Face Challenges Confidently

179 Tana Oil & Gas Corp. v. Cernosek

Wednesday, September 2nd, 2015

Richard F. Brown

The following is not a legal opinion. You should consult your attorney if the case may be of significance to you.
Tana Oil and Gas Corp. v. Cernosek, 188 S.W.3d 354 (Tex. App.—Austin 2006, pet. denied), is a class action royalty accounting case on processed gas brought by lessors against their lessee under leases with several varieties of “net proceeds” or “amount realized” royalty clauses. Lessee entered into a field-wide gas purchase and processing contract with the gas processor, in which lessee agreed to sell to the gas processor at the well all gas produced from the class members’ combined leases and the right to process the gas. In exchange, the processor agreed to pay lessee 84% of the combined monthly sales prices of the natural gas liquids extracted from the raw gas and 84% of the residue gas. The gas contract also obligated lessee to provide its proportionate part of gas at no cost to the gas processor for plant fuel and compression. Thus, this was an 84% POP contract on a wellhead sale with pricing and volumes determined at the tailgate of the plant, after deductions for line losses, fuel, and compression. Lessee was reimbursed for compression by a separate contract, and lessee added those receipts to the amount it received under the POP contract and accounted on the total to its lessors for their royalty. The lessor class contended they were entitled to royalties based on 100% of the gross metered volumes of gas sold at the well (i.e. they should be paid on 100% POP, rather than 84% POP), that lessee should pay royalties on gas the processor consumed, and that lessee had improperly burdened the royalty owners with downstream post-production costs. A judgment for the class of approximately $3,000,000 was reversed and rendered on appeal.
Depending on the specific royalty provision in the applicable lease, lessee was generally obligated to pay a fractional share of either the “amount realized” or “net proceeds” from its sale of gas at the well. The term “amount realized” has been construed to mean the proceeds received from the sale of the oil or gas. Lessee sold the raw gas to the processor at the well and received 84% of the resale price of the residue gas and extracted liquids, after treatment. The class members argued that because lessee was obligated to pay royalties on 100% of the total volume of gas sold at the well, they were entitled to royalties on the additional 16% of the proceeds from the sale of the residue gas and the extracted liquids after processing, regardless of the fact that lessee did not receive, and was not owed, this portion of the post-processing sales proceeds under the contract.
The court found the sale of raw gas at the well was separate and distinct from the third- party sales of the residue gas and extracted liquids on the open market. Lessee did not sell the residue gas or the liquids; lessee sold raw gas at the well, before any value was added by preparing the gas for market. Therefore, “[t]his pricing formula represents the negotiated value of the raw gas.” Lessee did not receive all of the proceeds from the sales of the residue gas and the liquids, but only 84%. By paying the class member lessors royalties on 100% of the money lessee actually received, lessee ultimately paid royalties on 100% of the total volume of raw gas sold at the well. Because lessee paid royalty based on the proceeds received, the court held lessee did not breach the leases owned by the class members.
The court also held that the leases permit the deduction of reasonable post-production costs. The class members argued it was improper for lessee to deduct the compression and treating costs from the sales of the raw gas lessee sold at the well. The court again stated that lessee was required to pay royalties on either the amount it realized or its net proceeds from the gas at the well. The Supreme Court has stated that the term “net proceeds” expressly contemplates deductions, while the phrase “at the well” means before value is added by preparing the gas for market. Therefore, the plain language of the applicable royalty clauses acknowledges that deductions may be necessary to determine the value of gas at the well. The post-production costs added value to the raw gas sold by lessee, and if these costs are not deducted, then the class members’ royalties would be based on the proceeds lessee received from the sale of the raw gas, plus the costs incurred to prepare the gas for sale on the open market. Thus, lessee’s net proceeds cannot be determined unless post-production costs are deducted, and no royalty is due on post-production expenses.
Similarly, the court also found that lessee did not breach the leases by failing to pay royalties on gas consumed by the processor. “We do not know, nor is it relevant, why [lessee] agreed to these terms. Our only concern is whether [lessee] fully complied with its obligations as stated in the lease agreements.” Under the lease agreements, lessee was to pay the class members royalties on the net proceeds it actually received from the sale of raw gas at the well.
The case clearly and firmly stands for the principle that the price payable for royalty purposes on a wellhead sale of gas may be determined by reference to a downstream point of sale and be contingent upon the price received at that point, i.e. a classic POP contract. Under a “proceeds” lease, lessee must pay royalty on the full amount received by lessee, net of reasonable and necessary post-production costs. This was a summary judgment case, so no issues were presented on the reasonableness of such fees, nor were there any issues about affiliate sales.