Opinion ID: 3214719
Heading Depth: 2
Heading Rank: 3

Heading: Is the Equipment Used in Processing?

Text: The three Tax Code subsections under which Southwest sought an exemption require that the property at issue be used in actual “processing”—application of materials and labor necessary to modify or change the characteristics of tangible personal property. See TEX . TAX CODE § 151.318 (a)(2), (5), (10); 34 TEX . ADMIN . CODE § 3.300(a)(10). As noted previously, it is undisputed that hydrocarbons undergo physical changes as they move from underground reservoirs to the surface; the disagreement is about the role Southwest’s equipment plays in those changes. Hydrocarbons generally reside within porous formations or reservoirs of rock under great pressure from the overlaying earth. 2 ERNEST E. SMITH & JACQUELINE LANG WEAVER, TEXAS LAW OF OIL AND GAS § 8.2[B][1], at 8-22.5. When a well penetrates and is completed in the reservoir, the differential between the pressure inside the wellbore and the pressure on hydrocarbons in the formation causes the hydrocarbons to flow out of the formation and into the well. Id. The casing for which Southwest sought the exemption is a steel pipe that is inserted into a borehole that keeps the borehole from collapsing. Portions of the casing are cemented into place. The tubing for which Southwest also sought an exemption is a smaller tube that hangs inside the casing. Most of the hydrocarbon fluids will flow to the surface through the tubing while gas separated from the fluids generally moves into and up the space between the tubing and the casing. As the hydrocarbons flow 10 into and up the casing and tubing, the changing pressure and temperature result in their separating into gas and liquids. Southwest argues that the casing and tubing system both begins and continues the “processing” of hydrocarbons into separate substances of oil, gas, and condensates. But the trial court found that the direct causes of the changes in the hydrocarbons were pressure and temperature changes, while the equipment was only an indirect cause of them. And the evidence supporting those findings is not challenged by Southwest. For example, Robert Newton, the Permian Basin division manager for Clayton Williams Energy (the owner of Southwest Royalties) testified that the wells begin the process of separating the hydrocarbons into gas and liquid by creating a pressure drawdown and bringing the hydrocarbons into the wellbore, which then separates them. He later explained, however, that the casing maintains, but does not cause, pressure, and if hydrocarbons enter an uncased borehole and move toward the surface, they exhibit the same physical changes. Terry Payne, a petroleum engineer, testified for Southwest that the wells were the cause of the change to the hydrocarbons because without them the hydrocarbons would stay in the ground. But he also testified that the phase changes the hydrocarbons undergo result from changes in pressure and temperature. Thomas Richter, a petroleum engineer, testified for the State that the phase changes were a natural, physical process that occurs from the reservoir to the top of a well and whether casing was in the well was only incidental to the changes. He explained that the casing and tubing were essentially only conduits through which the hydrocarbons exit the reservoir and proceed to the surface. No evidence identified any way Southwest’s equipment acted upon the hydrocarbons 11 to cause a modification or change in them other than by being the vehicle through which they exited the underground formation and traveled to the surface. While the parties and amici argue extensively over whether oil and gas production generally is processing, our inquiry is more narrow; it is whether the equipment for which Southwest is seeking an exemption was used in the actual physical application of materials and labor to the hydrocarbons that was necessary to cause, and caused, a physical change to them. “Used” and “actual” are not defined in the statute so we look to their common, ordinary meanings. $1,760.00 in U.S. Currency, 406 S.W.3d at 180. “Used” is defined as “employed in accomplishing something,” and “actual” is defined as “existing in act and not merely potentially.” MERRIAM -WEBSTER’S COLLEGIATE DICTIONARY 12, 1297 (10th ed. 2000). While the equipment unquestionably was both used in and necessary to the efficient recovery of hydrocarbons from their reservoirs, there is no evidence that the equipment acted upon the hydrocarbons to modify or change their characteristics. The changes in the substances were caused not by the application of equipment and materials to them, but by the natural pressure and temperature changes that occurred as the hydrocarbons traveled from the reservoir through the casing and tubing to the surface. Both parties rely on lower court decisions interpreting terms in Tax Code section 151.318. Those cases are consistent with our conclusion. In Rylander v. Haber Fabrics Corp., Haber Fabrics challenged the Comptroller’s decision that Haber did not “process” second quality fabric by sorting, airing, inspecting, cutting, and packaging it to be first quality grade. 