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Post-Production Deductions in Gas Royalties

What are post-production deductions in gas royalties?

UntitledPost-production deductions (“PPDs”) are charges against royalty payments that reflect a producer’s (lessee’s) efforts to transform newly produced gas into a marketable product and then to sell the product. Such charges cause the royalty payments to bear a proportionate share of the costs of gathering, transportation, processing, treating, and administrative marketing (or some part of the foregoing costs). PPDs lessen royalty payments. Royalty owners have incentives to minimize or eliminate PPDs so that they can obtain larger royalty payments.

For gas, most PPDs arise from “tariffs” – those gathering and transportation expenses imposed by pipelines, which pipelines must disclose by way of publicly filed tariff rates. Some gas-related PPDs do not result from tariffs, but instead from private contracts between a producer and a gatherer/processor. The most common example: per-MCF fees, or percentage-of-proceeds fees, for gas-plant processing.

What does the law say about post-production deductions?

In Texas and states following the Texas approach to oil and gas law and industry practice (e.g., Pennsylvania, North Dakota, Louisiana, and to some extent New Mexico), the producer may charge all PPDs against royalty payments, unless the lease contract says otherwise. The Texas approach regulates PPDs little by way of the common law (i.e., judge-made law arising from lawsuits and published legal opinions). Nonetheless, the Texas approach attempts to curtail excessive and unreasonable PPDs (while still allowing for some PPDs against royalty) by way of the “duty to market” in “proceeds” and “amount realized” leases, and by way of the “market value” concept in “market value” and “market price” leases. In other words, if the PPDs are excessively and unreasonably high, then the duty to market or the market value concept disallows the excessive portion of the charges against royalty.

In Oklahoma and states following the Oklahoma approach to oil and gas law and industry practice (e.g., Kansas, Colorado, West Virginia, and to some extent New Mexico), the producer may not charge any PPDs against royalty payments, unless a certain PPD enables the producer to obtain a higher downstream sales price for the oil or gas than it otherwise would have obtained, and the producer shared the marketing overage with the royalty owner. The Oklahoma approach uses the common law more than the lease contract to regulate PPDs, and it generally disallows them. The Oklahoma approach is known as the “marketable condition rule”: in either proceeds leases (aka amount realized leases) or in market value leases, the producer must bear all PPDs necessary to create a marketable product and cannot charge such PPDs against royalty.

How can a royalty owner minimize or eliminate post-production deductions?

In Texas and like states, the royalty owner must draft the lease’s royalty-valuation clause to use a “gross proceeds” standard (or perhaps “market value” standard) and must never use the phrase “at the well” or “at the point of sale” – anywhere in the lease. The lease should include also a clause that expressly disallows PPDs against royalty. In Oklahoma and like states, such a strong lease would be helpful, but generally the marketable condition rule will disallow PPDs against royalty.

Here are several helpful strategies for drafting a royalty-valuation clause that is free of post-production costs:

  1. Hire experienced oil and gas legal counsel to draft one of the many styles of clauses, including “proceeds” (aka “amount realized”) and “market value” clauses, that entitle a royalty owner (lessor) to fair, competitive gas royalties.
  1. As a supplement to a strong royalty-valuation clause, use the same legal counsel to draft a no-deductions clause and to screen out dangerous phrases and provisions that allow for a lessee’s taking of post-production deductions.
  1. Consider including a clause to take gas in kind, if the gas volume would justify independently marketing the gas and if several markets could buy the gas.
  1. Use experience legal counsel to draft clauses that regulate directly a producer’s (lessee’s) marketing efforts, especially affiliated marketing.

How can Holmes PLLC address a problem with post-production deductions?

In addition to a vibrant and varied commercial law practice, Holmes PLLC represents royalty owners, bank-operated royalty/mineral trusts, non-operating working interest owners, and surface-estate owners by way of various legal matters in the Barnett Shale and in the legacy oil and gas fields of Texas and New Mexico. Also, when feasible, James Holmes of the firm will assist in the marketing of his clients’ share of production and in pursuing other transactional remedies and work-outs as alternatives to litigation.

James Holmes spent most of the years between 2002 and 2015 in litigation against large oil and gas producers. The disputes concerned upstream pricing, processing, general production issues, and all aspects of upstream-midstream marketing – specifically, how such activities lessened the firm’s clients’ royalty income or working-interest revenues and related expenses.

Seeking to avoid expensive and time-consuming litigation when necessary, Holmes PLLC regularly helps royalty owners and non-operating working interest owners with contract negotiation, leasing, conveyancing, joint-interest and upstream accounting, measurement and reporting, and severance and ad valorem taxation. Only when necessary, and after pre-suit negotiations have proven ineffective, the firm will advise clients to pursue a litigation strategy.