Opinion ID: 2633380
Heading Depth: 2
Heading Rank: 3

Heading: Payment of Royalties

Text: The royalties on the gas sold were computed in two ways based on where the gas was sold. [5] For gas sold at the wells, the lessors were paid royalties based on a percentage (1/8th) of the proceeds received by the lessees for the sale of the gas. For these royalties, the lessors contend that the royalty payments were improper because the gas was not marketable at the well, and therefore, should not have been sold at the well. As such, the lessors argue that the royalties they received for these sales were much lower than the royalties they would have received had the gas been sold away from the wells. The lessors also argue that the sales made at the well were not arms-length transactions by the lessees, and that the purchasers of the gas, who subsequently sold the gas downstream at the interstate pipeline for a higher price, were closely linked with the lessees. Accordingly, the lessors contend that these transactions were improper and constituted a breach of the duty to market the gas. The lessees argue, however, that the royalties paid on the gas sold at the well were properly paid because the gas was marketable at the well, and the royalties were calculated using the gross proceeds received by the lessees for those sales. For the gas sold away from the wells, the lessors were paid royalties based on the price of the gas sold minus deductions for the cost of gathering, compression, and dehydration. The lessors argue that these deductions were improper and that their royalties should have been paid based on one-eighth (1/8th) of the proceeds received from the sale of the gas, with no deductions for gathering, compression, and dehydration. The lessors suggest that these costs are required in order to place the gas in a marketable condition, and therefore, these costs should be borne solely by the lessees. The lessees label the method of calculation of these royalties the work-back or net-back method. Under the work-back method, costs of transportation, processing and treatment are deducted from the ultimate proceeds of sale of the oil or gas and any extracted or processed products to ascertain wellhead value. Oil and Gas Terms, supra, at 1188. According to the lessees, the royalty calculations were made by deducting the reasonable transportation related costs from the price obtained for the gas at the interstate pipeline after it had been gathered, compressed, and dehydrated. The lessees contend that these expenses were properly deductible, since the gas was marketable at the well and these transportation expenses served only to increase the value of an already marketable product. Moreover, the lessees argue that since the royalties under the leases were to be paid based on the value at the well, the work-back calculation was the appropriate method to determine the amount of the royalty payments under the leases.