French v. Occidental Permian Ltd.

CourtSupreme Court of Texas
Citation440 S.W.3d 1
Docket NumberNo. 12–1002.,12–1002.
PartiesMarcia Fuller FRENCH, et al., Petitioners, v. OCCIDENTAL PERMIAN LTD., Respondent.
Decision Date27 June 2014

440 S.W.3d 1

Marcia Fuller FRENCH, et al., Petitioners
v.
OCCIDENTAL PERMIAN LTD., Respondent.

No. 12–1002.

Supreme Court of Texas.

Argued Feb. 5, 2014.
June 27, 2014.
Rehearing Denied Oct. 3, 2014.


440 S.W.3d 1

Sean D. Jordan, Sutherland Asbill & Brennan LLP, Austin, TX, for Amicus Curiae American Petroleum Institute.

Dominic Jude Ricotta, Hicks Thomas LLP, Houston, TX, for Amicus Curiae Apache Corporation.

440 S.W.3d 2

Cory Pomeroy, Texas Oil & Gas Assoc'n, Austin, TX, for Amicus Curiae Texas Oil & Gas Association.

Brent Barton Hamilton, Brady & Hamilton, L.L.P., Lubbock, TX, Clark Rucker, Robert C. Grable, Marianne M. Auld, Kelly Hart & Hallman LLP, Fort Worth, TX, for Petitioner, Marcia Fuller French, et al.

Dennis Cameron, Gable & Gotwals, Tulsa, OK, Ernest E. Smith III, University of Texas School of Law, Austin, TX, John A. “Jad” Davis Jr., Davis, Gerald & Cremer, P.C., Midland, TX, Marie R. Yeates, Vinson & Elkins LLP, Houston, TX, Michael Andrew Heidler, Vinson & Elkins LLP, Austin, TX, for Respondent Occidental Permian Ltd.

Opinion

Chief Justice HECHT delivered the opinion of the Court.

One method of enhanced oil recovery is to inject carbon dioxide (CO2) into a reservoir to sweep the oil to the production wells. The CO2returns to the surface entrained in casinghead gas produced with the oil.1 In this case, royalty owners contend that the royalty due on the casinghead gas under the parties' agreements must be determined as if the injected CO2were not present, and that they are not required to share with the working interest the expense of removing the CO2from the gas. We disagree and therefore affirm the judgment of the court of appeals.2

I

A

Petitioners, collectively “French”,3 own the royalty interests under two oil and gas leases in the Cogdell Field, one from the owners of the Fuller Rough Creek Ranch in Scurry and Kent Counties in 1948, and the other from the owners of the Cogdell Ranch in Kent County in 1949. Respondent Occidental Permian Ltd. (“Oxy”) owns the working interest.

The Fuller Lease calls for a royalty “on gas, including casinghead gas or other gaseous substance produced from said land and sold or used off the premises or in the manufacture of gasoline or other product therefrom” equal to “the market value at the well of one-eighth (1/8th) of the gas so sold or used”. The Cogdell Lease calls for a royalty of “1/4 of the net proceeds from the sale” of “gasoline or other products manufactured and sold” from casinghead gas “after deducting [the]

440 S.W.3d 3

cost of manufacturing the same.” Both provisions were standard forms in common use at the time.4

Generally speaking, a royalty is “free of the expenses of production [but] subject to postproduction costs, including ... treatment costs to render [production] marketable”, but “the parties may modify this general rule by agreement.”5 Under the Fuller Lease, the royalty on casinghead gas is based on its market value at the well—“what a willing buyer under no compulsion to buy will pay to a willing seller under no compulsion to sell.”6 Since gas is a commodity, its market value at the well does not depend on the individual producer's costs of bringing the gas to the surface. As a result, the royalty owner does not share in the costs of production. But postproduction processing that makes the gas marketable enhances its value after it leaves the well. The market price of the processed gas reflects the value of the unprocessed gas at the well only if reasonable postproduction processing costs are deducted.7 In effect, for gas sold only after processing, the royalty owner shares in those costs, which may vary depending on the quality of the gas coming from the ground.8 Under the Cogdell Lease, the

440 S.W.3d 4

royalty on casinghead gas products is based on the proceeds from their sale, which, again, are unaffected by production expenses, and expressly net of manufacturing—i.e., postproduction—costs. Thus, under both leases, the casinghead gas royalty is net of postproduction expenses but not production expenses. Postproduction, as the word itself implies, ordinarily means after production in time, but in this case, the royalty owners contend that the production process does not end at the wellhead. The dispute is over whether certain expenses are properly considered to be production costs or postproduction costs.

