Marcia Fuller French, et al. v. Occidental Permian Ltd., No. 12-002 (Tex. July 27, 2014)

Occidental Permian Ltd. owned the working interest and leaseholders held the royalty interests on two oil and gas leases in a unit. The royalty owners in the unit had consented to enhanced recovery operations and gave Occidental, as the working interest owner, discretion in determining how to conduct the operations. Occidental initially used secondary recovery methods, such as the injection of water, to enhance production, which Occidental treated as production expenses. By 2001, the secondary recovery methods became less effective, and Occidental began tertiary recovery operations by injecting CO2 into the reservoir.

The third wave of production from the reservoirs was highly effective, with approximately 106 active wells in the unit producing about 5,800 barrels of oil daily, compared to an estimated production of only 200 barrels per day without the carbon dioxide injections. However, the CO2floods also resulted in casinghead gas heavily laden with CO2. Occidental could have chosen to reinject the gas into the reservoir but, instead, decided to process the gas to recover natural gas liquids to be marketed and to create concentrated streams of CO2 for reinjection. Unlike the secondary recovery expenses, Occidental viewed the cost to remove the CO2 from the casinghead gas as postproduction expenses properly deducted from the royalties due the leaseholders. The royalty owners disputed the expenses and argued that the costs to remove the CO2 were production expenses, such that the royalty calculation should be based on the value of the “native” casinghead gas stream that existed before the CO2 injections.

Following a bench trial, the royalty owners were awarded $10 million in damages based on the trial court’s conclusion that the costs of removing the CO2 were production costs that should be borne exclusively by Occidental as the working interest owner. The Court of Appeals for the Eleventh District of Texas reversed the trial court’s decision and held that CO2 removal costs were postproduction expenses incurred in making the gas marketable.

The Texas Supreme Court affirmed the Court of Appeals and held that the removal of CO2injected in tertiary operations is a postproduction expense that should be deducted from the leaseholders’ royalty payments. The Court noted that Occidental was not obligated to remove the CO2 from the casinghead gas but, instead, could have chosen to directly reinject the gas into the field, in which case the royalty owners would not be entitled to royalties on the reinjected gas. By choosing to process the gas, Occidental was creating greater economic benefit to the royalty owners, who would share in the value of the extracted natural gas liquids. Moreover, the royalty owners had given Occidental total discretion in determining how and whether to conduct the enhanced recovery operations, they had benefitted from that decision, and so they must share in the CO2-removal costs. The decision to process the gas also had the overall benefit of encouraging the full recovery of hydrocarbons and precluding waste.

The decision encourages new and continued use of CO2 in the production of oil, a technique that has proven quite successful over the last several decades. However, the same rationale employed by the Texas Supreme Court could lead to the opposite result in states that have adopted the “marketable product” rule or some version of it. Production companies and operators should not assume that the costs of removing CO2 will automatically be deductible in every state.