Opinion ID: 1225461
Heading Depth: 1
Heading Rank: 7

Heading: oklahoma's royalty calculation method is flawed

Text: ¶ 15 Wood and CLO suffer from a common infirmity. Both correctly require the lessee to prepare the product for sale, but err in treating marketability as a question of law rather than one of fact. [34] Absent any factual inquiry into the actual market conditions relevant to the gas in question, the court arbitrarily declares certain costs as necessary to produce a marketable product. Sans factual inquiry, it is impossible to determine the very existence of a market. [35] There may be actual arms-length equivalent sales of similar gas wherein the buyer, after purchase, will perform certain activities that, according to the court's pronouncements in Wood and CLO, would fall upon the lessee as a matter of law. Treating marketability as a question of law ignores market realities. [36] ¶ 16 Oklahoma royalty jurisprudence allows the physical location of marketing activities to cloud the determination of cost deductibility. The practice of requiring the lessee to pay for all on-site costs, which originated in Johnson, [37] was expressly accepted in Wood. [38] Even CLO, which seems to cast away the location-based analysis in favor of the more widely accepted marketability model, perpetuates the infirmity by citing with approval Wood's compression cost analysis. [39] There is no pre- Johnson authority for requiring the lessee to pay for all activities that take place on the leased premises. More importantly, it should make no difference to the lessor whether the lessee performs marketing functions at the well or at some other place. The Johnson location-based royalty analysis illogically regards the cost of transportation to off-site purchasers differently from all other marketing costs. I would (as today's opinion appears to do) excise this arbitrary distinction from Oklahoma oil-and-gas jurisprudence. ¶ 17 After studying Professor Anderson's research and noting recent case law evolving in other jurisdictions, I now realize that the alternative solution I proposed in Wood  the Texas and Louisiana approach to royalty calculation  is equally flawed. Measuring the royalty payment at the wellhead is a property-based approach that requires the lessor to share costs once the extracted gas changes from real to personal property (i.e., the time of severance from the ground). [40] As Professor Anderson notes in his detailed study of royalty law, history does not support a property-law interpretation of royalty clauses. [41] ¶ 18 Extant body of United States jurisprudence demonstrates an absence of property-law type interpretation of royalty clauses, notwithstanding modern cases to the contrary. [42] Courts have traditionally applied contract principles to interpret royalty obligations, concentrating on the language of the lease and the intent of the parties. [43] Professor Anderson notes that case law has not allowed the lessor to receive cost-free transportation of the product to a distant point of sale. [44] Under typical royalty clauses, the lessor should not receive royalty on the enhanced value of gas that was marketable in fact prior to its enhancement. [45] We should follow this historically true model and refuse to apply property-law notions to determine royalty payments at the wellhead. ¶ 19 In addition to its historical inaccuracy, the wellhead-based royalty determination uses an unrealistic mathematical calculation to determine the royalty amount. Since there are often no sales at the wellhead [46] to help determine wellhead market value, it becomes necessary to subtract all post-wellhead costs from the final selling price. [47] The flaw in this work-back process is that it ignores the realities of the market. [48] Market price is determined in the real world by both willing sellers and buyers working at arm's length, not by a mathematician's hypothetical calculations. [49] The work-back view assumes that there is an eager buyer for every gallon of oil or gas that is pumped from the earth, no matter how unfit for use. In reality, the raw wellhead product may be completely unmarketable or of little value to buyers. [50] ¶ 20 The party in the best position to calculate costs and assign them to each stage of the marketing process is the lessee. [51] When confronted by a court that employs a wellhead-based calculation in order to minimize royalty payments, the lessee can too easily shift profits downstream in the production process, pass costs upstream, or both. [52] Skillful and self-serving accounting can skew the royalty calculation, minimizing the lessor's share.