underpayment of royalty

If you are involved in a royalty case, or plan to be, read Occidental Permian, Ltd. v. French et al. The appellate court decided there was no evidence to support the trial court’s findings that the lessors were underpaid. (See my too-long December 6 post for the underlying facts.)  In this case the plaintiffs were the losers.

Takeways (In a hurry? This all you need.)

  • Reliance by an expert on his ”previous experience” is no evidence. Result: Proponent loses.
  • Reliance by an expert on his “historical knowledge in dealings in the business in the industry”, and not on a specific contract, is no evidence. Result: Proponent loses.
  • Reliance by an expert on a hypothetical fact situation that varies from the facts of the case is no evidence. Result: Proponent loses.
  • If an expert doesn’t include every component of a calculation that must be made in order to arrive at a value, there is no evidence that allows the court to arrrive at the value. Result: Proponent loses.

(Before you say “That all obvious.Why didn’t counsel and the court get it?”,  know that in trial things move fast, very fast. Like the TV sports replay, it looks easy in slo mo).

This suit was different from most royalty suits in that it was not about the price paid, but whether the lessors were paid on the proper volume of gas produced. The essential question was whether the evidence showed that Occidental underpaid royalties by deducting an in-kind processing fee paid to Kinder Morgan (KM) from its royalty calculation. The lessors were paid royalties on the 70% of the NGLs retained by the lessee Occidental after paying the in-kind fee to KM, and nothing on residual gas.

No evidence supported the trial court’s finding of underpayment under the comparable-sales method, said the appellate court. The sale price is compared to other sales that are comparable in time, quality, quantity, and availability of marketing outlets. Kuss, the lessors’ expert, failed to support his opinion with an actual sale contract, but rather on his “historical knowledge in dealings in the business in the industry”, and he had no experience selling gas with similar high CO2 content. Thus, his opinion was meaningless. It was entirely based on a hypothetical native gas (with no impurities) rather than the actual CO2–laden casinghead gas that was actually produced from the well. Accordingly, there was no evidence.

The lessors’ attempt to use the net-back method was also unsuccessful. The testimony failed to allocate costs to all of the production and postproduction activities at the Cynara facility. “If any of the activities that took place at Cynara [were] postproduction activities, there is no evidence in the record to support the market value at the well under the net-back method because there are some postproduction costs that have not been deducted, and [it] could not ascertain those costs from the record.”

Under the Fuller lease (a proceeds lease), because the cost of removing the CO2 (a postproduction activity) was not calculated, there was no evidence of the cost of manufacturing, and thus the net proceeds on which the lessees would be paid.

The trial court found that Occidental breached its implied duty to market under the Codgell lease by deducting the in-kind fee paid to KM, thereby obtaining a financial benefit for itself that was not shared with royalty owners. Having found no underpayment of royalty, the court looked for other evidence to support the finding. Lessors’ expert Kuss testified that a reasonably prudent operator would not have accepted the 70/30 split with KM. Because that testimony was based on hypothetical “native gas”, free from impurities, and not the gas stream at issue, the assumed facts varied from the actual facts.  There was no evidence of a breach of the duty.

Here’s wishing you a merrier Christmas than this fellow:  http://www.youtube.com/watch?v=jGFnSqMFQFo