On June 27, the Supreme Court of Texas issued an opinion in Marcia Fuller French, et al v. Occidental Permian Ltd., No 12-002 (Tex. June 27, 2014), a case closely followed by the oil and gas industry.1 In its unanimous decision and on an issue of first impression, the court declared that removal of carbon dioxide (CO2) utilized in tertiary operations is a postproduction expense that must be deducted from the royalty due a lease holder. In doing so, the court rejected royalty owners’ arguments that casinghead gas2 should be valued in its “native” state as if the CO2 had not been injected. The case is significant because many producers are utilizing enhanced recovery operations – like the CO2 floods at issue – to extend the life of leases across the state.

Factual Background

The lease holders own royalty interests under two oil and gas leases in the Cogdell Canyon Reef Unite (CCRU). Occidental Permian Ltd. (Oxy) owns the working interest. The royalty owners consented to the injection of extraneous substances into the oil reservoir and gave the working interest complete discretion in determining whether and how to conduct the operations.

Over the years, Oxy utilized secondary recovery methods such as injecting water into the reservoir to enhance production in the CCRU. Oxy treated these operations as production expenses, and the royalty owners were not charged for the costs. Eventually, these operations became less effective and, in 2001, Oxy began tertiary recovery operations by injecting CO2 into the reservoir.

The CO2 injections increased oil production, but also resulted in the production of casinghead gas heavily-laden with CO2. Rather than reinject the CO2-laden casinghead gas into the reservoir, Oxy elected to process the gas to recover natural gas liquids (NGLs) to be marketed and to secure concentrated streams of CO2 for reinjection. Oxy viewed these processes as postproduction expenses and charged royalty owners for the expenses accordingly. The royalty owners disputed the expenses, arguing they were actually production expenses and that the royalty should be based on the value of the “native” casinghead gas stream that existed before the CO2 flood.

The royalty owners brought suit against Oxy, alleging it had underpaid royalties following the tertiary recovery operations. Following a non-jury trial, the trial court entered judgment for the royalty owners and awarded more than $10 million in damages, finding that the costs of removing the CO2 were production costs that should be borne exclusively by Oxy. The Court of Appeals reversed the decision, holding that there was insufficient evidence to support the trial court’s findings, and that the CO2 removal costs were postproduction expenses to make the gas marketable.

Texas Supreme Court’s Decision

In affirming the Court of Appeals decision, the Texas Supreme Court rejected the royalty owners’ position that the costs of removing CO2 are a production expense and that royalties should be calculated on the “native” gas at the well, excluding the costs of CO2 removal.

The court distinguished the processing of the CO2-laden gas from the process of separating oil and water during water flooding of secondary recovery operations. The Court observed that “separating water from oil is essential to continued economic production” of the reservoir and the process is “relatively simple.” In contrast, “separating the CO2 from the casinghead gas is not necessary for the continued production of oil” and requires special technology.

The Court also observed that Oxy has no obligation to process the CO2-laden casinghead gas. For example, casinghead gas may be, and in some instances is, reinjected directly into the field, and royalty owners would not be entitled to royalties on the reinjected gas. By choosing to process the casinghead gas, Oxy has created an economic benefit to royalty owners who share in the value of the extracted NGLs. Oxy’s decision to process the gas also furthers the state’s policy of encouraging the full recovery of hydrocarbons and precluding waster.

The court therefore concluded that “having given Oxy the right and discretion to decide whether to reinject or process the casinghead gas, and having benefitted from that decision, [royalty owners] must share in the cost of CO2 removal.”