Shale Law in the Spotlight – North Dakota Supreme Court Rules that Post-Production Costs Cannot be Deducted from Royalties Paid to State

Case Summary: Newfield Exploration Company et al. v. State of North Dakota et al., No. 2019 ND 193

Written by Chloe Marie – Research Specialist

On July 11, 2019, the Supreme Court of North Dakota concluded that post-production costs relating to the processing of gas into a marketable form could not be subtracted from royalties paid to the State of North Dakota. This article provides a comprehensive summary of this case.

Background

Newfield, an oil and gas company, entered into several natural gas leases with the State of North Dakota containing provisions that required royalties to be calculated based on gross proceeds from the sale of the gas. Newfield agreed to sell the gas produced at the wells to Oneok Rockies Midstream, LLC; however, royalty payments were to be made only after Oneok put the gas into marketable form and sold it. The manner in which Newfield actually paid royalties to the state was described by the Supreme Court in the opinion as follows: “[t]he price Oneok pays to Newfield for the gas is calculated based on 70-80% of the amount received by Oneok when Oneok sells the marketable gas. The 20-30% reduction of the price for which the marketable gas is sold account for Oneok’s cost to process the gas into a marketable form and profit.”

In June 2016, the State of North Dakota initiated an audit of Newfield and later argued that the audit revealed that Newfield did not pay enough royalties on the gas sold under the leases. More particularly, the State of North Dakota claimed that “Newfield is paying royalties based on gross proceeds reduced to account for deductions necessary to make the gas marketable and that reducing the gross payments by those deductions is contrary to the express terms of the lease.”

Subsequently, Newfield brought legal actions against the State of North Dakota seeking a Court Order declaring that the royalty payments were calculated correctly based upon the gross amount Newfield received from Oneok. After both parties moved for summary judgment, the District Court of McKenzie County, Northwest Judicial District, ruled in favor of Newfield’s motion for summary judgment agreeing that the lease “allows the reduction of the royalty payments to account for expenses incurred to make the natural gas marketable.”

The State of North Dakota appealed the District Court’s decision to the Supreme Court of North Dakota alleging that the District Court erred in its interpretation and that such method of calculation was the wrong way forward. The State argued that sharing in the post-production costs was contrary to the leases while Newfield countered that “it can pay a royalty based on a payment that has been reduced to account for the expense of making the gas marketable, as long as the expense is incurred by a third party.”

The North Dakota Supreme Court’s ruling

The State Supreme Court opined that, as a general rule, the lessor and lessee should apportion the costs of making the product marketable between them, unless otherwise specified in a contract.

Subpart (f) of the leases contained royalty provisions stating that “[a]ll royalties … 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 Supreme Court interpreted the language in Subpart (f) as clearly meaning that “the State’s royalty must include the value of any consideration, in whatever form, that directly or indirectly compensates, credits or benefits Newfield.”

Here, the Supreme Court observed that it was apparent that the “full value of the consideration paid to Newfield is not determined until Oneok has incurred the cost of making the gas marketable and subsequently sold the gas.” In other words, Newfield based its royalty calculation on the amount Oneok received for the marketable gas. This amount was later reduced to reflect the post-production costs incurred by Oneok. The Supreme Court found it to be unequivocal that Newfield benefitted from the post-production costs incurred by Oneok to make the gas marketable and consequently paid less in royalties to the State. As such, the court held that such method of calculation was contrary to the language of the leases.

Based upon this reasoning, the Supreme Court reversed the District Court’s judgment on July 11, 2019, ruling that “[g]ross proceeds from which the royalty payments under the leases are calculated may not be reduced by an amount that either directly or indirectly accounts for post-production costs incurred to make the gas marketable.”

References:

Newfield Exploration Company et al. v. State of North Dakota et al., No. 2019 ND 193 (N.D. 2019)

 

 This material is based upon work supported by the National Agricultural Library, Agricultural Research Service, U.S. Department of Agriculture.