In French v. Occidental Permian, Ltd., No. 12-1002 (Tex. June 27, 2014), the Texas Supreme Court provided guidance on how to calculate royalties where production is obtained through an enhanced recovery technique like the injection of carbon dioxide (CO2). In an issue of first impression, the Court (1) rejected the royalty owners’ claim that the royalties on casinghead gas should be determined as if the injected CO2 were not present, and (2) held that, under the applicable contracts, the costs of removing CO2 from the gas were post-production expenses that the royalty owners must share with the working interest owner.

Occidental Permian, Ltd. (Oxy) held the working interest in a field covered by two leases, one of which was a “market value” lease and another which was a “proceeds” lease. After production had substantially declined, Oxy began injecting large amounts of CO2 into the field, which significantly enhanced production but resulted in production of CO2-laden casinghead gas. Some of the casinghead gas was simply transported from the production wells to the injection wells and pumped back into the reservoir. But to increase the concentration of CO2 in the reinjected stream and to realize the value of other natural gas liquids (NGLs) entrained in the casinghead gas, Oxy processed the gas to (1) remove the CO2 and other contaminants for reinjection into the reservoir and (2) extract the NGLs for sale.

Oxy contracted with Kinder Morgan to build the multi-million dollar Cynara plant to process the CO2-laden gas to remove most of the CO2, the contaminants and some of the NGLs. Kinder Morgan in turn contracted with Torch Energy Marketing to further process the gas at a separate Snyder plant, where the rest of the CO2 was removed and the remaining NGLs were extracted. Oxy paid Kinder Morgan a monthly fee based on the volume of gas that was processed, plus an in-kind payment of 30 percent of the total NGLs. Oxy paid the plaintiffs a royalty on 70 percent of the NGLs, but not on the 30 percent that was paid in-kind to Kinder Morgan.

The plaintiff royalty owners (French) argued that, except for the removal of contaminants and the extraction of NGLs at the Snyder plant, the costs of processing the casinghead gas were production costs that should be borne solely by Oxy. These costs included the transportation of the casinghead gas from the wellhead to the Cynara plant, the processing at the Cynara plant, the transportation of the partially-processed streams of NGLs and gas to the Snyder plant, the removal of CO2 there, and the transportation of the CO2 streams from both plants back to the injection wells. French also argued that the royalty should be based on the value of the native casinghead gas without the injected CO2. French prevailed on these arguments at trial, obtaining a judgment in excess of $10 million. However, the Eastland Court of Appeals reversed the judgment and the Texas Supreme Court affirmed the Eastland Court, albeit for different reasons.

The Supreme Court first rejected French’s argument that the cost of removing the CO2 was analogous to the cost of separating water from the oil, which Oxy had always treated as a cost of production. The Court reasoned that separating water was much simpler than separating CO2, and was essential - not merely beneficial - to the continued production of oil. The Court also noted that Oxy was free, under the parties’ agreements, to simply reinject all of the casinghead gas, but instead further processed it for the benefit of all parties. Thus, “French, having given Oxy the right and discretion to decide whether to reinject or process the casinghead gas, and having benefitted from that decision, must share in the cost of CO2 removal.”

The costs of the gas processing activities aimed at returning the CO2 to the reservoir were production costs borne by Oxy, which the Court found were covered by Oxy’s monetary payment to Kinder Morgan. But the Court held that all of the other processing costs were post-production costs in which the royalty owners must share under both the “market value” and “proceeds” leases.