The practice of deducting post-production costs from the landowner’s royalty remains one of the most controversial and disputed issues here in Pennsylvania. Many landowners sought to insulate their royalties from such deductions by negotiating gross royalty clauses in their leases. Remarkably, some drillers are now simply ignoring the gross royalty clause and taking deductions regardless of this express language and the parties’ original intent. In light of a recent decision by the North Dakota Supreme Court, drillers may no longer be able to ignore royalty clauses which require the royalty to be calculated on the “gross proceeds” received by the driller. As detailed below, the North Dakota Supreme Court in Newfield Exploration Co. v. State of North Dakota, et al., (2019 ND 193, July 11, 2019) held that the term “gross proceeds” in the parties’ lease required the royalty to be calculated without any deductions.
At issue in Newfield was an oil and gas lease (the “Board Lease”) that was entered into between Newfield Exploration Co. (“Newfield”) and North Dakota Board of University and School Lands (the “Department”) in 1979. Pursuant to the Board Lease, Newfield drilled and operated several wells throughout North Dakota (the “Wells”). In 2016, the Department conducted an audit of Newfield’s production records and subsequently concluded that Newfield was improperly calculating royalties under the Board Lease. The Department contended that Newfield was calculating the royalty on the net proceeds as opposed to the gross proceeds as required by the Board Lease:
Lessee agrees to pay lessor the royalty on any gas, produced or 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 an arm’s length transaction.
. . . .
All royalties on oil, gas carbon black, Sulphur, or any other products 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 Department discovered that Newfield was only receiving between 70% to 80% of the actual sales price for its processed gas. The remaining 20% to 30% was being retained by ONEOK Midstream LLC (“ONEOK”) pursuant to certain gas processing agreements. Under these agreements, Newfield contracted with ONEOK to gather, transport and process gas produced by the Wells. After ONEOK processed the raw gas, it then sold the processed gas at a downstream location. ONEOK paid Newfield an amount equal to the downstream sale, less the gathering and processing costs incurred by ONEOK. The 20% to 30% reduction in price accounted for ONEOK’s cost to move the gas and process the gas into a marketable product. The Department argued that its royalty should be based on 100% of the downstream sales price and Newfield’s practice of calculating the royalty on the net price (i.e. 70% to 80% of the actual sales price) constituted a material breach of the Board Lease.
In 2018, Newfield filed suit seeking a declaration from the court that it was paying royalties in accordance with the Board Lease. Newfield argued that the Department’s royalties were, in fact, calculated based on the gross amount “received” by Newfield from ONEOK and were not subject to any deductions. Moreover, Newfield argued that because title to the raw, unprocessed gas transferred to ONEOK at the well-head, the alleged costs downstream from this location were paid by Newfield, not the Department. In essence, Newfield argued that because ONEOK, rather than Newfield, charged the post-production costs which reduced the overall proceeds subject to the royalty calculation, the Department’s royalty was properly calculated on a “gross” albeit lesser amount. The trial court agreed with Newfield and held that the Board Lease required the royalty payments to be based only on the gross amount Newfield actually received from ONEOK. Since the Department’s royalty was calculated on the actual proceeds received by Newfield, no breach occurred and the trial court ruled in favor of Newfield.
The Department appealed the trial court’s decision to the North Dakota Supreme Court. On appeal, the Department argued that the term “gross proceeds” must be read to exclude any deductions, regardless if the costs were charged by Newfield or ONEOK. The Department further argued that term “gross proceeds” has commonly been understood to mean a royalty without the deduction of any costs. See, West v. Alpar Res., 298 N.W. 2d 484 (N.D. 1980) (“[G]ross proceeds” means “proceeds without deduction for expenses”); Mittelstaedt v. Santa Fe Minerals, 954 P.2d 1203 (Okla. 1998) (“[T]he term gross proceeds usually implies no deductions of any kind”); Chesapeake Exploration v. Hyder, 483 S.W. 3d 870 (Texas 2016) (noting that a proceeds lease is “sufficient in itself to excuse the lessors from bearing post-production costs”). Since the Board Lease required the royalty to be calculated on the “gross proceeds of sale,” the Department argued that the royalty must be valued at the downstream point-of-sale (i.e. at the sales location downstream from ONEOK’s processing plant). This implicitly meant that the royalty must be calculated on the actual sales price received at that location, free of any processing or gathering costs charged by ONEOK.
The North Dakota Supreme Court agreed and reversed the trial court. The court first observed that in an oil and gas lease, the term “gross proceeds” generally means that the lessor’s royalty is to be “calculated based on the total amount received for the product without deductions for making the product marketable.” See, Newfield Exploration, p. 3. The panel then opined that this “gross proceeds” language must be read in harmony with the entire royalty clause, specifically the second paragraph (i.e. Subpart (f)). This paragraph expressly required the royalty to “be payable on an amount equal to the full value of all consideration” Newfield received for the gas. The Supreme Court concluded that the gathering and processing activities performed by ONEOK added “value” to the gas stream and, therefore, the Department’s royalty must be calculated on the “full value” of the processed gas, which necessarily included the value of the gathering and processing activities:
“[S]ubpart (f) of the lease unambiguously provides the State’s royalty must include the value of any consideration, in whatever form, that directly or indirectly compensates, credits or benefits Newfield. Here, Newfield unquestionably benefits from ONEOK’s expenditures to make the gas marketable. . .”
See, Newfield Exploration, p. 5. The court observed that Newfield benefitted from the gathering and processing activities performed by ONEOK and such value must be accounted for when calculating the Department’s royalty. As such, the panel opined that Newfield breached the Board Lease by calculating the Department’s royalty based “on an amount that has been reduced to account for expenses incurred to make the gas marketable. . .” In the court’s view, the term “gross proceeds” meant not only the actual downstream sales price, but any value added between the well-pad and the point-of-sale.
The author submits that Newfield Exploration reached the correct result but the court’s reliance on Subpart (f) may have been unnecessary. The first paragraph in the royalty clause clearly states that the Department’s royalty is “to be based on gross proceeds of sale where such sale constitutes an arm’s length transaction.” This language denotes the point-of-sale as the royalty valuation point. Although title to the gas transferred to ONEOK at the well pad, no actual “sale” occurred until after the gas was processed and exited the ONEOK plant. And there were no “gross proceeds” until that downstream sale of the processed gas took place. Given the deliberate reference to a “sale” in the royalty clause, it is clear that parties intended the royalty to value and calculated at the point-of-sale, free of any costs or expenses. Consequently, the court’s reliance on Subpart (f) and the discussion concerning the “full value” of the consideration may have been unwarranted and perhaps unwise.