13 S.W.3d 845, 848 (Tex. App.—Austin 2000, no pet.). The trial court agreed with Haber, and the court of appeals affirmed. Id. at 847. The court of appeals held that Haber’s activities satisfied the Comptroller’s definition of 12 processing because Haber “applies materials and labor to modify or change the characteristics of the fabric.” Id. Here, in contrast, while Southwest applied the equipment to move substances from underground reservoirs to the surface, it did not apply the equipment to modify or change their characteristics. Rather, as the trial court found, inherent characteristics of the hydrocarbons and natural forces of changing pressures and temperatures caused the changes. In Sabine Mining Co. v. Strayhorn, the court considered whether “dragline” machines were property used in manufacturing and, therefore, exempt from sales tax. 2007 WL 2390686 (Tex. App.—Corpus Christi 2007, no pet.) (mem. op.). The company seeking the exemption, Sabine Mining, used the draglines to remove overburden—a layer of dirt and rock—from atop underground coal deposits. Id. at . The removal of the overburden reduced weight and pressure on the coal and exposed it to oxygen which caused fracturing. Id. These changes altered the physical appearance of the coal and also increased its energy content. Id. The court concluded that the changes to the coal were not a “direct” result of the draglines. Id. at . The court explained that a reasonable interpretation of “direct” implies a close link with no intervening causes, and the dragline was merely an “indirect” cause of the changes. Id. at . This is similar to the situation here where natural pressure and temperature changes are, as the trial court found, the direct causes of the changes to the hydrocarbons and the equipment was an indirect cause. Southwest also asserts that in two other matters the Comptroller has granted exemptions for equipment used in oil and gas extraction and mineral operations. But in neither of those matters did the Comptroller conclude that bringing oil and gas to the surface, without additional affirmative action using property to effect changes in their characteristics, was “processing.” See Comptroller 13 Hearing 31,253 (1998) (“It has long been the position of the Agency that the act of bringing oil to the surface of the earth is not processing . . . . [W]e have concluded that injecting carbon dioxide for the purpose of thinning or increasing the gravity of the oil creates a physical change in the oil and is, therefore, a processing activity.”); Comptroller Letter Ruling 200903457L (2009) (“Although the act of producing oil or gas (bringing oil or gas to the surface of the earth) is not processing[,] the use of liquid carbon dioxide (CO2) to thin or increase the gravity of crude oil causes a physical change in the oil and thus constitutes processing for sales and use tax purposes.”). Southwest also cites Comptroller decisions that determined processing occurred below ground, but these decisions are inapposite. Our decision does not turn on the fact that the alleged processing occurred underground as opposed to above ground. Rather, it turns on the fact that the trial court did not find, and there is no evidence that, the equipment was applied to cause changes in their characteristics as the hydrocarbons moved from the reservoir to the surface. See Comptroller Hearing 31,842 (2004) (finding that pumping superheated water into sulphur formations caused a physical or chemical change in the sulphur); Comptroller Letter Ruling 9506L1351F01 (1995) (finding that equipment used to break apart the ground and shatter the underlying limestone and shale into pieces to be processed into cement qualified as manufacturing equipment); Comptroller Hearing 27,940 (1992) (concluding that explosives used to blast rock and sandstone formations were used in processing gravel and sand); Comptroller Hearing 23,055 (1988) (determining that dynamite used to blast rock out of the earth and start reducing the size of large boulders to gravel was exempt). And regardless of the Comptroller’s prior interpretations, the question here is one of statutory 14 construction which “ultimately is one left to the courts.” Roark Amusement & Vending, 422 S.W.3d at 638.