In 1954, not long after primary production had begun from the Canyon Reef formation, the leases were pooled to form the Cogdell Canyon Reef Unit (“CCRU”). The purpose, as stated in the Unitization Agreement among the working interest owners and royalty owners, was “to effect secondary recovery operations or pressure maintenance for oil and gas from the Canyon Reef ... to increase the ultimate recovery of oil therefrom”.9 In the Agreement, 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:

Royalties owners hereby grant unto the working interest owners, at the working interest owners' sole discretion, ... the right to inject gas, extraneous gas, water, air or other substances, or any combination of two or more of them, in whatever amounts the working interest owners may deem expedient, into the unit area....

* * *

The working interest owners shall have full discretion in determining if gas, extraneous gas, air, water or other substances, or any combination of two or more of them, should be injected into the unit area in connection with secondary recovery and pressure maintenance operations. In any event the working interest owners shall be the sole judges of the kind of secondary recovery and pressure maintenance operations which shall be conducted in the unit area....

The Agreement defined “gas” as “natural gas (including casinghead gas) and all of its constituent elements produced from wells on lands and leases in the Cogdell Field producing from the Canyon Reef underlying the unit area.” Thus, the working interest owners were given discretion to reinject casinghead gas into the field as part of the operations. The parties agreed that no royalty would be paid on such gas:

440 S.W.3d 5

All unitized substances ... used in connection with the operation or development of the unit area [or] in injection operations in the unit area ... shall be deducted before the royalties, overriding royalties and other payments out of production payable to royalty owners hereunder are determined, calculated or paid; and no royalty, overriding royalty or other payment out of production shall be due or payable to any royalty owner hereunder on any unitized substances so ... used....10 “Unitized substances” were defined to include “all oil, gas, ... or any other substance produced and saved from the Canyon Reef underlying the unit area.”

Finally, the Agreement assigned the cost of the operation to the working interest except to the extent it was already to be borne by the royalty interests:

No part of the costs and expenses incurred in the development and operation of the unit area, including secondary recovery and pressure maintenance costs, shall be charged to any royalty owner unless such royalty owner is already obligated to pay such costs or expenses by the terms of other agreements. Such costs and expenses shall be borne by the working interest owners....

The parties' only other agreements were the leases. Thus, the costs of secondary recovery were not to be charged to the royalty owners except as permitted by the leases—that is, in determining the market value of the gas at the well under the Fuller Lease and the cost of manufacturing casinghead gas products under the Cogdell Lease.

B

The secondary recovery operation in the CCRU involved injecting water into the reservoir to increase and maintain pressure lost through primary production and to sweep oil toward producing wells. The operation has proved very successful. The CCRU has produced more than 270 million barrels of oil and billions of cubic feet of casinghead gas,11 together valued at more than $1.15 billion, with about half the oil remaining in the reservoir. Waterflooding continues, but by the late 1990s, it had become less effective. Oil production had declined from some 30,000 barrels per day at the peak to about 1,500 barrels per day.

Since the CCRU was formed, several methods of enhanced oil recovery have been developed, sometimes referred to as tertiary because they typically follow secondary recovery. One is by injecting CO2 into the reservoir. This increases pressure in the reservoir, just as water injection does. But more importantly, CO2 is miscible with water and, under high pressure and temperature, with oil. In solution with oil and water, CO2 can act to reduce oil's viscosity and reduce surface tension, thus easing separation of oil from water in the...

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