Specifically, by using “net proceeds” in the leases, the Legislature intended to permit lessees to deduct the post-production costs incurred in connection with the sale of their gas,” and that the “in the field” language had “no bearing on the interpretation of the 1931 lease, and [did] not limit their ability to deduct postproduction costs from the gross sales price under the 1947 lease.”
The New Mexico Supreme Court noted that “[i]n oil and gas leases it is typical for the royalty clause to specify the calculation of net proceeds ‘at the well’. […] When the well is specified as the point of valuation, it is generally understood that the ‘lessee is entitled to deduct all costs that are incurred subsequent to production, including those necessary to transport the gas to a downstream market and those costs, such as dehydrating, treating, and processing the gas, that are either necessary to make the gas saleable in that market or that increase the value of the gas.”
However, “at the well” was not included in the language here. Instead, these leases provided that royalty be paid on net proceeds “from the sale of such gas in the field” and “from the sale of gas from each gas well.” Both the District Court and the Supreme Court agreed that “the key question [was] whether a lease which provides for royalty payable upon ‘net proceeds…in the field’ or ‘from the sale of gas from each gas well’ compels a different royalty calculation than a lease which provides for ‘net proceeds . . . at the well.’” After reviewing intent, the leases, and other external evidence, both Courts agreed that the language permitted Lessees to “net (deduct) from their gross sales price any post-production costs they reasonably and necessarily incur in selling the gas.”
The Commissioner also argued that Lessees were bound by an implied covenant to market the gas, and that required Lessees to “place the gas in a marketable condition and require[d] that the expenses incurred in obtaining a marketable product, such as gathering, dehydrating, and treating, be born by Lessees.” The District Court dismissed the Commissioners’ claim, holding that “to imply a covenant which forces Lessees to bear the costs of placing the gas in a marketable condition would require the district court to alter the express terms of the lease, and ruled it had no power to so alter the lease.”
On appeal, the Commissioner argued that “under New Mexico law, the [s]tate leases inherently include a duty to market gas.” This, he said, prohibited the deduction of post-production costs that occur before the product was in a marketable condition. As to this argument, the Supreme Court rightly noted that “[a]lthough Commissioner’s counterclaim is couched in terms of a breach of the implied covenant to market, the substance of the counterclaim relies upon an offshoot to the implied covenant to market, termed the ‘marketable condition rule.’ Previously, the Supreme Court had declined to rule on whether “the marketable condition rule is inherent in the implied covenant to market, and whether, if recognized in New Mexico, the marketable condition rule would be implied in fact or at law.” In this case, they again declined to decide whether the marketable condition rule applies in New Mexico.
So the question still remains in New Mexico: are we sliding into the marketable condition rule? As noted above, the Supreme Court has twice declined to answer. However, until, this rears its not-so-pretty head again, producers can rest a little easy knowing that if their leases provide similar language, there is no question that royalty is to be calculated at the well, and post-production costs may be rightfully deducted.