Opinion ID: 1829970
Heading Depth: 3
Heading Rank: 6

Heading: Condensate/Slop Oil

Text: The trial court awarded the State $678,394 in royalties due on the sale of condensate. As to that award, we reverse the trial court's judgment. [C]ondensate is a light oil that is produced with the gas. [15] It also is a term that is undefined in the form lease. Because this dispute involves a product that does not fit any of the descriptions of condensate, we refer to it as slop oil. The parties agree that the product in question, slop oil, is a mixture of heavy hydrocarbons called diamondoids, which are present in the reservoir, and diesel fuel, which is injected into the gas stream as the well produces. Exxon purchases the diesel and injects it into the wellstream as a solvent to maintain the diamondoids in a liquid state. Without the diesel, the diamondoids would solidify into a wax-like substance and interfere with the extraction of the gas. The diesel-diamondoid mixture is removed from the gas stream and sold as slop oil or spent diesel. According to testimony presented at trial by George Hite, a witness for the State, only the Mobile Bay field experiences the problem with diamondoids. Other testimony confirms that the diamondoids contaminate[] [the diesel] to such a level that it can't be used for diesel again. It's sold as a lower-grade... slop oil. [16] Although Exxon paid royalties on the sale of the slop oil, it calculated the amount of those royalties by deducting the cost of the diesel oil injected into the wells-tream and then paid royalties on the net amount realized under paragraph 5(b) as for a manufactured product. The State argues that no deductions are permissible because condensate [17] is specifically mentioned in paragraph 5(a) and is subject to royalties calculated on the gross proceeds. Exxon argues that the diamondoids degrade the value of the injected diesel and that royalties are due only when the volume of diamondoids is sufficient to increase the value of the injected diesel. Here, both parties agree that for the most part the diamondoids add no value to, and actually degrade the value of, the diesel. Thus, according to Exxon, the diamondoids generate no proceeds unless they contribute sufficient volume to allow Exxon to sell the degraded diesel for more than its original cost, in which case Exxon does pay a royalty on the value the diamondoids add to the slop oil. The State does not dispute that Exxon has paid royalties in those circumstances. The State, however, asserts that Exxon must pay a royalty on the gross proceeds, rather than deducting the costs of the other components of the slop oil. The testimony at trial demonstrates that there is no independent value generated by the diamondoids. James A. Griggs, director of the State Lands Division of DCNR, testified that there probably is no market or may not be a ready market for diamondoids. Thus, it is not the diamondoids but the degraded diesel fuel that generates proceeds. Paragraph 5(a) requires royalties on the gross proceeds from products, including condensate, produced and sold from the leased area. Diesel, a constituent part of slop oil, is not produced from the leased area. Although the diamondoids are extracted from the leased area, it cannot be said that the misnamed condensate mixture of diesel and diamondoids is produced from the leased area. It is a product described in paragraph 5(b) as not covered by the royalty provisions of subparagraph 5(a). By the terms of paragraph 5(b) the product is a manufactured product subject to the royalty provisions of paragraph 5(b) on the net amount realized, as defined therein. Because the State does not dispute that Exxon has paid royalties on the diamondoids when they added value to the injected diesel, and because we find the judgment requiring the payment of royalties on the diesel portion of the slop oil to be unsupported by the leases, we reverse the judgment insofar as it awards the State $678,394 in additional royalties on the sale of slop oil.