490 French v. Occidental Permian Ltd.

Richard F. Brown

 
The following is not a legal opinion.  You should consult your attorney if the case may be of significance to you.
 
French v. Occidental Permian Ltd.  held that royalty owners were required to share in the cost of removal of carbon dioxide (“CO₂”) from casinghead gas re-injected for secondary recovery operations because removal was a post-production cost.  The royalty owners (“French”) owned the royalty interest under two leases with Occidental Permian Ltd. (“Oxy”).  The Fuller Lease required payment of one-eighth of market value at the well, and the Cogdell Lease required payment of one-fourth of net proceeds after deducting the cost of manufacturing.
 
Generally, a royalty is “free of the expenses of production [but] subject to post-production costs, including . . . treatment costs to render [production] marketable. . . .”   Therefore, under both leases, French was entitled to royalty payments on casinghead gas minus post-production expenses without taking into consideration production costs.   Under the agreement for a CO₂ flood, French agreed that Oxy could, in Oxy’s discretion, re-inject the gas stream, and no royalty was payable on the substances injected.
 
During secondary recovery operations, Oxy injected the unit with CO₂ to increase the recovery of oil and gas, which returned to the surface in the form of casinghead gas combined with natural gas liquids (“NGLs”), such as ethane, propane, butane, pentane, and natural gasoline (heavier molecules).  Oxy contracted with Kinder Morgan to process the CO₂-laden gas to remove at least 90% of the CO₂ and most of the hydrogen sulfide (“H₂S”) for the purpose of reinjection, and to extract the NGLs for sale.  Oxy agreed to pay Kinder Morgan a monthly fee of $.33/mcf of gas delivered, plus 30% of the total NGLs in kind and all of the residue gas.   The issue before the court was whether Oxy’s payment to Kinder Morgan was a cost of production to extract CO_{2 ­}and H₂S for reinjection or a post-production cost for extracting the NGLs.
 
French argued that Kinder Morgan’s removal of NGLs and H₂S was an incidental byproduct of its removal of CO₂ to aid in Oxy’s production of oil and gas, which should result in higher royalty payments because the cost of Kinder Morgan’s services was a production cost, and not a post-production, cost.   Oxy asserted that the removal of CO₂ was necessary to make the NGLs marketable, which made the payment for Kinder Morgan’s services a post-production cost.   French attempted to analogize the removal and separation of CO₂ from the casinghead gas to that of the removal of water from oil during the secondary recovery phase.  The court dismissed this argument because the separation of the huge volume of water from the oil was necessary for economic production and to make the oil marketable; however, the separation of CO₂ from the casinghead gas was not necessary to continue oil production, which was the purpose of the secondary recovery efforts.  Furthermore, the Unitization Agreement did not require that Oxy extract any of the NGLs to continue production of oil from the unit, and if Oxy had not engaged in separating out the NGLs, then French would be entitled to nothing.   Therefore, “. . . 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 CO₂ removal.”
 
The significance of this case is that there is no precedent for the payment of market value royalty involving separation of extraneous substances injected into the field.  Here, the cost of separation was held to be a post-production cost, but the result turned in part upon the Unitization Agreement.  Because the gas stream could be re-injected without paying any royalty, and because extracting the NGLs from the gas stream was not necessary for oil production, the separation was a post-production cost.