Opinion ID: 6336934
Heading Depth: 3
Heading Rank: 2

Heading: Hess Operations and Royalty Payments

Text: Hess owned approximately ten percent of the working interest in the Unit since it was formed. During the relevant audit period, Hess sold a small percentage of the CO2 it produced from the Unit under an arm’s-length contract with Fasken Oil and Ranch, Ltd. (“Fasken Contract”). Id. at 222. Hess had no other sales of CO2 during the relevant period. Id. at 224. Hess instead used the vast majority of the CO2 allocated to its Leases for its own use in enhanced oil recovery (“EOR”) projects in the Permian Basin in West Texas and New Mexico. 9 Id. at 223–24. In addition to sourcing its own CO2 from the Unit, Hess also purchased a large volume of CO2 from other Unit working-interest owners to use in its EOR operations (“Hess Purchase Contracts”). Id. To transport the CO2 from the Unit to the Permian Basin EOR units, Hess first transported the CO2 through the Rosebud Pipeline and Sheep Mountain Pipeline to a 9 Enhanced oil recovery is the extraction of crude oil from an oil field that cannot be extracted otherwise. The process involves injecting liquified CO2 into the pore space of reservoir rock to help displace oil and drive it to a production wellbore. At the surface, the CO2 is separated from the oil, the oil is sold, and the CO2 is reused again in the EOR reservoir. This means that the CO2 used in EOR operations is part of a continual process and is not sold. See, e.g., ROA, at 223–24. 10 Appellate Case: 21-2011 Document: 010110678144 Date Filed: 05/02/2022 Page: 11 hub in Denver City, Texas (“Denver Hub”). Id. at 221. From the Denver Hub, Hess transferred the CO2 into two other pipelines for delivery into the Permian Basin EOR units. Id. Each step of transportation required the CO2 to be at a particular pressure. The wellhead pressure of the CO2 in the Unit ranged from 16 to 78 pounds per square inch gauge (“psig”), but the pressure necessary to enter the Rosebud Pipeline was 1,850 psig. Id. Accordingly, before the CO2 could enter the Rosebud Pipeline, Hess gathered the CO2 on the Unit and compressed it to 1,850 psig. Along the route to the Permian Basin EOR units, the pressure of the CO2 again was appropriately adjusted to meet the varying pressure requirements: 1,925 psig at the interconnect between the Rosebud Pipeline and Sheep Mountain Pipeline; 2,150 psig at the outlet of the Sheep Mountain Pipeline at the Denver Hub; and upwards of 2,500 psig to enter the Permian Basin EOR units. Id. at 221–22. To comply with the applicable laws, Hess was required to value its CO2 production for royalty purposes. Because Hess transported the majority of its federal CO2 production to the Permian Basin EOR units (only a small percentage went to the Fasken Contract) and the CO2 continued to be reused in the Permian Basin EOR units, Hess had no other sales of CO2 to use as reference for royalty valuation. Id. at 224. During the audit period, Hess paid royalties based on “the Unit Average,” which the Unit Operator provided lessees on a monthly basis using a “netback approach.” Id. Under the netback approach, the Unit Operator determined the Unit Average by taking the price or value lessees in the Unit received for their sale of the CO2 at the Denver Hub. Id. The Unit Operator then deducted transportation costs 11 Appellate Case: 21-2011 Document: 010110678144 Date Filed: 05/02/2022 Page: 12 from those values and prices to arrive at a value for the CO2 removed at the Unit. Id. Hess reported these prices as the basis of its royalty payments throughout the audit period. Id. Beginning in March 2004, Hess also started reporting the compression and dehydration costs it incurred for delivery to the Permian Basin EOR units as a transportation allowance. Id. Hess reported compression and dehydration costs in the amount of $806,290.73 during the audit period. Id. at 276.